LexisNexis Corporate & Securities Law Community 2011 Top 50 Blogs

Bon mots

"You can observe a lot just by watching." Yogi Berra

"We do not distain to borrow wit or wisdom from any man who is capable of lending us either." Henry Fielding, Tom Jones

"In our complex society the accountant's certificate and the lawyer's opinion can be instruments for inflicting pecuniary loss more potent than the chisel or the crowbar." United States v. Benjamin, 328 F.2d 854, 862 (2d Cir. 1964)

Donner Corporation International et. al., Exchange Act Rel. 55313 (February 20, 2007)

Broker dealer research reports, Appeal of NASD action

Days between appeal and decision – 10 months, 8 days.
Days between last brief and decision – 8 months.
Pages – 32


This is a significant opinion that reiterates several critical points concerning the duties of broker-dealers as to research reports. The conduct here was egregious and involved canned issuer paid for glowing research reports on speculative stocks where there was no disclosure of the payments. The reports omitted various negatives concerning the companies including going concern qualifications, financial distress and other significant facts. Research reports must contain an "accurate picture of the risks associated with the issuers" and may not only contain positive information, particularly when the issuers are struggling or are startups. Negative information contained in public filings by issuers must not be omitted.

The defense argument that an auditor's going concern qualification need not be disclosed because it is merely an opinion wins points for creativity. Unfortunately audits themselves result only in opinions so obviously the argument fails.

Key points

  • Inculpatory investigative testimony by a respondent given closer in time to the events at issue should be given greater weight that contradictory trial testimony.
  • The "in connection" requirement of Section 10(b) is met by a false research report. "Where the fraud alleged involves public dissemination in a document such as a press release, annual report, investment prospectus or other such document on which an investor would presumably rely, the 'in connection with' requirement is generally met by proof of the means of dissemination and the materiality of the misrepresentation or omission." SEC v. Rana Research, Inc., 8 F.3d 1358, 1362 (9th Cir. 1993). The requirement is also satisfied when a statement is made "in a manner reasonably calculated to influence the investing public." Orlando Joseph Jett, Securities Act Rel. No. 8395 (Mar. 5, 2004), 82 SEC Docket 1211, 1250-51 n. 37 (citing SEC v. Texas Gulf Sulphur Co., 401 F.3d 833, 862 (2d Cir. 1968)).
  • "[T]he materiality of information relating to financial condition, solvency and profitability is not subject to serious challenge." "Material facts include . . . those facts which affect the probable future of a company and which may affect the desires of investors to buy, sell, or hold the company's securities.
  • "While there was not necessarily a duty to disclose the issuer's complete financial information in research reports, where the research reports disclosed selected "positive" financial information, there was a duty to disclose all material information.
  • Recommending stock as a "speculative buy" did not relieve the publisher of research reports of the duty to make full and accurate disclosures of all material information.The incomplete nature of research reports was not ameliorated by any duty of investors to read public filings by issuers because the research reports themselves were required to "convey a complete and accurate picture and could not depend on other information available to investors."
  • When a securities recommendation is made to a customer, full disclosure must be made of all material facts. A broker may not satisfy that obligation by pointing to bits and pieces of information that appeared in the media or elsewhere and were never brought to the customer's attention.
  • "Disclosure of a "going concern" qualification of financial statements may not be omitted on the ground that such qualification is merely "opinion."
  • Failure of the NASD to take action following an examination of the firm does not exonerate the respondents.
  • Reduction in sanctions is not warranted because there was no evidence in the record that investors purchased any stock in reliance on the research reports.

Appeal by former member firm (Donner Corp.), firm's president (Baclet) and two registered representatives (Uberti and Runyon). The NASD found that Donner, Baclet, and Uberti violated Section 10(b) and NASD rules by preparing and disseminating twenty-five research reports. It found that Uberti and Runyon violated those same provisions in connection with an additional two research reports. In addition the NASD found that Danner, Baclet, and Uberti violated Securities Act Section 17(b) because they received undisclosed compensation for preparing the research reports. Finally, Donner and Baclet were found to have failed to have adequate supervisory procedures and failed to document Donner's approval of research reports by a principal of the firm. Donner was expelled, Baclet and Uberti were barred and Runyon was suspended for six months. Runyon was fined $20,000 and ordered to requalify as a principal.

Donner distributed research reports on low priced stocks for compensation. Such reports were 70 percent of Donner's revenue. Sometimes, Donner received additional compensation in the form of stock of the issuer if the stock reached a target price after the research was issued. Many of the reports recommended the stocks as a speculative or strong buy. None of the research reports disclosed the compensation. The sole relevant disclosure was that Donner may provide investment banking services to the issuer. Sometimes the research reports disclosed that Donner may receive "a fee" for those services. The research reports were drafted by an "independent contractor" hired by Donner. The contractor had no previous experience as a securities analyst and worked full time at an orthodontics manufacturer. He was paid $100 per report. He was given no training by Donner. Donner told him to follow a "template" drafted by Donner that Baclet knew was "generally positive" and opined that the company was highly undervalued and was poised to become a "major player." The contractor obtained information for his drafts from public sources available on the internet, but made no attempt to verify the information he obtained.

Uberti was the contractor's primary contact at Donner. Although he reviewed the drafts, he claimed he had no "compliance" responsibility for the reports despite the fact that he admitted it was his obligation to determine if the drafts had inaccurate information. Baclet admitted that he reviewed a substantial number of the reports. Virtually all the company's public filings contained "going concern" qualifications to the financial statements that were not reported in Donner's optimistic research reports. Other highly important negative information was also included in the public filings that was omitted from the research, including inadequate working capital, cash flow deficiencies, and loan defaults. Baclet was responsible, according to Donner's written supervisory procedures, for review of research reports. He admitted that in reviewing the research reports, he did not compare them to the public filings of the issuers. Indeed, he admitted that at the time of the evidentiary hearing that he had only read a small number of the reports.

Compliance officers at the firm were not licensed with the NASD and did not review the reports. In 2001 Uberti and Runyon left Donner and formed an unregistered firm that also prepared research reports. They jointly prepared research reports on behalf of this firm. They too hired the same contractor to prepare research reports. These reports were similar to those distributed by Donner and ignored negative information contained in public filings by the issuers.

The misrepresentations in the research reports were clearly material. The fact that the company continued in business after the date of the going concern qualification does not render the qualification immaterial. The fact that Form 8-K disclosure is not triggered by a going concern qualification does not render such qualification immaterial. Form 8-K does not purport to define the universe of material facts that require disclosure.

Baclet's scienter is established by his contracting with an unqualified contractor, his responsibility as principal of Donner to review the research, staffing of the compliance and legal departments with unqualified or inexperienced staff, failure to compare the research reports with public filings by the issuers and knowledge that Donner was paid by the issuers to publish positive research reports. Because he did not review the final reports, he had no basis to believe that the research presented an "accurate picture of the risks associated with the issuers."

Uberti's scienter is established by his knowledge that public filings he reviewed contained negative information about the issuers that was not included in the research. He reviewed the research reports and knew of the omissions. Uberti could not rely on Baclet or the compliance and legal staff because he had actual knowledge of the falsity of the research reports. He had no knowledge of the type of review that Baclet, legal and compliance conducted. The record established that Uberti had substantial responsibility for writing the final reports.

Runyon together with Uberti reviewed and authorized all the research reports issued by the firm they formed after they left Donner. Each had actual knowledge of the negative information in public filings by the issuers that was not included in the research reports.

Securities Act Section 17(b) was violated where there was no disclosure of the full amount of actual compensation paid by the issuers for the research. Disclosure that the broker-dealer "may" contract for investment banking services with the issuer and sporadic disclosure that such services might be in the form of a "fee" did not comply with Section 17(b). The reports were prepared for compensation from the issuer and the specific amount of compensation was never disclosed. Uberti knew that Donner received compensation from the issuers and wrote the disclaimer contained in the research. Baclet negotiated the compensation with the issuers.

Donner's compliance procedures were inadequate because they did not specify the procedures to be used for preparation, review and approval of research reports. There was no written record of who reviewed and approved each research report. The sanctions against Donner and Baclet were upheld. The Commission remanded for reconsideration of the sanction against Uberti. It noted that the hearing panel initially suspended him for two years, but that the NASD on appeal had imposed a bar against him. The hearing panel also found that Uberti was remorseful.