Otto, Kevin L. v. SEC ( 2001 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 00-3897
Kevin Lee Otto,
Petitioner,
v.
Securities and Exchange Commission,
Respondent.
On Petition for Review of an
Order of the Securities and Exchange
Commission File No. 3-9938.
Argued April 17, 2001--Decided June 12, 2001
Before Fairchild, Cudahy, and Coffey,
Circuit Judges.
Coffey, Circuit Judge. On September 15,
2000, the Securities and Exchange
Commission ("SEC" or "Commission") issued
an order pursuant to the Securities
Exchange Act of 1934, 15 U.S.C. sec.
78s(d)(1), affirming disciplinary action
taken by the National Association of
Securities Dealers, Inc. ("NASD") against
Kevin Otto. Otto, a securities salesman
associated with an NASD member firm at
the time of the misconduct charged, seeks
review of the SEC order pursuant to 15
U.S.C. sec. 78y(a)(1). We deny Otto’s
petition and affirm the SEC’s order.
I. Factual Background
During all times relevant to the
disposition of this case, Kevin Otto
worked as a general securities
representative for various NASD member
firms including Hamilton Investments,
Inc., Wellington Investment Services
Corporation, and First Montauk Securities
Corporation. Mary Sue Smith/1 became a
client of Otto’s beginning in 1988 or
1989 and followed him through his various
firm transfers.
In February 1992, Otto solicited $22,000
from Smith for an investment in the
Wisconsin Business Club ("WBC"). In a
letter to Smith Otto explained that:
WBC is a group of people that network to
bring to the table business opportunities
which enable me to make some cash. These
are opportunities that you and I as
individuals probably wouldn’t see. . . .
Again as I stated on the phone this is
not an investment nor is it offered by
any securities company. It has nothing to
do with me as a broker or my brokerage
firm. This is a private thing. It is kind
of fun. I think you’ll like it. . . .
Liquidity depends on what the funds are
in.
Otto further professed that the return
was reported as a Treasury Bill rate
"plus a couple of percentage points."
Smith provided Otto with the $22,000;
unbeknownst to her, WBC did not exist.
Rather than invest the $22,000 into WBC
as he had suggested he would, Otto
instead placed the $22,000 partly in his
personal bank account and partly in a
Charles Schwab account for PowerSource
Battery Corporation, an unprofitable
company that he owned and operated with a
partner, Donna LeBrecht. Otto used
Smith’s funds for "personal stuff,"
business expenses related to the
operation of PowerSource, and expenses
related to the investigation of other
business opportunities. Despite the
illicit infusion of capital, PowerSource
filed for bankruptcy protection in March
of 1992.
To cover up his misuse of her funds,
Otto prepared and sent to Smith
fictitious portfolio updates that falsely
reflected a WBC balance. In April 1994,
Smith requested funds from her WBC
account. Because he could not immediately
return Smith’s money, Otto stalled the
repayment with more deceit, explaining in
a letter that "the invest[ment] club has
invested cash. May take a few weeks to
find a replacement for your position. . .
. Once we sell your seat, we are out
unless another opens up." In May, he
wrote to Smith that her account’s value
was $28,576.24 and he had arranged for
"all dividends and/or capital gains to
date" to be forwarded to Smith. Otto
further explained to her that it could
take a few weeks to liquidate, and
suggested that she withdraw approximately
$3,000 immediately, leaving $25,000 in
the club to remain active, thus
attempting to prolong the charade that he
had invested Smith’s money in WBC. Smith
signed an authorization agreeing to leave
$25,000 in the fictitious club, and
received a personal check form Otto in
the amount of $3,576.24 in June 1994.
Initially the check was returned for
insufficient funds, but later Smith was
able to deposit it.
Because of the two-month delay between
her request and her receipt of the WBC
funds, Smith decided to withdraw all of
the WBC funds. Still, Otto did not
immediately return Smith’s money. In a
letter dated July 27, 1994, he continued
to represent that WBC existed as a
legitimate investment club and blamed the
delay in receiving her money on the
investment club.
I’ve not yet received our exit papers for
the investment club. As your request is
unusual things don’t happen that fast.
The group has assured me that funds will
not be less than its value at the time
the funds were requested. . . . This is
an exclusive club with most people of
professional investment background. I
pushed to get us in, therefore I can’t
cause a lot [sic] wave[s]. I should hope
to receive our exit papers soon and
subsequently the funds.
Otto finally sent Smith a check for
$26,346 (the fictitious balance of
Smith’s WBC account) on October 22, 1994,
approximately six months after her
initial request to withdraw her funds.
In October 1994, Smith sent to Otto’s
then-employer, First Montauk Securities
Corporation, copies of records and
letters Otto had sent her regarding her
WBC account. Nearly thirty months later,
on March 14, 1997, NASD filed a complaint
against Otto, charging him with violating
Conduct Rule 2110, which requires members
to "observe high standards of commercial
honor and just and equitable principles
of trade." At a subsequent hearing before
the NASD Regional District Business
Conduct Committee ("DBCC"), Otto admitted
that WBC did not exist as anything other
than an "insignia." Otto claimed,
however, that Smith had authorized him to
use the funds as he did. According to
Otto, Smith faced marital difficulties
and wanted to use WBC in order to hide
the money from her then-husband. Otto
further claimed that the only reason
Smith made a complaint against Otto was
because of the request of her father,
also one of Otto’s clients, who was upset
with Otto’s handling of his account.
Smith’s complaint was admitted into
evidence at the hearings, but she did not
testify. On August 7, 1998, the DBCC
found that Otto violated Conduct Rule
2110 and imposed a penalty composed of a
censure, a permanent bar from associating
with any NASD member, a fine of $110,000,
and an assessment of costs in the amount
of $3,110.75.
Otto appealed the DBCC’s decision to the
National Adjudicatory Counsel ("NAC") for
NASD. At the hearing before the NAC, Otto
again admitted that WBC never existed and
that he used Smith’s funds for his
business and personal expenses. Again
Smith did not testify. The NAC found that
"Otto’s misuse of [Smith’s] funds was
inexcusable. His misconduct, coupled with
his total refusal to acknowledge that he
had misused his client’s funds by using
her money for his own personal and
business benefit, makes him a danger to
the investing public." Further, in its
decision, the NAC explained that even
though the guidelines did not recommend a
bar for Otto’s conduct, it considered a
bar "essential based on the egregious
nature of Otto’s conduct." In support, it
noted three aggravating factors: 1) the
series of lies and deception beginning
with his solicitation of Smith’s funds
and continuing throughout her attempts to
withdraw her funds; 2) his failure to
accept responsibility for his misuse of
Smith’s funds; and 3) his attempt to lay
blame on others, specifically upon Smith
herself with his theory that she
attempted to use WBC to hide the money in
a marital dispute. Accordingly, on June
28, 1999, the NAC affirmed the censure
and bar, but reduced the fine to $35,000
because it concluded that the DBCC used a
"conversion" sentencing guideline rather
than an "improper use of funds"
guideline.
Otto appealed the decision of the NAC to
the SEC, which reviewed his case de novo.
On September 15, 2000, the SEC sustained
the censure, bar, $35,000 fine, and
costs. The SEC found that Otto "deceived
his client with a network of lies." The
SEC pointed out that, by his own
admission, the investment club into which
Otto told Smith he had placed her funds
did not exist. The SEC further found that
when Smith sought to get her money back,
Otto repeatedly delayed returning her
money and continued the fiction of the
investment club, failing to tell Smith
that he used her money for his own
benefit. The SEC found that Otto’s
admittedly false statements to Smith
demonstrated "deception of a client about
the use of money [that] is unethical and
reprehensible." In addition, the SEC
rejected Otto’s procedural objections,
finding that the NASD proceedings were
fair, noting that Otto admitted "all of
the facts necessary to determine his
guilt." Finally the SEC held that the
sanctions imposed by the NASD were not
excessive or oppressive, concluding that
Otto’s conduct "demonstrates a serious
misunderstanding of the obligations he
owes to a customer as a registered
representative." Otto now appeals.
II. Issues
Otto raises two issues in his appeal.
First, he contends that the NASD
proceedings violated his due process
rights because hearsay evidence was
admitted and relied upon, because he did
not have the opportunity to cross-examine
Smith, and because the length of time
that passed between the misconduct and
the hearings deprived Otto of the
opportunity to present witnesses on his
behalf who had died during the delay.
Second, Otto argues that the SEC abused
its discretion in sustaining the NASD
sanctions that exceeded the recommended
sanctions under the NASD guidelines.
III. Analysis
The SEC is the federal agency charged
with the regulation of the securities
industry, but because the SEC lacks the
resources to police the entire securities
industry, it relies on participants in
the markets to govern themselves. See
Gold v. SEC, 48 F.3d 987, 990 (7th Cir.
1995); Mister Discount Stockbrokers, Inc.
v. SEC, 768 F.2d 875, 876 (7th Cir.
1985). The NASD is a registered
association of securities broker-dealers
registered with the SEC pursuant to 15
U.S.C. sec. 78o-3(a) and empowered to
enforce association members’ compliance
with federal securities laws, Commission
regulations, and the association’s own
rules and regulations by imposing
appropriate sanctions. When enforcing
members’ compliance with applicable rules
and regulations, the NASD must provide "a
fair procedure for the disciplining of
members and persons associated with
members . . . ." 15 U.S.C. sec. 78o-
3(b)(8); Mister Discount Stockbrokers,
Inc., 768 F.2d at 876.
The disciplinary process established by
the NASD provides that the NASD Regional
District Business Conduct Committee has
original jurisdiction of all complaints
regarding member violations and may
conduct hearings, make findings and
impose penalties. Id. In turn the final
actions taken by the District Committee
are subject to review by the NASD Board
of Governors. Any final disciplinary
sanctions imposed by the Board of
Governors is subject to "full and
independent review by the SEC as to the
facts as well as the law." Gold, 48 F.3d
at 990; 15 U.S.C. sec. 78s(d)(2). Because
the SEC conducts de novo review of the
NASD’s sanctions, this court’s
consideration of alleged errors in the
NASD proceedings is limited. We will
"consider errors in [the NASD]
proceedings ’only if and to the extent
that they infected the Commission’s
action by leading to error on its part.’"
Schellenbach v. SEC, 989 F.2d 907, 909
(7th Cir. 1993); accord Gold, 48 F.3d at
990; Mister Discount Stockbrokers, Inc.,
768 F.2d at 877.
Our review of the proceedings before the
SEC is not so limited. Gold, 48 F.3d at
990. This court may overturn an SEC
sanctions order if it is unwarranted in
law or without justification in fact. Id.(citing Nowicki v. United States, 536
F.2d 1171, 1178 (7th Cir. 1976)).
Nevertheless, our review of the SEC’s
findings of fact is highly deferential.
Indeed, the SEC’s findings of fact are
conclusive if supported by substantial
evidence. Schellenbach, 989 F.2d at 909.
Further, we will reverse the Commission
decisions concerning sanctions only if
this court finds that the SEC abused its
discretion. Id.; Mister Discount
Stockbrokers, Inc., 768 F.2d at 879. With
this limited scope of review in mind, we
turn to Otto’s arguments.
A. Fairness of NASD Proceedings
Otto initially argues that the NASD
proceedings violated his due process
rights urging three separate grounds: 1)
the NASD admitted into the record Smith’s
unsworn hearsay statements; 2) the NASD
did not provide him with an opportunity
to cross-examine Smith; 3) a six-year
delay between the time of the misconduct
and the date of the hearing prejudiced
him because he could not call favorable
witnesses who had died. None of Otto’s
arguments has merit.
We note at the outset that
Constitutional standards do not apply
unless the NASD is a state actor. See
R.J. O’Brien & Assoc., Inc. v. Pipkin, 64
F.3d 257, 262 (7th Cir. 1995). The fact
that the NASD is subject to "extensive
and detailed" governmental regulation
does not necessarily convert that
organization’s actions into those of the
state. See Jackson v. Metropolitan Edison
Co., 419 U.S. 345, 350 (1974). Indeed,
although we have not expressly ruled on
the question of whether the NASD is a
state actor, we have previously expressed
doubt about "the proposition that the
comprehensive regulation of securities
exchanges by the federal government would
turn those exchanges into government
actors." Gold, 48 F.3d at 991 (suggesting
that the New York Stock Exchange was not
a state actor, but declining to rule on
the merits of that issue because
petitioner had waived the argument on
appeal). In addition, several of our
Sister Circuits have reached the
conclusion that the NASD is not a state
actor. See, e.g., Desiderio v. Nat’l
Ass’n of Sec. Dealers, Inc., 191 F.3d
198, 206 (2d Cir. 1999) (noting that the
NASD is a private corporation that
receives no federal or state funding;
that its creation was not mandated by
statute; and that the government has no
voice in the selection of its members);
First Jersey Sec., Inc. v. Bergen, 605
F.2d 690, 699 n.5 (3d Cir. 1979). In any
event we need not decide the issue of
whether the NASD is a state actor in this
case because Otto admitted all of the
facts necessary to establish his guilt,
which dooms his due process arguments.
At his hearing before the NASD Board of
Governors, Otto admitted, among other
things, that WBC was fictional, that
Smith was the only investor, and that he
used Smith’s funds for his "personal
stuff." Further, when Smith requested to
withdraw her WBC funds in April 1994,
Otto continued his deception and delayed
returning her money. First, he explained
to her that it could take a few weeks to
find a replacement and urged her to
instead remain in the club. Later, Otto
sent her a letter blaming the non-
existent club for the delay in the return
of her money. Ultimately, he continued
his deception long enough to retain her
money for six months after she initially
requested it.
Despite his admissions, Otto nonetheless
presses the argument that he somehow was
prejudiced by Smith’s absence at his
hearings. The premise of Otto’s argument
is that if he were allowed to cross-
examine Smith/2 she would have
confirmed his explanation that she used
WBC to hide assets from her husband and
that she had given him permission to use
the funds for his personal and business
expenses. Otto’s argument, however, is
nothing more than pure fancy. First,
there was no evidence that Smith had any
prejudice against Otto that might have
undermined the credibility of her
complaint. Second, the facts of her
complaint were not contradicted by any
direct testimony, and instead were
largely corroborated by Otto’s own
admissions. Moreover, Smith’s former
husband did testify at the hearing and
expressly rejected Otto’s assertion that
the parties were contemplating divorce or
separation during the time Smith had
invested in WBC. Finally, Otto’s letters
to Smith reveal the utter incredibility
of his assertion that Smith was using WBC
to hide assets from her husband--for if
Smith had been aware that WBC did not
exist (as Otto suggests she was) then
what need was there to persist in blaming
the delay in the return of her funds on
the non-existent club? Otto’s argument
has no foundation in fact. Furthermore,
even if it did, it is well established
that hearsay evidence is admissible in
administrative proceedings, if it is
deemed relevant and material. Keller v.
Sullivan, 928 F.2d 227, 230 (7th Cir.
1991) (citing Richardson v. Perales, 402
U.S. 389 (1971)). In addition to its
relevance, Smith’s complaint was
supported by several indicia of
reliability--most notably the
corroboration from Otto’s admissions.
Otto also suggests that the delay in
holding the hearing violated his due
process rights because several witnesses,
who would have testified that they
participated in the WBC, died before the
hearing was held. This claim is equally
fanciful as Otto’s claim that his due
process rights were violated by his
inability to cross-examine Smith. The
testimony of these witnesses would have
largely been irrelevant. Otto admitted
that he used Smith’s money for his
business and personal expenses and
whether other people had invested in the
fictitious club he created is of no
moment. Further, Otto admitted at the
hearing that, besides himself, Smith was
the only investor in WBC, thus directly
contradicting the testimony he suggests
he would have presented.
Given Otto’s admissions coupled with the
incriminating documentation he sent
throughout her investment, Otto’s claims
that the proceedings were unfair and
violated his due process rights must
fail. Rule 2110 required Otto to "observe
high standards of commercial honor and
just and equitable principles of trade."
Nothing in the record even remotely
suggests that an error in the NASD
proceedings infected the SEC’s review.
Consequently, our review is limited only
to consideration of whether the SEC
abused its discretion in holding that
Otto violated Conduct Rule 2110. It did
not. Otto’s admissions and letters to
Smith more than amply provide a basis to
conclude that Otto did not "observe high
standards of commercial honor and just
and equitable principles of trade."
B. Severity of Sanctions
Otto next argues that the sanctions
imposed exceeded the recommended
sanctions under the NASD’s guidelines,
and thus, were improperly imposed. Otto
also suggests that the NASD and SEC did
not weigh all of the factors referenced
on the NASD’s sanction guidelines in
reaching their determinations that the
sanctions imposed were warranted. The
NASD outlines eight factors relevant to
imposing sanctions: 1) prior or other
similar misconduct; 2) attempts to
conceal conversion, misappropriation, or
misuse; 3) forgery of documentation or
customer’s signature; 4) duration of the
period the securities or funds were
converted; 5) essentially stealing versus
mistaken belief of authority to use; 6)
value of converted, misappropriated or
misused funds or securities (loss to
customer); 7) prompt and voluntary
restitution, clear evidence that the
funds or securities were returned to the
customer; 8) other aggravating or
mitigating factors. The sanction
guidelines, however, are not rigid
andmechanical and serve only as a
starting point for determining the proper
disciplinary action. In the Matter of
Steven D. Goodman, 2001 WL 62607 (S.E.C.)
at *5 (Jan. 26, 2001).
Otto comingled Smith’s funds with his
own for the sake of his own personal
convenience and deprived her of the
opportunity to invest those funds in a
legitimate investment. Further, he
concealed this use of funds from Smith.
Although he did ultimately return the
funds, he put her funds at risk for more
than two years. When Smith asked Otto to
return her money, he continued to lie to
her, attempted to convince her to leave
her money invested in the fictitious WBC
account, and only returned her money
after six months. Given the ongoing
deception in the face of a request for
the return of her funds and Otto’s
refusal to accept responsibility for his
misuse of Smith’s funds, we agree with
the SEC’s decision to approve the NASD’s
imposition of sanctions.
The SEC’s order is AFFIRMED.
FOOTNOTES
/1 During the course of events that gave rise to
this appeal, Smith changed her name to Mary Sue
Laskowski. For convenience sake, we refer to her
throughout this opinion as "Smith."
/2 In an attempt to secure Smith’s presence, Otto’s
attorney sent to her a "subpoena." The document
bears the indicia of the NASD (despite the fact
that neither the NASD nor Otto himself had sub-
poena power) and "commands" her to appear with
documents, falsely threatening her with punish-
ment for contempt if she failed to comply. Otto’s
attempt to badger and even intimidate Smith into
testifying only further undermines his claims and
further suggests that he did not "observe high
standards of commercial honor."