The Ninth Circuit Court of Appeals denied a petition for review of an SEC Order upholding fines and sanctions against the firm and three of its employees. The underlying charges were based on alleged violations of Securities Act Sections 5(a) and 5(c). The Court concluded that substantial evidence supported the Commission’s findings and that Petitioners failed to meet their duty of inquiry to claim a Section 4(4) brokers’ exemption. World Trade Financial Corporation v. U.S. Securities and Exchange Commission, No. 12-70681 (9th Cir. Opinion Filed January 16, 2014).
World Trade is a registered broker-dealer and member of FINRA. Petitioners Jason Adams and Rodney Michel were responsible for supervising firm brokers and trading activity. Mr. Michael was responsible for establishing supervisory systems while Mr. Adams handled client accounts and reviewed trading. Petitioner Frank Brickell is a principal of the firm and its CCO.
This action centers on the sales of shares of IStorage, a firm which was the product of a reverse merger between Camryn Information Services, Inc., a public shell company, and IStorage, a development stage firm, in November 2004. At the time of the merger IStorage had four shareholders, each of whom owned 12.5% of the outstanding shares. At the request a law firm representing the shareholders, an opinion letter was issued stating that the shares need not be restricted because, among other things, none of the shareholders had been an officer, director or 10% shareholder of the company for the previous three months. The opinion was incorrect. Nevertheless, the transfer agent removed the legends. A forward stock split followed which gave the three shareholders 5.2 million shares evidenced by certificates that were not restricted.
The shareholders then paid three individuals to promote the stock. Payment was in shares. Each promoter subsequently opened an account at World Trade. From mid-December 2004 through late March 2005 World Trade sold about 2.3 million shares of IStorage stock to the public.
Mr. Brickell, as COO, believed that his role was limited to checking with the transfer agent. Accordingly, he failed to make any inquiry into the status or origins of the shares. Yet at the time IStorage was a little known entity with a short history and had recently undergone a reverse merger and forward split. The stock was thinly traded and the shares had just begun to trade.
Messrs. Michel and Adams also believed that the transfer agent was responsible for investigating the status of the shares. At the time the firm had a Supervisory Manual which listed procedures for the sale of restricted and unregistered stock under a safe harbor provision of Rule 144. The procedures included a list of conditions that needed to be fulfilled. In practice employees of the firm simply checked to see if the certificate had a legend. In any event, Petitioners admitted that neither the transfer agent nor the clearing firm considered itself responsible for conducting any inquiry on behalf of World Trade.
The SEC affirmed the conclusions of FINRA and the NAC that Petitioners violated Section 5 of the Securities Act and NASD Rules 2110 and 3010. The Commission affirmed the fines and sanctions imposed.
The key fact question for the Ninth Circuit was if substantial evidence supported the Commission’s findings of fact. Questions of law were reviewed de novo.
First, Petitioners argued that the broker’s exemption applied here. Petitioners claimed that the SEC carries the burden of demonstrating that the Section 4(4) exemption was “vitiated because of the presence of a statutory underwriter.” This, the Court concluded, is contrary to established law. Public policy strongly supports registration. The Securities Act is designed to promote full disclosure and protect investors. Accordingly, exemptions are narrowly construed against those claiming them. Once FINRA established a prima facie case that the transactions violated Section 5, the burden shifted to Petitioners to demonstrate the applicability of the claimed brokers’ exemption.
Second, it is well established that a broker must conduct a “reasonable inquiry” to claim a Section 4(4) exemption. A broker is not a “mere order taker.” Rather, the broker must conduct an inquiry which may vary in scope depending on the facts and circumstances of the transaction. In some instances the inquiry may be brief while in others a more extensive analysis may be required.
Here, in view of the nature of the entity and the transaction, it is clear that there were numerous red flags which required examination. While the Petitioners claim that they relied on “industry practice” and third parties, they failed to demonstrate such a practice. And, in any event, even if it existed “it would only be suggestive of reasonableness and would not absolve Petitioners of liability under the federal securities laws.”
Third, Petitioners claim that the Commission erred by finding that the firm’s supervisory system was inadequate is also incorrect. NASD Rule 3010 requires member firms to establish, maintain, implement and enforce supervisory systems that are tailored to their business and reasonably designed to achieve compliance. That means doing more than relying on the presence or absence of restrictive legends. This is particularly true here in view of the numerous red flags surrounding the transaction.
Finally, the Court rejected claims that the sanctions were inappropriate. To the contrary they were in the mid-range of FINRA’s sanction guidelines. The evidence supported the fact that the violations were egregious. Accordingly, the petition was denied.