Time between appeal and decision - 8 months, 23 days
Time between final brief and decision - 5 months, 19 days
Pages - 33
Comment
This case includes a comprehensive discussion of why misuse of offering proceeds is always material regardless of whether or not individual investors testify to the contrary. It also notes that diversion of offering proceeds to pay personal expenses can not be cured by a general statement in offering documents that proceeds might not actually be used for the business purposes proposed. This decision contains a comprehensive nine page explanation of why the sanctions are appropriate.
Respondent was barred as an investment adviser, fined $85,000, and ordered to disgorge $84,300 plus prejudgment interest after he used $84,300 of a $100,000 private placement offering to pay personal living expenses. The lesson from this case is that investment advisers, whether registered or not, are held to the highest standards of disclosure and honesty when dealing with clients and the most severe sanctions will be imposed even when the violations involve a relatively small amount of money and only a few investors.
Also, a note of significance to practitioners. The Commission ruled that respondent had waived his ability to claim inability to pay disgorgement or a civil penalty because he had not raised the issue before the trial judge. Further, the financial statements he submitted were vague, and had no supporting documentation. Finally, the Commission found that because waivers due to inability to pay are discretionary, it would not grant a waiver due to the egregious nature of Disraeli's violations.
Summary
This is an appeal from an ALJ's initial decision by a pro se investment adviser and a corporation he incorporated. The ALJ found that both respondents violated the anti-fraud provisions of Securities Act Section 17(a) and Exchange Act Section 10(b). The ALJ also found that Disraeli violated: Section 206 and Rule 206(4)-4(a) of the Advisers Act by making materially false statements in connection with the offer and sale of securities; Advisers Act Sections 203A and 207 by registering with the Commission when he did not qualify to register and by making material misstatements and omissions on his application; Advisers Act Section 204 and various rules thereunder by failing to maintain books and records.
The ALJ revoked Disraeli's adviser registration, barred him from association with a broker-dealer or investment adviser, imposed a $120,000 civil penalty, ordered him to pay disgorgement of $84,300 plus prejudgment interest, and imposed a cease and desist order on both respondents.
The Commission upheld the sanctions except that it lowered the penalty to $85,000.
Discussion
Disraeli offered and sold stock in Lifeplan Associates in a private placement offering to his investment advisory clients. He claimed the $100,000 to be raised would be used to form two investment funds, one to be a hedge fund, and the other to purchase consumer debt. The offering documents claimed that Lifeplan was registered with the SEC as an investment adviser. Disraeli told investors that the funds would earn 20% per year. By December 2003, nine clients had bought $95,000 of stock in Lifeplan from Disraeli. Not all paid the same price for their shares. $83,500 of the money raised was immediately transferred to Disraeli's personal bank account from which he made payments for personal living expenses.
After becoming concerned about his disclosures concerning use of proceeds, after consulting with a lawyer, Disraeli distributed a new offering document and a rescission offer. Despite the fact that Disraeli had started spending the proceeds of the offering after raising $30,000, the new offering document claimed that he would escrow the offering proceeds until he had raised the $50,000 minimum. In addition to claiming the proceeds would be used to organize and fund the two investment vehicles, it stated that there could be no assurance that the funds would actually be used for those purposes. Neither offering memorandum disclosed the use of funds by Disraeli for personal expenses. Nor did they disclose a federal tax lien against Disraeli. None of the funds raised were used for the purposes specified in the offering materials and no investments were purchased.
After the SEC staff began an investigation, Disraeli produced a promissory note whereby he purported to agree to repay the $84,300. The ALJ found that the evidence strongly suggested that the note had been backdated. The ALJ also found Disraeli not to be a credible witness.
One investor testified at the hearing that he knew that Disraeli was going to use the offering proceeds for personal expenses and claimed he did not believe the use of proceeds was material. Several other investors signed affidavits with similar claims. Another investor testified he was not aware of Disraeli's use of the offering proceeds and that he would not have invested had he known those facts.
Needless to say, the Commission found the undisclosed use of the offering proceeds to be a material departure from the representations in the offering materials. It also found that Disraeli's failure to escrow funds until the minimum had been raised to be a material departure from the offering materials.
The Commission rejected Disraeli's claim his misrepresentations were not material because his investors did not consider them to be. It noted that "the reaction of individual investors is not determinative of materiality, since the standard is objective, not subjective (footnote omitted)." It also found that investor ratifications of his conduct do not exonerate him because materiality depends on a finding of the significance of the information to an objective reasonable investor.
In other words, the Commission ruled that the use of offering proceeds for purposes not specified in offering documents is material as a matter of law.
Also, the Commission rejected Disraeli's claim that he did not commit fraud because his investors were sophisticated. It noted that "the sophistication of investors does not justify misleading them. (footnote omitted)"
The Commission also noted that Disraeli was not protected by the statement in the second offering document that the use of proceeds might not actually conform to the disclosed uses. It noted that "[a] statement that the use of proceeds may vary from a company's current intentions cannot cure the diversion of offering proceeds from specific business expenses identified in offering memoranda to the personal use of the company's officers (footnote omitted)."
Disraeli claimed he could not violate the anti-fraud provisions of the Advisers Act because when the offering began, he was not a registered investment adviser. However, Section 206 of the Advisers Act is not limited to registered advisers. While the offering was occurring, Disraeli was charging his clients fees for investment advice. He therefore met the definition of an adviser and was subject to the anti-fraud provisions of Section 206.
Disraeli also violated Rule 206(4)-4(a) which requires an adviser to disclose to clients any material facts about his financial condition that are reasonably likely to impair his ability to meet his contractual obligations to clients. His misappropriation of offering funds, and undisclosed IRS lien were facts that should have been disclosed.
Disraeli was registered with the Commission as an investment adviser from 1993 to 1997 when he voluntarily withdrew his registration after a change in the statute that prohibits an adviser from registering with the Commission unless it has more than $25 million of assets under management or is an adviser to a registered investment company. In 2002 the state of Texas entered a cease and desist order against Disraeli. In 2003 Lifeplan filed a registration application with the Commission despite the fact that it had only about $4 million under management. Disraeli claimed, pursuant to Commission rules that he believed Lifeplan would meet the minimum registration requirements within 120 days. The rule is designed to exempt only "start up" advisers. The rule should only be relied on when the registrant has actual indications of interests from clients that they will transfer sufficient assets to the adviser.
Lifeplan did not qualify as a start-up because it was the successor to Disraeli's previous advisory business. Disraeli admitted that he had no indications of interest from clients sufficient to meet the $25 million minimum. Nor was Disraeli able to claim the "muti-state" exemption from the minimum for advisers who operate and are required to register in at least 30 states because he had not actually obtained actual clients in 30 states.
