Jerome B. Vernazza v. Securities and Exchange Commission, Ims/cpas & Associates Vernon T. Hall Stanley E. Hargrave v. Securities and Exchange CommissionJerome B. Vernazza v. Securities and Exchange Commission, Ims/cpas & Associates Vernon T. Hall Stanley E. Hargrave v. Securities and Exchange Commission
Thomas D. Giachetti, Princeton, NJ, and Ashleigh C. Swayze, Stark & Stark, PC, Lawrenceville, NJ, for petitioners IMS/ CPAs & Associates, Vernon T. Hall, and Stanley E. Hargrave.
Eric Summergrad, Deputy Solicitor, and Mark Pennington, Assistant General Counsel, Securities and Exchange Commission, Washington, DC, for the respondent.
D.W. NELSON, Senior Circuit Judge.
Petitioners Jerome B. Vernazza, Vernon T. Hall, Stanley E. Hargrave, and IMS/ CPAs & Associates (“IMS“) seek review of an order of the Securities and Exchange Commission (“Commission“) imposing sanсtions for violations of several antifraud provisions of the securities laws. The Commission determined that the petitioners, who are investment advisers or persons associated with advisers, knowingly or recklessly made materially false statements and omissions to their clients and in their papers filed with the Commission. The Commission found that the petitioners falsely represented that they received no referral fees and had no financial interest in any of the recommendations they made to their clients. Because the Commission‘s findings are supported by substantial evidence, we deny the petition for review.
FACTUAL BACKGROUND
The facts are largely undisputed. Vernazza, Hall, and Hargrave are partners in IMS, a firm registered with the Commission as an investment adviser. Vernazza also was registered as an adviser, but withdrew his registration in 1997. Vernazza, Hall, and Hargrave also owned the accounting firm Hall & Vernazza, CPAs (“H&V“), which for all practical purposes was the same business as IMS.
The day after the loan was made, World and H&V entered into a Shareholder Servicing Agreement (“SSA“), the terms of which are central to this case. The SSA provided that World would pay H&V for services related to World‘s Permanent Portfolio Family (“PPF“) of Funds, such as marketing the funds and providing tax advice to investors. A schedule to the SSA stated that compensation would be based on “time, effort, and complexity of services at an annual rate not to exceed” a series оf percentages of “Additional Assets.” “Additional Assets” was defined as the value of the investments in PPF funds made by clients of H&V or IMS. The percentage “caps” ranged from 0.25% to 0.6% of the Additional Assets, depending on which of the three PPF funds the client invested in, whether the client had been previously invested in the Tax Fund, and when the investment was made. The highest percentages were applied to investments made by former Tax Fund clients before June 30, 1995 — the day before the loan was due to be repaid. The SSA did not indicate any other basis, such as an hourly rate of pay, for determining H&V‘s compensation. Thе SSA also contained a minimum investment requirement whereby H&V would not be paid at all until its and IMS‘s clients had purchased at least $1,000,000 in PPF funds.
H&V‘s actual compensation from World was always the maximum amount payable under the SSA caps. Petitioners never sent World an accounting of hours worked, services performed, or hourly rates. The only accounting in the record is a list of the investments made by H&V and IMS clients, with the “Servicing Fee” determined by the percentages in the SSA.
According to Vernazza, the reason that H&V‘s compensation was determined by the caps is that H&V had performed services entitling it to more money than it could recover under the caps. As of the first bill sent to World, H&V had performed services entitling it to about $60,000, but because this amount was greater than the caps, it was paid only according to the caps and the extra amount was rolled over to the next period. This happened throughout the life of the agreement; Vernazza testified that H&V performed services worth a total of about $131,000, but that H&V‘s compensation was limited by the caps because the value of the services performed exceeded the amount payable under the caps. Vernazza stated that he billed the work at either $100 per hour or $250 per hour; he alsо stated that H&V had discussed a range of $150-200 per hour with World but had never agreed on a specific hourly figure.
The payments made by H&V to World on the $60,000 loan closely tracked the payments made by World on the SSA. H&V missed the first payment on the loan, a $12,000 payment due in January 1993. The payment finally was made on April 12, 1993, the day after H&V received its first SSA payment from World in the amount of $13,060. By September 5, 1993, World had paid H&V $24,431 under the SSA; H&V had in turn paid World $24,000 under the promissory note for the loan. H&V continued to be paid under the SSA until 1996.
During this period, petitioners made representations, in engagement letters to their clients, that they had no financial interest in and did not receive commissions for recommending PPF funds. Multiple engagement letters from IMS to its clients, for example, stated that “IMS warrants that they have not and will not receive any commission or any payment from, nor do they have any financial interest in, any recommendation made.”
As advisers, Vernazza and IMS also were required to furnish clients with disclosure statements comprising the same information as Part II of the Form ADV. See
PROCEDURAL HISTORY
On July 11, 1996, the Commission‘s Division of Enforcement initiated proceedings against the petitioners, alleging fraud in violation of both the Securities Act of 1933,
The ALJ‘s order was reviewed de novo by the Commission, and it was, in large part, affirmed. The Commission found fraud in violation of several statutes and regulations, and false statements to the Commission in violation of Advisers Act § 207,
STANDARD OF REVIEW
Under all of the statutes in question, the Commission‘s findings of fact are reviewed for substantial evidence. See
An agency‘s interpretation or application of a statute is a question of law that we generally review de novo. Brower v. Evans, 257 F.3d 1058, 1065 (9th Cir. 2001). But “when it appears that Congress delegated authority to [an] agency generally to make rules carrying the fоrce of law, and that the agency interpretation... was promulgated in the exercise of that authority,” the agency interpretation may be rejected only if it is unreasonable or contrary to clear congressional intent. United States v. Mead Corp., 533 U.S. 218, 226-27 (2001) (citing Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984)). An agency interpretation of a different form is not afforded such deference, but is nonetheless given some weight. Id. at 234-35.
DISCUSSION
I. The Commission‘s Findings of Fraud.
The Commission found fraud in violation of Securities Act § 17(a),
A. Petitioners Made Materially False Statements.
We have no trouble concluding that the petitioners made materially false statements when they claimed not to recommend securities in which they had an ownership or sales interest, not to receive economic benefits in connection with giving advice to clients, and not to recommend securities in which they had a financial interest. It is indisputable that potential conflicts of interest are “material” facts with respect to clients and the Commission. See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 201 (1963) (noting that an investment adviser must “fully and fairly reveal[] his personal interests in [his] recommendations to his clients“).
The second aspect of the SSA, the system of “caps,” continued to create a financial interest in recommending PPF funds even after the minimum investment provision had been satisfied. We need not decide whether the SSA caps facially created a financial interest because it is obvious that they did so in practice. As noted аbove, Vernazza indicated that H&V had performed work in excess of the compensation it was entitled to under the caps, and thus the balance was carried forward. At this point, as long as a balance was carried forward, H&V‘s compensation was wholly dependent on the amount of money invested by its and IMS‘s clients. When compensation is predicated entirely on the amount of money invested in a fund by a person‘s clients, that person has a financial interest in recommending that fund. The petitioners had a financial interest in recommending PPF funds, and their representatiоns to the contrary were false statements of material fact.
Petitioners argue that the Commission erred by not crediting Vernazza‘s testimony that he put in substantial work under the SSA and kept records of this work, thus finding that the work performed under the SSA was minimal. As long as a balance was carried forward, however, the amount of work actually performed under the SSA is irrelevant. Petitioners still had a financial interest in recommending World‘s funds, even if they also needed to, and in fact did, perform other services under the SSA.5
B. Substantial Evidence Supports the Commission‘s Finding of Scienter.
It is undisputed that scienter is a rеquired element for violations of Securities Act § 17(a)(1), Exchange Act § 10(b) and Rule 10b-5, and Advisers Act § 206(1). Scienter is not required for the other violations of the Advisers Act. The parties do, however, dispute the meaning of “scienter“; the petitioners suggest that scienter requires specific intent to defraud.
In this Circuit, a violation of Exchange Act § 10(b) and Rule 10b-5 may be supported by “knowing or reckless conduct,” without a showing of “willful intent to defraud.” Nelson v. Serwold, 576 F.2d 1332, 1337 (9th Cir. 1978); see also Howard v. Everex Sys., Inc., 228 F.3d 1057, 1063 (9th Cir. 2000). A similar showing is required for violations of Securities Act § 17(a)(1). See, e.g., SEC v. Dain Rauscher, Inc., 254 F.3d 852, 856 (9th Cir. 2001). We apparently have never considered what constitutes scienter under Advisers Act § 206(1), but because its language is nеarly identical to that of Securities Act § 17(a)(1),6 we now hold that the same definition — knowing or reckless conduct — applies to Advisers Act § 206(1).
Petitioners argue that, because there is no direct evidence of their intent to defraud their clients, the Commission‘s finding of scienter lacks substantial evidence. We are not persuaded. The Commission identified the applicable standard of care correctly and had the requisite evidentiary basis to conclude that the petitioners were in violation.
The Commission correctly determined that the petitioners had a duty to disclose any potential conflicts of interest accurately and completely, and to recognize that the SSA created such a potential conflict. Although the Commission‘s determination of the duty of care is not the kind of formal interpretation that is entitled to Chevron deference, “an agency‘s interpretation may merit some deference whatever its form, given the `specialized experience and broader investigations and information’ available to the agency.” Mead Corp., 533 U.S. at 234 (quoting Skidmore v. Swift & Co., 323 U.S. 134, 139 (1944)). In this case, we defer to the Commission‘s experience and expertise in determining that investment advisers are knowledgeable enough to recognize that an arrangement such as the SSA creates potential conflicts of interest.8
The Commission‘s determination that the petitioners either knowingly or recklessly violated their duties is supported by substantial evidence. The Commission is entitled to draw inferences from the evidence, including an inference that the petitioners’ failure to disclose their potential conflict of interest was not merely an innocent oversight. As the Second Circuit determined in a similar context, the petitioners’ argumеnts
misapprehend the nature of our review of an administrative agency‘s decision. Petitioners essentially argue that this court should draw inferences from the evidence contrary to those drawn by the Commission. In other words, they ask us to “supplant the [administrative agency‘s] reasonable determinations.” Cellular Tel. [Co. v. Town of Oyster Bay], 166 F.3d [490,] 494 [(2d Cir. 1999)]. But based on the record ... we cannot say that the SEC lacked “such relevant evidence as a reasonable mind might accept as adequate to support [its] conclusion.” Universal Camera Corp. v. NLRB, 340 U.S. 474, 477 (1951) (quoting Consolidated Edison Co. v. NLRB, 305 U.S. 197, 229 (1938)) (internal quotation marks omitted). We thus uphold the SEC‘s finding of scienter.
Valicenti Advisory Servs., Inc. v. SEC, 198 F.3d 62, 65 (2d Cir. 1999) (first and fifth alterations in original) (parаllel citations omitted). The record supports the Commission‘s conclusion that the petitioners acted knowingly or recklessly in failing to disclose the required information and affirmatively misstating the nature of their agreement with World.
II. The Exclusion of Expert Testimony.
IMS argues that the ALJ erred in excluding “expert” testimony of a lawyer who, in IMS‘s words, “would have testified to the complexities of the Form ADV and the difficulties in answering some questions on the form due to ambiguous terms.” IMS suggests that the expert‘s testimony was relevant to show the standard of care applicable to completing Forms ADV, which in turn is relevant to show whether the petitioners were reckless in erroneously filling out the forms, which in turn is a possible basis for scienter. The Commission concluded that “[w]hether Form ADV is difficult or not is irrelevant; investment advisers are obligated to respond to questions in Form ADV correctly and seek whatever assistance they need in fulfilling this obligation.”
We do not approve of the Commission‘s general statement that “[w]hether Form ADV is difficult or not is irrelevant,” which implies that a strict liability standard always applies to the identification of conflicts of interest. In a different case, where the financial interests are more complex or uncertain, an investment adviser might not be reckless to answer a particular question incorrectly or incompletely. In such a case, expert testimony might also be relevant to determine whether the adviser‘s conduct is so far outside the range of reasonable conduct so as to be considered reckless. But this is not such a case. We agree with the Commission that expert testimony was unnecessary here because the answers given by petitioners were so clearly misleading or erroneous as to be “highly unreasonable act[s] or omission[s].” Dain Rauscher, 254 F.3d at 856.
III. The Appropriateness of the Sanctions Imposed.
The Commission ordered the petitioners to disgorge the amount received by H&V under the SSA, ordered a suspension of IMS as an adviser for six months, and barred Vernazza, Hall, and Hargrave from associating with advisers for six months. The petitioners argue that these sanctions — and especially the suspensions — are impermissibly punitive, unduly harsh, inconsistent with similar cases, and untimely. Advisers Act § 203 provides that the Commission may suspend the registration of registered advisers or bar association with advisers as a penalty for making false material statements, and may impose monetary penalties for any violations of the Securities Act, the Exchange Act, or the Advisers Act.
In support of their arguments that the suspensions are too punitive or too harsh, the petitioners cite six allegedly similar Commission cases in which the sanctions did not include a suspension. There are significant differences between this case and the other Commission orders; none of the cases cited considered the scheme at issue here, each of them was settled, and in each case, the Commission either considered remedial actions already taken by the adviser or the adviser agreed, as part of the settlement, to institute policies and procedures to prevent future violations. See Duff & Phelps Inv. Mgmt. Co., Advisers Act Release No. IA-1984, 75 S.E.C. Docket 2362 pt. IV & VI, 2001 WL 1152581, at *10-13 (Sept. 28, 2001); Sage Advisory Servs. LLC, Advisers Act Release No. IA-1954, 75 S.E.C. Docket 1073 pt. IV, 2001 WL 849405, at *9 (July 27, 2001); Fleet Inv. Advisors, Inc., Advisers Act Release No. IA-1821, 70 S.E.C. Docket 1217 pt. IV, 1999 WL 695211, at *9 (Sept. 9, 1999); Renaissance Capital Advisors, Inc., Advisers Act Release No. IA-1688, 66 S.E.C. Docket 408 pt. V & VI, 1997 WL 794479, at *5-7 (Dec. 22, 1997); Oakwood Counselors, Inc., Advisers Act Release No. IA-1614, 63 S.E.C. Docket 2034 pt. V, 1997 WL 54805, at *5-6 (Feb. 10, 1997); S Squared Tech. Corp., Advisers Act Release No. IA-1575, 62 S.E.C. Docket 1446 pt. VI, 1996 WL 464141, at *6 (Aug. 7, 1996). Furthermore, the cases demonstrate a range of sanctions, from simple disgorgement to fines as high as $100,000 and bans on accepting new clients. See, e.g., Duff & Phelps Inv. Mgmt. Co., 75 S.E.C. Docket 2362 pt. VI, 2001 WL 1152581, at *10 (imposing sanctions including a $100,000 fine); Renaissance Capital Advisors, Inc., 66 S.E.C. Docket 408 pt. VI, 1997 WL 794479, at *7 (imposing sanctions inсluding a ban on new clients for sixty days).
conflict of interest put them in a position where their recommendations to their clients could be more influenced by their own financial interest than by an assessment of client need. Clients were harmed because they were deceived.... Moreover, [petitioners‘] fraudulent scheme spanned several years.... [T]heir failure to grasp the obligation to disclose ... evidences a disturbing misapprehension of their duties towards their clients. [Petitioners‘] occupations present opportunities for similar future violations.
Given these considerations, we are not convinced that imposing a six-month suspension is unreasonable.9
The petitioners also argue that the Commission‘s sanctions are untimely, both because the Commission did not institute formal proceedings against them until 1996, and because the Commission then waited three years to decide their appeal from the ALJ. We will not consider the fоrmer argument because the petitioners failed to raise it before the Commission, and no reasonable grounds for this failure are evident. See Securities Act § 9(a),
The petitioners argue that the Commission waited an unreasonably long period of time before deciding their appeal from the ALJ, and that this delay undermines the Commission‘s stated rationale for the suspensions — that the petitioners might repeat their wrongful conduct. Petitioners havе not pointed to any evidence of lackadaisical conduct on the part of the Commission or of any improper reason for the delay. We decline to conclude that a delay, absent such evidence, undermines the Commission‘s position that suspensions are necessary to prevent repeated violations by petitioners.10
IV. The Commission‘s Authority to Bar Association with Unregistered Advisers.
Vernazza argues that the Commission lacks the authority to bar him from associating with unregistered, in addition to registered, investment advisers. This argument challenges the unambiguous language of the statute, which allows the Commission to bar violators “from being associated with an investment adviser,”
We decline to consider this issue because Vernazza did not raise it before the Commission. As noted above, the judicial review provision of the Securities Act requires issues to be raised before the Commission, see
PETITION DENIED.
Notes
Vernazza‘s own testimony on this matter was equivocal. The hearing officer first asked why hе needed to reconstruct records of the hours worked “if you had already been doing it periodically to send to World Money Management?” Vernazza replied, “We hadn‘t been.” He then stated:
Actually, I did have some compilation — at the end of 1993 when I had the surgery and also at that particular time the lack of cooperation started from World Money Managers and then subsequently — I don‘t know if this has anything to do with it — but subsequently in 1994 they were under investigation by the Securities and Exchange Commission and everything just stopped. So then in 1994 when I went back to provide this information for the [Commission] Staff, I lоoked for some of that information and it was not there so I reconstructed the best I could.
This testimony is not sufficient to compel a conclusion that the Commission erred in not crediting Vernazza‘s accounting of the hours he worked.