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2004
CASE ANALYSIS

 In the Matter of the Application of CHRIS DINH HARTLEY for Review of NASD Action 
Securities Exchange Act of 1934 Release No. 50031, July 16, 2004

http://sec.gov/litigation/opinions/34-50031.htm 


In the Matter of Department of Enforcement vs. Chris Dinh Hartley (Disciplinary Proceeding No. C01010009 HEARING PANEL DECISION, November 5, 2002)
http://www.nasdr.com/pdf-text/oho_dec02_19.txt

In the Matter of Department of Enforcement vs. Chris Dinh Hartley (NAC, Complaint No. C01010009, December 3, 2003)
http://www.nasdr.com/pdf-text/nac1203_02.txt

FLIC Note Sales

Chris Dinh Hartley was a "non-captive" insurance agent primarily engaged in selling life insurance and variable annuities for Pruco Securities Corporation (Pruco) and other insurance companies. In August 1996, he attended a presentation given by Randy Scianna, an insurance agent and owner of his own insurance agency, that was aimed at recruiting salespersons for the promissory notes of First Lenders Indemnity Corporation ("FLIC"), which was engaged in the purchase and resale in the commercial market of automobile installment loan contracts, and was offering promissory notes that matured in nine months and paid 10% interest. According to FLIC, the proceeds from the sale of its notes would be used to purchase additional automobile loan contracts. 

A "captive agent" is required to sell only the products of his or her employer.

Scianna provided Hartley with various materials concerning FLIC, including a Dun and Bradstreet report and FLIC's "Disclosure Document" that was used to solicit sales of the company's notes. According to Hartley, Scianna assured him that FLIC's notes were not securities. However, the second page of the Disclosure Document that Hartley received recited in block capital letters as follows: 

"THE COMPANY BELIEVES THAT THE NOTES ARE EXEMPT SECURITIES... THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION."

Remember this issue for later --- FLIC stated in writing that it believed the notes are exempt securities.

Hartley decided to sell FLIC notes to his customers. On September 9, 1996, he signed a FLIC agent agreement and a FLIC "Representative's Compliance Declaration." As required, he initialed each of the statements in the Declaration, including the following: 

" I have notified my Broker/Dealer of my participation in providing this exempt security to my clients."

"In the eyes of my Broker/Dealer I am in complete compliance." 

 

 However, Hartley had not given Pruco any notification of his decision to sell FLIC notes. Scianna also questioned Hartley as to whether he had checked with Pruco, and Hartley replied that he had asked for permission to sell FLIC notes and had been told that "it was fine."

From September 21, 1996 through January 10, 1997, Hartley sold six FLIC notes in the total amount of $255,000 to five customers, two of whom were Pruco clients. Hartley earned a total of $10,160 in commissions on his sales.  According to Hartley, in late September or October 1996, he had a brief conversation about the FLIC notes with his Pruco supervisor, Marlene Kasparian.  Kasparian had remarked to Hartley that she had money in the bank that "wasn't doing anything." Hartley suggested that she might be interested in purchasing a FLIC note that he was selling. Kasparian replied that she wasn't interested, and did not question Hartley about the notes or his sales.

 FLIC's Fraudulent Transfers

In mid-January 1997, Scianna began receiving complaints from FLIC noteholders that they were not being paid when notes matured or were receiving late or no interest payments. Hartley also began receiving calls from clients asking why their monthly interest checks were late. In early March, Scianna advised Hartley to stop doing business with FLIC and, on March 10, returned a FLIC subscription agreement and check to Hartley that Hartley had forwarded from one of his customers. Thereafter, Hartley discontinued the sale of FLIC notes.

Pruco agents customarily updated the firm as to their outside activities once a year following Pruco's annual compliance meeting. After Pruco's compliance meeting in November 1997, some eight months after his last abortive sale of a FLIC note, Hartley amended his Form U-4 by including the name FLIC in a list of 40 outside entities with which he had conducted business during the year.  

Susan Korp, the business manager of Hartley's office who was then serving as compliance officer, questioned Hartley about FLIC, and Hartley told her that he had sold FLIC promissory notes. Korp passed this information on to the office's interim managing director. The director approved Hartley's amended Form U-4 without taking further action.

Nearly two years later, in August 1999, Hartley received a letter from an attorney representing the receiver appointed for FLIC by a bankruptcy court. The letter stated that the receiver's investigation had revealed that FLIC had been engaged in a Ponzi scheme, and that the commissions paid to Hartley for selling FLIC notes constituted fraudulent transfers recoverable by the receiver. The letter further stated that the court had authorized the receiver to sue Hartley to recover his commissions. It offered to settle the matter for 85% of the amount that FLIC had paid Hartley, and threatened suit unless Hartley accepted the settlement offer within 14 days. Hartley promptly remitted payment, accepting the receiver's settlement offer.

 NASD Rule 3040

3040. Private Securities Transactions of an Associated Person

(a) Applicability

No person associated with a member shall participate in any manner in a private securities transaction except in accordance with the requirements of this Rule.

(b) Written Notice

Prior to participating in any private securities transaction, an associated person shall provide written notice to the member with which he is associated describing in detail the proposed transaction and the person's proposed role therein and stating whether he has received or may receive selling compensation in connection with the transaction; provided however that, in the case of a series of related transactions in which no selling compensation has been or will be received, an associated person may provide a single written notice.

(c) Transactions for Compensation

(1) In the case of a transaction in which an associated person has received or may receive selling compensation, a member which has received notice pursuant to paragraph (b) shall advise the associated person in writing stating whether the member:

(A) approves the person's participation in the proposed transaction; or

(B) disapproves the person's participation in the proposed transaction.

(2) If the member approves a person's participation in a transaction pursuant to paragraph (c)(1), the transaction shall be recorded on the books and records of the member and the member shall supervise the person's participation in the transaction as if the transaction were executed on behalf of the member.

(3) If the member disapproves a person's participation pursuant to paragraph (c)(1), the person shall not participate in the transaction in any manner, directly or indirectly.

(d) Transactions Not for Compensation

In the case of a transaction or a series of related transactions in which an associated person has not and will not receive any selling compensation, a member which has received notice pursuant to paragraph (b) shall provide the associated person prompt written acknowledgment of said notice and may, at its discretion, require the person to adhere to specified conditions in connection with his participation in the transaction.

(e) Definitions

For purposes of this Rule, the following terms shall have the stated meanings:

(1) "Private securities transaction" shall mean any securities transaction outside the regular course or scope of an associated person's employment with a member, including, though not limited to, new offerings of securities which are not registered with the Commission, provided however that transactions subject to the notification requirements of Rule 3050, transactions among immediate family members (as defined in IM-2110-1, "Free-Riding and Withholding"), for which no associated person receives any selling compensation, and personal transactions in investment company and variable annuity securities, shall be excluded.

(2) "Selling compensation" shall mean any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security, including, though not limited to, commissions; finder's fees; securities or rights to acquire securities; rights of participation in profits, tax benefits, or dissolution proceeds, as a general partner or otherwise; or expense reimbursements.

 

 

 

 

RRs must provide prior written notice to the member firm before participating in any manner in a private securities transaction.

 

Notice must disclose proposed transaction in detail; RR's role; and compensation.

 

Firm must approve/disapprove in writing .

 

If "approved," the transaction is carried on firm's books.

Hartley appeared pro se before an NASD Hearing Panel, which found that during the period September 1996 through January 1997, Hartley violated NASD Conduct Rules 3040 and 2110 by selling promissory notes for compensation without giving Pruco prior written notification and receiving Pruco's prior written approval.  Specifically, the Panel found that without informing Pruco and obtaining its approval, Hartley sold six FLIC notes in the total amount of $255,000 to five customers and earned commissions of $10,160 on the sales. The Panel imposed a $7,500 fine and a 30 day suspension.  The NASD's National Adjudicatory Council (NAC) called the matter for review, Hartley again appeared pro se, and the NAC increased his suspension to 90 days. Hartley appealed the $7,500 fine and 90 day suspension to the SEC and did so through a lawyer.

SEC Appeal

As part of his SEC appeal, Hartley did not dispute that the FLIC notes were securities.  Regardless, the SEC believed that the notes are included within the definition of "security" in Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Exchange Act of 1934 as "any note," and that they are not excluded from that definition under the Supreme Court's "family resemblance" test as set forth in Reves v. Ernest & Young, 494 U.S. 56, 63-65 (1990).  Consequently, the SEC concluded that Hartley violated NASD Conduct Rule 3040 by selling securities for compensation without giving Pruco prior written notification and receiving Pruco's prior written approval.

 In concluding that the notes were securities, the SEC found that 
  • FLIC's notes did not resemble any of the instruments that the Court recognized as not constituting securities, and there is no basis for adding the notes to the list of non-securities. 
  • Investors were attracted by the notes' high rate of interest, and FLIC purportedly sought to raise money from their sale to carry on its regular business. 
  • The notes were distributed throughout the United States. 
  • Purchasers of the notes reasonably considered that they were making an investment, and no other scheme of regulation was available.

NASD determined that Hartley's violation of Rule 3040 also constituted a violation of Conduct Rule 2110, which requires adherence to high standards of commercial honor and just and equitable principles of trade. Hartley argues that he did not violate Rule 2110. The SEC sustained the violation.

NASD Conduct Rule 2110 requires that members and associated persons "observe high standards of commercial honor and just and equitable principles of trade."

Is this double dipping?  No, courts have held that a violation of one NASD rule can constitute a violation of just and equitable principles of trade. Sirianni v. SEC, 677 F.2d 1284, 1288 (9th Cir. 1982) (ruling that failure to provide notice of private securities transactions was inconsistent with just and equitable principles of trade); Stephen J. Gluckman, Securities Exchange Act Rel. No. 41628 (July 20, 1999), 70 SEC Docket 418, 428 (finding that failure to provide notice of private securities transactions was inconsistent with just and equitable principles of trade). See also Gerald James Stoiber, 53 S.E.C. 171, 180 n.22 (1997), aff'd. on other grounds, 161 F.3d 745 (D.C. Cir. 1998); Steven B. Theys, 51 S.E.C. 473, 480 (1993).
 

Hartley complained that NASD did not consider or gave insufficient weight to various mitigating circumstances, and that his conduct was "neither intentional, reckless, nor grossly negligent."  Under Section 19(e)(2) of the Exchange Act, the SEC must sustain NASD sanctions unless it finds them excessive or oppressive or an undue burden on competition. Hartley argues that no sanctions should be imposed on him, let alone what he characterizes as the overly severe sanctions that NASD assessed. He complains particularly about his suspension, which NASD's National Adjudicatory Council ("NAC"), after calling this matter up for review, increased to 90 days from the 30 days assessed by the NASD Hearing Panel.  Hartley's major contentions are that he was guilty of only an innocent mistake, that he reasonably believed that the FLIC notes were not securities, and that he did not try to deceive anyone.  Notwithstanding his assertions, the SEC deemed that the evidence in the record substantially undercut his protestations.

As the SEC saw it, both FLIC's Disclosure Document and its Compliance Declaration put Hartley on notice that the FLIC notes might well be securities.  Okay . . . but let's be frank here.  The FLIC Disclosure Document clearly stated that the company believed the notes were exempt securities.  I'm not sure that any reasonable person would deem that to be "notice" to the contrary.  Unfortunately, what seems to have been the petard upon which Hartley blew himself up was his false affirmation that he had notified Pruco of the transaction.

 
Further, the SEC seemed troubled that Hartley made no further inquiry, and never gave Pruco notice prior to his sales even though the Declaration required him to represent that he had done so.  Okay . . . but, once again, let's be frank here.  If a reasonable person believes that he or she is NOT selling a security, then you wouldn't be required to give notice of a securities transaction.  I never did and still don't like this "piling it on" approach to legal reasoning.   Reduced to its absurdity, the NASD and SEC are essentially arguing that if my aunt were a man, she'd be my uncle --- FLIC clearly opined that the notes weren't a security!

 
Standing on firmer footing, the SEC determined that Hartley falsely affirmed in the Declaration that he had given Pruco notice and obtained its approval for his sales, and he repeated the same falsehoods to Scianna. The SEC concedes that Hartley "notes briefly to Kasparian" about his involvement with the FLIC notes after he had begun selling them, but admonishes that the notice was not in the context of making inquiry or seeking approval. Nor did he provide Kasparian with the necessary details about the notes and his sales activities. Even on his amended 1997 Form U-4, submitted long after his sales of FLIC notes had ended, Hartley merely included FLIC's name in a list of 40 entities with which he had conducted business during the year. He is also criticized for furnishing additional information only when questioned. Okay . . . but, once again, again, let's be frank here.  This whole exercise is splitting so many hairs that I feel as if I'm becoming a barber.   One, even if he merely noted "briefly" that he was selling notes, he still made notification.  Further, the fact that he included FLIC's name on his Form U4 means that he still made that disclosure.  Finally, even if he submitted information "only when questioned" it also evidences his cooperation.  Frankly, I'm not clear what the SEC is really suggesting --- are brokers required to be clairvoyant and answer questions before they're asked?

Ultimately, what NASD and SEC are missing or else glossing over, is that Hartley largely acted in a manner consistent with an individual who thought he was selling a legal, non-security product and did virtually nothing to hide his conduct.  Whatever the nature of his notices or disclosures --- he still made them.

In reviewing the NASD's evaluation of its applicable Sanction Guidelines factors, the SEC refuted Hartley's claims that he wasn't given enough credit for what he described as mitigating factors --- moreover,  the SEC found that five of the seven guideline factors served to aggravate Hartley's offense. 

Hartley's sought consideration of the fact that he only sold to two Pruco customers, and they did not use money from their Pruco account to purchase the notes. Noting the purpose of Rule 3040 is to protect investors from unsupervised sales and securities firms from exposure to loss and litigation from transactions by associated persons outside the scope of their employment. See, e.g., Jim Newcomb, Exchange Act Rel. No. 44945 (October 18, 1991), 76 SEC Docket 172, 181, the SEC failed to see how investors and firms are better protected if customers use funds for outside transactions with firm personnel that are not taken from the customers' accounts with the firm. 

Hartley also complained that the NAC failed to recognize that FLIC note holders will recoup from 44% to 74% of their funds in the FLIC bankruptcy proceeding. He also noted that he "voluntarily" returned the commissions that he earned on his FLIC transactions. The SEC did not consider that Hartley was deserving of a reduction in sanctions because his clients may be able to recover some of their losses. Moreover, they characterized his   surrender of his FLIC commissions as an act that occurred only after he was threatened with a lawsuit by FLIC's receiver in bankruptcy.

Nonetheless, the SEC noted that the NASD has already taken into account other mitigating factors cited by Hartley -- Pruco's inadequate training and supervision, the fact that Hartley told Kasparian that he was selling FLIC notes (although he did not provide all of the details), and that Hartley cooperated in NASD's investigation and expressed genuine remorse. No further reduction in sanctions were warranted based on these considerations.

Rule 3040 Sanction Guidelines Factors 

(1) had an interest in the issuer, 

(2) attempted to create the impression that his employer sanctioned the activity, 

(3) sold away to customers of his employer, 

(4) provided his employer with verbal notice of all relevant factors, 

(5) sold the securities despite an employer's prohibition or warning, 

(6) was properly registered to sell the securities, and 

(7) sold directly to customers or referred them to a properly registered individual.

Decision

The SEC sustained the NASD's imposition of a $7,500 fine and a 90 day suspension.


BILL SINGER'S COMMENTARY

There are a number of things that I find wrong with this decision.  Most notably, when the NASD brought its case to trial before an NASD Hearing Panel, its Enforcement staff sought a $10,000 fine and a four month suspension.  Let's put that into perspective. Perhaps Mr. Hartley felt totally innocent of the charges --- or perhaps he felt that he had engaged in a minor violation caused by a simple misunderstanding.  Accordingly, he may have been prepared to pay a $10,000 fine but didn't see the need for a suspension --- or let's say he was prepared to offer a two month suspension.  In any event, assume that he felt that by going before a Panel and telling his story, he would obtain a lesser sanction than that demanded by Enforcement.

So, what happened?  Apparently, Mr. Hartley did quite well before the Panel.  He appeared without a lawyer and muddled through as best he could.  If you read the Panel decision, you'll see such language as 

Respondent expressed remorse and promptly relinquished his FLIC commissions Respondent immediately ceased soliciting the FLIC notes when _______ indicated that there might be a problem. Respondent also promptly relinquished his commissions to FLIC's receiver when requested to do so.38 (Tr. p. 196). The Hearing Panel was also favorably impressed with Respondent's remorse and sincerity.39 Korp testified that Respondent was one the most outstanding Pruco agents and she held him in very high regard. (Tr. pp. 96-97). The Hearing Panel views Respondent as a truthful and trustworthy man who is not likely to engage in similar misconduct in the future.

In fact, the Panel seemed so impressed that they rejected Enforcement's requested sanctions by reducing the sought fine by 25% to $7,500 and the sought suspension by 75% to 30 days.  And remember, Dinh, pulled this off by himself.  There wasn't any lawyer representing him.

And then things take a nasty turn.  The NAC calls the matter on appeal --- not the parties.  And the NAC claims it does so because it wants to examine the sanctions.  Except Hartley had already appeared before a Hearing Panel, presented evidence and testimony, witnesses were called, and he won his case --- if you use the fact that the sanctions imposed upon him following that trial were less than those sought by his prosecutors.  Despite putting him through that hearing, despite having an entire hearing process to provide for face-to-face confrontation, the NAC intervenes and ups the suspension from one month to three.  And the NAC's main concern seems to be crystallized in this statement:

Finally, the Hearing Panel found that Hartley testified truthfully, cooperated with NASD's investigation, expressed genuine remorse for his violative conduct and promptly remitted his commissions to FLIC's receiver when asked to do so. We accept the Hearing Panel's findings in this regard. Nevertheless, we are troubled that Hartley falsely represented in his FLIC compliance declaration that he had advised Pruco of his participation and had received permission from Pruco to participate in the offering. This compliance declaration also should have put Hartley on notice that greater disclosure to Pruco may have been required.

What was the point of the trial?  The Hearing Panel saw and heard Hartley and the various witnesses --- a critical opportunity to assess everyone's credibility.  The Panel had the same opportunity to decide how upset it should be about Hartley's false representations in his FLIC declaration.  Based upon all of that, the Panel suspended Hartley for 30 days.  In what can only be characterized as gross second-guessing, the NAC said "Nah . . . let's triple the suspension."  From my perspective the NAC has wrongly substituted it's second-hand observations for the primary ones of the Panel.  What was the point of the trial?

But there's a larger issue here.  There is a critical check and balance missing from the NASD's disciplinary system.  Supposing Hartley agreed that he was guilty but having read the caselaw and considered the facts of his case, he believed he should only pay a $5,000 fine and do 30 days suspension.  Now, let's assume that whoever is calling the shots on the NASD's prosecution team is playing what we call hardball.  Let's imagine that he's trying to bluff Hartley and rather than agree to a settlement of 30 days is demanding four months, hoping to get three months.  Worse, let's assume that this staffer realizes he's dealing with a pro se respondent and assumes he can intimidate him into settling.  The NAC's and the SEC's actions in considering this appeal totally fail to address that situation.  Clearly, and I am prepared to debate this anywhere and anytime, the procedural rule should be quite simple:

At the opening of an NASD hearing, the Hearing Officer should ask Enforcement to specify on the record the sanction it demands from the Respondent.  Respondent should then be given an opportunity to accept that proposed sanction.  If that sanction is rejected, the hearing proceeds.  In the event that the Panel awards a sanction less than that sought by Enforcement at the hearing, neither the NAC nor the SEC should be permitted to increase said sanction on appeal.  This necessary procedural device will ensure that regulatory staff always attempt to fairly resolve proposed enforcement proceedings.



RRBDLAW.COM AND SECURITIES INDUSTRY COMMENTATORô © 2004 BILL SINGER

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