The NASD barred Edward Durante from the securities industry in 1983 for the publication of manipulative/deceptive quotations, unauthorized transactions, and a failure to respond to regulatory inquiries.  Durante’s company Diablo Associates organized, controlled and promoted the Silicon Valley IPO Network (SVIPON), which was a conglomeration of ten companies.

Interbet, Inc. (Interbet), one of ten SVIPON subsidiary companies, was incorporated in 1996 to offer Internet casino gambling but never became operational.  As of April 1997, Interbet still had no revenue, net losses of nearly $200,000, and held only $3,600 in cash.  On June 13, 1997 Interbet entered into a reverse merger with Bio-Chem, Inc., a publicly-held shell that had never generated revenue, had $50,000 in cash raised through the sale of 100,000 shares at 50¢.  Bio-Chem typically traded under $1 on the OTCBB; however, during June 1997 it rose to $6.25 (without any revenues) under the new symbol EBET at $6.25.  By August 28, 1997, the share price had fallen to 25¢ per share.  By September 28, 2001, Interbet, now known as Virtual Gaming, was selling at $.01 per share. 

Okay, now we change the focus of this narrative to the role of Dane S. Faber, a former general securities principal, municipal securities principal, registered options principal, general securities sales supervisor, and general securities representative with SC.  Faber sold Interbet to at least 30 customers.  He knew Interbet was a development stage company and reviewed its marketing materials and business plan; nonetheless, he testified that he didn’t know that Interbet had not engaged in any business, had only 2 full-time employees, and had lost about $200,000 since inception. Faber did not review public filings and was unaware of whether any existed.  He had no recollection of press releases, didn’t do any research about Biochem or Interbet and relied solely upon SC, which said it had done “due diligence” on Interbet.  Faber claimed SC told him that it had retained attorneys to review Interbet and that they were buying shares for themselves.  Faber said he thought Interbet offering was an IPO, unaware of the “reverse merger,” notwithstanding the fact that there was no prospectus or registration statement.  Buffalo , Worley, and Trading Manager David Cave all testified that they knew the offering was a reverse merger --- and Worley said he told that to Faber, who purportedly concurred and said he was “not going to do any of it.”  Cave said that Durante held a meeting at which he told SC’s sales staff that “this is a reverse merger, not an IPO.”

Smith Culver enteres into a relationship with Durante --- BD's President and Head of Bond Trading fired March 1997

Dane S. Faber sells Interbet to at least 30 Smith Culver customers --- claims he thought it was an IPO

Section 10(b) of the Exchange Act makes it unlawful for any person to "use or employ, in connection with the purchase or sale of any security . . ., any manipulative or deceptive device or contrivance in contravention of" the Commission's rules." 15 U.S.C. § 78j(b).

Rule 10b-5 makes it unlawful for any person to "employ any device, scheme, or artifice to defraud" or to "engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." 17 C.F.R. § 240.10b-5.

NASD Conduct Rule 2120 prohibits an NASD member from "effect[ing] any transaction in, or induc[ing] the purchase or sale of, any security by means of any manipulative, deceptive, or other fraudulent device or contrivance."

NASD Conduct Rule 2310 requires that, in making securities transaction recommendations to their customers, registered representatives have reasonable grounds for believing that the recommendations are suitable for their customers based upon the facts, if any, disclosed by their customers as to their other security holdings and their financial situation and needs. Registered representatives are required before effecting any transactions for their customers to make reasonable efforts to obtain information concerning their customers' financial status, tax status, investment objectives, and such other information used or considered to be reasonable by the registered representatives in making recommendations to their customers.

NASD Conduct Rule 2110 requires that registered representatives "observe high standards of commercial honor and just and equitable principles of trade."

A: A fact is material if there is 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 available. See Basic v. Levinson, 485 U.S. 224, 240 (1988) ("materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1570 n.12 (9th Cir. 1990) (information is material if a reasonable investor would consider it important to her decision to do business with a registered representative); SEC v. Rogers, 790 F.2d 1450, 1458 (9th Cir. 1986) (deeming information material if "there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision" (quoting Caravan Mobile Home Sales, Inc. v. Lehman Bros. Kuhn Loeb, Inc., 769 F.2d 561, 565 (9th Cir. 1985)).

A: Faber did not disclose to either McKinzie or Kinney that Interbet was a speculative security and that the company had no operations, had never generated revenue, and had incurred losses. Faber also represented that the Interbet offering was an IPO when it, in fact, resulted from a reverse merger. As a result of Faber's representations, Kinney thought Interbet was engaged in an offering that would raise funds for its operations. These facts would be important to a reasonable investor. Hanly v. SEC, 415 F.2d 589, 595-7 (2d Cir. 1969); SEC v. Hasho, 784 F. Supp. 1059, 1109 (S.D.N.Y. 1992).  

A: The SEC has held that it is inherently fraudulent to predict specific and substantial increases in the price of a speculative security. See, e.g., Steven D. Goodman, Exchange Act Rel. No. 43889 (Jan. 16, 2001), 74 SEC Docket 707, 713; Joseph Barbato, 53 S.E.C. 1259, 1274 (1999); Cortlandt Investing Corp., 44 S.E.C. 45, 50 (1969). The fraud is not ameliorated where the positive prediction about the stock's future performance is cast as opinion or possibility rather than as a guarantee. Hasho, 784 F. Supp. at 1109.

Practice Pointer
1. Don't predict dramatic rises in speculative stocks.

2.  Saying it's just your opinion won't help

A: Scienter may be proven by showing recklessness, which the courts have defined recklessness as "'an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.'" Howard v. Everex Sys., Inc., 228 F.3d 1057, 1063 (9th Cir. 2000); Sunstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977) (quoting Franke v. Midwestern Okla. Dev. Auth., 428 F. Supp. 719, 725 (W.D. Okl. 1976)). Scienter with respect to violations of NASD's antifraud rule may be established by demonstrating intentional or reckless conduct. Tretiak, 79 SEC Docket at 3178; Kevin Eric Shaughnessy, 53 S.E.C. 692, 696 and n.8 (1998).  Notwithstanding, proof of scienter is not required to find a violation of just and equitable principles of trade under NASD Conduct Rule 2110. Jack H. Stein, Exchange Act Rel. No. 47335 (Feb. 10, 2003), 79 SEC Docket 2276, 2286 n.31; DWS Sec. Corp., 51 S.E.C. 814, 821 n.28 (1993).

Scienter is satisfied by a showing of recklessness

Q. But what about when the customer says "okay," and agrees to the recommendation --- doesn't that end the issue of suitability?

A: No, a recommendation is not suitable merely because the customer acquiesces in the recommendation. Rather, the recommendation must be consistent with the customer's financial situation and needs. Stein, 79 SEC Docket at 2280; Howard, 78 SEC Docket at 430; Gordon Scott Venters, 51 S.E.C. 292, 295 n.8 (1993).

Just because the customer says "okay," doesn't make a recommendation suitable 

Faber's recommendation of Interbet stock to McKinzie was unsuitable. McKinzie was an inexperienced investor who previously had invested only in CDs and savings accounts. Faber knew that she had a modest income and net worth and was investing for her retirement. When she opened her account at SC, she instructed Faber to increase her retirement savings through the purchase of bonds. Because of her limited means and net worth, she could not afford the loss of substantially all of the assets she had invested in her account with Faber. All of these factors demanded an investment strategy that limited risk. See Chase, 79 SEC Docket at 2897; Guevara, 72 SEC Docket at 1287-88.  Instead, Faber recommended that McKinzie purchase approximately $52,000 of Interbet shares. These funds constituted nearly all of her SC portfolio and more than two-thirds of her total liquid assets. Interbet had no revenues and had never showed any profits. Moreover, Faber recommended that McKinzie concentrate her entire portfolio at SC in one speculative security. This concentration created a substantial risk that McKinzie could lose all, or virtually all, of her account balance. We have repeatedly found that high concentration of investments in one or a limited number of speculative securities is not suitable for investors seeking limited risk. Chase, 79 SEC Docket at 2897 (respondent violating NASD's suitability rule by recommending that his customer purchase shares in a highly speculative unprofitable start-up company until her entire portfolio comprised this one investment); Stephen Thorlief Rangen, 52 S.E.C. 1304, 1308 (1997) (respondent violated New York Stock Exchange rule requiring adherence to just and equitable principles of trade by recommending transactions so that, in one instance, one customer's entire net worth was invested in a single stock, and in another, 80 percent of the equity in a customer's account was concentrated in one stock); Venters, 51 S.E.C. at 293 (respondent violated NASD's suitability rule by recommending that a 75 year-old widow with no more than $35,000 net worth invest $2,300 in a company that was losing money, had never paid a dividend, and whose prospects were totally speculative).

What the regulators will look for:
1. Customer's experience, income, and net worth

2.  Customer's risk tolerance (focus on liquid net worth)

3. Portfolio concentration and diversification