As if FINRA's somewhat terse report even remotely sets forth the context of this case, which wound up before the SEC on appeal. Read this story in Forbes' Street Sweeper column for the details: UPDATE: The Wells Fargo Broker Who Would’nt Give In to FINRA Bar

The Weigh In

The 2004 NASD Hearing Decision

• Alvin W. Gebhart, Jr. was suspended for 12 months in all capacities and fined $100,000.
• Donna T. Gebhart was suspended for 7 months in her capacity as general securities representative and fined $7,500.
• Both Respondents found jointly and severally liable for $5,141.21 in hearing costs.

The 2005 National Adjudicatory Council Decision

Round One: 2006 SEC Opinion

In 2006, the SEC reviewed the Gebharts' appeal of NASD findings and sanctions. In the 2006 SEC Opinion, the SEC held that the Gebharts, registered representatives of member firm of the NASD, had engaged in private securities transactions without giving prior written notification to, or obtaining prior approval from, member; sold unregistered securities; and made material misrepresentations and omissions in the sale of securities. The SEC sustained the NASD's findings of violation. The SEC also sustained NASD's sanctions:

• Alvin Gebhart: Barred
• Donna Gebhart: Fined $15,000 and suspended  for one year. NASD imposed two separate one-year suspensions on D. Gebhart (one year for private securities transactions and sales of unregistered securities and one year for violations of federal and NASD antifraud provisions) that were to be served concurrently.
• NASD also assessed costs against the Gebharts, jointly and severally, in the amount of $5,141.21.

Round Two: 9th Circuit Remand on "scienter" issue

Following appeal to the Ninth Circuit Court of Appeals, that court affirmed the SEC's finding that registered representatives of member firm of registered securities association engaged in private securities transactions without giving prior written notification to, or obtaining prior approval from, member. However, the Circuit Court remanded for further findings on whether representatives violated antifraud provisions with the requisite scienter when they made material misrepresentations and omissions in the sale of securities.

Round Three: SEC's 2008 clarification

Upon remand, the SEC held in a 2008 Opinion that the representatives recklessly made material misrepresentations and omissions, and association's findings of liability. Accordingly the SEC sustained the sanctions imposed.  

Round Four: Case Closed

Thereafter, the Supreme Court of the United States denied a petition following the United States Court of Appeals for the Ninth Circuit’s denial of petition for review.

The Nitty Gritty: Scienter Is Not Mere Negligence

An interesting aspect of this case is the issue of whether "scienter" is satisfied by mere negligence or whether the state of mind requires something more. In responding to this issue, the SEC's 2008 Opinion provides an interesting commentary (pages 15 - 17 of the Opinion):

The Gebharts nevertheless argue that they should not be found liable for fraud because they acted in good faith, and therefore without the requisite state of mind. They contend that, as found by the NASD Hearing Panel, the Gebharts "truly believed that they had fulfilled their responsibilities to assure that MHP and CSG were appropriate investments . . . ." The Hearing Panel decision on this point was overturned by NASD's National Adjudicatory Council ("NAC"), which found that the Gebharts were reckless and concluded that the four factors identified by the Hearing Panel provided "scant reasons for the Gebharts to believe they had fulfilled their duty to investigate." The NAC decision is NASD's final action. 33/

The Court of Appeals in its remand opinion identified subjective and objective components in an analysis of recklessness, and we acknowledge the Gebharts' assertions that they believed they had done enough to confirm the truthfulness of their statements to clients. We consider evidence of good faith to be relevant to a determination of whether a respondent acted with the requisite state of mind. That evidence must be considered with all other evidence of knowledge or recklessness because the reasonableness and, therefore, the credibility of that claim of good faith must be evaluated in light of the circumstances of each case and in light of the conduct expected from a reasonable person.

The Court questioned whether the 2006 Opinion should be interpreted as holding that good faith cannot be a defense to a finding of scienter whenever the evidence indicates that the respondents lacked a "reasonable basis for recommending the [securities], because they failed to discharge [their] duty to investigate before making the recommendations." 34/ The Court seems concerned that our view is that a good faith belief founded on negligent actions satisfies the recklessness prong of scienter. We take this opportunity to reiterate our adherence to the recklessness standard as an extreme departure from the standards of ordinary care and our view that negligence does not qualify as scienter.

Thus, the evidence the Gebharts forward to demonstrate their good faith beliefs is and should be part of the complete mix of facts bearing on an evaluation of their state of mind, but, in the end, a respondent's belief that he acted in good faith must be tested by reference to objective criteria; i.e., the applicable standard of conduct is determined in accordance with the degree to which the respondent had acted extremely unreasonably. A respondent's asserted good faith belief is not plausible if he ignores facts that place him on notice of a risk of misleading clients. The Court in remanding this proceeding recognized this when it said: "When warranted, the SEC is entitled to infer from circumstantial evidence that a defendant must have been cognizant of an extreme and obvious risk and reject as implausible testimony to the contrary." 35/ The Sundstrand court also emphasized the need to refer to external standards when it originally defined recklessness, 36/ and other courts have similarly identified the ultimate importance of objective measures in securities fraud cases. 37/

Unlike the examples given by the Sundstrand court in which the subjective component would preclude liability for objectively reckless misconduct, the Gebharts do not claim that they "genuinely forgot" to disclose material information, i.e., that their statements had no basis in fact. Rather, their claim is that they were not reckless because, even though they knew their representations were based primarily on Archer's assertions and the silence of others, they nonetheless thought that they had done enough. The Gebharts similarly argue that they were truly and completely unaware of the fraud that the principals of MHP were perpetrating, that they were victims themselves of that fraud, and that they therefore lacked scienter. As the Gebharts assert, "It is simply implausible to suggest that the Gebharts knew or suspected that MHP would be unable to repay these loans while, at the same time, loaning it money."

These arguments are insufficient. As discussed above, the Gebharts made no meaningful attempts to confirm the validity of their assertions to clients that the Notes would be fully secured. They made these unsupported representations to clients despite not knowing whether they were true or false and despite having several and varied reasons to doubt the truth of their own statements. Our de novo review of the evidence in this case therefore leads us to conclude that, contrary to the Gebharts' assertions, they must have known when they made their misrepresentations that their actions presented an unacceptable danger of misleading their clients.

Moreover, accepting arguendo that the Gebharts were unaware of MHP's fraud, this does not alter our conclusion: the Gebharts face liability not because they knew of or failed to discover MHP's fraud, but because they made specific representations to clients about the security of the Notes without taking any basic steps to verify the truthfulness of those representations. Even if the Gebharts were unaware of MHP's actual fraud, we conclude that they still must have known of the risk of misleading their clients given their extreme departure from the standards of ordinary care. The Gebharts are legally bound as knowing that the representations were false. 38/