If you’re the SEC’s Enforcement Division, suing primary violators is one thing. Bring cases against “gatekeepers”, or professionals who allow access to securities markets, can be quite another. Theories of liability are not always obvious, and often involve searches for evidence of “red flags” that should have been caught before a fraud was allowed to happen.
But the SEC brought such a case last month when it sued ten former brokers at Albany, N.Y.-based McGinn Smith & Co., the firm at the center of an $80 million investment scheme that was exposed in 2010. The principals there, Timothy McGinn and David L. Smith, raised roughly $120 million from investors in more than 25 unregistered debt offerings, allegedly misrepresenting the returns these investments would generate all the while. The SEC alleged that McGinn and Smith knew it would never be possible to repay investors their principal, let alone the quarterly interest payments promised. Instead, they allegedly misused offering proceeds to support their financially troubled entities, to make payroll for MS & Co., and naturally – for procuring strippers for a “sexually themed” cruise. For their efforts, McGinn and Smith are currently serving time in federal prison, though the SEC’s case has not been resolved.
Three years later, the SEC caught up with the McGinn Smith brokers who sold these notes. According to the SEC’s administrative order, the brokers should have conducted a searching inquiry prior to recommending the products to their customers. The brokers allegedly continued to sell McGinn Smith notes even after being told that customers placed in some of the firm’s offerings could only be redeemed if a replacement customer was found, though the offering documents said otherwise. In January 2008, the brokers learned that four earlier offerings that raised almost $90 million had defaulted, but they failed to conduct any inquiry into subsequent offerings and continued to recommend McGinn Smith notes.
The SEC has charged all ten brokers with violating Sections 5 and 17(a) of the Securities Act and Section 10(b) of the Exchange Act. Anthony Guzzetti, the managing director of McGinn Smith’s private client group, was also charged under Section 15(b) of the Exchange Act with failing to supervise the other nine.
As New York Regional Office Director Andrew Calamari put it in the press release, “As securities professionals, these brokers had an important duty to determine whether the securities they recommended to customers were suitable, especially when red flags were apparent.” Without my weighing in on the merits of the SEC’s allegations, Calamari is right. SEC v. Hasho, 784 F. Supp. 1059, 1107 (S.D.N.Y. 1992), is my go-to case on this topic. There we learn:
Securities dealers owe a special duty of fair dealing to their clients. Charles Hughes & Co. v. SEC, 139 F.2d 434, 437 (2d Cir. 1943). By making a recommendation, a securities dealer implicitly represents to a buyer of securities that he has an adequate basis for the recammendation. Hanly v. SEC, 415 F.2d 589, 597 (2d Cir. 1969). The Second Circuit has held that “brokers and salesman 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. He must analyze sales literature and must not blindly accept recommendation made therein.” Id. at 595-96. By his recommendation, a registered representative “implies that a reasonable investigation has been made and that his recommendation rests on the conclusions based on such investigation.” Id. at 597. Although the degree of independent investigation which must be made by a securities dealer will vary in each case, securities issued by smaller companies of recent origin obviously require thorough investigation.
The text goes on. Registered representatives who deal in thinly traded and little-known securities ought to keep a copy of it by their desks. It could help when the SEC comes looking for its next batch of gatekeepers.