Bar For Unsuitable Recommendations Upheld - Risky Strategies Per Se Unsuitable For All Unsophisticated Investors And May Not Be Recommended

Luis Miguel Cespedes, Exchange Act Rel. 59404, February 13, 2009

Time since appeal filed – 11 months 2 days
Time since last brief – 8 months 11 days
Pages – 19
Footnotes – 36

Summary

This one is a blockbuster because it adopts a per se suitability rule prohibiting reps from recommending risky strategies including non-diversified investments or margin for unsophisticated investors of modest means – even those who want to speculate. It is one of the most important Commission cases in many years on the issue of suitability.

Cespedes was a registered rep at A.G. Edwards. NYSE censured and barred him for 10 years based on unsuitable recommendations to 14 customers. He recommended margin debt and  high concentration in technology based unit investment trusts that was not suitable for his elderly and unsophisticated customers.

Unit investment trusts are not actively managed and are non-diversified. They are heavily weighted in only a few stocks. They are much more volatile than more diversified investments such as mutual funds. Not only did Cespedes recommend his clients invest in unit investment trusts, but he also recommended they use margin debt to make the investments. All the clients were unsophisticated, trusted Cespedes, and were seeking low risk investments with little or no risk to their principal. Most were retired or nearing retirement age, and had modest annual incomes and net worth.

The case is of note because it emphasizes that a rep has a duty "to make 'a customer-specific determination of suitability and to tailor his recommendations to a customer's financial profile and investment objectives.'" (footnote omitted)

It is also very important because it prohibits a rep from recommending risky investments or strategies even to an unsophisticated investor of modest means who wants to speculate.

Discussion

This case is interesting because the Commission appears to be adopting a per se rule concerning suitability – risky investments may never be recommended for unsophisticated investors of modest wealth. Indeed, the Commission noted that regardless of whether a customer wants to engage in speculation a registered rep must abstain from making recommendations inconsistent with the customer's financial situation. In other words, speculative investment recommendations are per se unsuitable for certain investors, regardless of the investor's objectives. Further, highly concentrated investments or highly speculative strategies such as margin are per se not suitable for investors who seek safe non-speculative investments and who can not stand the loss of their entire principal.

The opinion includes significant discussion of the inherent risks due to non-diversification and trading on margin. It finds that these strategies are wholly unsuitable for investors who seek to preserve capital, are unsophisticated or are seeking non-volatile investments.

Also of note is that the Commission relied on customer new account documents for determining customer objectives. It rejected Cespedes claim that customer objectives might have changed, noting that this claim was inconsistent with actual investor testimony

Comment

The Commission emphasized that risky investments, including margin, may never be recommended for unsophisticated investors of modest wealth. Reps under such circumstances may perhaps take orders, but must refrain from recommending.

Conviction For Lying Under 18 U.S.C. § 1001 Grounds For Bar - Double Jeopardy Defense Rejected

Gary M. Kornman, Exchange Act Rel. 59403, February 13, 2009

Time since appeal filed – 1 year 3 months 14 days
Time since last brief – 9 months 4 days
Pages – 25
Footnotes – 88

Summary

Kornman pled guilty in federal court of lying to the SEC in violation of 18 U.S.C. § 1001 in July 2007. The Commission upheld the ALJ's bar from associating with any investment adviser, broker, or dealer.

The decision is significant as it reiterates the fact that an administrative bar is not punishment for purposes of double jeopardy purposes.

Discussion

Kornman was part owner and a registered rep with Heritage Securities a registered broker-dealer that sold variable life insurance and annuities. He was also the manager of an investment adviser that managed two hedge funds. According to his plea agreement Kornman told SEC staff in a telephone interview that he did not know who had trading authority over the brokerage accounts that traded on behalf of the hedge funds despite knowing that he personally had such trading authority. In his plea he admitted the statement was intentionally false, material and made for the purpose of misleading the Commission in its investigation of his trading activity. He was sentenced to two years supervised probation. He was ordered to pay a $143,000 fine.

Exchange Act § 15(b) authorizes disciplinary proceedings based on, among other things, any felony that "involves . . . the purchase or sale of any security, the taking of a false oath, the making of a false report . . . arises out of the business conduct of a broker, dealer, . . . [or] investment adviser . . . . [or] involves the violation of . . . chapter . . . 47 of title 18, United States Code . . . ." The Commission noted that § 1001 is a part of chapter 47 of title 18 of the United States Code. Further, since the Commission's investigation involved possible insider trading in the brokerage account of the hedge funds he managed Kornman's conduct arose out of the conduct of the business of a broker, dealer, or investment adviser.

Kornman was associated with an investment adviser because he was the general partner of a hedge fund. The Commission may sanction persons who are investment advisers even if they are exempt from registration under the Advisers Act. Teicher v. SEC, 177 F.3d 1016, 1017-18 (D.C. Cir. 1999).

Kornman's defense was based on an argument that the Commission had no jurisdiction because his offense was not in connection with the purchase or sale of securities. The Commission rejected this claim based on the fact that the statute does not require that the conviction involve either securities fraud or be "in connection with" the purchase or sale of a security.

The Commission also rejected Kornman's argument that it had no jurisdiction because by the time the proceedings were instituted he was no longer associated with a regulated entity at the time of his conviction. This argument was rejected because the statute requires only that the person be associated at the time of the conduct, here the false statements to SEC staff.

Kornman also made numerous arguments that were collateral attacks on his conviction and the admissions he made in his plea agreement. He is collaterally estopped from attacking either in this proceeding.

Kornman claimed his due process rights were violated because the ALJ ruled against him based on a motion for summary disposition and did not hold an evidentiary hearing. There is no due process right to a hearing before an administrative body when there are no contested issues of fact.

Kornman argued that the bar was a violation of the double jeopardy clause because the bar was tantamount to a second criminal punishment. The Commission has previously rejected this argument – see William F. Lincoln, 53 S.E.C. 459. Further the courts have long held that an industry bar and other regulatory sanctions not to be criminal punishment for double jeopardy purposes. See, e.g., Cox v. CFTC, 138 F.3d 268, 272 (7th Cir. 1998)(industry bar); SEC v. Palmisano, 135 F.3d 860, 864-865 (2d Cir. 1998)(disgorgement and civil penalty).

Last Kornman argued that because the SEC appeared at his sentencing and requested a penalty in lieu of disgorgement in its then pending civil case res judicata prevented a subsequent proceeding. There was no claim preclusion here because the two causes of action are not identical and there was no privity between the Department of Justice and the SEC. Further, Kornman's plea acknowledged that the Commission could bring future administrative proceedings against him.

Comment

This proceeding was clearly delayed substantially by the Commission's insistence that Kornman be given an oral argument on his claims. It is passing strange that the Commission would approve the ALJ's granting of a motion for summary disposition – rejecting Kornman's claim that he was required to be given an evidentiary hearing – and at the same time delay its own resolution of the appeal by insisting on giving Kornman an oral argument. The Commission has long insisted on allowing oral arguments on appeal when the case clearly raises no novel or unique issues. It is well known among defense counsel that a sure way to delay resolution of a Commission administrative case is to request oral argument. The Commission should stop granting oral arguments as a matter of routine and reserve them for the truly rare cases that raise difficult factual or legal issues. Indeed this case is a perfect example of why oral argument is not appropriate in routine cases. Here, the Commission's decision was issued a mere one month and six days after the oral argument.