Authorities on the Failure to Disclose Material Facts

Authorities on the Failure to Disclose Material Facts

Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.

A. SEC Administrative Actions

1. In re Dawson-Samberg Capital Management, Inv. Adv. Act Release No. 1889 (Aug. 3, 2000).

i) An investment adviser has a duty to disclose to clients all material information which might incline an investment adviser consciously or unconsciously to render advice which is not disinterested. See Dawson-Samberg Capital Management, Page 5

ii) The standard of materiality is whether a reasonable client or prospective client would have considered the information important in deciding whether to invest with the adviser. Id.

2. In re Rupay-Barrington Investment Services, Inc., Inv. Adv. Act Release No. 1839 (Sept 30, 1999).

Held: The Commission censured respondent after it found that respondent had failed to disclose to investors that their funds were being used to repay a disgruntled investor who demanded a refund on her investment in three bonds sold to her.

3. In re Joseph J. Barbato, Securities and Exchange Act Release No. 41034 (February 10, 1999).

Where a registered representative omits to disclose material information necessary to make his statements not misleading to customers about an investment he is recommending, including known risk factors and negative information about the stock, the representative violates the antifraud provisions. See Joseph J. Barbato, Page 11.

4. In re Richmark Capital Corporation and Dyle Mark White, Initial Decision Release No. 201 (March 18, 2002).

i) When a person or entity has information that another is entitled to know because of a fiduciary or similar relationship of trust and confidence, a duty to speak arises.

ii) A broker is considered to be a fiduciary of his customer, owing the customer a duty to disclose material information.

5. In re Pryor, McClendon, Counts & Co., Inc., Securities Exchange Act Release No. 45402 (February 6, 2002).

The Commission has held that a broker-dealer has a duty to disclose to its customer information indicating that the customers agent is engaged in fraud with respect to the customers investments. In failing to make that disclosure, the broker-dealer shares in the agents liability to the customer with respect to any transactions involving the broker-dealer. See Pryor, McClendon, Counts & Co., page 7.

6. In re Leslie E. Rossello, Securities Exchange Act Release No. 7922 (Dec. 1, 2000).

i) To the extent there are sales charges associated with such a purchase or sale of mutual funds, such as contingent deferred sales charges on either the fund to be liquidated or the fund to be purchased, members should discuss with the customer the effect of those charges on the anticipated return on investment. See Page 4 Leslie E. Rossello, quoting NASD Notice To Members 94-16 (March,1994).

ii) Reasonable investors consider the cost of the transactions an important fact in their deliberations. Thus, Rossello [broker] misrepresented or omitted material facts when she failed to disclose that these customers would pay CDSCs, misstated or failed to disclose the amount of the CDSCs, and failed to disclose that they could have switched to a comparable fund at no cost.

iii) Rossello owed a fiduciary duty to her customers. Her customers relied on her advice and routinely followed her recommendations. Rossello had an affirmative duty to disclose the unsuitable nature of the frequency of these particular mutual fund switches to her customers. See Leslie E. Rossello, Page 5.

7. In re First Capital Strategists, Inv. Adv. Act Release No. 1648 (Aug. 13, 1997).

Held: Named Respondents who supervised a broker failed to disclose to client the brokers unauthorized trading since this fact was material to the client and the trades were not authorized by the internal guidelines of which they were or should have been aware. See First Capital Strategists Page 10.

8. In re Richard-Alyn & Co., Richard B. Feinberg, and Alan S. Feinberg, Initial Decision Release No. 151 (Sept. 30, 1999).

i) The Commission has stated that the duty of best execution must evolve as changes occur in the market that give rise to improved executions for customer orders, including opportunities to trade at more advantageous prices. Order Execution Obligations, 62 SEC Docket at 2242-43. Indeed, in 1998, in Newton v. Merrill Lynch, the court held that a broker-dealer’s execution of a customer trade at the NBBO when a better price was readily available breaches the duty of best execution and constitutes a material misrepresentation in violation of the Antifraud provisions. 135 F.3d at 273-274.

ii) The standard of materiality is whether or not a reasonable investor would have considered the information important.

9. In re D.E. Wine Investments, Inc., W. Randall Miller, Kenneth B. Karpf, and Duncan E. Wine, Initial Decision Release No. 143 (June 9, 1999).

The implicit representation that a broker-dealer makes when it opens its doors for business as a professional securities firm that its conduct will be fair is rendered false when the broker-dealer fails to disclose an excessive markup.

10. In re., Inc., Securities Exchange Act Release No. 46052 (June 10, 2002).

Information regarding the financial condition of a company is presumptively material. SEC v. Blavin, 760 F.2d 706, 711 (6th Cir. 1985).

B. NASD Regulatory Material

11. Special NASD Notice to Members 99-33, NASD Regulation Advises Members About Maintenance Margin Requirements For Certain Volatile Stocks

Disclosure of Credit Terms To Customers

In reviewing margin procedures, firms also should confirm that they are providing appropriate disclosure of credit terms to customers with margin accounts. Under the federal securities laws, brokers that extend credit to customers to finance securities transactions are required to furnish, in writing, specified information regarding the terms of the loan.9

These disclosures must be made on both an initial and periodic basis. For instance, at the time a customer opens a margin account, a broker must provide the customer with a written statement disclosing, among other things, the annual rate of interest, the method of computing interest, and what other credit charges may be imposed. These initial disclosures help to ensure that the customer understands the terms and conditions of the margin loan and allow the customer to compare available credit terms.10 A firm also is required to provide periodic (at least quarterly) written statements to the customer, which disclose such information as opening and closing balances, total interest charges, and other charges resulting from the extension of credit.

12. NASD Notice To Members 00-07, Disclosure To Customers Engaging In Extended Hours Trading (January, 2000).

The growth of extended hours trading provides retail customers with greater opportunities to trade securities and manage their portfolios, and in so doing, provides access to markets that were previously limited to institutional customers. Participation in extended hours trading may offer certain benefits to retail customers, but entails several material risks. Depending on the particular extended hours trading environment, these risks may include:
  • lower liquidity;
  • higher volatility;
  • changing prices;
  • unlinked markets;
  • an exaggerated effect from news announcements; and
  • wider spreads.
In light of these risks, members have an obligation to their retail customers to disclose the material risks of extended hours trading to customers before permitting them to engage in extended hours trading. NASD Regulation commends the many members that have already provided detailed disclosures about the risks of extended hours trading. This Notice is a reminder that these disclosures are not only a laudable business practice, but are a regulatory requirement under just and equitable principles of trade. See NASD Notice to Members 00-07, Page 21.

13. NASD To Member 99-11, NASD Regulation Issues Guidance Regarding Stock Volatility (February, 1999).

Recent events show that the way some stocks are traded is changing dramatically, and the change in trading methods may affect price volatility and cause increased trading volume. This price volatility and increased volume present new hazards to investors, regardless of whether trading occurs on-line or otherwise. Firms are reminded that their procedures for handling customer orders must be fair, consistent, and reasonable during volatile market conditions and otherwise. See NASD Notice to Members 99-11, Page 55. The Notice goes on to suggest that broker-dealers make specific disclosures to customers in order to educate retail customers about their procedures for handling the execution of a securities transaction, particularly during volatile market conditions, along with any additional disclosures they deem appropriate. See NASD Notice to Members 99-11, Page 56.

14. NASD Notice To Members 97-29, NASD Regulation Discusses Member Disclosure Obligations And Requests Comment On the Appropriateness of Adopting A Rule Governing Risk Disclosure (May, 1997).

The obligation to disclose all material facts to a customer is related to the member’s requirement under NASD rules to attempt to obtain information from the customer sufficient to determine the suitability of any recommendation to purchase or sell a security. Broker/dealers also have obligations under federal securities laws, as well as common law, fiduciary duties, to advise customers of the risks of securities transactions. (see endnote 5) Disclosure of the risks of investing in a particular securities product relative to other investments or the relative risks and rewards of liquidating an insured product to invest in an uninsured securities product is required if the circumstances surrounding the investment decision lead the member to believe the investor would regard the fact as material to his or her investment objectives and financial situation.

15. NASD Notice To Members 93-87, NASD Provides Guidance for Reinvestment of Maturing Certificates of Deposit in Mutual Funds.

The NASD believes that the appropriate disclosures for certain mutual fund investment alternatives should, at a minimum, include the following:

For money market funds, investors should be advised that, although fund managers strive to maintain a stable net-asset value, the funds are not federally insured and there is no guarantee that a stable net-asset value will be maintained.

For fixed income or bond funds, investors should receive clear disclosures that, although such funds may pay higher rates than CDs, their net-asset values are sensitive to interest rate movement and a rise interest rates can result in a decline in the value of the customers investment.

For equity funds, while there may be less possibility that investors will confuse such funds with an insured product such as a CD, they should be clearly advised of the higher degree of risk to capital associated with equity mutual funds.

16. NASD Notice To Members 94-16, NASD Reminds Members of Mutual Fund Sales Practice Obligations.

In recommending the purchase or sale of a mutual fund to a customer, members must disclose all material facts to the customer. To determine adequately whether a fact concerning a mutual fund investment would be material to an investor, the member must attempt to obtain information sufficient to evaluate the suitability of the proposed investment for that investor. Material fats may include, but are not limited to, the funds investment objective; the funds portfolio, historical income, or capital appreciation; the funds expense ration and sales charges; risks of investing in the fund relative to other investments; and the funds hedging or risk amelioration strategies. Disclosure of these and other facts concerning a proposed investment is required if the circumstances surrounding the investment decision lead one to believe the investor would regard as material to his decision whether to invest inn the fund.

To the extent there are sales charges associated with such a purchase or sale, such as contingent deferred sales charges on either the fund to be liquidated or the fund to be purchased, members should discuss with the customer the effect of those charges on the anticipated return on investment. Further, if a member recommends the purchase of a fund from a particular fund family, the member should disclose all fees or charges that may be imposed.

Other information that may enter into the determination of whether a particular fact concerning a proposed fund investment is material includes, but is not limited to, the relative risks and rewards of the investment being liquidated to the proposed investment, the risk aversion of the investor, and the age and/or life expectancy of the investor. While many of these enumerated items are inextricably intertwined with the suitability determination, the NASD believes merely determining that an investment may be suitable for a particular investor does not excuse the member from disclosing material information to that investor.

Members are also advised that, although the prospectus and sales material of a fund include disclosures and may matters, oral representations by sales personnel that contradict the disclosures in the prospectus or sale literature may nullify the effect of the written disclosures and may make the member liable for rule violations and civil damages to the customers that result from such oral representations.

17. NASD Notice to Members 01-31, SEC Approves NASD Rule Proposal Requiring Delivery of Margin Disclosure Statement to Non-Institutional Customers. (May, 2001).

i) A report issued last year by the General Accounting Office (GAO) noted that the SEC has determined from the customer complaints it has received that many investors who traded online did not understand margin requirements. The lack of disclosure relating to when firms would sell securities in a margin account to cover margin loans was among the leading margin-related complaints that the SEC received. See NASD Notice To Members 01-31, Page 285.

ii) Although NASD Regulation recognizes that some members are providing disclosures to customers relating to margin, the content of these disclosures is not consistent from firm to firm and may not always be in a form that is understandable to investors. As such, the rule change requires members to deliver to non-institutional customers a specified disclosure statement that discusses the operation of margin accounts and the risks associated with trading on margin.6 The rule change also requires members to deliver the disclosure statement or an abbreviated version of the disclosure statement annually to all non-institutional customers with margin accounts. See NASD Notice To Members 01-31, Page 286.

18. NASD Notice To Members 95-80, NASD Further Explains Members Obligations and Responsibilities Regarding Mutual Fund Sales Practices. (Sept, 26 1995); Special NASD Notices To Members.

To make appropriate recommendations, members and their associated persons, collectively referred to herein as members must know the key points regarding the mutual funds they recommend or sell. Members must ensure:
  • Complete and balanced disclosure is made to investors regarding the distinctions among classes of a multi-class fund or feeders of a master-feeder fund;
  • If an expense ration is represented as an advantage of a particular fund, it is explained in the context of and compared with other mutual find expense ratios;
  • If a mutual fund portfolio may include financial derivatives, the potential risks involved are fully disclosed and explained;
  • When performance information is presented, the concepts of total return, yield, and distribution rates are explained to and understood by the investor;
  • Any recommendation made is suitable and based on the investors investment objectives;
  • Any recommendation that a customer switch mutual funds is made with the investors best interests in mind, rather than based on incentives received by the associated person;
  • Materials designed for internal or dealer only use are not distributed in any manner to the public, orally or in writing; and
  • Electronic communications are treated the same as any other advertising and/or sales literature, and are supervised and used only under the same parameters
Member who fail to carry out these obligations and responsibilities, or who do not communicate information concerning mutual funds accurately and completely, may be subject to NASD disciplinary action.

19. NASD Notice To Members 91-74, Replacement of Certificates of Deposit by Bond Mutual Funds.

At the preset time, many certificates of deposit held by individuals are expiring. There has been an intensive marketing effort by some mutual funds and many NASD members to persuade such individuals to invest in bond mutual funds, because of the higher yields that may be realized, rather than renew their certificates of deposit.

There is nothing inherently wrong with persuading a customer to exchange one investment vehicle for another provided that there is full and fair disclosure of the differences between the products.

One specific feature of such an exchange that must be disclosed to the customer is the greater degree of risk to capital that the customer may experience. The fact that higher yields may be realized from the bond fund must be balanced by disclosure that the customers capital is exposed to a risk not present in ownership of a certificate of deposit.

20. NASD Notice To members 98-107, NASD Reminds Members of Their Obligations To Disclose Mutual Fund Fees. (Dec. 1998).

i) NASD Rule 2210(d)(1) generally requires that all member communications with the public provide a sound basis for evaluating the facts regarding a particular security or service and that they include material qualifications necessary to ensure that the communications are fair, balanced, and not misleading.1 Rule 2210 also prohibits the use of exaggerated, unwarranted, or misleading statements or claims. NASD Regulation has long interpreted Rule 2210 to prohibit members from making misleading or confusing presentations in their sales material concerning the fees and expenses associated with a variety of investment products and services, including discount brokerage, wrap accounts, and variable products. In particular, NASD Regulation strongly objects to presentations that list specific fees that do not apply, without discussing the fees or expenses that do apply. Such presentations raise investor protection concerns because of the possibility that the presentations may confuse investors about the range of fees and expenses that the investors must pay when they purchase and own particular products. See NASD Notice to Members 98-107, Page 783.

ii) Disclosure of Sales Loads Under SEC Rule 482

Members also are reminded that Securities and Exchange Commission (SEC) Rule 482 under the Securities Act of 1933 and SEC Rule 34b-1 under the Investment Company Act of 1940 require that sales material presenting data about the performance of an advertised mutual fund, also disclose the maximum amount of any sales load or other nonrecurring fee. In addition, SEC Rule 156 under the Securities Act of 1933, which provides guidance on when sales material may be misleading, indicates that statements about investment expenses may be relevant to whether an implicit representation about future performance has been made. Id.

21. NASD District Business Conduct Committee for District No. 9 v. Steven D. Goodman, Complaint No. C9B960013 (November 9,1999).

i) Brokers owe a special duty of fair dealing to their clients. Charles Hughes & Co. v. SEC, 139 F.2d 434, 437 (2d Cir. 1943), cert. denied, 321 U.S. 786 (1944) (finding that registered representatives dealing in OTC stocks are under a special duty not to take advantage of a customer’s trust and confidence). By making a recommendation, a broker implicitly represents to a buyer of securities that he has a reasonable basis for the recommendation. See Hanly v. SEC, 415 F.2d 589 (2d Cir. 1969). The United States Court of Appeals for the Second Circuit held in Hanly that “brokers and salesmen are under a duty to investigate . . . . Thus a salesman cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant. He must analyze sales literature and must not blindly accept recommendation[s] made therein.” Id. at 595-96. The court in Hanly also stated that:

[T]he standards by which [brokers] . . . must be judged are strict. [A broker] cannot recommend a security unless there is an adequate and reasonable basis for such recommendation. He must disclose facts which he knows and those which are reasonably ascertainable. By his recommendation he implies that a reasonable investigation has been made and that his recommendation rests on the conclusions based on such investigation.

ii) Where [a] salesman lacks essential information about a security, he should disclose this as well as the risks which arise from his lack of information.'” Hasho at 1107 (quoting Hanly at 597). We conclude that Goodman deliberately ignored that which he had a duty to know. As a result, when the transactions were completed, customers MG, RT, and ER were left with rosy expectations of gain without risk. See Berko v. SEC, 316 F.2d 137, 143 (2d Cir. 1963).

22. NASD District Business Conduct Committee For District No. 3 v. Prendergast, Complaint No. C3A960033 (July 8, 1999).

i) The complaint alleged, and the DBCC found, that the Prism PPM made projections of expected return without a reasonable basis. We agree. Certain language used in the PPM is especially illustrative. For instance, at one point the PPM provides:

Although the components of [Prism’s products] are not newly designed financial instruments, the manner in which Prism has combined certain elements of traditional investment products inside of a separate “hedge fund” which contains its proprietary S&P 500 stock index trading programs enhances historical yields by as much as 100% per year. (Emphasis added)

This statement suggests that the Prism program created some kind of synergy that would double the return historically realized on the unidentified individual investment products that were to make up the Prism product. Because the Prism product had no real experience, having only been computer tested, the lack of a disclosure in the same section informing investors that the product had no actual yield history was misleading. Furthermore, the failure to provide the “historical yields” to which Prism was being compared makes the statement impossible to verify. Finally, as the DBCC noted, the projections of substantially above-market returns are inherently suspect. We find that this statement is materially misleading.

ii) We agree with the DBCC that these characterizations and statements were exaggerated and materially misleading. Specifically, we find that it was misleading to characterize a new and unproven product as “high yielding,” to state or imply that an investment is a mutual fund when it is not registered as an investment company and subject to the regulations imposed upon the registered investment companies with which it is being compared,5 to suggest that a product’s earnings potential exceeds 95 percent of the mutual funds available when that product has no earnings experience, to state or imply that the issuer is presently providing certain products or services when no such products and services are being provided, to state or imply attributes that have not yet been established, to make projected rates of return without a reasonable basis and to, in general, fail accurately to describe an investment. See, e.g., In re Larry Ira Klein, Exchange Act Rel. No. 37835, at 7-8 (Oct. 17, 1996) (finding statement that “interest and face value at maturity are guaranteed” by the issuer without disclosing any credit ratings for various debt securities was materially misleading).

iii) The DBCC noted that investors had to parse through the small print of magazine articles attached to the offering memorandum in order to evaluate the accuracy of Prendergasts claims in the PPM, and as such the PPM failed to comply with the requirement to disclose in the offering memorandum all information necessary for the disclosures made not to be misleading.

iv) Moreover, the DBCC found that the failure of the PPM to provide information concerning the required payment for participation was a material omission, as was the failure to compare Prendergasts performance to traditional market measures such as the Dow and bank rates, which would have put the performance claim in the proper perspective.

v) Furthermore, the representations in the PPM did not accurately and completely set forth the circumstances and significance of the rankings. If Zadeh is correct (and correctly quoted) concerning the “universe” of money managers, then less than 5 percent of them participated in the Zadeh program. It would have been material for an investor reading the performance and ranking claims to know that some 95 percent of money managers were not part of the evaluation and ranking and, further, that those who were involved had paid to be rated. We are also concerned that the PPM did not include Prendergasts actual percentage returns and compare them to other market indicators. Such information should have been provided because it affects the investor’s ability to evaluate the claim that Prendergast is a top money manager.

vi) We do not believe the disclosures adequately communicate the possibility that the program simply would not succeed in the real world. Although the PPM does articulate some of the assumptions upon which the program is based and cautions that certain transaction costs will increase as the size of the fund increases, it does not address such issues as whether the viability of the program is affected by the amount of money in the fund and the extent to which the program is capable of dealing with volatility beyond that which it assumes. The broad disclosures in paragraph 14 that the market is unpredictable and that unforeseen events in the world can impact the performance of an investment are not an adequate substitute for a discussion of the effect that movements within the specific market targeted by the hedge fund could have on the value of this investment. See, e.g., Blatt v. Merrill Lynch, Pierce, Fenner & Smith Inc., 916 F. Supp. 1343, 1356 (D.N.J. 1996) (noting that vague disclaimers that an investment has risks are usually inadequate and holding that the disclosed warnings in the prospectus in question did not adequately alert potential investors to the Fund’s alleged speculative nature).

vii) These price predictions, which led investors to believe that they could expect extraordinarily high returns over a very short period of time, lacked a reasonable basis. Moreover, we agree with the DBCC that predicting future prices of speculative securities is inherently misleading, particularly in the absence of strong cautionary language. viii) In addition, Prendergast’s use of the accounting method of a mutual fund as a basis for comparing Prism’s accounting could be viewed as attaching the same level of financial stability to the Prism product that mutual funds possess. Not only is this comparison misleading based on the differences between the accounting methods, but it could also be taken as suggesting that Prism is subject to the same type of regulation as that of a mutual fund, namely the Investment Company Act of 1940. Prendergast’s use of this comparison, especially in light of his failure to disclose the differences between Prism’s fund and mutual funds, was materially misleading. viv) Furthermore, Prendergast’s statement that “things are not as bad as they seem” is incredible in light of the significant losses that Prism’s S&P trading program had experienced as of August 30, 1994. Prendergast’s September 21 letter also stated that “[w]e have not and will not run out of money to invest or trade with.” This statement is misleading because there is simply no way to guarantee that the fund will not lose everything, especially in light of the fund’s track record at the point when the statement was made. Taken as a whole, this letter was clearly meant to cloak the true state of affairs of the Prism fund and was materially misleading. ix) In brief, we find that the communications discussed above violated the requirements of Conduct Rule 2210. These communications did not contain a balanced statement of the benefits of the investment and its risks. Indeed, the letters minimized the losses incurred and emphasized the positive occurrences. They also omitted material facts (such as the basis for various claims and adequate disclosure of the risks of such investments); included statements that were exaggerated, unwarranted and misleading; made promises of specific results; made exaggerated or unwarranted claims; and provided forecasts that were unwarranted. Accordingly, we find that Prendergast violated Conduct Rule 2210 by sending these communications. See In re Sheen Financial Resources, Inc., Exchange Act Rel. No. 35477 (Mar. 13, 1995) (stating that failure to discuss risks specifically associated with investment is material fact, omission of which contributed to finding advertisement misleading).

23. NASD District Business Conduct Committee For District No. 3 v. Kevin J. Kunz & Kunz and Cline Inc. Management, Inc., Complaint No. C3A960029 (July 7, 1999).

i) In re Kevin Eric Shaughnessy, Exchange Act Rel. No. 40244, at 4 (July 22, 1998) (finding material omission where respondent recommended a security without disclosing his self-interest in the transactions); In re Michael A. Niebuhr, Exchange Act Rel. No. 36620 (Dec. 21, 1995) (“A salesperson must disclose all material facts, including ‘adverse interest,’ such as a self-interest that could influence a recommendation.”).

ii) Absent disclosure of this litigation history, investors received only positive information about Southwick’s background, a factor which the PPMs highlighted as an important consideration. Accordingly, we find that Southwick’s litigation history would have been viewed by a reasonable investor as an important consideration in determining whether to purchase the VesCor investments.

24. NASD Dept of Enforcement v. Ryan Mark Reynolds, Complaint No. CAF990018 (June 22, 2001).

i) “[A] company’s ‘financial condition, solvency, and profitability’ [are] clearly material.”);

ii) The SEC has held that, in the enforcement context, a registered representative may be found in violation of the NASD’s rules and the federal securities laws for failure to fully disclose risks to customers even though such risks may have been discussed in a prospectus delivered to the customers. (“Klein’s delivery of a prospectus to Towster does not excuse his failure to inform her fully of the risks of the investment package he proposed.”); Robert A. Foster, 51 S.E.C. 1211, 1213 n.2 (1994) (“Notwithstanding Foster’s distribution of the prospectuses, he is liable for making untrue statements of material facts and omitting to state material facts . . . . As the Commission has long held, information contained in prospectuses ‘furnishes the background against which the salesman’s representations may be tested.'”) (Order Instituting Proceedings, Making Findings and Imposing Sanctions) (quoting Ross Secs., Inc., 41 S.E.C. 509, 510 (1963)).

iii) Professional standards in the securities industry require much more than unquestioning reliance on information provided by the issuer. See Everest Secs., 52 S.E.C. at 963 (“When an issuer seeks funds to finance a new and speculative venture, brokers . . . ‘must be particularly careful in verifying the issuer’s obviously self-serving statements as to its operations and prospects.'”) (citing Hamilton Grant & Co., 48 S.E.C. 788, 794 (1987)).25 Reliance on the advice of the issuer’s counsel is also unavailing. See, e.g., Arthur Lipper Corp. v. SEC, 547 F.2d 171, 182 (2d Cir. 1976) (holding that a broker could not rely on advice of issuer’s counsel; to be considered a relevant factor, the advice must come from a wholly disinterested party), cert. denied, 434 U.S. 1009 (1978); Michael Ben Lavigne, 51 S.E.C. 1068, 1071 n.18 (1994) (same), aff’d, 78 F.3d 593

(9th Cir. 1996) (table format).

In light of the aforementioned discussion, we find that Reynolds was grossly negligent in directly participating in the publication of an advertisement containing material misrepresentations, exaggerated and misleading claims, unwarranted price and performance predictions, and omitting material information. This conduct was inconsistent with high standards of commercial honor and just and equitable principles of trade, and therefore violated Conduct Rule 2110.

25. NASD Dept of Enforcement v. Dane Stephen Faber, Disciplinary Proceeding No. CAF010009 (May 3, 2002).

i) Faber failed to disclose that Interbet had no business, never generated any revenues, and had suffered losses since its inception. Faber did not know about that negative information, even though it was publicly available. As a result, he did not educate himself about the full range of risk factors involved in a purchase of the stock. Material facts include not only earnings of a company, but also those facts that affect the probable future of a company and that may affect the desires of investors to buy, sell, or hold the company’s securities. See Hasho, 784 F. Supp. at 1108. Failure to disclose the speculative nature of a recommended security or negative financial information about the issuer violates the anti-fraud provisions of the securities laws and NASD rules.

ii) Predictions of specific and substantial price increases for speculative securities of unseasoned companies are inherently fraudulent and unjustifiable. See Id. ; Steven D. Goodman, No. 43889, 2001 SEC LEXIS 144, at *14 (Jan. 26, 2001).24 Predictions of a substantial increase in the price of any security without a reasonable basis is also fraudulent. See Hasho, 784 F. Supp. at 1109; C. James Padgett, No. 38423, 1997 SEC LEXIS 634, at **23-24 (Mar. 20, 1997), aff’d, 159 F.3d 637 (D.C. Cir. 1998) (table). Courts and the SEC have found no reasonable basis for price predictions where the issuers had suffered losses or operated at small profits. See, e.g., Hasho, 784 F. Supp. at 1109; Martin Herer Engelman, No. 35729, 1995 SEC LEXIS 1197, at *22 (May 18, 1995). Moreover, the Court in Hasho stated:

The fraud is not ameliorated where the positive prediction about the future performance of securities is cast as opinion or possibility rather than as a guarantee. Such material statements violate the anti-fraud provisions if no adequate basis existed for making such a statement.

26. NASD Dept of Enforcement v. Charles K. Waddell, Disciplinary Proceeding No. C05000021 (May 14, 2001).

The NASD has previously held that NASD Conduct Rules 2110, 2120 and SEC Rule 10b-5 are each “designed to ensure that sales representatives fulfill their obligation to their customers to be accurate when making statements about securities.” DBCC No. 9 v. Euripides, Complaint No. C9B950014, 1997 NASD Discip. LEXIS 45 (NBCC July 28, 1997), at * 16-17. “A salesperson has a duty to make an adequate independent investigation in order to ensure that his representations to customers have a reasonable basis.” In re Frank W. Leonesio, 48 S.E.C. 544, 548 (1986).

27. NASD Notice to Members 01-31

SEC Approves NASD Rule Proposal Requiring Delivery of Margin Disclosure Statement To Non-Institutional Customers.

Although NASD Regulation recognizes that some members are providing disclosures to customers relating to margin, the content of these disclosures is not consistent from firm to firm and may not always be in a form that is understandable to investors. As such, the rule change requires members to deliver to non-institutional customers a specified disclosure statement that discusses the operation of margin accounts and the risks associated with trading on margin.6 The rule change also requires members to deliver the disclosure statement or an abbreviated version of the disclosure statement annually to all non-institutional customers with margin accounts.

C. SEC Staff Communications

28. Speech by SEC Staff: Key Issues in SEC Examinations of Broker-Dealers, By Lori A. Richards, Dir., Office of Compliance Inspections and Examinations. Before the Legal and Compliance Division, Securities Industry Association Union League Club, New York, N.Y. (Sept. 17, 2002).

More complex products require that registered representatives spend more time explaining them to customers.

29. U.S. Securities and Exchange Commission: Letter From The Office of Compliance Inspections and Examinations: To Registered Investment Advisers, on Areas Reviewed and Violations Found During Inspections. (May 1, 2000).

i) Fundamental to the Advisers Act is an adviser’s fiduciary obligation to act in the best interests of its clients and to place its clients’ interests before its own. As part of its fiduciary duty to clients, an adviser has an affirmative obligation of utmost good faith and full and fair disclosure of all material facts to clients. Advisers are required to disclose any facts that might cause the adviser to render advice that is not disinterested. When an adviser fails to disclose information regarding potential conflicts of interest, clients are unable to make informed decisions about entering into or continuing the advisory relationship. See Page 1.

ii) Examples of failures to disclose material information to clients would include:
  • An adviser fails to disclose all fees that a client would pay in connection with the advisory contract, including how fees are charged, and whether fees are negotiable.
  • An adviser fails to disclose its affiliation with a broker-dealer or other securities professionals or issuers; and
  • An adviser with discretionary assets under management fails to disclose that it is in a precarious financial condition that is likely to impair its ability to meet contractual commitments to clients. See Pages 1, 2.
iii) The Advisers Act prohibits advisers from making misleading statements or omitting material facts in connection with conducting an investment advisory business. The following are examples of false advertising or other misrepresentations to clients found during examinations:
  • The use of testimonials, which include any statement of a client’s experience with the adviser or a client’s endorsement of the adviser. Testimonials are prohibited under the Advisers Act.
  • A representation or implication that the adviser has been sponsored, recommended or approved, or that its abilities or qualifications have in any respect been passed upon by the Commission or any officer of the Commission. This is prohibited by the Advisers Act. Also, the staff has taken the position that the use of the initials R.I.A. (“Registered Investment Adviser”) following a name on printed materials would be misleading because, among other things, it suggests that the person to whom it refers has a level of professional competence, education, or other special training, when in fact there are no specific qualifications for becoming a registered investment adviser.
  • A reference to past, specific, profitable, recommendations made by the adviser, without the advertisement setting out a list of all recommendations made by the adviser within the preceding period of not less than one year, and compliance with other specific conditions.
  • A representation that any graph, chart, formula or other device can, in and of itself, be used to determine which securities to buy or sell, or when to buy or sell such securities, or can assist persons in making those decisions, without the advertisement prominently disclosing the limitations and the difficulties regarding its use.
  • A representation that a report, analysis or other service was provided without charge, when the report, analysis, or other service was provided with some obligation. See Page 2,3.

D. NYSE Regulatory Material

30. In the matter of Arbitration Between Julie Schuman v. Merrill Lynch, Inc., Glenn Conner and William Bachrach, NYSE Arbitration Decision No. 1992-002525 (Dec. 22, 1995).

Held: In making each recommendation to purchase a non-traded limited partnership, he failed to disclose to Claimant that he was still a defendant in the injunction action referred to above, that he was in increasing default in the payment of taxes and his wages were attached, and that Respondent Merrill Lynch was not providing supervision as required by its own rules and those of the NYSE. Each of these facts would have been considered by a reasonable, prudent investor to be material and significant in the evaluation of a brokers investment recommendation. Each omission was made with the intent to deceive or with a reckless disregard for the truth. Had these facts been known to Claimant she would not have continued to place her confidence and sole reliance in Respondents and would not have authorized these investments. Thus, each of these investment authorizations was procured by the Respondents through fraud and deceit. See Julie Schuman v. Merrill Lynch, Inc., Glenn Conner and William Bachrach, Page 2.

E. Financial Education Network Development

31. Mason A. Dinehart – Financial Education Network Development, October 4, 1997, updated January 20, 2003.

(Caution: The following was pulled from Mason A. Dineharts web site. All text below that is not in quotations must be paraphrased or attributed to Mason A. Dinehart.)
DISCLOSURE A broker also has a duty to disclose all material information related to an investment recommendation. In California, this duty is valid, irrespective of the sophistication of the investor! This means all information that may be reasonably relevant to an investor in making an informed investment decision. Also, a broker has an obligation to disclose the various risks of an investment recommendation. Brokers must be truthful in all communications with customers. Nothing material may be left out of these communications with investors. Essentially, their communications should provide a sound basis for evaluating any recommended securities. Exaggerated, false or misleading statements are flatly prohibited. When a registered representative recommends the purchase or sale of a stock to a customer, he or she must not only avoid affirmative misstatements, but must also disclose material adverse facts about which the salesperson is, or should be, aware. Particular care should be taken with respect to the accuracy and completeness of information concerning low-priced, speculative securities. In this connection, members should focus on the completeness of disclosure concerning securities issued by companies whose ability to operate as a going concern is subject to question or contingent on gaining additional financing. This includes disclosure of any conflicts of interest that could influence the salesperson’s recommendations or the customer’s decision to purchase or sell the security. (NASD Notices to Members # 96-32 & # 96-60) Additionally, brokers on occasion receive extra compensation for emphasizing certain products. Examples would be the firm’s own proprietary products or certain mutual funds during IRA season! Several mutual funds offer full dealer re-allowance to highlight a new fund or raise sales early in the year as investors beef up their IRA’s to reduce their tax bills. Here is how re-allowance works: Funds that use a broker to sell their shares usually add a sales charge, or “load”, either at the time of sale or later. The majority of that money goes to the brokerage firm and the broker’s commission. But a portion, usually between 0.25% and 0.50% of the money invested, goes to the fund company. When the company offers full dealer re-allowance, however, it pays that money to the brokerage firm, which may share the windfall with its brokers. Customers usually aren’t told about such added commissions unless they ask, whereby it can be argued that these incentives can tempt brokers to choose personal gains over a client’s best interest. Since this re-allowance doesn’t result in an additional fee to the investor, many are unaware of this incentive. It is usually only disclosed in the small print – securities regulators require that these deals be noted in a fund’s prospectus or statement of additional information. In the Spring of 2002, mutual fund families offering such dealer incentives included MFS Investments, Oppenheimer Funds, and Zurich Scudder Investments. Best practice brokers should always disclose these sales incentives to their customers to uphold their responsibilities of fair dealing.
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