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From Securities Regulation Daily, April 6, 2015

SEC did not arbitrarily change its definition of "egregious"

By Rodney F. Tonkovic, J.D.

A petition for review of an SEC order has been denied by a Tenth Circuit panel. FINRA imposed sanctions on ACAP Financial, Inc. and its head trader for the sale of unregistered securities that were upheld by the SEC. The petitioners contended that the trader's conduct did not meet the meaning of "egregious" as defined by the Commission. The panel found fault with this premise, however, concluding that the Commission has never defined "egregious" in the way posited by the petitioners (ACAP Financial Inc. v. SEC, April 3, 2015, Gorsuch, N.).

Background. The story begins with Greyfield Capital, a defunct Canadian company. In the court's words, "a couple of con men" obtained a signature stamp belonging to Greyfield's former president and embarked on a penny stock pump-and-dump scheme. Eventually, the market caught on to the scheme, and regulators turned their attention to Greyfield and those who helped facilitate the sale of its unregistered shares.

ACAP is a FINRA member firm, and the majority of its business is in liquidating penny stock. The Greyfield schemers kept accounts at ACAP and used the firm to sell their shares. FINRA found that ACAP, and its then-head trader and compliance manager, Gary Hume, violated FINRA rules through unregistered sales of Greyfield shares without any applicable exemption from registration. FINRA fined ACAP $100,000; Hume was fined $25,000 and suspended from the securities industry for six months. The SEC reviewed and sustained these sanctions.

Was it "egregious?" On appeal, ACAP and Hume (hereinafter, “Hume”) did not dispute their liability. Hume argued that FINRA's Sanction Guidelines reserve a suspension like that doled out to Hume for "egregious" cases. According to Hume, the SEC defines "egregious" as an intentional or knowing violation of a regulatory or fiduciary duty, which did not happen in this case. The court observed that this argument, essentially that the Commission's decision-making was "arbitrary and capricious," sounded promising, but failed in its essential premise.

According to the court, Hume failed to "identify any administrative rule or decision indicating that the SEC has ever concluded that intentional or knowing violations, or breaches of fiduciary duties, are necessary to a finding of 'egregious' conduct." The Commission's case law, the court explained, suggests that this behavior is sufficient and that there are still other forms of misbehavior that qualify as "egregious." The Commission "has never understood the term “egregious” to require proof of intent, knowledge, or a breach of a fiduciary duty," the court said. In short, Hume did not show that the Commission changed a preexisting policy.

Hume next contended that the Commission acted arbitrarily by failing to consider mitigating factors contained in the Sanction Guidelines. The court noted that generally, an agency's unexplained failure to consult its own guidelines can be found to be arbitrary. In this case, however, Hume pursued five mitigating arguments before the Commission, and the record showed that the Commission considered, and rejected, them all with a reasoned explanation. "The duty to hear an argument," the court remarked, "doesn't entail the duty to swallow it."

Finally, Hume suggested that the remedies endorsed by the Commission were too harsh. In this case, however, there was unrebutted evidence of Hume's extensive supervisory failures, and the Commission concluded that this cast doubt on his ability to carry out his obligations as a securities professional. The court noted further that the six-month suspension was comparable to sanctions imposed in similar cases. The fines were similarly well within the Sanction Guidelines' baseline range. The petition for review was accordingly denied.

No larger arguments. At times, the court seemed to wish that it had been presented with an occasion to address "meatier" arguments than were presented here. The court pointed out that Hume's brief appeared in various places to fault the Commission for not giving sufficient content to the term "egregious" and for using adjudicative proceedings to expand the term beyond intentional misconduct and breaches and then apply the new definition to Hume. To the court's seeming disappointment, however, Hume's brief disclaimed any attempt to pursue arguments along these lines, conceding instead that the Commission is permitted to flesh out the meaning of "egregious" in successive adjudications. The court was left with the narrow, and easily dispelled, claim that "egregious" requires a showing of intent, knowledge, or a breach of a fiduciary duty.

The case is No. 13-9592.

Attorneys: Timothy R. Pack (Clyde Snow & Sessions) for ACAP Financial, Inc. Benjamin L. Schiffrin for the SEC.

Companies: ACAP Financial, Inc.

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