FRAUD AND SCIENTER
Every so often the Securities and Exchange Commission (SEC)
issues a decision that lays it all out in plain English. Recently, the SEC published
its decision In the Matter of Alfred M. Bauer and J. Stephen Stout , which examined
limited partnership and mutual fund fraudulent sales practices. In detailing her findings,
the SEC Administrative Law Judge (ALJ) prepared an unusually clear and instructive
decision offering insight into the mechanics of how a regulatory case is developed,
analyzed, argued, and decided. RRs would be well-advised to read this educational
decision.
The ALJ determined that from at least June 1991 through at
least April 1992, Stout :
- recommended and sold certain securities, including securities
purchased on margin, to customers for whom such investments were not suitable in light of
their age, financial condition and conservative investment objectives;
- prepared and delivered reports to at least one customer that
materially overstated the value of the investments sold, thus inducing the customer to
make subsequent purchases of securities that were at least partially based on these false
valuations; and
- made, in at least one customer’s account, unauthorized
purchases of securities, including purchases on margin.
Prior to June 28, 1991, Stout sold limited partnerships to
all the accounts at issue in this proceeding, and the limited partnerships remained in the
accounts thereafter. By July 1991, the ALJ determined that Stout knew that the illiquid,
speculative, limited partnerships were questionable investments. Beginning in the summer
of 1991, Stout sold his customers high commission mutual funds. Stout has been the subject
of sixty-three customer complaints; most concerned Prudential or PaineWebber limited
partnerships but some included allegations such as misrepresentation, unauthorized
trading, and unsuitable recommendations. Prudential and Stout were defendants in a class
action that arose out of the offer and sale of limited partnerships collectively known as
the VMS Funds (later known as the Banyan Funds). Both Prudential and PaineWebber
entered into multi-million dollar settlements with the Commission pertaining to their
conduct in the offer and sale of limited partnerships.
SEC ANTIFRAUD PROVISIONS
The SEC charged Stout with violating Section 17(a) of the
Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
These two Sections are the dynamic duo of federal securities industry fraud cases and when
coupled with Rule 10b-5 are better known as the "antifraud provisions."
Section 17(a) of the Securities
Act make it unlawful "in the offer or sale of" securities, by jurisdictional
means, to:
employ any device, scheme, or artifice to defraud,
obtain money or property by means of any untrue statement of a
material fact or any omission to state a material fact necessary to make the statement
made not misleading, or
engage in any transaction, practice, or course of business
which operates or would operate as a fraud or deceit upon the purchaser.
Section 10(b) of the Exchange Act and Rule 10b-5
thereunder proscribe similar practices "in connection with" the purchase or sale
of securities. |
SCIENTER
In order to prove violations of 17(a)(1) and 10(b), the SEC
needs to establish that respondents acted with scienter. Now this latin word is the
source of much confusion within the brokerage industry. Most RRs wrongly believe that the
SEC must prove that you knew what you were doing at the time was criminal.
Scienteris
an arcane concept that lawyers have difficulty grasping and even more trouble
explaining to a client. The United States Supreme Court defined scienter as "a mental state embracing intent to deceive, manipulate, or defraud."
More plainly, if an RR knows what he intends to do is wrong and does it, he has acted with
scienter.
But now let's consider a variation on the theme. An RR
intends to engage in a sales practice that she personally doesn't believe is wrong.
Nonetheless, if we were to assemble a number of reasonable persons and ask their opinion,
they would differ. In fact, these reasonable jurors would conclude that the RR's
conduct was highly unreasonableand represents an
extreme departure from the standards of ordinary care.
Federal courts describe such conduct as being reckless
and deem it sufficient to satisfy the requirement of scienter.
So you may be found guilty of securities fraud if you knew
what you were doing was wrong or if you were reckless in not knowing. Consequently,
the myth that the SEC must prove that you intended to commit a crime is wrong.
First, the proof necessary is not that you intended to commit a crime, but a
lesser burden of an intent to do wrong. Second, the prosecutors need not prove that
you knew your conduct was wrong, but may demonstrate that even if you claim you didn't
know the error of your ways that such a belief was highly unreasonable, i.e., reckless.
| Scienter is not required to
establish a Section 17(a)(2) violation; a finding of the lesser standard of negligence. |
STILL NOT CONFUSED? TRY THIS
Be careful not to confuse scienter with wilful.When one is charged with a securities
industry violation involving a showing of wilful conduct, such a finding does not require
proving an intent to commit a wrong (scienter) but merely an intent to commit an
act. Sounds like a lot of mumbo jumbo? Well, think of it this way: scienterinvolves
some responsibility to know what you're doing is wrong; wilful merely consists of intending to do what you subsequently did.
Let's take the following example. You're given a lead
card for Mr. John Doe and you call him. You obtain an order from Mr. Doe for the
purchase of 100 shares of XYZ. Among the questions you ask Mr. Doe is whether he is
over 18 years of age. It turns out that Mr. Doe is only 14. Did you telephone
Mr. Doe with the intent to defraud a minor into giving you an order to buy XYZ? No,
and therefore you likely would not be found to have acted with scienter. Was your
reliance upon Mr. Doe's express statement that he was over 18 years of age reckless?
No, because it would likely not be considered highly unreasonable or an extreme
departure from standards of ordinary care for you to have relied upon the express
representation. Finally, did you wilfully telephone Mr. Doe? Yes, because you
intended to make the call at issue.
SCIENTER AND STOUT
The ALJ concluded that because Stout's intent was to
deceive and defraud he acted with the requisite scienter to sustain a violation
of 17(a) and 10(b). First, the ALJ determined that Stout
- directly benefited from the breakpoint violations, short-term
trading in mutual funds, and churning;
- understood the costs of a short-term trading strategy, which
increased commissions;
- knew his recommendations were unsuitable and contrary to his
customers’ investment objectives;
- utilized false valuations; and
- engaged in unauthorized and unsuitable trading.
When the mix of factors above is weighed, the ALJ was
compelled to the conclusion that Stout acted with scienter. Notably the ALJ
believed that Stout knew the valuations he provided materially overstated the values
of the limited partnerships. In the alternative, the ALJ also believed that Stout was reckless
in not knowing the valuations materially overstated the worth of the limited partnerships.
The ALJ also noted that Stout's use of margin trading in accounts with conservative
objectives without discussing it with the investors also shows an intent to deceive
them.The ALJ believed that the commissions that resulted from Stout's actions provided a
motive, and that by lulling clients with misleading valuations of limited partnerships, he
was able to prolong his misconduct.
Next installment: What's Really Involved in
Churning
For Further Reference:
In the Matter of Alfred M. Bauer and J. Stephen Stout, Initial Decision 134, Admin. Proc. 3-9034 (January 7, 1999).
In the Matter Alfred M. Bauer and J. Stephen Stout, Order Making Findings and Imposing Remedial Sanctions, 63 SEC Docket 0040 (Oct. 15, 1996).
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