SECURITIES AND EXCHANGE COMMISSION
In the Matter of
OPINION OF THE COMMISSION
EQUAL ACCESS TO JUSTICE ACT PROCEEDINGS
Applicant, who had prevailed in Commission administrative proceedings, sought an award of attorneys' fees and expenses under the Equal Access to Justice Act. Held, the application is denied because the Division's position in the underlying action was substantially justified and because applicant did not incur any fees or expenses.
Peter J. Anderson, Kristen Jones Indermark, and Todd Ratner, of Sutherland Asbill & Brennan LLP, for Kirk Montgomery.
William P. Hicks, William A. Rees, and William S. Dixon, for the Division of Enforcement.
Appeal filed: July 18, 2000
Briefing completed: October 18, 2000
The Division of Enforcement appeals from the decision of an administrative law judge awarding Kirk Montgomery attorneys' fees and costs in the amount of $211,943.27 under the Equal Access to Justice Act ("EAJA").1 On December 9, 1998, administrative proceedings were instituted against Montgomery and Richard Hoffman alleging violations of the securities laws. During the period at issue, Montgomery was the chief compliance officer of FSC Securities Corporation, a registered broker-dealer based in Atlanta, Georgia. Hoffman was a top-producing FSC salesperson and principal who operated a one-person office of supervisory jurisdiction ("OSJ") from the basement of his home in Palm, Pennsylvania.2 The Division alleged that Hoffman violated various antifraud provisions of the securities laws,3 in connection with the purchase and sale of mutual funds by his customers, and that Montgomery failed reasonably to supervise Hoffman with a view to preventing those violations.4 On January 27, 2000, the law judge dismissed the charges against both respondents.5 On April 6, 2000, Montgomery filed an EAJA application, which was granted by the law judge on June 27, 2000.
The EAJA provides that a respondent who has prevailed against the government in an adversary adjudication may recover the fees and other expenses that were "incurred by that party in connection with that proceeding, unless . . . the position of the agency was substantially justified or . . . special circumstances make an award unjust."6 The Division contends both that its position in the underlying case against Montgomery was substantially justified and that Montgomery did not incur fees and expenses within the meaning of the EAJA. In particular, the Division asserts that it was substantially justified in alleging that (i) Hoffman violated antifraud provisions; (ii) Montgomery was Hoffman's supervisor; and (iii) Montgomery's supervision was unreasonable.
Montgomery charges that the Division is improperly attempting to "relitigate" the findings in favor of Montgomery made by the law judge in the underlying proceeding.7 The standard applicable to a determination of whether an award under the EAJA is warranted, however, is different from that governing liability in a disciplinary proceeding. As a consequence, the conclusions reached by the law judge in the underlying case are not dispositive of Montgomery's EAJA claim.8
In evaluating the Division's allegations of fraud and failure to supervise in the underlying case, a "preponderance-of-the-evidence" standard applied.9 Under the EAJA, we make an "independent evaluation"10 to determine whether the Division's case against both respondents had "a reasonable basis in law and in fact,"11 i.e., whether the allegations were "'justified in substance or in the main'. . . to a degree that could satisfy a reasonable person."12 We therefore have conducted a de novo review of the record.13 Based on that review, we have determined that the Division's allegations were supported by sufficient evidence to satisfy a reasonable person and that an award under the EAJA, therefore, is unwarranted.
Antifraud Allegations Against Hoffman
The Division's case against Hoffman centered on a series of mutual fund trades or "switches" that he recommended to his customers during 1994. Among other things, the Division alleged that these trades were fraudulently unsuitable for the customers; recommended by Hoffman without disclosure of associated material facts, including attendant risks and costs; and done for the benefit of Hoffman rather than his customers. To support these allegations, the Division presented testimony and sworn statements from customers and an expert witness, along with account statements and prospectuses of the mutual funds involved. We believe that the evidence establishes that the allegations against Hoffman were substantially justified.
Clarence Leister, a 71 year-old retiree and neighbor of Hoffman's, relied on social security and his investments to support himself and his wife. In April 1991, Leister invested a total of roughly $70,000 in two mutual funds operated by two different mutual fund families, generating a commission for Hoffman on each purchase. Approximately three years later, Hoffman recommended that the Leisters liquidate those earlier mutual fund investments to buy two different mutual funds from the same two fund families. Because the four mutual funds involved were operated by just two fund families and because those fund families charged no fees for intra-family transfers, the liquidation and reinvestment could have been accomplished without additional sales charges to the Leisters. Instead, Hoffman structured the trades in a way that, according to the Division's expert witness, Mary Calhoun, "caused the Leisters to take excess sales charges . . . [of] $4,587. In other words, they could have accomplished the same transactions but . . . paid lower sales charges for total savings of $4,587."
In addition, the Leisters' investment in one of the funds did not take advantage of a breakpoint discount that was offered. Had the Leisters invested an additional $1,048 in this fund, they would have reached a breakpoint that would have reduced the front-end load they were paying by one percent, saving them $440.14 As Calhoun testified, "that would be . . . like getting $1,048 worth of mutual funds for $608." Leister testified that he was unaware of the breakpoint discount. We previously have found antifraud violations where a salesperson sold mutual fund shares in a manner resulting in his customer not realizing benefits of breakpoints, or otherwise structured orders to increase commissions.15 The misconduct alleged with respect to the Leisters' account is comparable to that which has provided the basis for findings of securities fraud in the past.
Hoffman conceded that the way in which he structured the Leisters' transactions "was a complete blunder . . . a mistake I certainly regret making." The law judge credited Hoffman's claim that his mishandling of the Leisters' account was "an in advertentmistake," in part because, as the law judge reasoned, "it would be counterproductive to swindle a friend and neighbor in a small community." Unfortunately, it is frequently the case that unscrupulous stock salespersons exploit close personal relationships for illegal gain, with little or no apparent concern for the potential adverse reaction within their communities.16 Moreover, even if Hoffman did not intend to defraud the Leisters, there is substantial evidence that he acted, at a minimum, with recklessness, and thereby demonstrated the requisite scienter.17
Aleta Detwiler, who was saving for her retirement, testified that she could not afford to lose any of the money she had invested with Hoffman. Detwiler, who described herself as "very inexperienced" regarding investment matters, "completely" relied on Hoffman for investment advice. In late 1992, Hoffman advised Detwiler to move approximately $35,000 that she had invested in the Delaware Decatur Fund to the Kemper Investment Total Return Portfolio. Hoffman claimed that the move would help Detwiler's "retirement planning, and in the long run give [her] a greater return."
Although Kemper charged no front-end load fee, it assessed a three-percent contingent deferred sales charge during the first two years after purchase. In March 1994, less than two years later, Hoffman recommended that Detwiler liquidate her Kemper investment, and reinvest the proceeds in the Templeton Developing Markets Trust Fund, which charged a front-end load.
According to Detwiler, she was never told that, as a result of following Hoffman's recommendations, she would be assessed a deferred sales charge by Kemper and a front-end sales load by Templeton. Nor was Detwiler told that she could have exchanged her shares in the Kemper Investment Total Return Portfolio for another fund within the Kemper family without paying additional sales fees. She believed, based on her discussions with Hoffman, that the trades he was recommending would not result in her paying any new fees.
Hoffman testified that he "did mention [to Detwiler] that there were the costs and the risk factors and all," but conceded that "it was a type situation where I could have used more time in meeting with her." The law judge "accepted" Hoffman's claim that he discussed costs with Detwiler because Detwiler did not complain about the assessed costs at the time of the trades and because Hoffman's testimony is "consistent with the routine he followed in meeting with customers."
To the extent the law judge made a credibility finding in favor of Hoffman, it does not preclude a finding of substantial justification on the part of the Division. A determination of substantial justification may be premised on evidence, including testimony, that was rejected by the initial trier of fact.18 Notwithstanding the law judge's adverse credibility finding, we consider Detwiler's testimony to support a finding of substantial justification.
The Division also presented evidence that Detwiler was never told that the Templeton fund invested in high risk, lower quality debt securities, commonly referred to as "junk bonds," or that the fund's prospectus stated that an investment in the fund could be "considered speculative." Detwiler testified that she would not have invested in the Templeton fund had she been informed of the associated risks.19 The Division's expert Calhoun testified that the Templeton fund was unsuitable for Detwiler given Detwiler's financial situation, her lack of understanding regarding the associated risks, and her investment objectives. It is a violation of the antifraud provisions for a salesperson to recommend a security to a customer when he knows that such security is unsuitable in light of the customer's investment objectives and needs.20
Frances Koester, a 90-year old retiree, invested $100,000 with Hoffman. Koester "depend[ed]" on Hoffman's investment advice because she did "not know much about investments." Initially, in 1992, Hoffman recommended that Koester use funds from certificates of deposit to purchase shares in the Delaware Fund Group's Delchester High Yield Bond Fund and Delaware Government Bond Fund. During the first quarter of 1994, Koester complained to Hoffman about the return she was receiving on the Delaware Government Bond Fund. On Hoffman's recommendation, Koester liquidated the government bond fund and invested the proceeds in the Van Kampen American Capital High Yield Bond Fund.
Calhoun opined that investors, like Koester, who require income must "maintain their principal, because if they lose their principal they lose the base that supports the ability to earn income." Calhoun testified that junk bond funds such as the high yield bond funds Hoffman recommended are unsuitable for conservative investors like Koester because they "pose substantial risk of principal loss."21
Calhoun further opined that, assuming the suitability for Koester of an investment in a second junk bond fund, it was "improper" of Hoffman to invest Koester's funds outside of the Delaware fund family because doing so resulted in Koester paying unnecessary fees.22 Hoffman's expert witness justified Hoffman's recommendation of a non-Delaware fund because it gave Koester diversification. Notwithstanding the conflicting views of the two expert witnesses, we believe that the Division was substantially justified in alleging fraud with respect to Hoffman's handling of Koester's account, as it was with respect to the other customers discussed above.
Failure to Supervise
Allegations Against Montgomery. Montgomery was charged with failing reasonably to supervise Hoffman with a view to preventing Hoffman's antifraud violations. The law judge rejected these allegations because, in her view, there was not "a scintilla of evidence to support a finding that Montgomery was Hoffman's supervisor." Additionally, she held that, even assuming he was Hoffman's supervisor, Montgomery's supervision was reasonable.23 As discussed below, we believe that, in reaching these conclusions, the law judge failed to appreciate the significance of much of the Division's evidence. Moreover, the law judge's decision conflicts in several important respects with well-established principles and precedent regarding the supervision of securities professionals.
Montgomery's Supervisory Role. The Division alleges that Montgomery was Hoffman's supervisor because FSC's written supervisory procedures identified Montgomery as responsible for home office supervision of OSJ principals, like Hoffman, and because Montgomery failed to delegate that responsibility to anyone else at the Firm. In addition, the Division argues that Montgomery had the "requisite degree of responsibility, ability or authority to affect" Hoffman's conduct and, consequently, should be deemed his supervisor on that basis.24
A. Montgomery contends that the evidence established that the responsibility for supervising the sales activities of OSJ principals was not assigned to any specific person at FSC but remained with the Firm. According to Montgomery, the responsibility for supervising Hoffman "was diffused among various areas within the home office, including the compliance department." We have held, however, that "[a] firm can act only through individuals."25 A firm cannot, by itself, be deemed a salesperson's supervisor.26 We further have held that the individuals identified as having particular supervisory duties in a firm's written procedures are responsible for discharging those duties.27
Pursuant to requirements established by the National Association of Securities Dealers, Inc. ("NASD"),28 FSC adopted written supervisory procedures and identified the Firm personnel responsible for implementing those procedures. FSC's supervisory procedures expressly stated that the "Chief Compliance Officer" had "RESPONSIBILITY [for] Home Office Supervision of Branch Office Activities." Under "Home Office Supervision of Branch Office Activities," the supervisory procedures further provided that, in seeking to comply with NASD requirements "to reasonably ensure adequate supervision of Registered Representatives who are located in branch offices away from the home office," the "Chief Compliance Officer [was] responsible for the implementation and execution of the home office review procedures and policies." The supervisory procedures identified Montgomery as FSC's chief compliance officer, and it is undisputed that he held that position during the period at issue.
Hoffman was asked, for example, whether he knew that Montgomery was his "direct supervisor, that, in fact, Mr. Montgomery was required to approve all of [his] transactions." Hoffman responded "I knew that he was . . . ."29
Testimony by Richard Young also supported the Division's allegations that Montgomery's compliance department was responsible for supervising OSJ principals such as Hoffman. Young, who worked for Montgomery as FSC's manager of compliance in 1994, testified that the Firm's compliance department was the "supervising entity" for OSJ principals who were also salespersons "in supervising their personal business," and was responsible for "[r]eviewing their transactions, completing audits."30
Montgomery himself authored several documents stating that the compliance department administered the few supervisory procedures the Firm had for monitoring the sales practices of principals of OSJs. In an internal 1994 memorandum to the Firm's operations officer, Montgomery described FSC's supervision as follows:
Our OSJ's supervise sales activities of their reps and we supervise the OSJ's both through direct supervision of their personal business and through oversight supervision of their rep's activities. This was virtually all done through our annual compliance visit, a series of compliance memos and communications, and through the review of certain transactional subscription documents required to be submitted through the home office . . . .31
Montgomery also admitted in this memorandum that "virtually all" of the supervisory procedures employed by the Firm to supervise OSJs were administered by his department. Similarly, in an October 1991 draft response to concerns raised by Commission staff following an examination of the Firm, Montgomery stated that top producing OSJs are "monitor[ed]" through "Audits/checklists/Exception Reports." Each of these compliance procedures also was the responsibility of the compliance department.32
Montgomery claims that, while this evidence may establish that the compliance department "was responsible for supervising Hoffman," it does not establish that Montgomery "bore this responsibility personally." We disagree. As discussed, Montgomery was given express responsibility for the supervision of branch office activities in the Firm's supervisory procedures and, in practice, the department he headed was the only Firm entity that administered applicable supervisory procedures. The supervisory responsibility assigned to Montgomery remained with him because he never delegated it.
Montgomery also asserts that other FSC personnel supervised Hoffman. Montgomery notes that FSC's supervisory procedures assigned to his subordinate, the director of compliance, LaVerne Zellman, responsibility for the "[s]upervision of OSJ Branch Office Activities." That assignment, however, was limited. Zellman testified that she was only to ensure that each OSJ had an OSJ principal and that the Firm audited each OSJ annually. Her testimony is consistent with the description of her duties contained in FSC's supervisory procedures and is not disputed by Montgomery. Moreover, Hoffman confirmed that he had little regular contact with Zellman.
Montgomery further asserts that unspecified "trading desk and operational principals" provided "in-house oversight review" of the Firm's sales force. This assertion was undermined, however, by the testimony of Michael Brown, an FSC financial principal and director of operations until August 1994. Brown testified that the Firm had no expectation that the registered principals processing Firm trades at the wire order desk would check each trade for suitability or other sales practice abuses. According to Brown, the focus of the wire desk was to process trades quickly and to remedy "[a]nything that slowed that down."
The Division's expert Elizabeth Ferguson, a compliance consultant, testified that it was "unreasonable" to believe that trading desk principals "would sit for every order . . . and bring up on their computer the person's compliance data and trading history . . . because they have thousands of those orders a day . . . ." Moreover, even if the traders had tried to review trades for suitability, they would have been thwarted in their efforts by flaws in the Firm's customer data base.33 There is also evidence that Montgomery was aware of flaws in the Firm's data base.
B. Evidence also supports the Division's claim that Montgomery was Hoffman's supervisor because he had the requisite degree of responsibility, ability, or authority to affect Hoffman's conduct. According to the law judge, Montgomery "could and did bring problems or potential problems to the attention of senior management, but, at times, his recommendations to discipline, fire, or not to hire were ignored." Because Montgomery could not, on his own, take certain disciplinary measures or "implement general procedural changes," the law judge concluded that Montgomery was not Hoffman's supervisor. Montgomery similarly argues that, because his authority to discipline Hoffman was limited to making recommendations to FSC's senior management, that authority was insufficient, as a matter of law, to establish supervisory liability. We disagree.
We repeatedly have found supervisors liable even though they did not have unilateral disciplinary authority;34 rather, it is sufficient if a respondent plays a significant, even if shared, role in a firm's supervisory structure.35 As the Division's expert witness testified, "even branch managers in traditional firms who are OSJs and are supervising, in some cases, up to 100 brokers, can't [terminate personnel] on their own authority by themselves. But that . . . doesn't make them any less the supervisor of their daily activities."
Hoffman testified that he felt obligated to "adhere to any directives that would come from [Montgomery] or his staff" and to "submit to him on any compliance issues." Hoffman added that he assumed that, if he did "not submit to [compliance] directives, [he] would not be with FSC Securities any more."
Thomas Hutchins, FSC's chief operating officer during the period at issue, testified that Montgomery had significant --albeit not unilateral -- authority to discipline registered representatives for violations of Firm policies and the securities laws. For example, Montgomery could terminate Firm personnel with the concurrence of other FSC officials. Montgomery also could act on his own to address less serious misconduct such as violations of Firm procedures requiring wireorder execution of mutual fund transactions in excess of $10,000 by, for example, imposing fines or canceling trades.
Montgomery had the authority and responsibility to affect Hoffman's conduct. The fact that he "share[d] in the responsibility to take appropriate action to respond to . . . misconduct,"36 or that his authority was subject to countermand at a higher level, does not negate a finding that he had supervisory responsibility.37
Montgomery contends that we previously declined to find supervisory liability in Louis R. Trujillo,38 because Trujillo, an assistant branch manager, played a "largely advisory" role with respect to firm supervision. Montgomery argues that Trujillo holds that there can be no supervisory liability if the authority of the respondent was limited merely to making recommendations. We disagree. The issue in Trujillo was not whether the respondent was a supervisor -- we assumed that he was -- but whether, as a supervisor, he acted reasonably under the circumstances. Critical to our decision there, and relevant to our analysis here, is that, although Trujillo had limited authority, he "made reasonable and diligent efforts to inform" his superiors of the need to take action against a "prized and powerful" salesperson.39 As discussed below, the same cannot be said of Montgomery.
* * * *
Based on the foregoing, we believe that the Division was substantially justified in alleging that Montgomery was Hoffman's supervisor.
We believe that the Division's allegation that Montgomery's supervision of Hoffman was unreasonable was substantially justified. As we frequently have observed, firms must provide effective oversight of branch offices located at considerable distances from headquarters and, in particular, of the salespersons who head those offices.40 Thus, "[s]upervision is reasonable only if there is adherence to appropriate internal company procedures."41 FSC's procedures, which in theory placed supervisory responsibility for OSJ principals with the chief compliance officer but which in practice allowed such principals to supervise themselves, were clearly inadequate.42
Montgomery provided no effective supervision of Hoffman's sales activities. Hoffman testified that he approved his own trades as an OSJ principal. As we have held, it is unreasonable to expect a salesperson to supervise himself.43 Moreover, Montgomery knew that the Firm's policy of relying on OSJs to monitor the Firm's sales practices was problematic, "particularly where remote locations are involved." Montgomery warned in an internal memorandum that regulators are "no longer allowing the 'OSJ does it' response but . . . want to know additionally a) who in the home office is responsible for ensuring that the structure works and b) a demonstration that where the OSJ does not catch an infraction, that the home office will."44
While Montgomery identified the Firm's annual branch office audits as an important component of its supervisory system, the Division introduced evidence establishing that the annual audits were not an effective supervisory tool. According to Division expert Ferguson, "these audits were really a pro forma exercise." She also expressed the opinion that it was "impossible" to perform "any sort of in-depth or accurate or complete audit" in an office the size of Hoffman's under those circumstances.45 Ferguson opined that preparation is an important aspect of a successful audit. She testified that FSC failed to prepare its auditors for one-day audits so that "they would know what they were looking for and where to look for it."
Ferguson also stated that, after the field audit was finished, no effort was made to verify the accuracy of responses given by the branch, to put the results in a form for submission to Firm officials for comments, or to recommend corrective measures. Hoffman confirmed Ferguson's opinion, testifying that, although he completed questionnaires in connection with the audit, he could not recall anyone ever discussing with him, or verifying, his answers to the questionnaires.
In an internal memorandum dated August 1995, roughly a year after the period at issue, Montgomery himself conceded that the Firm's supervisory structure was problematic:
We have to begin substantively reviewing and supervising OSJ business in the home office. This must include some level of direct client contact in random or problem circumstances, as well as greater demonstration of client suitability reviews conducted by the home office. This is a key area of SEC concern and it must become a more focused and documented practice of ours. (emphasis in original)
Although the law judge found that Montgomery was unaware of red flags suggesting violative conduct by Hoffman, Montgomery's neglect of the supervisory responsibilities assigned to him almost guaranteed that he would find no indication of wrongdoing. Despite Hoffman's status as one of FSC's most productive salespersons, Montgomery failed to review, or cause another principal to review, Hoffman's sales activity (or that of any other OSJ principal) for indications of sales practice abuses such as mutual fund switching or unsuitability.46 Consequently, Montgomery had no basis to evaluate the sales practices of Hoffman or any other OSJ principal and very limited likelihood of encountering any red flags. In light of the foregoing, we conclude that the Division was substantially justified in alleging that Montgomery failed reasonably to supervise Hoffman with a view to preventing Hoffman's violations.
The law judge found that Montgomery had incurred the expenses of his defense within the meaning of the EAJA, holding that "[t]o rule otherwise would thwart the purposes of the EAJA." We believe that the law judge's conclusion conflicts with relevant precedent, and we hold that Montgomery did not incur fees or expenses within the meaning of the statute.
It is undisputed that Montgomery's legal fees and expenses were paid by FSC. It also appears that FSC was required, under applicable Georgia law, to reimburse Montgomery for his legal costs (had the Firm not already paid them) because Montgomery prevailed.47 Under such circumstances, the EAJA requires that an application for reimbursement be denied.
In United States v. Paisley,48 the United States Court of Appeals for the Fourth Circuit denied an EAJA claim of several former corporate officers because the corporation was required by state law to indemnify employees who were "successful on the merits or otherwise," holding that:
[T]o effectuate the purposes of EAJA, a claimant with a legally enforceable right to full indemnification of attorney fees from a solvent third party cannot be deemed to have incurred that expense for purposes of the EAJA, hence is not eligible for an award of fees under the Act.49
Like the applicants in Paisley, Montgomery has a right to indemnification under state law because he prevailed in the underlying action. He therefore cannot be deemed to have incurred any expenses.
In SEC v. Comserv Corp.,50 the Eighth Circuit found that an EAJA applicant had not incurred any expenses where the expenses had been paid by his former employer pursuant to a severance agreement. The court also noted that, aside from the severance agreement, the employer "very likely would have been required to indemnify" the respondent because of a state law making such indemnification mandatory under "certain circumstances."51 As a result, the court found that the respondent was free to pursue his defense without worry about legal fees.52 The court reasoned that, under the circumstances, it would "turn the word upside down" to hold that the respondent "incurred" such fees.53 Moreover, the court found that fee shifting in that case would not serve the "primary intent of Congress in creating EAJA [which is] . . . 'to diminish the deterrent effect of the expense involved in seeking review of, or defending against, unreasonable government action.'"54
Like the respondent in Comserv, Montgomery has incurred no attorneys' fees. Moreover, the potential availability of expense reimbursement through the EAJA apparently was not a consideration for Montgomery in deciding to challenge the Division's allegations. That decision was made, according to Montgomery, in significant part based on FSC's offer to pay the fees. Consequently, this case does not implicate the public policy objectives that motivated Congress to adopt the EAJA.
Montgomery claims that "'the presence of an attorney-client relationship suffices to entitle prevailing litigants to receive fee awards' under the EAJA," citing Ed A. Wilson, Inc. v. GSA.55 In Wilson, however, the applicant's attorneys' fees had been paid by its insurer. The court concluded that the applicant, through its payment of insurance premiums, "incurred legal fees insofar as [it] . . . paid for legal services in advance."56 There is no evidence that Montgomery similarly incurred legal fees through any sort of prepayment arrangement or otherwise.
As noted in Wilson, "[b]ecause the [EAJA] exposes the government to liability for attorney fees and expenses to which it would not otherwise be subjected, it is a waiver of sovereign immunity."57 It is also well established that "[a]ny such waiver must be strictly construed in favor of the United States."58 In addition, there is a "'strong presumption' that the plain language of the statute expresses congressional intent" and that presumption "is rebutted only in 'rare and exceptional circumstances' when a contrary legislative intent is clearly expressed."59 Based on the plain language of the EAJA, we conclude that, since Montgomery never incurred any expenses, he is not entitled to recover under the EAJA.
After a careful examination of the record, we are satisfied that the Division was substantially justified in bringing proceedings against Montgomery. We also find that Montgomery did not incur fees and expenses within the meaning of the EAJA. Accordingly, we shall deny his claim under the EAJA for attorneys' fees and expenses.60
An appropriate order will issue.61
By the Commission (Chairman PITT and Commissioners HUNT and UNGER).
Jonathan G. Katz
Admin. Proc. File 3-9786-EAJ
In the Matter of
ORDER DENYING APPLICATION UNDER THE EQUAL ACCESS TO JUSTICE ACT
On the basis of the Commission's opinion issued this day, it is
ORDERED that the application of Kirk Montgomery for an award of attorneys' fees and costs under the Equal Access to Justice Act be, and it hereby is, denied.
By the Commission.
Jonathan G. Katz
|1||Kirk Montgomery, Initial Decision Rel. No. 168 (June 27, 2000), 72 SEC Docket 2366.|
|2||Under former Article III, Section 27 of the NASD's Rules of Fair Practice, since revised and renumbered as Conduct Rule 3010, each NASD member was required to designate certain branch offices as offices of supervisory jurisdiction "in order to supervise its registered representatives and associated persons in accordance with [NASD] standards . . . and one or more appropriately registered principals in each OSJ . . . with authority to carry out the supervisory responsibilities assigned to that office by the member."|
|3||Section 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q(a), and Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 thereunder, 17 C.F.R. § 240.10b-5.|
|4||Exchange Act Section 15(b)(4)(E), 15 U.S.C. § 78(b)(4)(E), authorizes the Commission to sanction associated persons of broker-dealers who fail reasonably to supervise persons subject to their supervision with a view to preventing violations of the federal securities laws.|
|5|| Richard Hoffman, Initial Decision Rel. No. 158 (Jan. 27, 2000), 71 SEC Docket 1510. The initial decision was not appealed and became final on March 6, 2000. See Richard Hoffman, Exchange Act Rel. No. 42495 (March 6, 2000), 71 SEC Docket 2430.
Although we are authorized to review an initial decision on our own initiative, see 17 C.F.R. § 201.411(c), we did not do so here. Our earlier determination should not be construed as an endorsement of the law judge's analysis of Montgomery's position or adequacy as a supervisor. As discussed below, we fundamentally disagree with much of the law judge's analysis of this case.
|6||5 U.S.C. § 504(a)(1). See also 17 C.F.R. §§ 201.31 et seq. (setting forth the Commission's rules pertaining to the EAJA).|
|7||Montgomery also complains that the Division "devoted half of its brief to rehashing the evidence presented against Hoffman, despite the fact that the ALJ's dismissal of the charges against Montgomery was based on the assumption that Hoffman had violated the securities laws." At the same time, however, Montgomery asserts that the Division must demonstrate that it substantially prevailed as to each element of the allegations made against Montgomery, which include the allegation that Hoffman committed violations.|
|8||See, e.g., Pierce v. Underwood, 487 U.S. 552, 569 (1988) ("fact that one court agreed or disagreed with the Government does not establish whether [the Government's] position was substantially justified").|
|9||See Steadman v. SEC, 450 U.S. 91 (1981) (holding that preponderance-of-the-evidence standard applies to disciplinary proceedings brought under the securities laws).|
|10||FEC v. Rose, 806 F.2d 1081, 1087 (D.C. Cir. 1986).|
|11||Rita C. Villa, Exchange Act Rel. No. 42502 (Mar. 8, 2000), 71 SEC Docket 2438, 2443. The Commission's rules state that "[t]he burden of proof that an award should not be made to an eligible prevailing applicant is on counsel for [the] Division . . . which must show that its position was reasonable in law and fact." 17 C.F.R. § 201.35. See also Cornella v. Schweiker 728 F.2d 978, 982 (8th Cir. 1984) (the standard for awarding fees "represents a middle ground between an automatic award of fees and an award only where the government position was frivolous").|
|12||Pierce v. Underwood, 487 U.S. at 565.|
|13||See Villa, 71 SEC Docket at 2443 (holding that EAJA appeals are considered de novo). As the District of Columbia Circuit has held, it is "[o]nly through a fresh look occasioned by application of the 'substantially justified' standard [that we can] "honor Congress' intent, manifest in the inclusion of this standard, not to permit a prevailing party automatically to recover fees." FEC v. Rose, 806 F.2d at 1087.|
|14||The law judge declined to find a breakpoint violation because Leister "did not have the additional $1000 cash to reach a breakpoint." It appears, however, that the Leisters had more than enough to satisfy the breakpoint had the transactions been structured differently, or, in any event, might have been willing to borrow funds to get the discount had they been aware of its availability.|
|15||See, e.g., Stephen J. Stout, Exchange Act Rel. No. 43410 (Oct. 4, 2000), 73 SEC Docket 1441, 1451, 1462; Paine, Webber, Jackson & Curtis, 43 S.E.C. 1052, 1054 (1969) (settled case) ("In selling the mutual fund shares in amounts close to but less than break points, and to customers known to have available for investment total amounts which exceeded the break points, it was incumbent on the salesmen to disclose . . . the savings in sales charges obtainable through increasing the amount of the purchase . . . .").|
|16||See, e.g., Laurie Jones Canady, Exchange Act Rel. No. 41250 (Apr. 5, 1999), 69 SEC Docket 1468 (Davenport, Iowa salesperson defrauded customers, including elderly neighbor, with whom she had close personal relations), petition denied, 230 F.3d 362 (D.C. Cir. 2000); Meadows v. SEC, 119 F.3d 1219, 1226 (5th Cir. 1997) (salesperson committed securities fraud as a result of recommendations made to "his fellow country club members").|
|17||See, e.g., Jay Houston Meadows, 52 S.E.C. 778, 784-85 (1996) ("The various courts of appeal have held that recklessness satisfies the scienter requirements of the antifraud provisions of the securities laws."), aff'd, 119 F.3d 1219 (5th Cir. 1997). We further note that even negligent conduct can establish liability under Sections 17(a)(2) and 17(a)(3) of the Securities Act. Id. at 785 n.16.|
|18||See Natchez Coca-Cola Bottling Co. v. NLRB, 750 F.2d 1350, 1353 (5th Cir. 1985) (government was substantially justified where it would have established prima facie case if witnesses' testimony had been credited). See also SEC v. Fox, 855 F.2d 247, 253 (8th Cir. 1988) (denying EAJA claim since Commission was substantially justified in alleging materiality of information at issue, notwithstanding that trier of fact "properly" deemed information not material).|
|19||The law judge determined that Hoffman must have discussed with Detwiler the risks associated with his recommendations -- despite Detwiler's contrary recollection -- because doing so was, again, part of his regular "routine." As discussed above, such a finding by the law judge does not preclude a finding of substantial justification with respect to this aspect of the allegations against Hoffman.|
|20||See Laurie Jones Canady, 69 SEC Docket 1468 (and the cases there cited).|
|21||Henry Ferguson, an expert witness who testified for Hoffman, challenged Calhoun's assertion regarding the risks involved in junk bond funds, claiming that "typically" the default rate for junk bonds has been "low."|
|22|| According to Calhoun,
[I]t's a classically improper switch where one fund with a similar objective is ignored in the family in which the investor already holds funds and . . . a fund in another family is purchased, subjecting the investor to the forfeiture, if you will, of the sales charge already paid, which in this case was a front-end load on the Delaware U.S. Government Fund, which had only been held two years or less; and then the payment of an additional sales charge on the American Capital High Yield Fund.
Calhoun also dismissed concerns expressed by Hoffman about placing all of Koester's assets in a single fund.
|23||The law judge also found that the allegations against Montgomery failed because they were derivative of those against Hoffman, which were, in her view, also unsupported.|
|24||John H. Gutfreund, 51 S.E.C. 93, 113 (1992) (settled case). We have followed our analysis in Gutfreund in litigated cases. See, e.g., Patricia Ann Bellows, Exchange Act Rel. No. 40411 (Sept. 8, 1998), 67 SEC Docket 2910, 2912; Conrad C. Lysiak, 51 S.E.C. 841, 844 n.13 (1993), aff'd, 47 F.3d 1175 (9th Cir. 1995) (Table).|
|25||Stuart K. Patrick, 51 S.E.C. 419, 421 (1993), aff'd, 19 F.3d 66 (2d Cir.), cert. denied, 513 U.S. 807 (1994). That individual supervisory responsibility rests, at least initially, with a firm's president, "unless and until he reasonably delegates particular functions to another person in that firm, and neither knows nor has reason to know that such person's performance is deficient." Universal Heritage Inv. Corp., 47 S.E.C. 839, 845 (1982); Steven C. Pruett, 46 S.E.C. 1138, 1141 (1978).|
|26||See Patrick, 51 S.E.C. 419 (rejecting claim that supervisory responsibility rested solely with the respondent's firm).|
|27||See, e.g., Steven P. Sanders, 53 S.E.C. 889 (1998) (person identified in compliance manual as responsible for recommending action to ensure regulatory compliance held accountable for supervisory failure under rules of self-regulatory organization).|
|28||Article III, Section 27 of the NASD Rules of Fair Practice then in effect -- the corresponding supervisory rule currently in effect is Conduct Rule 3010 -- required firms to set forth in writing its supervisory procedures and the firm personnel responsible for implementing those procedures. See, e.g., Steven P. Sanders, 53 S.E.C. at 901 ("Every firm is required to assign supervisory responsibilities in writing, including the names of the responsible personnel.").|
|29|| Montgomery's counsel also asked Hoffman to distinguish "between Mr. Montgomery as the chief compliance officer, holding a position[,] as opposed to Mr. Montgomery, the individual, dealing with you on a daily basis supervising your activities." Hoffman responded: "I -- I'm sorry, sir, I did not recognize or I do not remember that he was my direct supervisor." Montgomery added that he did not "recall that anyone was designated to be our overseer." (emphasis added).
We do not view this testimony as necessarily contradicting Hoffman's earlier assertion that Montgomery was his supervisor. Montgomery's supervisory status is premised in large part on the responsibilities given him by the Firm's supervisory procedures. Since the basis of the case against Montgomery was his failure properly to supervise Hoffman, Hoffman's testimony, which evidences obvious confusion on Hoffman's part regarding who if anyone was his supervisor, is consistent with the position advocated by the Division.
|30||Young also testified that the OSJ principals did not "answer to" any single person in the Compliance Department, but to the department generally. As discussed below, to the extent this was the way FSC operated with respect to Hoffman, it supports the Division's allegations of Montgomery's supervisory failure.|
|31||Montgomery essentially repeated this statement in an August 1995 memorandum.|
|32||Following its examination, the staff informed the Firm that it was troubled by FSC's limited ability to monitor mutual fund transactions, the kinds of transactions at issue here, and its supervision of "top producing employees [who] are also designated supervisors," a group that included Hoffman.|
|33||Brown testified that, in the event a reviewing principal sought to retrieve customer data, such as information relating to the customer's investment objectives, the data he obtained would have been unreliable.|
|34|| See, e.g., James J. Pasztor, Exchange Act Rel. No. 42008 (Oct. 14, 1999), 70 SEC Docket 2611, 2621 n.28 (supervisor not relieved of responsibility because he had to report to firm president who repeatedly overruled his decisions).
Montgomery argues that Pasztor is distinguishable because there the supervisor was a branch manager and aware of improper conduct by the registered representative involved. We believe that the principles enunciated in Pasztor are applicable to the situation presented. Although there is no evidence that Montgomery was aware of misconduct by Hoffman, he was aware of flaws in FSC's supervisory procedures which made the detection of such misconduct highly unlikely.
The law judge held that Montgomery was not Hoffman's supervisor in part based on her finding that Montgomery had made specific recommendations to enhance FSC's compliance program which had been rejected by his superiors. Montgomery also claimed that he could not be held liable for supervisory failure because he lacked the resources to enhance the Firm's compliance program. We have held, however, that "[a] supervisor must act to ensure that each associated person is receiving appropriate supervision despite constraints on the supervisor's powers." Id. at 2621 n.27. See also George Lockwood Freeland, 51 S.E.C. 389, 392 (1993) (financial principal of firm held liable for supervisory failure where owner refused to cooperate with his compliance efforts, holding that principal was "required to insist on [owner's] cooperation and compliance with applicable requirements or to resign.") (NASD proceeding).
|35||See, e.g., John H. Gutfreund, 51 S.E.C. at 113 (firm's chief legal officer could be deemed supervisor where he "share[d] in the responsibility to take appropriate action to respond to the misconduct").|
|36||John H. Gutfreund, 51 S.E.C. at 113. See also Steven P. Sanders, 53 S.E.C. at 904 ("where supervisory responsibility is shared between firm executives, each can be held liable for supervisory failure."); James L. Owsley, 51 S.E.C. 524, 536 (1993) (firm president and compliance officer shared supervisory responsibilities for branch office).|
|37||See James J. Pasztor, 70 SEC Docket at 2621 n.28 (supervisor not "relieved of responsibility because he had to report to [firm president who] could overrule his decisions.").|
|38||49 S.E.C. 1106 (1989).|
|39||Id. at 1110.|
|40||See, e.g., Consolidated Inv. Serv., Inc., 52 S.E.C. 582, 586 (1996) (supervisory failure by firm officials who claimed to be unaware of misconduct by "big producer" who operated one-person satellite office where officials "took no steps to ascertain whether" producer was complying with firm procedures); Houston A. Goddard, 51 S.E.C. 668, 674 (1993) (finding of supervisory failure based in part on fact that salesperson "was operating out of a one-person office, a substantial distance away from any [firm] supervisory or compliance personnel") (NASD proceeding); Donald T. Sheldon, 51 S.E.C. 59, 79 (1992) (firm president who neither monitored, nor established procedures to monitor, branch offices held liable under Exchange Act), aff'd, 45 F.3d 1515 (11th Cir. 1995); Universal Heritage, 47 S.E.C. at 845 ("stringent home office supervision" required where branch manager permitted to make market in stock).|
|41||Consolidated Inv. Serv., Inc., 52 S.E.C. at 586.|
|42||FSC, without admitting or denying the allegations against it, consented to the entry of a Commission order finding that, between 1992 and 1995, the Firm failed to provide reasonable supervision to an unidentified salesperson who operated a one-person OSJ and engaged in fraudulent sales practices. FSC Sec. Corp., Exchange Act Rel. No. 40765 (Dec. 9, 1998), 68 SEC Docket 2318. FSC agreed to be censured, to pay a civil penalty of $50,000, and to certain undertakings relating to the hiring of an independent consultant to review its supervisory procedures.|
|43||See, e.g., Bradford John Titus, 52 S.E.C. 1154, 1158 (1996) (compliance director held liable, under NASD rules, for supervisory failure based on finding that salesperson, who was operating as independent contractor out of two-person "non-branch" office, could not supervise himself); Stuart K. Patrick, 51 S.E.C. at 422 ("Supervision, by its very nature, cannot be performed by the employee himself.") (applying supervisory rule of New York Stock Exchange). According to Division expert Ferguson, "[y]ou can't rely on people to supervise themselves. That's not a system of supervision." Ferguson added that such a system "would defeat every supervisory requirement and safeguard developed by every firm and regulatory agency in the securities industry."|
|44||Montgomery added, in this memorandum, that "[a] number of recent SEC actions have held home office personnel personally responsible for break downs in supervision where the structure was deemed unreasonable." (emphasis in original).|
|45||In a written report that the Division introduced, Ferguson concluded that "the method of review of accounts was woefully inadequate and not likely to detect improper trading as occurred in Hoffman's accounts."|
|46|| Although the law judge found that Montgomery did not "systematically review the daily sales activity of Hoffman or any other one-person OSJ," she stated that the Division "concede[d] that he was not required to do so" because there is no "law requiring Montgomery to review or ensure the regular review of Hoffman's customer accounts . . . ." The absence of such review, however, is relevant to a determination of whether Hoffman's supervision was reasonably designed to prevent violations. Moreover, the Division introduced evidence that Montgomery provided almost no supervision of Hoffman, let alone daily review of trading in his customer accounts.
Montgomery contends that his failure to review Hoffman's trading activity should be considered in light of industry practice. The consequence, however, of Montgomery's failure to review, or designate a principal to review, Hoffman's trading activity was self-review by Hoffman. The evidence did not establish that such self-review was consistent with industry practice. Moreover, "compliance with custom or industry practice [is] a relevant, but not a determinative factor in determining whether the appropriate standard of care has been met." SEC v. Dain Rauscher, Inc., 254 F.3d 852, 856-57 (9th Cir. 2001).
|47||O.G.C.A. § 14-2-857(c) provides that "[a]n officer of a corporation who is not a director is entitled to mandatory indemnification under Code Section 14-2-852 . . . to the same extent to which a director may be entitled to indemnification or advances for expenses under those provisions." O.G.C.A. § 14-2-852 provides that "[a] corporation shall indemnify a director who was wholly successful, on the merits or otherwise, in the defense of any proceeding to which he or she was a party because he or she was a director of the corporation." See Crocker v. Stevens, 210 Ga. App. 231, 239, 435 S.E.2d 690, 699 (1993) ("Indemnification of a director is required where the director prevails on a claim in connection with his position as director, unless limited by the articles of incorporation."). In a January 1995 FSC organizational chart, Montgomery is identified as "VP & Counsel/Asst Sec." in addition to Chief Compliance Officer.|
|48||957 F.2d 1161 (4th Cir. 1992).|
|49||Id. at 1164.|
|50||908 F.2d 1407 (8th Cir. 1990).|
|51||Id. at 1413.|
|52||Id. at 1414.|
|53||Id. at 1415.|
|54|| Id. at 1415 (citing Cornella v. Schweiker, 728 F.2d at 981).
Montgomery argues that Comserv is distinguishable in that the party who ultimately would have received the award was, unlike FSC, itself ineligible to recover under the EAJA. Although this may have been a factor in the court's decision, it was not the determining factor, which was that the applicant, like Montgomery, "from the inception of the underlying lawsuit . . . was able to pursue his defense in the SEC action secure in the knowledge that he would incur no legal liability for attorneys' fees." 908 F.2d at 1414.
|55||126 F.3d 1406, 1409 (Fed. Cir. 1997).|
|56||Id. at 1410.|
|57||Id. at 1408.|
|58||Ardestani v. INS, 502 U.S. 129, 137 (1991). See also Buckhannon Board & Care Home, Inc. v. West Virginia Dept. of Health & Human Resources, No. 99-1848, 2001 U.S. LEXIS 4117, *8 (May 29, 2001) ("Under th[e] 'American Rule,' we follow 'a general practice of not awarding fees to a prevailing party absent explicit statutory authority.'") (citation omitted).|
|59|| 502 U.S. at 135-36 (quoting Rubin v. United States, 449 U.S. 424, 430 (1981)).
In Ardestani, the Supreme Court denied the application of a foreign national who had prevailed in an administrative deportation proceeding because such proceedings are not "adversary adjudications" and are therefore not entitled to recovery under the EAJA. The Court had "no doubt that the broad purposes of the EAJA would be served by making the statute applicable to deportation proceedings." The Court nevertheless concluded that "the plain language of the statute, coupled with the strict construction of waivers of sovereign immunity, constrain us to do otherwise." Id. at 138. We believe the Court's reasoning is applicable here.
|60||Montgomery requests that we hear oral argument in this appeal. The rules governing our consideration of EAJA appeals make no provision for oral argument, see Villa, 71 SEC Docket at 2448 n.22, and we see no need for oral argument here. Accordingly, we deny Montgomery's request.|
|61||We have considered all of the contentions made by the parties. We reject or sustain them to the extent that they are inconsistent or in accord with the views expressed herein.|