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2004
CASE ANALYSIS

In the Matter of the Application of ANTHONY H. BARKATE For Review of Disciplinary Action Taken by NASD
Securities Exchange Act of 1934 Release No.
49542, April 8, 2004

http://www.sec.gov/litigation/opinions/34-49542.htm

 A Little Background

Anthony H. "Andy" Barkate, formerly a general securities principal with Securities Service Network, Inc. ("SSN"), a member of NASD, appeals from NASD disciplinary action. NASD found that Barkate failed to inform SSN of approximately 93 private securities transactions, in which he sold $6.8 million worth of instruments and received $400,144 in selling compensation from an outside source. The investors to whom Barkate sold those instruments incurred substantial losses.  Barkate has admitted violating NASD Conduct Rule 3040 but on appeal to the SEC contends that the bar imposed by the NASD is excessive in light of certain factors that, he contends, mitigate his actions.  

NASD Conduct Rule 3040 prohibits any person associated with a member from participating in any manner in a private securities transaction outside the regular course or scope of such association unless that person provides prior written notice to the member. The notice must describe in detail the proposed transaction and the person's proposed role therein and state whether the associated person has received or may receive selling compensation in connection with the transaction.

Conduct Rule 2110 requires that members and associated persons "observe high standards of commercial honor and just and equitable principles of trade."

Is this double dipping?  No, courts have held that a violation of one NASD rule can constitute a violation of just and equitable principles of trade. Sirianni v. SEC, 677 F.2d 1284, 1288 (9th Cir. 1982) (ruling that failure to provide notice of private securities transactions was inconsistent with just and equitable principles of trade); Stephen J. Gluckman, Securities Exchange Act Rel. No. 41628 (July 20, 1999), 70 SEC Docket 418, 428 (finding that failure to provide notice of private securities transactions was inconsistent with just and equitable principles of trade).

From June 1996 until sometime in 2002, Barkate was the president and the general securities principal of former NASD member firm California Financial Network, Inc. ("CFN"). From June 1997 to April 1999, Barkate was also associated with SSN as a general securities principal. 

On September 4, 1997, Barkate executed a registered representative agreement with SSN authorizing him to operate his CFN office as an office of supervisory jurisdiction ("OSJ") for SSN. The agreement expressly prohibited Barkate from offering or selling any security to any purchaser without the written approval of SSN, and required him to disclose in writing to SSN all his sources of outside income. On September 18, 1997, Barkate sent to SSN an outside business activity disclosure form disclosing his outside insurance and advisory activities, which were subsequently approved by SSN. Barkate also received a copy of SSN's compliance and operations manual, which specifically prohibited the receipt of commissions from any source other than SSN in connection with any transaction without SSN's prior written consent: "[t]here are products represented as 'non-securities' that in fact are really 'non-registered securities' in violation of state and/or regulatory requirements. . . . If there is any doubt at all, please contact the Home Office promptly."   

The Financial Instruments at Issue

Around March 1998, an acquaintance of Barkate introduced him to the financial instruments offered by TLC Investments & Trade Co. ("TLC"). 

In May 1998, Barkate attended an annual SSN compliance seminar conducted by Darla Goodrich, the head of SSN's compliance department, during which she discussed SSN's prohibition against selling away and private securities transactions. Goodrich testified that she was particularly vocal about SSN's policy against selling away, and communicated that prohibition to SSN representatives through newsletters, notifications, memoranda, compliance letters, and seminars. In her view, it was "common knowledge" among SSN representatives that no one was permitted to sell any product without prior written notice to SSN and without SSN's approval.  

On June 11, 1998, Barkate received another compliance presentation as part of SSN's routine annual audit of his OSJ. Barkate did not mention TLC instruments to SSN officials on either occasion. 

From July 1, 1998 through March 29, 1999, Barkate sold instruments of TLC and its related entities.  At least one-third of the approximately 93 customers to whom Barkate sold the TLC instruments were SSN clients, and he used SSN facilities for his activities. Barkate testified that the TLC instruments were extremely important to him because he derived approximately 50% of his income from their sale. The TLC instruments included a promissory note identifying, among other things, the dollar amount and terms of the investment, and a separate investment agreement. The TLC promissory notes and investment agreements purportedly provided investors with tax lien certificates that represented the right to collect delinquent taxes on real property. TLC represented that these instruments would be secured by an interest in real property, which would be held by the investor and TLC as tenants-in-common. For a minimum $20,000 investment, TLC would guarantee a 10-12% annual rate of return to the investor.  These representations were unfounded, for TLC was engaged in a nationwide Ponzi scheme.  

On October 30, 2000, the United States District Court for the Central District of California issued an injunction against TLC and appointed a permanent receiver for TLC.

How the BD Learned of the Activity

On March 31, 1999, Barkate submitted a proposed CFN website to SSN for approval. The website advertised "10 to 12% 1 Year Guaranteed Tax Lien Certificates" and described a tax lien certificate as an "investment." The website claimed "Securities offered through Security Service Network, Inc. Member NASD/SIPC." When David Bellaire, SSN's in-house counsel, saw the proposed website, he searched Barkate's SSN file for information about the tax lien certificates because he feared they might be fraudulent. Bellaire testified that he was unable to find any disclosure of Barkate's involvement with TLC in the file. On April 1, 1999, SSN sent Bellaire to Barkate's SSN branch office to conduct an unannounced audit. During the audit, Bellaire found TLC sales awards, TLC brochures, and files relating to TLC sales in Barkate's office. Bellaire testified that Barkate admitted that he had not disclosed his TLC involvement to SSN and had failed to discuss the tax lien certificates with SSN's compliance department because he was concerned that SSN would not approve the activity. During the audit, no one at CFN provided Bellaire with any documents disclosing Barkate's TLC activities, nor did anyone claim that notice of Barkate's involvement with TLC had previously been provided to SSN. Within 10 days after the surprise audit, Barkate provided SSN with three forms disclosing his and two subordinates' TLC activities. On April 1, 1999, after Bellaire concluded his unannounced audit, SSN ordered Barkate to "cease and desist" from selling the TLC instruments and subsequently terminated his employment on April 12, 1999. 

Mitigation?

In making the determination regarding sanctions for violation of Conduct Rule 3040, NASD guidelines recommend consideration of several factors, including: 

  • whether respondent created the impression that his employer sanctioned the activity at issue; 
  • whether respondent sold away to customers of his employer; and 
  • whether respondent sold the product directly to customers. 

Barkate created the impression that SSN sanctioned the sale of TLC instruments because he

  • sold the TLC instruments from his office, which was an OSJ for SSN,

  • kept TLC marketing materials, sales awards, and files in that office, and

  • personally offered and sold the TLC instruments to his existing customers, many of whom were also SSN clients. 

Barkate, however, asserts that several factors mitigate his conduct. Although he stipulated during the NASD hearing that the TLC instruments that he sold were securities; on appeal to the SEC he asserted that he reasonably believed that the TLC instruments were not securities. 

The SEC noted that Section 3(a)(10) of the Securities Exchange Act of 1934 defines the term "security" to include "any note . . . or . . . investment contract.' and, more pointedly, that a a United States District Court concluded that the TLC investment contracts at issue are securities.  In concurrence with the court's conclusion, the SEC found that the TLC instruments represented an investment in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial efforts of others. Investors expended a minimum of $20,000 for each TLC investment contract with the expectation of profits to be derived from the rate of return "guaranteed" by TLC through its efforts to purchase and liquidate real property or acquire tax liens thereon. 

Moreover, the SEC concurred with the NASD's finding that these instruments are notes within the meaning of Exchange Act Section 3(a)(10) because they evidenced the four characteristics of a security identified in Reves v. Ernst & Young, 494 U.S. 56, 66-67 (1990). In Reves, the Supreme Court adopted a "family resemblance" test under which a note is presumed to be a security unless (1) an examination of the note, based on four factors identified by the Court, demonstrates that the note bears a strong resemblance to certain types of notes falling outside the category of a security, or (2) based on the same four factors, the note should be added to the list of non-securities.  

The 4 Point Reves Test

  1. The TLC instruments paid a high rate of interest. 
  2. They were widely distributed throughout the United States. 
  3. The instruments on their face and marketing materials used in selling them identified the instruments as investments, and 
  4. no other scheme of regulation is applicable. 

Barkate received the SSN compliance and operations manual which warned against selling away, noted that instruments that did not appear to be securities could be, and directed each registered representative to contact SSN before selling any instrument not approved by SSN. If Barkate had any doubt as to the status of the promissory notes, he could have contacted SSN's compliance department. Barkate admitted that he never consulted SSN regarding the status of the TLC instruments. 

Barkate also claims that he relied on a legal opinion prepared by TLC outside counsel declaring that the TLC instruments were not securities.  However, TLC's outside counsel represented TLC, not Barkate.  The SEC warns that a registered representative cannot rely on issuer's counsel to determine whether or not an instrument is a security.  

Barkate testified that he contacted TLC outside counsel's office to verify that he was in fact an attorney. Barkate did not speak to TLC's outside counsel, nor did he hire his own independent counsel before proceeding with the TLC transactions. Barkate failed to satisfy his burden of showing that he is not liable because he relied on the advice of counsel. The "advice of counsel" defense does not help Barkate here because he has not met any of its requirements. Contacting the office of an attorney who represents another party, as Barkate did, does not constitute advice of counsel. 

The "advice of counsel" defense requires that the applicant 

(1) make a complete disclosure to the attorney of the intended action, 

(2) request the attorney's advice of the legality of the intended action, 

(3) receive counsel's advice that the conduct would be legal, and 

(4) rely in good faith on that advice. 

See Michael F. Flannigan, Exchange Act Rel. No. 47142 (Jan. 8, 2003), 79 SEC Docket 1132, 1143 n.25; William H. Gerhauser, 53 S.E.C. 933, 943 n.25 (1998); Markowski v. SEC, 34 F.3d 99, 105 (2d Cir. 1994). Compare Arthur Lipper Corp. v. SEC, 547 F.2d 171, 182 (2d Cir. 1976) (stating that company counsel's primary concern lay in promoting the company's interest by assisting an executive vice-president and director of the company instead of petitioners). 

Barkate claims that he provided written disclosure of his TLC involvement to SSN on August 21, 1998, in accordance with NASD Conduct Rule 3030.  Barkate insists that he submitted an outside business form to SSN, along with supporting materials, notifying SSN of his TLC activities, and that the packing slip relating to that package shows the listing for the outside business disclosure form checked off as received by SSN. Barkate admitted that he did not update his Form U-4 to reflect his outside business activities with TLC.

The record supports NASD's finding that SSN did not receive Barkate's disclosure form in August 1998. Bellaire testified that Barkate did not disclose to SSN any association with TLC through an outside business disclosure form until several days after Bellaire's surprise audit of Barkate's SSN branch office. When Bellaire saw Barkate's proposed website on March 31, 1999, Bellaire immediately checked Barkate's file at SSN but did not find any disclosure of Barkate's TLC involvement, which would have been documented in that file. Bellaire testified that, during his unannounced audit, neither Barkate nor any CFN employee provided him with any documents disclosing Barkate's TLC involvement. Goodrich, head of SSN's compliance department during the relevant period, testified that she did not recall receiving any disclosure form from Barkate relating to TLC. Jeffrey Currey, an SSN compliance manager, testified that he did not recall receiving any disclosure forms from Barkate regarding TLC, tax liens, or promissory notes. While Barkate notes that he and two CFN employees, Cassandra Woodward and Dianna Jones, testified that a package containing the disclosure form was mailed on August 21, 1998, the NASD Hearing Panel credited the testimony of Bellaire, Goodrich, and Currey. The Hearing Panel determined that Barkate did not file the disclosure form as he claimed. The Hearing Panel also found that, in the NASD proceeding, Barkate fabricated an exhibit purportedly containing the disclosure form and TLC documents that Barkate allegedly sent to SSN on August 21, 1998.

Barkate claims that the majority of his TLC customers remain his customers and, to date, have recouped some of their investments from the TLC receiver. Under questioning by the Hearing Panel, however, Barkate recanted his estimate that investors were receiving 50% of the funds they invested and admitted that they were recouping less than 14%. In addition, Barkate admitted that he had been the subject of several lawsuits stemming from his sale of the TLC instruments. 

The SEC concluded that none of the factors argued by Barkate mitigated his conduct. Worse, the SEC agreed with NASD that other factors increase the seriousness of  conduct. These aggravating factors included 

  • the extended period - - approximately nine months - - over which Barkate's violations occurred, 

  • his numerous acts of misconduct that resulted in almost 100 TLC transactions, 

  • the $6.8 million in sales that Barkate generated, 

  • the substantial losses incurred by the investors to whom he sold TLC instruments, and

  • NASD also observed Barkate's lack of candor during his testimony and his failure to show remorse for his repeated violations. 

Ultimately, the SEC found that Barkate used SSN facilities to sell TLC instruments (often to SSN customers), engaged in private securities transactions without SSN's prior knowledge or approval, and participated in such transactions even though he knew that SSN prohibited all selling away. He personally engaged in numerous sales that resulted in substantial commissions to him and substantial losses to his customers. The SEC reiterated that if views selling away as a serious violation, and NASD Conduct Rule 3040 is designed not only to protect investors from unmonitored sales, but also to protect securities firms from loss and liability in connection with sales made by persons associated with them. Such misconduct deprives investors of a brokerage firm's oversight, due diligence, and supervision, protections investors have a right to expect. 

 The Verdict

The SEC sustained NASD's imposition of a bar and costs. 



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