SECURITIES AND EXCHANGE COMMISSION
In the Matter of the Application of
KEVIN D. KUNZ
KUNZ AND CLINE INVESTMENT MGMT., INC.
For Review of Disciplinary Action Taken by the
NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.
OPINION OF THE COMMISSION
REGISTERED SECURITIES ASSOCIATION - REVIEW OF DISCIPLINARY PROCEEDINGS
Violation of Rules of Fair Practice
Registered representative of a member firm and member firm of a registered securities association offered and sold securities using private placement memoranda containing material misrepresentations and omissions. Securities were neither registered nor exempt from registration under the Securities Act of 1933. Registered representative authorized firm's compensation of an unregistered person in connection with securities transactions. Held, Association's findings of violation and sanctions it imposed are sustained.
Donald L. Dalton, of Dalton & Kelley, for Kevin D. Kunz and Kunz & Cline Investment Management, Inc.
Alden S. Adkins and James S. Wrona, for NASD Regulation, Inc.
Appeal Filed: August 2, 1999
Last Brief Received: November 17, 1999
Kevin D. Kunz ("Kunz"), a registered representative and principal of Kunz & Cline Investment Management, Inc. ("K&C"), and K&C, a member of the National Association of Securities Dealers, Inc. ("NASD"), appeal from an NASD decision. Kunz became a registered representative in June 1984. He formed K&C with Jeffrey Cline ("Cline") in December 1994. The NASD found that Kunz and K&C used private placement memoranda ("PPMs") containing material misrepresentations and omissions to sell securities of VesCor Capital Corporation ("VesCor") that were neither registered nor exempt from registration under the Securities Act of 1933.1 The NASD also found that K&C, at Kunz's direction, compensated an unregistered person in connection with securities transactions.2 The NASD censured Kunz and K&C, fined them $20,000, jointly and severally, and fined Kunz $5,000, individually. The NASD also suspended Kunz from association with any member firm for 30 calendar days and in a principal capacity for one year, the suspensions to run concurrently. Further, the NASD ordered Kunz to requalify as a representative within 90 days of the conclusion of his suspension as a representative or to cease functioning in that capacity until he requalified, and to requalify as a principal before functioning in that capacity after conclusion of his suspension as principal. In addition, the NASD ordered K&C to retain an independent consultant, and upheld the District Business Conduct Committee's imposition of $2,597.20 in hearing costs. We base our findings on an independent review of the record.
A. VesCor was in the business of originating, purchasing, and selling loans secured by real property. VesCor financed its business through sales to the public of certain investment vehicles, including Wholesale Accrual Notes ("Accrual Notes"), Wholesale Monthly Income Notes ("Monthly Notes," or, collectively with the Accrual Notes, "Notes"), and Wholesale Mortgage Loan Participation Interests ("MLP Interests").3
Before 1994, VesCor sold all three investment instruments without registering the transactions under the Securities Act.4 In early 1994, the State of Nevada began an inquiry into the VesCor programs and concluded that the Notes and the MLP Interests were securities. VesCor agreed to a settlement with Nevada, pursuant to which VesCor was required to make a rescission offer to existing holders of the Notes and MLP Interests in Nevada. VesCor did this by partnering the offer to rescind with an offer to reinvest the funds in the Notes and MLP interests correctly identified in a PPM as securities. VesCor also made the same rescission offer to investors in other states and sought to raise new funds.5
Kunz had become acquainted with VesCor and Southwick in 1987, and he joined VesCor as an employee in August 1994.6 Kunz testified that, based upon comments Southwick madeto him, he expected to be able to take over management of VesCor approximately five years after his starting date because Southwick planned to retire. Shortly after Kunz started at VesCor, however, Southwick made his determination that the required rescission offerings should be made through the PPMs that offered to reinvest the funds. Southwick also decided that the transactions should be handled by a registered broker-dealer. As a result, he encouraged Kunz to leave VesCor in order to form a broker-dealer with Cline.
Southwick, through VesCor, agreed to provide the funds needed to form the broker-dealer. Kunz and Cline began the NASD member application process for K&C in October 1994. Kunz, Cline, and VesCor anticipated that, once K&C was registered with the NASD, K&C would act as selling agent or underwriter for the private placement offerings and possibly for an anticipated, later "SB-2 public offering."7 The NASD approved K&C's membership application on December 13, 1994. The VesCor transactions in question occurred after this date.
VesCor created six PPMs to accompany the simultaneous rescission offerings, providing two different PPMs for each of the three investment vehicles. One set of three was used for residents of Nevada, and another set of three was used for residents of other states. The PPMs indicated that the Notes and MLP Interests were securities that would not be registered under the Securities Act or any state securities laws.8 Only the PPMs for Nevada residents disclosed Southwick's litigation history (which included outstanding civil judgments totaling over $1.8 million stemming from his previous business activities), as required by VesCor's settlement withNevada.9 None of the PPMs disclosed the relationship between VesCor and Kunz and K&C. 10
All six PPMs used the same financial statement, which Kunz testified he saw for the first time in late November 1994 when the PPMs were ready to be distributed. He added that, when he saw the financial statement in the PPMs, he was surprised by the sizeable net operating loss that had accumulated since 1991. He stated that he questioned Southwick about the losses, and Southwick made some general comments and excuses. Kunz made no further investigation concerning any of the matters in the financial statements included in the PPMs.
Each financial statement contained a balance sheet dated as of September 30, 1994 showing under "Assets" an entry for "Investments" valued at $12,265,322. The balance sheet also included a note indicating that, of this amount, the sum of $9,191,509 was attributable to a single asset acquired in exchange for 750 shares of VesCor common stock four days before the closing date of the balance sheet: 20,000 acres of land grants in Cannon County, Tennessee.11 Each balance sheet also contained a "Statement of Shareholders Equity" showing that (1) the issuance of stock for the Tennessee land occurred on September 26, 1994, with each share of stock assigned a value of $12,177.85; (2) 250 shares of stock had been issued "for services" on September 15, 1994, with each share of stock assigned a value of $63.80; and (3) the remaining outstanding shares were valued at a total of $1,250.92 as of December 31, 1993. The Statement of Shareholder's Equity also indicated that, as of December 31, 1993, VesCor had accumulated losses of $1,309,426, and, as of September 30, 1994, had lost an additional $1,307,694, for total to-date losses of $2,617,120. The balance sheet and accompanying notes documented that,without inclusion of the Tennessee land, VesCor had assets of $5,671,761 and liabilities of $6,454,673, resulting in a negative net worth of approximately $800,000.
Kunz stated that during the fall of 1994, while he was still an employee of VesCor and the PPMs were being prepared, there were discussions concerning the need to improve VesCor's balance sheet and add assets to make it look better. He also stated that he understood that the purpose for VesCor's acquisition of the Tennessee land was to use the land as a balance sheet enhancement, "meaning that Southwick would acquire the property for a short period of time to make his private placement look good and sellable [sic]."12 Kunz also testified that he first learned of VesCor's acquisition of the Tennessee land asset when he saw the reference to it in the PPMs.
Kunz testified at the hearing that he was not surprised that the balance sheet contained such a large asset. He noted that he had heard Southwick say that VesCor was acquiring a $20 million piece of property, so when he saw that VesCor had paid approximately $9 million he thought the cost was reasonable. Kunz stated that he was not aware that VesCor had exchanged 750 shares of common stock for the Tennessee land asset until the NASD investigator pointed it out during the investigation. Kunz claimed to have sought confirmation from VesCor's counsel that VesCor had proper title to the Tennessee land. VesCor's counsel testified that he told Kunz only that there was a deed recorded. Had Kunz pursued this matter, he might have discovered, for example, that the deed concerning the Tennessee land asset referenced only land grant numbers as descriptions of the property being transferred, and did not contain any language typical of contemporary legal descriptions (e.g., parcel and tax assessor's numbers, subdivision, block and lot number, etc.).13
Kunz and K&C offered and sold VesCor securities to customers. Kunz admitted that he personally delivered PPMs to 113 investors. Kunz also testified that he mailed VesCor PPMs to a number of K&C customers, and that he discussed the investments with some customers on the telephone. Kunz stated that neither he nor K&C attempted to verify the number of nonaccredited investors14 for any of the VesCor offerings until the NASD requested information in connection with its investigation in September 1995. In fact, sales were made to many more than 35 nonaccredited investors for the Accrual Notes and the Monthly Notes.
B. Kunz met Bruce Anderson ("Anderson") in October 1994 through Southwick. Anderson had previously engaged in extensive marketing of VesCor securities, received and handled numerous client subscription agreements, and solicited sales of and sold VesCor securities. Kunz testified that Anderson expressed an interest in working as a registered representative at K&C so that he could participate in the private placement offerings.
Anderson had been registered as a Series 6 investment company products/variable contracts representative with W.S. Griffith & Co, Inc., although both he and Kunz mistakenly believed that he held a Series 7 registration.15 Based on this belief, Kunz submitted an application to the NASD for Anderson's license to be transferred to K&C. After that application was filed, and by the time K&C became registered in December 1994, Kunz learned that Anderson was, in fact, not qualified to offer the securities for sale. Although Anderson applied to take the Series 7 examination, he never did so, and the necessary registration for him with K&C was never approved by the NASD.
Since Anderson could not present the rescission offerings to his clients, Kunz met with Anderson, and then personally or by mail furnished Anderson's clients with the PPMs. More than 90 of Anderson's clients reinvested their funds in the VesCor offerings. Kunz paid Anderson a "consulting fee" of $88,936, the amount Kunz says Anderson would have received as commissions for sales of VesCor securities had he been licensed.16
Material Misrepresentations and Omissions
The record conclusively establishes, and Applicants do not dispute, that the PPMs on the basis of which Kunz and K&C offered and sold VesCor securities, materially misrepresented VesCor's financial condition and omitted disclosure of material information about the relationship between Applicants and VesCor and about Southwick's litigation history. The issue before us, then, is whether the conduct of Kunz and K&C in making such offerings and sales was inconsistent with high standards of commercial honor and just and equitable principles of trade, in violation of the NASD's Conduct Rule 2110.
Applicants argue that, while the true value of the Tennessee land asset may have been relevant, it was not material to investors' decision to invest in VesCor.17 The United States Supreme Court has addressed the issue of materiality in the investment context. In TSC Industries v. Northway,18 the Court determined that the question of materiality is an objective one. It further stated:
[T]here must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available.19
In light of the Supreme Court analysis, we find that the misrepresentation of the value of the Tennessee land asset was "material." The financial statements showed that the Tennessee land asset was VesCor's largest. With it, VesCor appeared to have a positive net worth of approximately $8 million, when in reality the company had a negative net worth of approximately $800,000.20 Applicants argue that the value of the Tennessee land asset was not material because investors were not investing in common shares of VesCor, but in deeds representing title to other real property. This argument is unpersuasive, especially with respect to the Notes. The Notes were direct obligations of VesCor. VesCor's historical and continued net loss was a fact important to a reasonable investor because it affected VesCor's ability to pay on the Notes. It "alter[ed] the total mix" of information for the investment decision.21
Kunz and K&C also claim that they were entitled to rely on information in the PPMs. As we noted in Everest Securities, Inc, 22 "[b]roker-dealers are under a duty to investigate the securities that they recommend, and their failure to do so subjects them to liability for violations of the anti-fraud provisions of the securities laws."23 Counsel for Applicants conceded in his closing argument before the DBCC that the existence of "red flags," especially concerning the veracity of a company's financial statements, would trigger an obligation to investigate further. Applicants claim that they were excused from investigation, however, because the financial statements were audited by an accountant. Applicants argue that there were no "red flags" that should have caused Applicants to doubt the accuracy of the financial statements and that, when inquiries were made about the Tennessee land asset, the responses from VesCor were satisfactory.
Contrary to Applicants' assertions, we find that Applicants were aware of numerous "red flags" concerning the Tennessee land asset that should have caused Applicants to question rather than rely on VesCor's auditor.24 VesCor acquired the "asset" in the midst of preparing financial statements for distribution to the public for the first time.25 Kunz knew of discussions about the need to improve the company's financial picture through infusions of cash, and that the search for investment partners had been unsuccessful.
Without the Tennessee land asset, the company's net worth would have been ($782,912). The PPMs indicated that VesCor acquired the asset in exchange for stock that was valued on a per share basis at approximately 200 times the value assigned just weeks earlier in another transaction involving the issuance of stock for services, and approximately 10 times the value assigned to shares owned by Southwick, the only other shareholder. In addition, VesCor's lack of other assets and accumulated losses should have caused Applicants to question the validity of a transaction purporting to exchange an asset valued at over $9 million for stock of little or no value. Despite these "red flags," Applicants did virtually no investigation concerning VesCor's financial statements or the Tennessee land asset.26
Applicants' failure to respond to these "red flags" amounted to willful blindness concerning problems with the valuation of the Tennessee land asset. They were therefore reckless in offering securities on the basis of representations in the PPMs concerning the Tennessee land asset.27 Even a cursory review of the deed property descriptions, the purported appraisal, and the fact that there was no title insurance would have indicated that the Tennessee land asset was virtually worthless. In addition, a review of option provisions in the Agreement would have shown that VesCor was really "renting an asset."28 We find that Applicants were reckless in marketing the securities for sale while relying on VesCor for information, rather than conducting an inquiry to address the concerns identified by the red flags.29 This failure was inconsistent with high standards of commercial honor and just and equitable principles of trade, in violation of NASD's Conduct Rule 2110.
The NASD also found that some of the PPMs Applicants used in the offer and sale of VesCor securities omitted to disclose the consulting relationship between Kunz and VesCor, the consulting fees paid to Kunz by VesCor, and VesCor's financing of K&C. The existence of these relationships would have been material to any prospective investor. When a broker-dealer has a self-interest (other than the regular expectation of a commission) in serving the issuer that could influence its recommendation, it is material and should be disclosed.30
In addition, Applicants were aware of the omission from the non-Nevada PPMs of disclosure about Southwick's litigation history.31 This omission was material because Southwick was, in effect, the alter ego of VesCor. As the PPMs state, Southwick had "effective control of all aspects of the business of the Company." Southwick was the President, Chief Executive Officer, Corporate Secretary, and Chairman and sole member of VesCor's Board of Directors. Southwick played a pivotal role in the success or failure of VesCor. The matters at issue in his earlier litigation, described in the Nevada PPMs but not in the non-Nevada PPMs, were directly related to the type of business activity in which VesCor engaged. Thus, the litigation history was an important factor in assessing Southwick's business acumen, as well as his history in financial dealings similar to those proposed for VesCor. Absent disclosure of Southwick's litigation history, investors received only positive information about Southwick's background, which the PPMs highlighted as an important consideration. For these reasons, we consider this litigation history to be a "fact that would have been viewed by a reasonable investor as having significantly altered the `total mix' of information made available," and therefore material.32
Applicants' only excuse for non-disclosure both of the financial relationship between Applicants and VesCor and of Southwick's litigation history was that Kunz relied on the advice of VesCor's counsel that disclosure was unnecessary. This purported reliance does not justify his failure. Reliance on "advice of counsel" requires a showing that the party claiming it made a complete disclosure to counsel, sought advice as to the legality of his or her conduct, and relied on that advice in good faith.33 It is well-established that a necessary element of reliance on advice of counsel is that the counsel be independent, and wholly disinterested.34 Counsel for someone else involved in the transaction about which advice is sought cannot have the necessary independence. While Kunz may have consulted VesCor's counsel, there is no indication that he retained VesCor's counsel to provide him with legal advice.35 Reliance on the advice of counsel also requires a showing that the party claiming it made a complete disclosure to counsel, sought advice as to the legality of his conduct, and relied on that advice in good faith.36 Kunz did not make such a showing. Therefore, Kunz could not have reasonably relied on the purported statements of VesCor's counsel.
For the reasons stated above, we find that Applicants offered and sold securities pursuant to PPMs that materially misrepresented VesCor's financial condition and omitted disclosure of material facts about Applicants and VesCor, and about Southwick's litigation history. We find that this conduct is inconsistent with high standards of commercial honor and just and equitable principles of trade, as required by NASD Conduct Rule 2110.
Offering Unregistered Securities to the Public
The NASD found that K&C, through Kunz, sold securities in transactions that were neither registered with the Commission nor exempt from registration. There is no dispute that the offerings of VesCor securities were not registered with the Commission, or that Applicantsoffered to sell, and sold, the securities in interstate commerce.37 Applicants contend, however, that the securities offerings were exempt from registration under either Regulation D or the private offering exemption in Section 4(2) of the Securities Act. We note that these exemptions are construed narrowly in order to further the purpose of the Securities Act.38 Applicants have the burden of demonstrating their entitlement to an exemption.39
A. Regulation D
Rule 506 under Regulation D40 provides an exemption for the offer and sale of securities that satisfy all of the requirements of Rules 501 and 502, where the offering does not involve more than 35 nonaccredited investors, and where nonaccredited investors involved had "such knowledge and experience in financial and business matters that [they are] capable of evaluating the merits and risks of the prospective investment. . . ." 41 Our review of the record indicates that there were 138 nonaccredited investors in all three offerings. If the offerings are considered a single, integrated offering, then Applicants would not be entitled to a Regulation D exemption.42 Applicants argue that the three VesCor offerings should not be integrated, and that VesCor should be entitled to a Regulation D exemption.
We consider five factors in determining whether apparently separate offerings should be viewed as one, integrated offering: (a) whether the offerings are part of a single plan of financing; (b) whether the offerings are made for the same general purposes; (c) whether the offerings are made at or about the same time; (d) whether the same kind of consideration is to be received; and (e) whether the offerings involve issuance of the same class of securities.43 Applicants argue that the first and second factors militate against integration. With respect to thefirst factor, Applicants state that there was no coordination between the offerings as to amount or timing. They further argue that, with one exception, none of their customers purchased investments of different types. As to the second factor, Applicants state that, since money raised from the sale of the MLP Interests could not be used for VesCor's operating expenses, the MLP Interests were not offered for the same general purposes as the Notes. Applicants' arguments concerning both factors are unpersuasive. The PPMs make it clear that the offerings were all made for the same general purpose - to finance VesCor's mortgage lending and trust deed business - and were part of a single plan of financing those activities.44
The third and fourth factors are met because all of the offerings were made at or about the same time. Furthermore, the consideration for the securities was the same: the rejection of the right to rescind a prior investment and the election to credit accumulated interest to principal. If a new or additional investment was made, the consideration was cash.
Applicants argue that the MLP Interests and the Notes were different classes of securities, and thus do not conform to the fifth factor. They point out that the MLP Interests were not of the same class of securities as the Notes because they were equity securities, not debt. Applicants admit that the Notes were all the same type of security, but argue that the Notes were of a different class because they have different terms of payment, i.e., the Accrual Notes were paid when they mature, and the Monthly Notes were paid on a monthly basis.45 Even assuming the validity of these arguments, consideration of the remaining factors militates in favor of finding that the three offerings were integrated.
Thus, applying the factors to the undisputed facts here, we conclude that the offerings of the MLP Interests and the Notes should be integrated. We therefore find that the offerings are not exempt under Regulation D.46
B. Section 4(2)
Section 4(2) of the Securities Act states that transactions not involving public offerings are exempt from registration. Exemptions under this section are construed narrowly in order to further the purposes of the Securities Act.47 There are a number of cases that provide guidance for determining whether a securities offering is exempt from registration as a private offering.48 We find that the Section 4(2) exemption is unavailable for these securities for a number of reasons.
First, the large number of diverse investors for each type of Note leads us to consider each to be a public offering.49 Second, the majority of the purchasers, and presumably themajority of the offerees, were not financially sophisticated enough to gain access to information about VesCor independently and were not in a position to verify the representations that had been made to them in the solicitation process by reviewing VesCor's records. Third, the size and manner of the offerings are more indicative of public, rather than private offerings.50 Fourth, there is no indication that all the offerees had any special relationship with VesCor that would have afforded them access to or information about VesCor that a registration statement would have provided, and, therefore, did not need the protection of the 1933 Act.51
* * *
Based on the foregoing discussion, we find that Applicants offered and sold VesCor securities that were not registered with the Commission and were not exempt from registration pursuant to Rule 506 of Regulation D or Section 4(2) of the Securities Act. We have approved of the NASD's uniform practice of considering violations of the securities laws to be inconsistent with high standards of commercial honor and just and equitable principles of trade, as required by NASD Conduct Rule 2110.52
Payments to an Unregistered Person for the Sale of Securities
There is no dispute in this case that while Anderson worked for K&C he was not properly registered with the NASD to offer or sell securities. Kunz testified that he knew when K&C became registered that Anderson was not registered. Applicants argue, however, that Andersonnever worked for K&C, and that his clients in any event had purchased VesCor notes before the rescission offer. They further argue that Anderson was only a consultant, and that it was Kunz who solicited and sold the VesCor private placements to Anderson's clients. They contend that the money paid by Kunz to Anderson was a consulting fee, not compensation for soliciting or selling securities.
Applicants' arguments are belied by Kunz's testimony. Kunz admitted that the payments he made to Anderson were amounts that Anderson would have received as commissions for sales of VesCor securities, rather than for consulting work. The fact that Kunz and Anderson termed these payments "consulting fees" is of little moment. As we have noted on more than one occasion, "the NASD's registration requirement `provides an important safeguard in protecting public investors' and, consequently, `strict adherence' to that requirement is `essential.'" In re Patricia H. Smith, Exchange Act Rel. No. 35898 (June 27, 1995), 52 SEC Docket 346 (quoted citations omitted). We find that, by paying Anderson for the sale of securities when Anderson was not registered with the NASD, Kunz acted in a manner inconsistent with high standards of commercial honor and just and equitable principles of trade, in contravention of the requirements of NASD Conduct Rule 2110.53
Applicants argue that the sanctions imposed should be modified and reduced. Section 19(e) of the Securities Exchange Act of 1934 governs our review of sanctions imposed by a self-regulatory organization.54 That provision provides that we shall sustain the sanctions imposed, unless we find they are excessive, oppressive, or impose an unnecessary or inappropriate burden on competition. Applicants' conduct was egregious. They offered and sold securities on the basis of false and misleading disclosures. They failed to investigate the validity and value of the largest single asset appearing in VesCor's financial statements: the Tennessee land asset. They knew that this asset was acquired only four days before the date of the financial statement, and that without this asset VesCor would have shown a negative net worth. They accepted without question VesCor's counsel's statements that there was no need to disclose VesCor's financing of K&C and Southwick's litigation history in the PPMs, despite the fact thatSouthwick was, in effect, the "alter ego" of VesCor. Applicants sold securities that were neither registered with the Commission nor exempt from registration. Kunz also compensated Anderson in connection with securities transactions, despite knowing that Anderson was unregistered.
The NASD censured Kunz and K&C. Kunz was suspended from associating with any NASD member firm in a registered capacity for 30 calendar days and in a principal capacity for one year, to run concurrently. Further, the NASD ordered Kunz to requalify as a representative within 90 days of the conclusion of his suspension as a representative or cease to function in that capacity until he requalified, and to requalify as a principal before functioning in that capacity after conclusion of his suspension as principal. In addition, the NASD ordered K&C to retain an independent consultant. Kunz and K&C were fined $20,000, jointly and severally. Kunz was fined $5,000 individually, and hearing costs of $2,597.20 were imposed jointly and severally. We do not find that the suspensions, the monetary sanctions or the imposition of hearing costs were excessive, oppressive or an undue burden on competition. These sanctions are within the range recommended by the applicable NASD Sanction Guidelines and warranted by the circumstances.
An appropriate order will issue.55
By the Commission (Chairman PITT and Commissioner UNGER).
Jonathan G. Katz
Admin. Proc. File No. 3-9960
In the Matter of the Application of
KEVIN D. KUNZ
KUNZ AND CLINE INVESTMENT MGMT., INC.
For Review of Disciplinary Action Taken by the
NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.
ORDER SUSTAINING DISCIPLINARY ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION
On the basis of the Commission's opinion issued this day, it is
ORDERED that the disciplinary action taken by the National Association of Securities Dealers, Inc. against Kevin D. Kunz and Kunz and Cline Investment Mgmt., Inc., and the Association's assessment of costs, be, and they hereby are, sustained.
By the Commission.
Jonathan G. Katz
|1||15 U.S.C. §§ 77a et seq.|
|2||The NASD found that this conduct violated Rule 2110 of the NASD's Conduct Rules. Rule 2110 provides that "a member, in conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade." This Rule is the successor and virtually identical to Article III, Section 1 of the Rules of Fair Practice, which was in effect in 1994.|
|3|| Each of the three investment vehicles allowed the investor to invest for a period of 30, 45, or 60 months. Investors in the Accrual Notes received interest at 12 percent per annum, accrued monthly. Investors in the Monthly Notes received interest at 10 percent per annum, payable monthly.
VesCor used funds from investors in the MLP Interests to originate or acquire mortgages, with the investor secured by the mortgage in proportion to the percentage of the mortgage financing provided by the investor. The investors' rate of return depended on the rate paid on the underlying mortgage. The PPMs for the MLP Interests stated that the target rate of return was 12 percent. VesCor kept the funds from the sales of MLP Interests in money market accounts until they were allocated to a specific mortgage.
|4||Kunz testified that Val E. Southwick ("Southwick"), the President, Chief Executive Officer, Corporate Secretary, Chairman, and sole member of VesCor's Board of Directors, told him that the Notes and the MLP Interests were simply investments in real estate, not securities. Kunz also testified that, until it distributed the PPMs, VesCor did not provide prospective investors with any financial statements.|
|5||Kunz testified that, from the beginning, one of the purposes for these offerings was to raise additional capital.|
|6||Kunz testified that, when he met Southwick in 1987, Southwick offered him the opportunity to sell VesCor notes that were similar to those at issue. Kunz initiallydeclined because he believed that the notes were "securities" and that such sales would have violated the NASD's selling-away rules because at the time Kunz was working as a general securities representative with a broker-dealer. He discussed the issue with Southwick, who told him that an attorney from Arizona had determined that the notes were not securities. Kunz stated that, although he never reviewed any opinions or any other documents from the Arizona attorney, he decided to accept Southwick's explanation, and sold VesCor securities to one or two clients at that time.|
|7||Kunz testified that the initial intention in forming K&C was that VesCor would control the firm. Kunz and Cline both testified that Southwick expressed the opinion on more than one occasion that, because of the financing provided by VesCor, he expected K&C to be VesCor's captive broker-dealer.|
|8||VesCor did submit "Notice of Sale of Securities Pursuant to Regulation D, Section 4(6), and/or Uniform Limited Offering Exemption" filings with the Commission for the private placement offerings, pursuant to 17 CFR § 230.501 et seq.|
|9||The PPMs stated that Southwick "has effective control of all aspects of the business of the Company," and noted the importance to investors of his background. Although the PPMs issued to Nevada residents contain five paragraphs concerning Southwick's litigation history, none of the PPMs provided to non-Nevada residents contained this information.|
|10||Kunz stated that he relied on VesCor's counsel with respect to the lack of disclosure both of VesCor's financing of K&C and of Southwick's litigation history. With respect to the financing, he stated that, since VesCor's counsel never raised the issue during the drafting of the PPMs, he (Kunz) assumed disclosure was not necessary. Kunz did ask VesCor's counsel whether disclosure of Southwick's litigation history was legally required. He testified that counsel told him inclusion was not required. Kunz did nothing further concerning this issue.|
|11||The purchase was made pursuant to an agreement dated September 26, 1994 ("Agreement"). The Agreement provided that, in addition to issuing stock as payment, VesCor would pay $25,000 in closing costs.|
|12||The terms of the Agreement support Kunz's understanding. The Agreement also granted VesCor call options so that it could repurchase its shares by transferring back the Tennessee Land Grants. These call options cost VesCor $30,000 for the first six month period, with extensions at the rate of $15,000 per calendar quarter for the next 18 months, and then at the rate of $18,000 per quarter thereafter.|
|13|| The record also contains copies of the handwritten Land Grants that were issued in the 1820's by which VesCor claimed ownership of the land. An excerpt from a 1977 book entitled, The Fountain Pen Conspiracy, by Jonathan Kwitny, which is a part of the record, provides a description and historical discussion of Tennessee land grant deeds:
The colony of North Carolina issued the grants to induce settlers to cross the mountains and farm the wilderness. A county postal inspector noted: "The grants gave you 5,000 acres and told you to go find it. They didn't tell you the land was in [a particular] county. There [were] no [counties]. If somebody came along and squatted on it and you didn't chase him out, it was his land." . . . . Somebody hasaccounted for virtually every square foot of . . . the . . . counties in eastern Tennessee. . . . So, conflicting land claims stayed on file over the years, all of them with a degree of legitimacy. The whole of a land grant could remain valid as a title even while every part of the grant was gradually occupied by squatters with better title. . . . Confidence men learned years ago that the real gold in them thar' hills lies in the confusing overlay of deeds. . . . The postal inspector noted further: "Some of this land has been registered twenty-five times. In Jamestown, the tax assessor's own house has been registered four times. They get 45,000 or 50,000 acres of registrations a month [the county contains only 305,000 acres]. And if anybody writes and asks if it's registered, they'll say, `Yes, it's registered.'"
Jonathan Kwitny, The Fountain Pen Conspiracy, pp. 82-83 (1977). This chapter provides numerous examples of famous judicial cases and instances in the twentieth century in which worthless Tennessee land grant deeds were used to pad the portfolios and balance sheets of "fraudulent banks, insurance companies, and other corporations."
|14||Rule 506 under Regulation D provides an exemption for the offer and sale of securities that satisfy all the requirements of Rules 501 and 502, if the offering does not involve more than 35 nonaccreditied investors. Rule 501, in pertinent part, defines an "accredited investor" as a "natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000," or a "person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year. . . ."||Under the NASD By-Laws, as an investment company products/variable contract representative, Anderson was limited to soliciting, purchasing, and selling redeemable securities of companies registered pursuant to the Investment Company Act of 1940, securities of registered closed-end companies during the period of original distribution only, and variable contracts and insurance premium funding programs and other contracts issued by an insurance company (except contracts that are exempt securities pursuant to Section 3(a)(8) of the Securities Act). See Schedule C to the NASD By-Laws, Part II, Section 2(d)(i)(a) and Part III, Section 2(b)(i) and (ii) (currently NASD Membership and Registration Rules 1022(d)(1)(A) and 1032 (b)(1) and (2)). Thus, the Series 6 registration was not adequate to permit Anderson's association with K&C.|
|16||Kunz paid the "consulting fees" to Anderson pursuant to two "Consulting Agreements" with Anderson, one entered into in December 1994 (back-dated to October 1, 1994), and the other dated January 1, 1995. Kunz stated that he entered into these agreements because Anderson could not be registered.|
|17||Applicants do not separately address the misrepresentation and omission issues in their brief on appeal. Instead, as to those issues, they stated that they would rely on the arguments made in their Brief in Reply before the NASD.|
|18||426 U.S. 438 (1976).|
|19||Id. at 449.|
|20||The "materiality of information relating to a company's financial condition, solvency and profitablity is not subject to serious challenge." SEC v. Murphy, 626 F.2d 633, 653 (9th Cir. 1980), cited by us in Charles E. French, 52 S.E.C. 858, 863 n.19 (1996).|
|21||VesCor's financial condition, solvency, and profitability cannot be viewed as insignificant factors with respect to the MLP Interests. The probable future success of the MLP Interests depended on VesCor's ability first, to avoid dissipation of investor money during the period after investment in a given MLP and prior to VesCor purchasing the underlying mortgages for that MLP, and also on VesCor's ability to purchase underlying mortgages at attractive rates during the life of each MLP. Therefore, VesCor's business acumen, as reflected by its historical and continued net loss, was material to a reasonableinvestor. See Leandro Emerg. Med. Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 809 (2d Cir. 1996) ("[M]aterial facts include . . . those facts which affect the probable future of the company.") (quoting SEC v. Texas Gulf Sulphur Co., 401 P.2d 833, 849 (2d Cir. 1968)).|
|22||52 S.E.C. 958, 962 (1996), aff'd in pertinent part, Everest Securities, Inc. v. SEC, 116 F.3d 1235 (8th Cir. 1997).|
|23||We stated further in Everest that "the mere fact that a security may allegedly be exempt from the registration requirements of the Securities Act `does not relieve a dealer of these obligations. On the contrary, it may increase his responsibilities, since neither he nor his customers receive the protection which registration under the Securities Act is designed to provide.'" Id. at n.15, quoting Securities Act Rel. No. 4445, 3 Fed. Sec. L. Rpt. (CCH) ¶ 22,759.|
|24||We held in Everest Securities, Inc., 52 S.E.C. at 963, that broker-dealers are required to "exercise a `high degree of care' in investigating and verifying independently [a company's] representations." In Everest we found that a broker-dealer was reckless in allowing a professional investigator it had hired to ignore "red flags" and rely uncritically upon information provided by an issuer's accountant.|
|25||VesCor acquired the Tennessee land asset only four days before the date of the financial statements.|
|26||Kunz admitted that he knew that VesCor had sizeable net operating losses dating back to 1991 and had acquired the Tennessee land asset to enhance its balance sheet for inclusion in the PPMs. Despite this knowledge, Kunz stated that he never really paid attention to the portion of the financial statements that referred to the Tennessee land asset. In fact, he testified that he did not know that VesCor had exchanged 750 shares of stock for it. He did nothing to investigate the validity of VesCor's financial statements, other than questioning VesCor's counsel whether VesCor had proper title to the Tennessee land, and Southwick about VesCor's losses.|
|27||See Everest Securities, 52 S.E.C. at 958.|
|28||See supra, n. 12.|
|29|| See Hanly v. SEC, 415 F.2d 589 (2d Cir. 1969), where the court found:
A salesman may not rely blindly upon the issuer for information concerning a company[.] (Id. at 597) Brokers and salesmen are under a duty to investigate. . . . Thus, a salesman cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant. (Id. at 595)
|30||See In re Michael A. Niebuhr, 52 S.E.C. 546, 552 (1995).|
|31|| All of the PPMs described Southwick's education and career-related background in real estate lending, including the fact that he began his career in real estate lending with an entity called Summit Systems, Inc. ("Summit"). The non-Nevada PPMs then refer to Southwick's formation of VesCor, and state that, during Southwick's tenure, VesCor's "assets and managed capital base" had increased to more than $18 million and that he had "built associate relations with over 160 institutional and other qualified note buyers which purchase[d] the Company's first trust deeds and notes."
Conspicuously absent in the non-Nevada PPMs is any mention of the fact that, because of his personal guarantees of Summit's obligations, Southwick "had been and continued to be involved in various litigation proceedings, including civil judgments still outstanding in an aggregate original principal amount of $1,830,386.76."
|32||426 U.S. at 449. We have found that nondisclosure of information concerning a person responsible for the success or failure of the enterprise is clearly material. See In re Gallagher & Co., 50 S.E.C. 557 (1991).|
|33||See Markowski v. Securities and Exchange Commission, 34 F.3d 99, 104-105 (2d Cir. 1994).|
|34||Id. at 105. See also C.E. Carlson, Inc. v. SEC, 859 F.2d 1429, 1436 (10th Cir. 1988), citing Sorrell v. SEC, 679 F.2d 1323, 1327 (9th Cir. 1982) and Arthur Lipper Corp. v. SEC, 547 F.2d 171, 181-82 (2d Cir. 1976), cert. denied, 434 U.S. 1009 (1978).|
|35||As we noted in Jacob Wonsover, Exchange Act Rel. No. 41123 (Mar. 1, 1999), 69 SEC Docket 694, 706 "it is not sufficient for [a broker-dealer] merely to accept `self-serving statements of his sellers and their counsel without reasonably exploring the possibility of contrary facts.'"(quoting in part Distribution By Broker-Dealers of Unregistered Securities, Securities Act Rel. No. 4445 (February 2, 1962), aff'd, Wonsover v. SEC, 205 F.3d 408 (D.C. Cir. 2000).|
|36||Markowski, 34 F.3d at 105.|
|37||Sections 4 and 5 of the Securities Act, 15 U.S.C §§ 77d and 77e, provide that a registration statement must be in effect for the sale of a security unless the transaction does not involve a public offering or there is a valid exemption from registration.|
|38||See SEC v. Blazon Corp., 609 F.2d 960, 968 (9th Cir. 1979).|
|39||SEC v. Ralston Purina Co., 346 U.S. 119, 126 (1953).|
|40||17 CFR § 230.506.|
|41||17 CFR § 230.506(b)(ii).|
|42||Even if the offerings were not integrated, the Accrual Notes and the Monthly Notes had 58 and 45 nonaccredited investors, respectively. Therefore, neither of the Notes offerings would be entitled to a Regulation D exemption.|
|43||See Securities Act Rel. No. 4552 (Nov. 6, 1962), 27 Fed. Reg. 11316. See also Rule 502(a) under Regulation D.|
|44|| Each PPM stated:
The Company intends to provide general funding for the operations of the Company's expansion activities with respect to a series of mortgages made or purchased at a discount. The sources of such funds would be the proceeds from the sale of [the subject security] and the sale of [the two other securities] pursuant to simultaneous offering memoranda.
Each of the PPMs also stated that VesCor's "principal business objective . . . in offering [the securities was] to invest the proceeds from the sale of such [securities] in loans secured by first Mortgages on real property."
|45||Applicants' argument ignores the salient fact that the Notes had exactly the same maturity periods.|
|46||Moreover, we note that the Notes each had more than 35 nonaccredited investors.|
|47||See SEC v. Blazon Corp., 609 F.2d 960, 968 (9th Cir. 1979). Although Applicants claim an exemption under Section 4(2), they offer no arguments in support of this claim. The party claiming a private offering exemption from registration has the burden of proving that it is met with respect to each offeree. SEC v. Murphy, 626 F.2d 633, 645 (9th Cir. 1980). Despite Applicants' failure, we address the issue below.|
|48||The United States Supreme Court, in SEC v Ralston Purina Co., 346 U.S. 119 (1953), has provided the framework for private offering analysis for the past 47 years. In Ralston Purina, the Court held that "the applicability of Section 4(2) should turn on whether the particular class of persons affected needs protection of the Act." In SEC v. Murphy, 626 F.2d at 644-45, the 9th Circuit provided the following factors to be considered in determining whether an offering is private: (a) the number of offerees; (b) the sophistication of the offerees; (c) the size and manner of the offering; and (d) the relationship of the offerees to the issuer. See also Mark v. FSC Secs. Corp., 870 F.2d 331 (6th Cir. 1989) for similar factors.|
|49||At least 160 investors invested in the offerings. At least 71 investors purchased the Accrual Notes, 52 investors purchased the Monthly Notes, and 49 investors purchased the MLP Interests. Although Applicants did not present evidence of the exact or approximate number of offerees that were contacted, it is probable that the number of offerees is greater than the listed purchasers. The list of purchasers indicates that they were an unrelated and diverse group who resided in different states. The diversity of the purchasers suggests that the offerees were likewise diverse and unrelated, militating against a "private offering." See Id. at 334 (Failure of a party claiming the exemption tointroduce evidence of the number and type of offerees may be fatal to his or her claim for a Section 4(2) exemption.).|
|50||Each PPM offered up to $6 million worth of securities priced at $5,000 per unit of investment. Such an offering is a significant amount. See, e.g., Murphy, 626 F.2d at 645 (finding a $7.5 million offering to be sizeable and one that should be considered public "absent a showing the investors did not need protection of the Act"). The securities were offered by VesCor, K&C, and, according to Kunz, by at least one other registered broker-dealer. This level of participation seems to be more indicative of a public, rather than a private offering. See Johnston v. Bumba, 764 F. Supp. 1263, 1274 (N.D. Ill. 1991), aff'd, 983 F.2d 1072 (7th Cir. 1992) (Table).|
|51||The Murphy court held that "[a] court may only conclude that the investors do not need the protection of the Act if all the offerees have relationships with the issuer affording them access to or disclosure of the sort of information about the issuer that registration reveals." SEC v. Murphy, 626 F.2d at 647.|
|52||See Eugene T. Ichinose, Jr., 47 S.E.C. 393, 397 n. 14 (1980), citing Management Financial Inc., 46 S.E.C. 226, 234 (1976).|
|53||The NASD dismissed the cause concerning unsuitable recommendations because it could find no clear evidence in the record that Applicants recommended the purchase of the VesCor securities. Applicants argue that we should dismiss the cause on its merits. Under Section 19 of the Securities Exchange Act of 1934, our review of disciplinary actions taken by self-regulatory agencies such as the NASD is limited to review of the disciplinary actions taken, and the findings of fact and application of NASD rules relating to them. Since the NASD dismissed this cause and took no disciplinary action based on it, we have no jurisdiction over this issue.|
|54||15 U.S.C. § 78s(e).|
|55||We have considered all of the contentions advanced by the parties. We have rejected or sustained them to the extent that they are inconsistent or in accord with the views expressed in this opinion.|