SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 58951 / November 14, 2008 Admin. Proc. File No. 3-11953r In the Matter of the Application of ALVIN W. GEBHART, JR. and DONNA T. GEBHART c/o Charles F. Goria Goria, Weber & Jarvis 1011 Camino Del Rio South, Suite 210 San Diego, CA 92108 For Review of Disciplinary Action Taken by NASD OPINION OF THE COMMISSION REGISTERED SECURITIES ASSOCIATION -- REVIEW OF DISCIPLINARY PROCEEDING Redetermination of Liability on Remand for Fraudulent Sale of Securities The Ninth Circuit Court of Appeals affirmed the Commission's finding that registered representatives of member firm of registered securities association engaged in private securities transactions without giving prior written notification to, or obtaining prior approval from, member. The Court remanded for further findings on whether representatives violated antifraud provisions with the requisite scienter when they made material misrepresentations and omissions in the sale of securities. Held, representatives recklessly made material misrepresentations and omissions, and association's findings of liability and the sanctions imposed therefor are sustained. 2 APPEARANCES: Charles F. Goria, of Goria, Weber & Jarvis, for Alvin W. Gebhart, Jr. and Donna T. Gebhart. Marc Menchel, James S. Wrona, and Michael J. Garawski, for Financial Industry Regulatory Authority, Inc., Department of Enforcement, for NASD. Case remanded: January 15, 2008 Last brief received: June 13, 2008 I. This proceeding is before us on remand from the United States Court of Appeals for the Ninth Circuit (the "Court"). On January 18, 2006, we issued an opinion and order (the "2006 Opinion") sustaining NASD disciplinary action against Alvin W. Gebhart, Jr., and Donna T. Gebhart, registered representatives formerly associated with Mutual Service Corporation, an NASD member firm. 1/ NASD found that the Gebharts, in offering and selling over $2 million in unregistered promissory notes from 1997 through early 2000, violated the registration and antifraud provisions of the federal securities laws as well as several NASD rules. NASD found that, because the promissory notes were securities, no registration statement was in effect as to the notes, and no exemption applied, the Gebharts' sales violated Section 5 of the Securities Act of 1933 2/ and NASD Conduct Rule 2110. 3/ NASD found further that the Gebharts had not obtained prior written permission from their firm to engage in the sale of the notes, thereby 1/ Alvin W. Gebhart, Jr., and Donna T. Gebhart, Securities Exchange Act Rel. No. 53,136 (Jan. 18, 2006), 87 SEC Docket 437, remanded, Gebhart v. SEC, 255 Fed. Appx. 254 (9th Cir. Nov. 21, 2007). On July 26, 2007, the Commission approved a proposed rule change filed by NASD to amend NASD's Certificate of Incorporation to reflect its name change to Financial Industry Regulatory Authority Inc., or FINRA, in connection with the consolidation of the member-firm regulatory functions of NASD and NYSE Regulation, Inc. See Exchange Act Rel. No. 56,146 (July 26, 2007), 72 Fed. Reg. 42,190 (Aug. 1, 2007). Because the disciplinary action here was taken before that date, we continue to use the designation NASD in this opinion. 2/ 15 U.S.C. § 77e. 3/ NASD Conduct Rule 2110 requires adherence to just and equitable principles of trade. 3 violating NASD Conduct Rules 3040 and 2110. 4/ NASD also found that the Gebharts violated several antifraud provisions: Section 10(b) of the Securities Exchange Act of 1934, Exchange Act Rule 10b-5, and NASD Conduct Rule 2120, in connection with their offer and sale of the notes. 5/ For selling unregistered securities and engaging in securities transactions without permission from their firm, NASD barred Alvin Gebhart and suspended Donna Gebhart for one year and fined her $5,000. For their violations of the antifraud provisions, Alvin Gebhart received another bar, and Donna Gebhart received a second one-year suspension (to be served concurrently with her first suspension) and a $10,000 fine. We sustained both NASD's findings of violation and the sanctions imposed. Following issuance of the 2006 Opinion, the Gebharts appealed those portions of the decision that found the Gebharts liable for selling securities without their firm's permission and for engaging in fraud. 6/ On November 21, 2007, the Court of Appeals affirmed the findings of liability with respect to the Gebharts' selling of securities without firm permission. 7/ However, the Court reversed the findings that the Gebharts had engaged in fraud, vacated the sanctions based thereon, and remanded the matter "for further findings on the factually intensive question of whether the Gebharts acted with the requisite scienter" to support the findings of fraud. 8/ In this opinion we address the Court's concerns, focusing on whether the Gebharts acted recklessly when they offered and sold the securities at issue in this case. 9/ We find that the Gebharts' 4/ NASD Conduct Rule 3040, titled "Private Securities Transactions of Associated Persons," prohibits involvement by associated persons of member firms in a transaction outside the regular course or scope of employment without providing prior written notice to the member firm. 5/ 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5. NASD Conduct Rule 2120 prohibits fraud in the offer and sale of securities. 6/ The Gebharts did not contest, in their appeal to the Court, the finding that the promissory notes in question were securities and that the Gebharts violated Securities Act Section 5 and NASD Rule 2110 by offering and selling the unregistered notes. Those findings are therefore final. 7/ Gebhart v. SEC, 255 Fed. Appx. at 256. 8/ Id. 9/ In reaching our decision, we have considered the arguments of the parties in briefs submitted pursuant to a scheduling order issued on February 6, 2008 as well as an order issued May 29, 2008 granting a request by the Gebharts to submit supplemental briefing (continued...) 4 conduct did, in fact, satisfy the Court's definition of recklessness, for the reasons explained below. II. For purposes of this opinion, the pertinent facts are as follows. The Gebharts were securities salespersons with Mutual Service Corporation ("MSC"), a broker-dealer and member of NASD. From 1997 to 2000, the Gebharts offered and sold to their clients nearly $2.4 million in unregistered promissory notes ("Notes") issued by MHP Conversions, LLC ("MHP"). MHP sold the Notes purportedly to finance the conversion of mobile home parks to resident ownership. MHP's sales literature represented that a related company, Community Service Group ("CSG"), would purchase the parks from the owner and then assist the park's residents with legal and financial arrangements so that they could ultimately purchase the property themselves. Gebhart, who has been in the securities industry since 1983, learned about the Notes in late 1995, while working at Mutual of New York ("MONY"), from another MONY salesman named Jack Archer. Gebhart thought highly of Archer, an ex-Marine and Vietnam veteran with more experience selling securities than Gebhart. Archer had a short discussion with Gebhart in which Archer briefly described the MHP trailer park program and asked if Gebhart would be interested in it. Gebhart referred three of his clients to Archer; all three invested funds with Archer, who paid Gebhart a finder's fee. 10/ According to the Gebharts, the fact that these clients did not complain about their investments later served as a basis for their recommendation of the Notes to others. The Gebharts understood that MHP was created to issue the Notes that were sold to individual investors to raise the funds necessary for CSG's purchase of the parks. However, the record is unclear as to these entities' actual roles in any transactions related to the ownership interests in the parks, and the Gebharts' own understanding of the mechanics of these transactions was vague. For example, asked why the Notes were issued by MHP, Gebhart testified, "Because 9/ (...continued) on the relevance of a recent decision of the United States District Court for the Southern District of California, SEC v. Platforms Wireless Int'l Corp., 559 F.Supp.2d 1091, 1096- 97 (S.D. Cal. 2008) (defining recklessness in the context of fraud as "'a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it'" and noting that "'recklessness only satisfies scienter under § 10(b) to the extent that it reflects some degree of intentional or conscious misconduct'" (quoting Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990) and In re Silicon Graphics, Inc. Sec. Litig., 183 F.3d 970, 977 (9th Cir. 1999))). 10/ Neither NASD nor we based any findings of liability on these three referrals. 5 of the fact that the parks – when they were trying to do a park [Archer] would tell us, 'I have this park that's going through a conversion.' We would get the name of the park to be done and get the check made out to that name and then it wouldn't work for some apparent reason and the check would be given back to the client. This is an easier way of facilitating the process, is what he explained to me." The Gebharts made no effort to understand or investigate why their clients were being sold second (and not first) deeds of trust, nor did they know or inquire about the identities of the first trust deed holders or the amounts of those outstanding first trust deeds. When asked to explain the process MHP used to issue and secure trust deeds on trailer parks it was converting, Donna Gebhart was unable to describe it, testifying, "I wish I could explain it more. I wish I would have known more." The MHP Notes had one-year terms with fixed interest rates of 18% for new investments and 14% on reinvested funds. Each Note stated that it would "ultimately be secured by a deed of trust" on the particular park to be purchased with the funds, but that "[u]ntil such time as said deed of trust is recorded, the sole asset of [the issuer] will be a deed of trust for the property known as Eastern Trailer Park . . . in the amount of $100,000." In late January 1996, Gebhart left MONY to join MSC; his wife soon thereafter became a registered representative and joined him in selling insurance and mutual funds and providing financial planning services in their California branch office. On October 2, 1996, at Archer's suggestion, the Gebharts themselves invested $7,000 in the Notes. 11/ On October 23, 1996, Archer asked the Gebharts if they were interested in selling Notes directly to their clients. The Gebharts had a lengthy discussion with him about the Note program. Archer represented that he had done his own due diligence and had received permission from his own firm to sell the Notes. In fact, Archer did not receive permission from his firm to sell the Notes. 12/ Archer also told the Gebharts that "all of the governmental agencies were involved," "the parks were in good shape," "had a lot of equity in them," and were only "45 to 55 percent leveraged." The Gebharts had also received from Archer a packet of marketing materials prepared by the issuer. 13/ 11/ The Gebharts eventually purchased nearly $70,000 in Notes, though some portion of this amount represents reinvestment of funds from matured Notes. As noted infra, the Gebharts had about half this amount invested in Notes when MHP eventually collapsed in the spring of 2000. 12/ Archer was a named respondent in the proceedings before NASD, but he defaulted and was barred by NASD from associating with any member firm. 13/ This included a sample promissory note, a "brochure" that featured a printout from CSG's Web site describing its park-conversion business, several local newspaper articles that reported successful park conversions, several one-page descriptions of converted parks, and "pro forma" financial information for one park conversion that provided a brief projected cash flow analysis and an investment summary that sketched the outlines of (continued...) 6 The Gebharts discussed the MHP Note program with their firm, MSC, in a single phone call soon after their conversation with Archer. Alvin Gebhart testified that, during this call, he had a relatively lengthy conversation with the compliance director at MSC, during which Gebhart explained the program in detail, disclosed that he would be receiving commissions on the sales, and answered "a lot" of questions. The MSC compliance officer testified that the call was "a casual five-minute conversation" in which Gebhart told him "very little" about the Notes. However, the parties agree that MSC did not give permission to the Gebharts to sell the Notes during that telephone call. The Gebharts forwarded a copy of the MHP marketing materials by courier to MSC but never received a response. Nevertheless, the Gebharts began offering and selling MHP Notes to their clients a few months later, in early 1997. In addition to having contacted MSC for permission to sell the Notes (permission they never received), the Gebharts made available to MSC auditors in November 1997 and February 1999 their transaction logs and client files that contained some evidence of MHP Note purchases. The auditors did not raise any objections to the Note program. Although the Gebharts appear to have made no attempt to hide from the MSC auditors information about the MHP Notes, it is unclear whether the auditors actually saw any of the evidence of the purchases. The Gebharts' administrative assistant also contacted MSC's operations department in September 1998 to inquire whether funds held in a retirement account could be used to purchase an MHP Note, and MSC's operations department faxed its approval of the MHP Notes for holding in a 403(b) account. The Gebharts' office assistant testified in a deposition in a related civil case that this communication with MSC about the Notes was limited solely to finding out what administrative steps the client needed to take to hold an MHP Note in her 403(b) account. Ultimately, two Note purchases were made with 403(b) funds, and the paperwork for these purchases cleared MSC's operations department without comment. It is undisputed, however, that MSC's compliance department, which was responsible for approving outside business activities, did not review these transactions. Nevertheless, Gebhart testified that he had done "the proper due diligence" by talking to Archer, contacting MSC, and visiting two of the trailer parks to be converted. Other than these 13/ (...continued) CSG's plan to borrow funds to convert the park. MHP was mentioned in these materials only in that the company's name appeared on the cover of the brochure along with CSG's. 7 two site visits, the value of which was questionable, 14/ the Gebharts made no attempt to gather information on the individual parks in which their clients would be investing through MHP. The Gebharts concluded that the Note program was a successful venture because they "didn't hear any complaints" from early investors. The Gebharts neither sought nor possessed any information about the management or financial health of MHP, apparently considering it irrelevant: Gebhart testified that he never imparted any information about MHP to clients because his clients "were, as I saw, lending money to a mobile home park itself." According to Donna Gebhart, "[i]t was always our understanding that [MHP] wouldn't have done a conversion on a park that wasn't – that didn't have good cash flow and that would be a deal worth them doing." Donna Gebhart did not explain what parameters she believed MHP used to determine if a deal was "worth doing," but testified that she simply "had faith with everybody that was involved that it was a good program." In selling the Notes to their clients, the Gebharts presented the MHP program as an option for investors who needed a substantial, fixed monthly income. For example, investor Maribeth Trogdon, a recent widow with two dependent children whose only income was from a part-time teaching job, testified about her discussions with the Gebharts in a deposition in a civil case brought against Gebhart and MSC by clients who bought MHP Notes. 15/ Trogdon testified that the Gebharts recommended that she invest a large portion (more than a third) of the life insurance 14/ Gebhart testified in a civil deposition in a related case that these site visits consisted of the following: What we did is I went up to the Flinn Springs trailer park, drove in, looked around to see the quality of it, to see if it's there, if it's a bona fide piece of real estate, there were mobile homes on it, people living in those mobile homes, whether it was upkept – kept up. Same thing in Aviation. I drove in, looked around, see if there's people living there, if mobile homes were there. In fact, they were. In this connection, we note that the Gebharts' clients eventually invested in several other parks in addition to the two that Gebhart visited. 15/ NASD declined to base findings on depositions from Trogdon and other customers given in related civil proceedings brought by Note purchasers against Archer, the Gebharts, and their firms (the "Noteholder suit"). However, we see no reason not to consider this evidence. The Gebharts' lawyer was present during these depositions, and never objected to their inclusion in the record below (nor have the Gebharts objected subsequently). Moreover, the testimony appears credible in that the customers make similar assertions about what they were told by the Gebharts. See Frank J. Custable, Jr., 51 S.E.C. 643, 648 (1993) (finding that "similarities in each customer's [challenged] testimony regarding [the salesperson's] behavior and treatment of them" strengthened finding of credibility). The testimony is also consistent with that of the Gebharts themselves. 8 proceeds from her husband's death into MHP Notes to replace her husband's income. Notes that Trogdon made in preparation for the deposition state that "[t]he investment was presented to me as a proven, long term way for me to receive a substantial monthly income." 16/ Trogdon also testified during the deposition that, when she asked the Gebharts how she could be sure the money she was putting toward the MHP Note "isn't being sent to Tahiti," the Gebharts replied that MSC "looks at all our business . . . and would tell them if there was anything incorrect by law." 17/ Investors testified that the Gebharts told them that the Gebharts had invested their own money in the Notes and that the program had so far been successful. Investor Donald Townsend, a retiree looking to supplement his retirement income "to take care of the bills," testified that Gebhart represented that MHP was "basically solvent and steadily growing[,] obtaining more parks[,] and had been paying the monthly interest with no problems." At the hearing, Gebhart confirmed that he believed the trailer park program was a successful venture because he "didn't hear any complaints" from the three clients he had referred to Archer in early 1996. Investors also testified that the Gebharts informed them that the MHP Notes would be secured by recorded deeds of trust, and that the parks would serve as sufficient collateral to secure all investments in the event of default. For example, Townsend testified, "I was told that [MHP] would purchase the mobile home parks with the money that's being loaned to them and that they would eventually secure the property with trust deeds . . . ." 18/ Investor Larry Tickel, a disabled former Wal-Mart store manager, testified that the Gebharts assured him that "there was no risk because [the Note] was secured by a deed of trust and then that [the parks] would not be overbought. So that way, if they had to sell the place, we would still get our money back." Following up, the NASD attorney asked Tickel, "Is that what Mr. Gebhart told you, that there was no risk?" Tickel responded, "Right." 19/ Similarly, Sylvia Kerr, a disabled former court reporter who made a total of four investments in MHP Notes, testified in a deposition in the Noteholder suit that she "didn't want 16/ Trogdon invested $160,000 in an MHP Note in March 1999. Trogdon, and all other investors whose testimony is cited in this opinion, represented in a signed proof of claim submitted to the district court handling MHP's bankruptcy that MHP failed to record a trust deed securing their promissory notes, and there is no evidence in the record that refutes the investors' claims. 17/ The Gebharts corresponded with their customers using letterhead that stated "Securities offered by Mutual Service Corporation." 18/ Townsend invested $40,000 in an MHP Note in June 1998; he re-invested those funds in another Note and added another $2,200 to his investment in June 1999. 19/ Tickel invested $20,000 in an MHP Note in August 1999. 9 to have any risk" with the money she wanted to invest, and she "remembered us laughing and them [i.e., the Gebharts] saying, 'Well, if you don't want to take any risk, this would be the place to put your money again.'" 20/ The Gebharts' recollection of their representations to their clients is consistent with the clients' testimony. Gebhart testified that he told clients, "If they invested into [an MHP Note] they would get a recorded deed of trust. If the worst case scenario came down they would be part owners of that park." Donna Gebhart similarly testified, "If [clients] asked us about it, either [Gebhart] or I would say the type of thing it is; they are mobile home park conversions. We would give them the knowledge we had about them and we would tell them that they would own a piece of the park . . . . [I]f it was like worst case scenario, if something happened and the park were to default, we all would own a portion and we could be able to sell the park and we would all get cashed out." However, MHP did not provide copies of the deeds of trust supposedly securing the Notes unless an investor requested one, and very few investors made such a request. The Gebharts recalled seeing one client's trust deed, but did not recall seeing any recording information. The Gebharts never asked for, nor received, a copy of the deeds of trust purportedly securing their own Notes. Indeed, the Gebharts point to only one trust deed contained in the record before us that was recorded; however, that recordation occurred in 1995, well before the Gebharts began selling Notes to their clients. Aside from the ambiguity of the recording status of the deeds purportedly securing their clients' Note purchases, the Gebharts did not have any information about the value of the properties that were intended to serve as collateral and did not know how many of these deeds of trust were supposedly filed against each property or the extent to which the properties were otherwise encumbered. The Gebharts had essentially no contact with the issuer. Archer handled all the paperwork for the Gebharts' clients who bought MHP Notes and told the Gebharts not to contact MHP or CSG directly. Gebhart testified that he spoke to the principal of MHP once about an "administrative matter," but on the few other occasions the Gebharts tried to contact the company, the staff "kept referring [the Gebharts] back to Archer." Archer shared his commissions with the Gebharts, paying them checks drawn on his personal bank account. 21/ They were paid 6-7% for new purchases and 3-4% for reinvested funds. By early 2000, the Gebharts had sold over $2.4 million in MHP Notes to more than forty clients, for which they received over $110,000 in commissions. 20/ Kerr invested $10,000 in an MHP Note in January 1998; she re-invested those funds in new Notes in February 1999 and February 2000. In September 1999 Kerr made an additional Note purchase in the amount of $11,000. 21/ Archer testified in a deposition in the Noteholder suit that the commissions he earned on MHP Note sales represented more than half of his income in 1998 and 1999. 10 In April 2000, MHP stopped making interest payments on the Notes. By this time, clients of the Gebharts had over $1.5 million invested in the securities; the Gebharts themselves had about $36,000 invested. On May 3, 2000, MHP sent a letter to Noteholders explaining that an illness of the company's owner was causing "cash flow problems." MHP claimed that approximately $605,000 worth of Notes had been secured by recorded deeds of trust but revealed that MHP owed nearly $3.7 million to holders of its promissory notes. 22/ The Gebharts reported in a May 2000 letter to their firm describing the collapse of the MHP Note program that "all of the mobile home parks appear[ed] to be substantially overencumbered," and that they had "no way of knowing this until May 11th of this year, when Mr. Archer showed us his note obligations." By their own admission, the Gebharts had been unaware that, by May 2000, Archer's clients had invested over $2 million in the same parks in which the Gebharts' own clients had invested over $1.5 million. By October 2000, the Gebharts had learned that MHP and related entities owned only "$500,000 - $700,000 in net assets" plus an insurance policy on the life of MHP's owner in the amount of $1 million. After the Gebharts notified MSC of MHP's collapse, MSC investigated the matter and, on August 11, 2000, terminated the Gebharts' association with the firm. Following MHP's collapse, the Gebharts took steps to recover the money that they and their clients had invested, including filing a petition for involuntary bankruptcy against MHP. Purchasers of MHP Notes sued Archer, Gebhart, MONY, and MSC. When the Gebharts' liability insurer refused to indemnify Gebhart, the Gebharts sued the insurer to force it to pay for Gebhart's defense and any damages awarded to the Noteholders. The Gebharts' clients ultimately recovered approximately 84% of their investments. III. Exchange Act Section 10(b), Exchange Act Rule 10b-5, and NASD Rule 2120 prohibit fraudulent and deceptive acts and practices in connection with the offer, purchase, or sale of a security. Violations of these provisions may be established by a showing that persons acting with scienter misrepresented material facts or "engage[d] in deceit" in connection with securities transactions. 23/ The 2006 Opinion found that the Gebharts made misrepresentations and omitted to state facts necessary to make other statements not misleading in connection with their offer and sale of 22/ It is unclear whether MHP's representation that $605,000 worth of Notes had been secured by recorded deeds of trust is accurate. Even if true, however, the Gebharts point to no evidence, and we have found none, that any of their own clients' trust deeds were recorded. 23/ Basic Inc. v. Levinson, 485 U.S. 224, 239 n.17 (1988); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976); Rule 10b-5(c), 17 CFR § 240.10b-5.