World Trade Financial Corp. v. U.S. Securities & Exchange Commission , 739 F.3d 1243 ( 2014 )

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
WORLD TRADE FINANCIAL No. 12-70681
CORPORATION; JASON TROY ADAMS;
FRANK EDWARD BRICKELL; RODNEY
PRESTON MICHEL,
Petitioners, OPINION
v.
U.S. SECURITIES & EXCHANGE
COMMISSION,
Respondent.
On Petition for Review of an Order of the
Securities and Exchange Commission
Argued and Submitted
November 7, 2013—Pasadena, California
Filed January 16, 2014
Before: M. Margaret McKeown, Ronald M. Gould,
and Jay S. Bybee, Circuit Judges.
Opinion by Judge Gould
2 WTFC V. SEC
SUMMARY*
Securities / Fines and Sanctions
The panel denied a petition for review of the Securities
and Exchange Commission’s Order upholding a variety of
fines and sanctions against petitioners for violating Sections
5(a) and 5(c) of the Securities Act of 1933, which prohibit the
sale or offer of a security without filing a registration
statement.
The panel held that substantial evidence supported the
Commission’s finding that petitioners violated Sections 5(a)
and 5(c) of the 1933 Securities Act. The panel also held that
petitioners did not meet their duty of inquiry necessary to
claim the Section 4(4) brokers’ exemption. The panel
deferred to the Commission’s discretionary determination as
to the appropriate fines and sanctions because they were
within the Financial Industry Regulatory Authority’s
guidelines and were supported by the evidence in the record.
COUNSEL
John Courtade (argued), Law Office of John Courtade,
Austin, Texas; Irving M. Einhorn, Law Offices of Irving M.
Einhorn, Manhattan Beach, California, for Petitioners.
*
This summary constitutes no part of the opinion of the court. It has
been prepared by court staff for the convenience of the reader.
WTFC V. SEC 3
Catherine A. Broderick (argued) and Jacob H. Stillman,
Securities and Exchange Commission, Washington, D.C., for
Respondent.
OPINION
GOULD, Circuit Judge:
World Trade Financial Corporation (“World Trade”),
Jason T. Adams, Frank E. Brickell, and Rodney P. Michel
(collectively, “Petitioners”) petition for review of the Security
and Exchange Commission’s (“Commission”) Order
Sustaining Disciplinary Action Taken by FINRA (the
Financial Industry Regulatory Authority), which upheld a
variety of fines and sanctions against Petitioners for their
violations of Sections 5(a) and 5(c) of the Securities Act of
1933, 15 U.S.C. §§ 77e(a), 77e(c) (“1933 Securities Act”),
which prohibit the sale or offer of sale of a security without
filing a registration statement, id. In its opinion, the
Commission found that Petitioners had traded unregistered
securities and that the Section 4(4) “brokers’ exemption” of
the 1933 Securities Act, which exempts “brokers’
transactions executed upon customers’ orders” from liability
under Sections 5(a) and 5(c), was unavailable to Petitioners
because they had not met their duty of inquiry given the
presence of many suspicious circumstances surrounding the
sales. The Commission also upheld the fines and sanctions
imposed by FINRA and the National Adjudicatory Council
(“NAC”) for these Section 5 violations as well as for
supervisory failures that violated the National Association of
Securities Dealers (“NASD”) Conduct Rules 2110 and 3010
establishing standards of supervision for registered
representatives, principals, and other individuals associated
4 WTFC V. SEC
with covered transactions. Petitioners urge us to reverse and
dismiss the Commission’s order, or alternatively, to vacate
the fines and sanctions and remand the case.
We conclude that substantial evidence supports the
Commission’s finding that Petitioners violated Sections 5(a)
and 5(c) of the 1933 Securities Act, and we hold that
Petitioners did not meet their duty of inquiry necessary to
claim the Section 4(4) brokers’ exemption. We defer to the
Commission’s discretionary determination as to the
appropriate fines and sanctions because they are within
FINRA’s guidelines and are supported by evidence in the
record. Accordingly, we deny the petition for review.
I.
World Trade, a broker-dealer registered with the SEC, has
been a member of FINRA since 1998, and Petitioners Michel
and Adams were its principals and owners at the relevant
times. Michel and Adams shared responsibility for
supervising the firm’s brokers and trading activity. Michel
had responsibility for establishing supervisory systems and
overall compliance. Adams handled client accounts,
performed trading operations, and reviewed trade tickets; he
reported to Michel. Petitioner Brickell joined World Trade in
2001 as a General Securities Representative and now serves
as a principal at the firm and as its Chief Compliance Officer.
The World Trade Supervisory Manual listed written
procedures for the sale of “restricted” stock, or “144 Stock,”
which included unregistered stock that could be traded under
the nonexclusive safe harbor provided in Rule 144 of the
WTFC V. SEC 5
1933 Securities Act.1 Those procedures included a list of
conditions that a representative was required to meet before
selling such securities, including obtaining current
information on the company and the terms under which such
stock should be sold. In practice, World Trade’s employees
identified restricted stock by checking whether the stock
certificate deposited by the customer bore a restrictive
legend.2 The only process in place for handling stock that
lacked a restrictive legend was to submit that stock to a
clearing firm to be cleared, transferred, and sold.
The history of the shares at issue here, however, show the
ease with which restrictive legends may be improperly
removed. Camryn Information Services, Inc. (“Camryn”)
was incorporated as a shell company in 1997. Camryn
conducted no business, and in November 2004, it entered into
a reverse merger with iStorage, a development-stage
company in operation since May 2004 that had little
operating history, no earnings, and was operating at a net loss
of $205,000.
At the time of the merger, iStorage had only four
shareholders, all of whom had been shareholders of Camryn.
Three of those shareholders each owned 12.5% of the
outstanding shares—1,000,000 shares each. At their request,
1
“Restricted stock” is defined as “[s]ecurities acquired directly or
indirectly from the issuer, or from an affiliate of the issuer, in a transaction
or chain of transactions not involving any public offering.” 17 C.F.R.
§ 230.144(a)(3)(i) (2012).
2
A “restrictive legend” is a statement placed on the certificate of a
restricted stock used to notify the holder of the stock that it may not be
resold without registration. Geiger v. SEC, 363 F.3d 481, 483 (D.C. Cir.
2004).
6 WTFC V. SEC
the law firm representing the shareholders issued an opinion
letter incorrectly stating that their shares need not bear
restrictive legends because: (1) the shareholders had held
them for more than two years; (2) none of the shareholders
had been an officer, director or 10% shareholder of the
company for the previous three months; and (3) that the
shareholders were not “affiliates” of Camryn under Securities
Act Rule 144(k). The law firm’s opinion letter was clearly
incorrect because the 12.5% shareholders had held their
shares within the previous three months. Regardless, a
transfer agent removed the restrictive legends from those
Camryn stock certificates, which were later converted into
unlegended iStorage stock certificates during the reissuance.
On November 3, 2004, iStorage issued a forward stock split
for the 12.5% shareholders and canceled the remaining
shares, leaving those three shareholders with 5.2 million
shares represented by unlegended certificates, which they
distributed to a variety of individuals and entities including
stock promoters and marketers.
Those shareholders paid three stock promoters, Robert
Koch, his sister Kimberly Koch, and Anthony Caridi, in
iStorage stock for their work promoting the stock. Robert
Koch opened an account with World Trade in August 2004,
Anthony Caridi did so in November 2004, and Kimberly
Koch opened her account in December 2004. Between
December 20, 2004 and March 24, 2005, World Trade sold
more than 2.3 million shares of iStorage stock to the public
on behalf of these three customers. The Kochs and Caridi
instructed Brickell to wire the proceeds quickly, and he
accordingly wired the $295,000 profit shortly after the
transactions cleared. Brickell earned approximately $9,270
in commissions on the sales. Believing that his inquiry
responsibilities were limited to questioning the transfer agent
WTFC V. SEC 7
regarding restrictions, Brickell acknowledged that he made no
inquiry into the status or origins of the shares, despite the
presence of several “red flags,” including that: (1) iStorage
was a little-known development stage issuer that had a very
short operating history; (2) the company had recently
undergone a reverse merger, forward stock split, and name
change; (3) the stock was thinly traded in the over-the-
counter market; and (4) iStorage had just begun trading
shortly before the initiation of trading by the Kochs and
Caridi. Most of this information was publicly available on
the Pink Sheets stock trading website, and Brickell
additionally knew that the Kochs and Caridi received stock as
compensation for advertising services.
Michel and Adams also both believed that the transfer
agent was responsible for investigating the status of
unlegended stock, asserting that “the regulatory scheme
places this responsibility squarely on the shoulders of the
transfer agent and the issuer and its counsel.” Petitioners also
admitted, however, that neither the transfer agent nor the
clearing firm considered itself responsible for conducting any
inquiry on behalf of World Trade.
The Commission affirmed the conclusions of FINRA and
the NAC that Petitioners violated section 5(a) and 5(c) of the
1933 Securities Act, as well as NASD Rules 2110 and 3010.
The Commission also affirmed the fines and sanctions
imposed on Petitioners for those violations.
II.
We review the Commission’s findings of fact for
substantial evidence. Steadman v. SEC, 450 U.S. 91, 96 n.12
(1981). And while we review the Commission’s conclusions
8 WTFC V. SEC
of law de novo, Gebhart v. SEC, 595 F.3d 1034, 1040 (9th
Cir. 2010), its findings of fact and law are only to be set aside
when “arbitrary, capricious, an abuse of discretion, or
otherwise not in accordance with law.” 5 U.S.C. § 706(2)(A);
Ponce v. SEC, 345 F.3d 722, 728 (9th Cir. 2003). Sanctions
are reviewed for an abuse of discretion, Vernazza v. SEC,
327 F.3d 851, 858, amended by 335 F.3d 1096 (9th Cir.
2003), and should not be overturned unless “unwarranted in
law or . . . without justification in fact,” American Power &
Light Co. v. SEC, 329 U.S. 90, 112–14 (1946).
Petitioners argue that the brokers’ exemption applies to
the transactions at issue and urge us to conclude that the
exemption does not require reasonable inquiry. They argue
that the supporting cases cited by the SEC stand for the
proposition that the SEC carries the burden of showing that
the Section 4(4) exemption was vitiated because of the
presence of a statutory underwriter. However, this
interpretation is contrary to established law. Public policy
strongly supports registration and the 1933 Securities Act is
designed “to protect investors by promoting full disclosure of
information thought necessary to informed investment
decisions.” SEC v. Ralston Purina Co., 346 U.S. 119, 124
(1953). Because registration is so important to the protection
of the investing public, exemptions to registration
requirements are construed narrowly against the parties
claiming their benefits. SEC v. Platforms Wireless Int’l Corp.,
617 F.3d 1072, 1086 (9th Cir. 2010). It is clear that once
FINRA established a prima facie case that the trades at issue
violated the Section 5 registration requirements, the burden
shifted to Petitioners to show the applicability of the Section
4(4) brokers’ exemption. Id.; SEC v. Murphy, 626 F.2d 633,
641 (9th Cir. 1980).
WTFC V. SEC 9
The Commission takes the position and the D.C. Circuit
has held that a broker must conduct a “reasonable inquiry” to
claim the Section 4(4) exemption for trades that violate
Section 5. The D.C. Circuit has concluded that a broker may
claim the Section 4(4) exemption if the broker “[a]fter
reasonable inquiry is not aware of circumstances indicating
that the person for whose account the securities are sold is an
underwriter with respect to the securities or that the
transaction is a part of a distribution of securities of the
issuer.” Wonsover, 205 F.3d at 415 (quoting 17 C.F.R.
§ 230.144) (emphasis added). We agree with the
Commission and the D.C. Circuit that a broker is not merely
an “order taker,” and must conduct a reasonable inquiry into
the circumstances surrounding the transaction before the
broker may claim the protection of the Section 4(4) brokers’
exemption. See, e.g., Robert G. Leigh, Exchange Act Release
No. 27667, 1990 WL 1104369, at *4 (Feb. 1, 1990). The
broker’s reasonable inquiry is important because “violations
of the antifraud and other provisions of the securities laws
frequently depend for their consummation . . . on the
activities of broker-dealers who fail to make diligent inquiry
to obtain sufficient information to justify their activity in the
security.” Laser Arms Corp., Exchange Act Release No.
28878, 1991 WL 292009, at *14 n.35 (Feb. 14, 1991)
(quoting Alessandrini & Co., Inc., Exchange Act Release No.
10466, 1973 WL 149302, at *6 (Oct. 31, 1973), aff’d without
opinion sub nom. Budin v. SEC, 508 F.2d 836 (2d Cir. 1974)).
The extent of the inquiry required for any given trade will
vary with the circumstances. The D.C. Circuit correctly
explained that:
An oft-quoted paragraph of a Commission
release clarifies when a broker’s inquiry can
10 WTFC V. SEC
be considered reasonable: “The amount of
inquiry called for necessarily varies with the
circumstances of particular cases. A dealer
who is offered a modest amount of a widely
traded security by a responsible customer,
whose lack of relationship to the issuer is well
known to [the dealer], may ordinarily proceed
with considerable confidence. On the other
hand, when a dealer is offered a substantial
block of a little-known security, either by
persons who appear reluctant to disclose
exactly where the securities came from, or
where the surrounding circumstances raise a
question as to whether or not the ostensible
sellers may be merely intermediaries for
controlling persons or statutory underwriters,
then searching inquiry is called for.”
Wonsover, 205 F.3d at 415 (quoting Distribution by Broker-
Dealers of Unregistered Securities, Exchange Act Release
No. 33-4445, 1962 WL 69442, at *2 (Feb. 2, 1962)). As
described above, in many cases that duty may be easily
satisfied. But where, as here, there are numerous red flags
indicating suspicious circumstances, a more searching inquiry
is required. See Wonsover, 205 F.3d at 415 (requiring a
“searching inquiry” where unfamiliar shareholders offered the
broker “a substantial block of little-known and thinly traded
security” under questionable circumstances). Petitioners did
not inquire into the origins of the iStorage stock despite the
significant red flags that we have identified. The
circumstances called for a more diligent inquiry, and
Petitioners did not satisfy their duty.
WTFC V. SEC 11
Petitioners contend that, to the extent that they had a duty
of reasonable inquiry, that duty was met by their reliance on
third-parties in conformity with industry practice. We reject
this argument for several reasons. First, substantial evidence
supports the Commission’s conclusion that Petitioners did not
establish an industry standard of reliance on third-parties to
meet the duty of reasonable inquiry. The Commission was
within its discretion to find unreliable the testimonial
evidence of interested parties, particularly when the only non-
interested witness, a FINRA examiner, testified that he could
not confirm such a custom and practice in the industry. And
any alleged lack of FINRA enforcement is discredited by the
frequency of Commission cases and releases reiterating the
broker’s duty of reasonable inquiry. See, e.g., Geiger v. SEC,
363 F.3d 481, 485 (D.C. Cir. 2004) (finding suspicious
circumstances giving rise to a need for heightened inquiry);
Laser Arms Corp., Exchange Act Release No. 28878, 1991
WL 292009, at *14 n.35 (Feb. 14, 1991); Robert G. Leigh,
Exchange Act Release No. 27667, 1990 WL 1104369 (Feb.
1, 1990) (“A broker relying on Section 4(4) cannot merely act
as an order taker, but must make whatever inquiries are
necessary under the circumstances to determine that the
transaction is . . . not part of an unlawful distribution.”);
Owen v. Kane, Exchange Act Release No. 23827, 1986 WL
626043, at *4 (Nov. 20, 1986) (finding that the broker had
“no reasonable basis” for believing a stock was exempt from
registration without making an investigation); Evans & Co.,
Exchange Act Release No. 21696, 1985 WL 548642, at *5–6
(Jan. 30, 1986) (“A broker-dealer . . . relying on Section 4(4)
cannot act as a mere order-taker. It must make whatever
inquiries are necessary under the circumstances to ensure that
its customer is not an underwriter.”).
12 WTFC V. SEC
Second, even if such an industry practice exists, it would
only be suggestive of reasonableness and would not absolve
Petitioners of liability under federal securities laws. See SEC
v. Dain Rauscher, Inc., 254 F.3d 852, 857 (9th Cir. 2001)
(noting the dangers of a “‘race to the bottom’ to set the least
demanding standard to assess . . . conduct.”). Third, brokers
rely on third-parties at their own peril, and will not avoid
liability through that reliance when the duty of reasonable
inquiry rests with the brokers. Wonsover, 205 F.3d at 415–16
(“If a broker relies on others to make the inquiry called for in
any particular circumstances, it does so at its peril.”); Stead
v. SEC, 444 F.2d 713, 716 (10th Cir. 1971) (“[C]alling the
transfer agent is obviously not a sufficient inquiry.”).
Substantial evidence supports the Commission’s finding that
Petitioners did not prove the existence of such an industry
practice in this case. And even if they had, an industry
practice of relying on third-parties would not necessarily
satisfy a broker’s duty of reasonable inquiry merely because
the practice was customary.
Petitioners further contend that the Commission erred
when it found Petitioners’ supervisory system to be
inadequate. They assert that FINRA’s lack of enforcement
and the industry standard practice show that the supervisory
system was reasonable. We reject these arguments.
NASD Rule 3010 requires member firms to establish,
maintain, implement, and enforce supervisory systems that
are tailored to their businesses and that are reasonably
designed to achieve compliance with securities laws and
regulations, as well as NASD Rules. NASD Rule
3010(a)–(b). We have no doubt that Petitioners’ supervisory
system was inadequate to detect unlawful distributions.
World Trade’s written procedures required no inquiry at all
WTFC V. SEC 13
by staff who were confronted with unlegended securities.
The facts of this case illustrate why both courts and the
Commission have cautioned against relying on the presence,
or lack thereof, of restrictive legends. See Quinn & Co. v.
SEC, 452 F.2d 943, 947 (10th Cir. 1971) (“[Petitioners] were
not entitled to rely on the lack of cautionary legends on the
stock certificates. Brokers and securities salesmen are under
a duty to investigate.”).
Rather than relying exclusively on the presence or
absence of restrictive legends, procedures must “be sufficient
to reveal promptly to supervisory officials transactions which
may, when examined individually or in the aggregate,
indicate that sales in a security should be halted
immediately.” Sales of Unregistered Securities by Broker-
Dealers, Exchange Act Release No. 9239, 1971 WL 127558,
at *2 (July 7, 1971). Here, the same red flags that heightened
Brickell’s duty to investigate similarly should have prompted
both Michel and Adams to investigate the trades, but neither
supervisor conducted any inquiry into the sales. In stark
contrast to what we hold to be their supervisory duty, Michel
and Adams both admitted that they believed they had no
independent responsibility to investigate any unlegended
shares or trades. That other firms may have had similar
practices does not excuse ignorance of the law, and
Petitioners’ supervisory system clearly fell short of the
required standard.
III.
Petitioners’ argument that the Commission’s sanctions are
excessive and punitive also fails. The Commission has
substantial discretion in deciding sanctions and fines, and we
conclude that it did not abuse its discretion in this case. See
14 WTFC V. SEC
Vernazza, 327 F.3d at 858. The sanctions were in the mid-
range of FINRA’s sanction guidelines, and evidence supports
the conclusion of FINRA, the NAC, and the Commission that
Petitioners’ violations were egregious because Petitioners
made no reasonable efforts to carry out their legal duties.
Petitioners’ assertion that they were following industry
practice does not relieve them of these duties. See O’Leary
v. SEC, 424 F.2d 908, 912 (D.C. Cir. 1970) (“[A]s to
petitioners’ protest that they ‘were first offenders,’ acting in
accord with advice of counsel, and causing no injury to the
investing public, we concur with Chief Judge Lumbard’s
statement in Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965):
‘While these factors might have warranted a lighter sanction,
they did not require one.’”).
We conclude that Petitioners violated Sections 5(a) and
5(c) of the 1933 Securities Act and that they may not claim
the Section 4(4) brokers’ exemption because they did not
meet their duty of reasonable inquiry. The Commission did
not abuse its discretion in upholding the sanctions imposed by
FINRA and the NAC. These sanctions were reasonable and
commensurate with petitioners’ serious and several breaches
of the duties they owed to the investing public.
DENIED.