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Fraud Charges and Sanctions Based On Recklessness Sustained Following Circuit Remand - Reps Can Not Rely Solely On Issuers And Must Do Due Diligence

Alvin W. Gebhart, Jr., Donna T. Gebhart, Exchange Act Rel. 58951, November 14, 2008

Time since remand - 9 months 30 days
Time since last brief - 5 months 1 day
Pages - 21
Footnotes - 51


The Ninth Circuit affirmed the Commission's earlier finding that respondents engaged in "selling away" (private securities transactions) without giving prior written notice to or obtaining prior approval from a FINRA member firm. The Court remanded for further findings on whether they acted with scienter in connection with fraud charges involving sales of securities. The Commission held respondents acted with scienter and committed fraud. FINRA's bar against Alvin Gebhart was upheld as was the one year suspension and $10,000 fine imposed on Donna Gebhart.


The Gebharts sold $2.4 million of unregistered promissory notes to forty investors between 1997 and early 2000 receiving $110,000 in commissions. NASD found they had not given notice to their firm or obtained permission to sell the notes. It further found that their sale was an unregistered offering in violation of Section 5 of the Securities Act. NASD also found the Gebharts violated the anti-fraud provisions. Alvin was barred and Donna was suspended for one year and fined $5,000 for the selling away and sales of unregistered securities. For the fraud Alvin was also barred and Donna received another one year suspension (concurrent with the other suspension) and a $10,000 fine. The Gebharts appealed to the Commission, but did not contest the charges involving sales of unregistered securities. The Court of appeals affirmed the Commission's decision so far as it applied to selling away. However, it remanded to the Commission the fraud charges for further findings on whether or not the Gebharts acted with sufficient scienter to sustain the fraud charges and sanctions.

The Gebharts sold primissory notes issued by MHP which planned to finance the conversion of mobile home parks to residential ownership. It raised money ostensibly to buy mobile home parks. The Gebharts had only a vague understanding of MHP's business plan and operations. MHP falsely represented that the notes would be secured by first deeds of trust. They made no effort to investigate whether the offering documents prepared by MHP were correct. Their only due diligence was contact with another sales agent, and visiting two of the trailer parks. They had no substantive contact with MHP. They concluded the business was a success solely because they heard no complaints from earlier investors. They had no information about the management or financial condition of MHP. They sold the MHP notes to unsophisticated investors with limited means who needed secure fixed income investments. One was a recent widow with young children and a part time job who they convinced to invest one third of her life insurance proceeds in MHP notes. Investors were told by the Gebharts that the notes were secured by first deeds of trust on the parks and that there was no risk in the investment. In fact, when MHP collapsed it turned out that of $3.7 million in notes sold, only $600,000 were secured by deeds of trust. The Gebharts did take various court actions to assist investors in recovering their losses, including a suit against their liability insurer to pay damages to note holders who had sued them. Ultimately investors recovered 84% of their investments.

Sales agents have an absolute duty to engage in appropriate due diligence before recommending an investment. The Gebharts acted with scienter due to their reckless behavior. The Ninth Circuit has adopted the recklessness definition in Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)("a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but 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."). There is a an objective component - whether a reasonably prudent securities professional under the circumstances would have done. The subjective component looks at the actor's actual state of mind at the time.

The Commission held that the Gebharts were reckless. They made representations about the safety of the notes without having performed any meaningful investigation into whether the notes were actually secured. They simply had no evidence that in fact deeds of trust had been recorded for all the notes. Nor did they have any knowledge of the actual value of the parks that MHP was purporting to buy.

The Gebharts argued that it was reasonable for them to rely on the unverified offering materials prepared by MHP. This does not establish good faith as the Gebharts ignored facts that should have alerted them to the risk they were misleading clients. As the Circuit noted "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." The Gebharts' complete lack of investigation and due diligence made it impossible for them to know whether the representations they made to their clients were true. They are liable not because they failed to learn of the fraud, but because they told investors the notes were risk free without verifying the facts upon which those conclusions rested.


The Commission here holds that extreme recklessness supports a finding of scienter. Given the duty of sales agents to conduct appropriate due diligence it is fraudulent to represent that an investment is completely secure and safe when literally no investigation has been conducted to determine whether that is true. Total reliance on an issuer doesn't cut it. This is especially true here as it would not have been difficult to determine whether the issuer was in fact recording deeds of trust to secure the notes. This case doesn't plow any new ground, but it is a nice restatement of the due diligence obligation of sales agents.