Schneider v. The Kansas Securities Comm'rs ( 2017 )

No. 115,383
IN THE COURT OF APPEALS OF THE STATE OF KANSAS
MARK R. SCHNEIDER,
Appellant,
v.
THE KANSAS SECURITIES COMMISSIONER,
Appellee.
SYALLABUS BY THE COURT
1.
The scope of judicial review of an administrative agency's action is defined by the
Kansas Judicial Review Act, K.S.A. 77-601 et seq. Under the KJRA, an appellate court
exercises the same statutorily limited review of the agency's action as does the district
court.
2.
Interpretation of a statute or an administrative regulation is a question of law over
which an appellate court has unlimited review. In doing so, courts no longer defer to the
agency's interpretation. When a statute is clear and unambiguous, courts give effect to
legislative intent expressed through the words of the statute, rather than make a
determination of what the law should or should not be.
3.
K.S.A. 2016 Supp. 77-621(c)(4) requires courts to grant relief if the agency
erroneously interpreted or applied the law.
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4.
K.S.A. 2016 Supp. 77-621(c)(7) requires courts to grant relief if an agency action
is based on a determination of fact, made or implied by the agency, that is not supported
by evidence that is substantial when viewed in light of the record as a whole. This
includes the evidence both supporting and detracting from an agency's finding.
Substantial competent evidence is relevant evidence that provides a substantial basis of
fact from which the issues can reasonably be determined.
5.
The purpose of the Kansas Uniform Securities Act, K.S.A. 17-12a101 et seq., is to
place the traffic of promoting and dealing in speculative securities under strict
governmental regulation and control in order to protect investors and thereby prevent the
sale of fraudulent and worthless speculative securities.
6.
K.S.A. 17-12a412(d)(13) of the Kansas Uniform Securities Act provides that a
person may be disciplined where he or she "has engaged in dishonest or unethical
practices in the securities, commodities, investment, franchise, banking, finance, or
insurance business within the previous 10 years." Violations of this provision include (1)
making unsuitable recommendations in violation of K.A.R. 81-14-5(d) and (2) breaching
the fiduciary duty to an investment client in violation of K.A.R. 81-14-5(c), by making
unsuitable recommendations.
7.
Unsuitable securities recommendations to an investment client under K.A.R. 81-
14-5(d)(1) are recommendations for the "purchase, sale, or exchange of any security
without reasonable grounds to believe that the recommendation is suitable for the client
on the basis of information furnished by the client after reasonable inquiry concerning the
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client's investment objectives, financial situation and needs, and any other information
known by the investment adviser or investment adviser representative."
8.
Under K.A.R. 81-14-5(c) an investment adviser representative "shall not fail to
observe high standards of commercial honor and just and equitable principles of trade in
the conduct of the person's business. An investment adviser or investment adviser
representative is a fiduciary and shall act primarily for the benefit of its clients."
9.
The Financial Industry Regulatory Authority, Inc. (FINRA) is a private entity that
acts as a self-regulatory organization for broker-dealers. From time to time it issues
notices to its members. Under the facts presented, the Kansas Securities Commissioner
did not use FINRA Notice 09-31 regarding certain investment vehicles and the expert
witness' testimony regarding the information contained in the Notice as the legal standard
for measuring appellant's conduct, but rather merely as evidence bearing upon whether
appellant engaged in dishonest or unethical practices in violation of the Kansas Uniform
Securities Act.
10.
Under the Rules and Regulations Filing Act, K.S.A. 2016 Supp. 77-415 et seq.,
"any standard, requirement or other policy of general application may be given binding
legal effect only if it has complied with the requirements of the rules and regulations
filing act." K.S.A. 2016 Supp. 77-415(b)(1). Under K.S.A. 77-425 "[a]ny rule and
regulation not filed and published as required by this act shall be of no force or effect."
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11.
A rule or regulation is defined by the Rules and Regulations Filing Act as "a
standard, requirement or other policy of general application that has the force and effect
of law, including amendments or revocations thereof, issued or adopted by a state agency
to implement or interpret legislation." K.S.A. 2106 Supp. 77-415(c)(4).
12.
As a general principle of administrative law, agency decisions must be based on
known rules and standards. Thus, rules and regulations must be filed and published so
that members of the public, and others affected thereby, are not subjected to agency rules
and regulations whose existence is known only by agency personnel. When an
administrative agency arbitrarily applies a rule that is not embodied in the statutes or
published as a rule or regulation, a respondent to an agency action is deprived of fair
notice and due process.
13.
A policy is a rule or regulation requiring filing and publication under the Rules
and Regulations Filing Act if (1) the agency does not exercise discretion in applying it;
(2) it has general application to those having to do business with the agency; and (3) the
agency treats it as having the effect of law.
14.
Under the facts presented, the agency's use of FINRA Notice 09-31 did not violate
the Rules and Regulations Filing Act, K.S.A. 2016 Supp. 77-415 et seq. The notice was
merely provided as evidence, not as agency policy, an agency regulation, or the
governing legal standard.
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15.
The nondelegation doctrine prohibits the delegation of governmental power to
unelected and politically unaccountable bodies. The nondelegation doctrine flows from
the separation of powers principles embodied in Art. 2, § 1 of the Kansas Constitution,
which provides that "[t]he legislative power of this state shall be vested in a house of
representatives and senate." Under the nondelegation doctrine, State agencies may not
delegate their power to make obligatory rules to private individuals or nongovernmental
entities.
16.
The Kansas Securities Commissioner's references to FINRA Notice 09-31did not
constitute a cession of governmental authority to a private entity in violation of the
nondelegation doctrine.
17.
Scienter is not required to prove a breach of fiduciary duty. The requirements of a
claim of breach of fiduciary duty are existence of a duty, breach of that duty, and
damages resulting from the breach. In the careless management of an investment and the
failure to keep the client advised regarding the status of the investment, there is no
scienter requirement to establish a breach of fiduciary duty.
Appeal from Shawnee District Court; REBECCA W. CROTTY, judge. Opinion filed June 2, 2017.
Affirmed.
Roger N. Walter and Trevor C. Wohlford, of Morris, Laing, Evans, Brock & Kennedy, Chtd., of
Topeka, for appellant.
Thomas E. Knutzen, Ryan A. Kriegshauser, and Christopher D. Mann, of the Office of the Kansas
Securities Commissioner, for appellee.
5
Before MCANANY, P.J., MALONE, J., and STUTZMAN, S.J.
MCANANY, J.: Mark R. Schneider appeals the district court's decision affirming
the Kansas Securities Commissioner's order finding that he engaged in a "'dishonest or
unethical'" practice in the investment advisory business in violation of the Kansas
Uniform Securities Act, K.S.A. 17-12a101 et seq., by selecting an investment for his
client that he had no reasonable grounds to believe was suitable. Schneider contends: (1)
the district court and the Commissioner erroneously adopted and applied the wrong legal
standard in concluding that he violated the Kansas Uniform Securities Act; and (2) the
Commissioner's factual findings are not supported by substantial competent evidence
when viewed in light of the record as a whole.
Facts
Schneider is an investment adviser representative and broker-dealer registered in
the State of Kansas and associated with the investment firm Plan, Inc., a Financial
Industry Regulatory Authority (FINRA) member-firm. Schneider has a bachelor's degree
in accounting and business administration, and he has held a certified financial planner
designation since 1987. For Schneider to be designated a certified financial planner
involved a 3-year process of taking classes and passing examinations.
FINRA is a regulatory organization for broker-dealers and broker-dealer agents.
As a member of FINRA, Schneider regularly received rules or regulation notices
intended to provide guidance to FINRA members.
Schneider served as Mary Lou and Jeffrey Silverman's investment adviser for
more than 20 years, managing the Silvermans' assets, tax returns, and life insurance.
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Schneider had full discretionary authority over the Silvermans' investments, and he had
the ability to trade on behalf of the Silvermans without their approval.
After battling lymphocytic leukemia for 15 years, Jeffrey died on January 3, 2010.
Mary Lou received $1,150,000 in death benefits from Jeffrey's life insurance policy,
which she initially deposited in bank accounts that were not under Schneider's control.
Prior to his death, Jeffrey handled all of the family's finances including the investment
decisions. His assets—consisting mainly of cash with a limited amount of mutual funds
and large cap equities—were conservatively managed by Schneider.
The day after Jeffrey's death, Mary Lou called Schneider to discuss her
investments. Consistent with the approach he typically took with clients who had recently
lost a spouse, Schneider advised Mary Lou not to change her investment portfolio for at
least a year. But a few months later, Mary Lou contacted Schneider again to discuss a
strategy for generating income from the life insurance proceeds that she received after her
husband's death. Mary Lou was not employed outside the home and still had children in
school, so she sought a way to invest the money to achieve financial independence and to
support her family. Because Mary Lou was not a sophisticated investor, she sought
advice from Schneider.
In May 2010, Schneider compiled a financial plan for Mary Lou which analyzed
her cash flow, expenses, retirement needs, and income requirements. The objective of the
plan was to invest her money to generate income in order for her to achieve financial
independence. Schneider's analysis showed that Mary Lou needed monthly income of
approximately $10,000 to pay her expenses. In order to generate the level of income
Mary Lou desired, Schneider projected that she needed an annual investment return of
6.7%.
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Schneider decided to pursue a short-term investment strategy in an attempt to meet
Mary Lou's investment goals. He chose to place Mary Lou's assets in inverse investment
products that were exchange traded funds (ETFs).
Schneider first became aware of inverse investment products in November 2000
after a downturn in investment markets. In 2001 and 2002, Schneider conducted
numerous seminars in order to educate his clients about these products. He visited the
headquarters of Rydex, one of the vendors of inverse funds, and spent a week visiting
with managers about these investment products. Inverse investment funds became an
integral part of Schneider's investment management strategy.
In 2006, Schneider starting using ETFs for his clients' investments. Schneider said
he preferred ETFs to inverse mutual funds. He noted that the ETFs had lower internal
expenses and the ability to trade like stock on equity markets.
In 2009, FINRA issued Regulation Notice 09-31, "Non-Traditional ETFs," an
interpretative statement to provide guidance to FINRA members and their agents in
recommending and selling securities to clients. This notice indicated that nontraditional
ETFs are useful for some sophisticated trading strategies. But the notice cautioned
members that they are "highly complex financial instruments" and unsuitable for retail
investors who hold them for more than one trading session, particularly in volatile
markets.
Schneider read FINRA Notice 09-31 when it was released, yet he did not interpret
the notice as an absolute statement that holding these investments for more than 1 day
was always unsuitable for his clients. Schneider claimed there was no difference in the
level of care required between nontraditional ETFs and other investment products.
According to Schneider, the risk comes from the market, not the particular investments.
8
Despite being aware of the information in FINRA Notice 09-31, Schneider placed
essentially all of his 160 retail clients in nontraditional ETFs, including Mary Lou, and he
held the nontraditional ETFs for periods lasting longer than 1 day.
By the middle of 2010, Schneider believed investment markets were overvalued
and that a stock market crash similar to what occurred a few years earlier was imminent.
Schneider met with Mary Lou and discussed investing in inverse funds as a short-term
investment strategy. Inverse funds are counter-cyclical: they typically go up as the
market declines. Schneider explained that his two-step strategy was first to invest in
inverse funds in order to take advantage of a declining market, and then to invest in
dividend paying equities after the anticipated market correction occurred. Schneider
stated that he "was under the impression that [Mary Lou] agreed to that."
Schneider liquidated the positions held in Mary Lou's discretionary accounts and
began buying leveraged and inverse ETFs.
The market was very volatile during this period of time. From June 2010 to
August 2010, Schneider placed stop-losses on these positions, which liquidated the
investment when the investment declined by a certain percentage. But every time a stop-
loss was triggered, Schneider placed a larger one in its place. Schneider first put the stop-
losses at 3%, then 4%, and finally at 10%. Schneider said he increased the stop-loss
parameters because Mary Lou's positions were being continually stopped out. Schneider
eventually removed the stop-losses entirely in September 2010.
Contrary to the advice in FINRA Notice 09-31, Schneider held various leveraged
and inverse ETF positions in Mary Lou's discretionary accounts for periods exceeding 1
day. The prospectus warned investors that these nontraditional ETFs were not intended to
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achieve their investment objectives for a period longer than 1 day. Many of Mary Lou's
positions were held for over 100 days, and three positions were held for 182 days.
Mary Lou saw some gains through the summer of 2010, but those gains did not
continue. By the end of 2010, Mary Lou's accounts managed by Schneider suffered a net
out-of-pocket loss of $68,327.69, or 3.4% of Mary Lou's total assets.
At no time did Schneider inform Mary Lou that he was using nontraditional ETFs,
the risks associated with those investments, or that he planned on using them in
contravention of how they were designed to be used. He did not advise her that her
investments exposed her to the potential for large losses. Schneider's unilateral decision
to invest Mary Lou's funds in nontraditional ETFs cost Mary Lou $94,710.
On October 2, 2012, the Kansas Securities Commissioner gave a notice of intent
to impose administrative sanctions against Schneider under K.S.A. 17-12a412 of the
Kansas Uniform Securities Act. The notice alleged that Schneider violated K.A.R. 81-14-
5(d)(1). The Commissioner contended that Schneider's "purchases of the inverse and
leveraged-inverse ETFs on behalf of Ms. Silverman constitute unsuitable
recommendations and a breach of his fiduciary duty as an investment adviser
representative."
Schneider requested a hearing, and the administrative law judge conducted a
hearing on October 23-24, 2014.
Jack Duval testified as an expert for the Commissioner. Duval stated that
nontraditional ETFs were not suitable investments for investors needing income and
growth, such as Mary Lou. Duval said that investing in nontraditional ETFs for more than
1 day is unsuitable for the average retail investor. In Duval's opinion, investing in the
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nontraditional ETFs for longer than a day is contrary to the prospectuses because these
ETFs are speculative investments that are subject to constant leveraging.
Duval testified that if an investment adviser intended to use nontraditional ETFs in
a manner not prescribed by the prospectus, it is a breach of fiduciary duty to fail to
explain the products and their associated risks to the investor, especially when the
investments are made under discretionary authority. In addition, Duval said that an
investment adviser breaches his or her fiduciary duty by failing to inform a growth and
income client that he or she is investing in speculative products—such as nontraditional
ETFs—even if the investments conformed to the prospectuses. During his testimony,
Duval referred to FINRA Regulatory Notice 09-31 and an article written by Duval,
"Leveraged and Inverse ETFs: Trojan Horses for Long-Term Investors."
Duval testified that inverse and leveraged ETFs should not be held for more than 1
day because the investment will necessarily erode and lose money as a result of the
constant leveraging trap. The constant leveraging trap refers to the daily internal
rebalancing to keep the fund leverage ratio constant and consistent with the target
relationship to the fund's underlying index. According to Duval, this daily rebalancing
works against the investor and causes the investment to erode in value and lose money.
Duval testified that an investment adviser representative exercising his or her discretion
in investing in and holding nontraditional ETFs for longer than 1 day constituted a breach
of the investment adviser representative's fiduciary duty. Duval testified that the
investment adviser would also have a duty to explain the product and the risks associated
with the product before using it.
Duval reviewed Mary Lou's account statements and found that many inverse ETFs
were held for long periods of time, many longer than 30 days. The investments were
unsuitable because they were used contrary to the way they were designed. Duval
11
concluded: (1) Mary Lou's losses were a direct result of Schneider's misuse of the ETFs;
(2) nontraditional ETFs were unsuitable investments for Mary Lou; and (3) it is a breach
of a fiduciary duty to place a client's assets into unsuitable investments.
On February 5, 2015, the ALJ issued his order, ruling that Schneider violated
K.S.A. 17-12a412(d)(13), K.A.R. 81-14-5(d)(1), and K.A.R. 81-14-5(c). The ALJ found
Duval to be a credible witness. He also found that Schneider appeared arrogant at the
hearing, and he took no responsibility for the fact that he might have been wrong in his
decision to invest Mary Lou's assets in nontraditional ETFs. The ALJ indicated that
Schneider claimed to know how nontraditional ETFs were to be used, but "the evidence
presented showed a total disregard for the accepted wisdom regarding the suitability of
Non-Traditional ETFs." The ALJ found evidence presented that indicated that
nontraditional ETFs were not designed to achieve their investment objectives over a
period of time longer than 1 day.
Both parties filed petitions for review. On May 1, 2015, following oral arguments,
the Commissioner confirmed the ALJ's findings of fact and conclusions of law in a final
order. The Commissioner also made additional findings of fact and conclusions of law,
including the following:
"Various regulatory notices and advisories indicate that an adviser must be intimately
familiar with Non-Traditional ETFs. It is clear from the respondent's testimony, when
taken as a whole, that he: 1) was not nearly as knowledgeable as he should have been
regarding the product; 2) disregarded accepted industry practice in how the product was
to be used; 3) ignored regulatory guidance; 4) failed to trade the product as intended; 5)
failed to monitor the investments appropriately; and 5) lost Silverman a significant sum
of money as a result."
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The Commissioner upheld Schneider's violations. Schneider was ordered to pay
restitution of $94,720.60 and a civil penalty of $25,000.
On May 29, 2015, Schneider filed a petition for review with the district court
under the Kansas Judicial Review Act (KJRA), K.S.A. 77-601 et seq. After reviewing the
agency record and the briefs, the district court affirmed the Commissioner's final order.
Schneider then appealed to this court.
Discussion
The scope of judicial review of a state administrative agency action is defined by
the KJRA, K.S.A. 77-601 et seq. We review decisions on petitions for judicial review of
agency actions as in other civil cases. K.S.A. 77-623. The party asserting the invalidity of
an agency's action bears the burden of proving invalidity. Likewise, the burden of
proving the invalidity of the Commissioner's actions and decision is on the party asserting
invalidity. K.S.A. 2016 Supp. 77-621(a)(1); Golden Rule Ins. Co. v. Tomlinson, 300 Kan.
944, 953, 335 P.3d 1178 (2014). Under the KJRA, we exercise the same statutorily
limited review of the agency's action as does the district court. Kansas Dept. of Revenue
v. Powell, 290 Kan. 564, 567, 232 P.3d 856 (2010).
Interpretation of a statute or an administrative regulation is a question of law over
which we have unlimited review. In re Tax Appeal of LaFarge Midwest, 293 Kan. 1039,
1043, 271 P.3d 732 (2012). In making the unlimited review of a Kansas statute, we no
longer defer to the agency's interpretation. See Douglas v. Ad Astra Information Systems,
296 Kan. 552, 559, 293 P.3d 723 (2013). When a statute is clear and unambiguous, we
give effect to legislative intent expressed through the words of the statute, rather than
make a determination of what the law should or should not be. Ullery v. Othick, 304 Kan.
405, 409, 372 P.3d 1135 (2016).
13
In K.SA. 2016 Supp. 77-621(c), the legislature set out eight standards under which
we grant relief under the KJRA. Here, Schneider relies on K.S.A. 2016 Supp. 77-
621(c)(4), (c)(7), and (c)(8) to support his argument that relief should be granted.
K.S.A. 2016 Supp. 77-621(c)(4) requires us to grant relief if the agency
erroneously interpreted or applied the law.
K.S.A. 2016 Supp. 77-621(c)(7) requires us to grant relief if the agency action is
based on a determination of fact, made or implied by the agency, that is not supported by
evidence that is substantial when viewed in the light of the record as a whole. After being
amended in 2009, K.S.A. 2016 Supp. 77-621 now defines "in light of the record as a
whole" to include the evidence both supporting and detracting from an agency's finding.
We must now determine whether the evidence supporting the agency's factual findings is
substantial when considered in light of all the evidence. K.S.A. 2016 Supp. 77-621(d);
Redd v. Kansas Truck Center, 291 Kan. 176, 183, 239 P.3d 66 (2010). Substantial
competent evidence is relevant evidence that provides a substantial basis of fact from
which the issues can be reasonably determined. Frick Farm Properties v. Kansas Dept. of
Agriculture, 289 Kan. 690, 709, 216 P.3d 170 (2009).
Finally, K.S.A. 2016 Supp. 77-621(c)(8) requires us to grant relief if the
Commissioner's action is otherwise unreasonable, arbitrary, or capricious.
Overview of Kansas Uniform Securities Act, K.S.A. 17-12a101 et seq.
The purpose of the Kansas Uniform Securities Act, K.S.A. 17-12a101 et seq., is to
place the traffic of promoting and dealing in speculative securities under strict
governmental regulation and control in order to protect investors and thereby prevent the
sale of fraudulent and worthless speculative securities. Klein v. Oppenheimer & Co., 281
14
Kan. 330, Syl. ¶ 1, 130 P.3d 569 (2006). An action under the Kansas Uniform Securities
Act may be prosecuted by the Commissioner under K.S.A. 17-12a412.
In this action, the ALJ, the Commissioner, and the district court found that
Schneider violated K.S.A. 17-12a412(d)(13) of the Kansas Securities Act, which
provides that a person may be disciplined where he or she "has engaged in dishonest or
unethical practices in the securities, commodities, investment, franchise, banking,
finance, or insurance business within the previous 10 years."
The Commissioner found that Schneider violated the Securities Act by committing
two dishonest or unethical practices under the Kansas regulations: (1) making unsuitable
recommendations in violation of K.A.R. 81-14-5(d) and (2) breaching his fiduciary duty
to Mary Lou by making unsuitable recommendations in violation of K.A.R. 81-14-5(c).
K.A.R. 81-14-5(d)(1) provides the standard for identifying a dishonest or unethical
practice based on suitability:
"Unsuitable recommendations. An investment adviser or investment adviser
representative shall not recommend to any client to whom investment supervisory,
management, or consulting services are provided the purchase, sale, or exchange of any
security without reasonable grounds to believe that the recommendation is suitable for the
client on the basis of information furnished by the client after reasonable inquiry
concerning the client's investment objectives, financial situation and needs, and any other
information known by the investment adviser or investment adviser representative."
K.A.R. 81-14-5(c) provides that an investment adviser representative's role is that
of a fiduciary:
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"(c) General standard of conduct. Each person registered as an investment
adviser or investment adviser representative under the act shall not fail to observe high
standards of commercial honor and just and equitable principles of trade in the conduct of
the person's business. An investment adviser or investment adviser representative is a
fiduciary and shall act primarily for the benefit of its clients."
Schneider notes that the only evidence presented that he breached his fiduciary
duty was that he made an unsuitable recommendation. Thus, the crux of the case turns on
whether Schneider had reasonable grounds to believe that the investment strategy was
reasonable.
The standard does not focus on whether the investment was suitable, but whether
the adviser had any reasonable grounds to believe the investment was suitable. See
K.A.R. 81-14-5(d)(1). This test is different from mere negligence in civil liability, as it
requires something more than a retrospective determination that the investment was
unsuitable, inappropriate, or lost money.
For the Commissioner to impose a regulatory sanction requires a showing of
something more than what a client must prove to prevail on a private cause of action for
suitability. Under the Kansas regulation, an adviser can have a reasonable basis for
believing an investment is suitable at the time the investment decision is made, and it
may later be determined in retrospect to be unsuitable. An adviser could be civilly liable
under a theory of negligence, but not subject to a regulatory sanction by the
Commissioner. See Jewett v. Miller, 46 Kan. App. 2d 346, 350, 263 P.3d 188 (2011)
(setting out essential elements of negligence).
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Schneider's claims of error
Schneider's claims on appeal are for the most part variations on a theme. (1) His
theme is that the district court and the Commissioner erred in adopting FINRA Notice 09-
31 as the governing legal standard for measuring his conduct. (2) For his first variation on
this theme, he contends the district court and the Commissioner erred in using FINRA
Notice 09-31 as a governing rule or regulation without complying with the Rules and
Regulations Filing Act, K.S.A. 2016 Supp. 77-415 et seq.; that is, by failing to adopt
FINRA Notice 09-31 as a rule or regulation and failing to publish it so that the general
public is aware of it. (3) For his second variation on this theme, he contends the district
court and the Commissioner erred in delegating to FINRA, a private entity, the
governmental power to establish, through FINRA Notice 09-31, the controlling legal
standard for measuring the conduct of investment advisers such as Schneider. (4) Finally,
Schneider contends the evidence was insufficient to support the conclusions of the district
court and of the Commissioner that Schneider engaged in dishonest or unethical practices
in violation of the Kansas Securities Act.
Though these claims clearly are interrelated, we will consider and discuss each of
them separately.
Did the Commissioner erroneously adopt FINRA Notice 09-31 as the governing legal
standard?
Schneider first argues that the Commissioner and the district court erred in
adopting the wrong legal standard in reaching the conclusion that he committed
misconduct. He claims the Commissioner continuously examined his actions under the
lens of FINRA Notice 09-31 rather than the controlling Kansas statute and administrative
regulations. Schneider asserts that the district court's and the Commissioner's use of
17
FINRA Notice 09-31 constituted an erroneous application of the law subject to review
under K.S.A. 2016 Supp. 77-621(c).
The Commissioner takes the position that neither the ALJ nor the Commissioner
adopted FINRA Notice 09-31 as a standard of general application having the force and
effect of law.
Schneider presents this issue as three different issues: (1) whether FINRA Notice
09-31 was erroneously adopted as a governing legal standard; (2) whether adopting
FINRA Notice 09-31 as a governing legal standard rendered the final order void; and (3)
whether adopting FINRA Notice 09-31 as a governing legal standard violated the
nondelegation doctrine. But these three issues turn on one primary question: Did the
ALJ, the Commissioner, or the district court adopt FINRA Notice 09-31 as a standard of
general application having the force and effect of law? The Commissioner claims that
FINRA Notice 09-31 was used merely as evidence and not as a governing legal standard.
Schneider asserts that the district court and the Commissioner erroneously relied
solely on the advice in FINRA Notice 09-31 providing that nontraditional ETFs are not
suitable for a time period of more than 1 day. He complains that the district court and the
Commissioner failed to take the additional step, as required by the Kansas standard, to
determine whether he had a reasonable basis for believing the investment was suitable.
He claims there is a conflict between FINRA Notice 09-31 and the Kansas regulation,
"which expressly grants an investment adviser latitude to take a subjective look into an
individual client's needs and form a reasonable basis for believing an investment is
suitable." Schneider claims it is "clear from the record" that throughout all of the stages
of the administrative proceeding the Commissioner took the position that the investments
were unreasonable if held for more than 1 day "without regard to the particular facts or
18
circumstances related to the client or any reasonable basis for the recommendation . . . ."
But the record does not support his assertion.
Schneider argues that the Commissioner failed to use the standard provided in
K.A.R. 81-14-5 at any stage of the proceedings, beginning with the first interview of
Schneider and continuing through the final order of the case. Instead, Schneider asserts
the Commissioner relied on the standard as stated in FINRA Notice 09-31 as a legal
standard rather than mere evidence. Schneider maintains that the adoption of the wrong
legal standard was an erroneous interpretation or application of the law. K.S.A. 2016
Supp. 77-621(c)(4) requires an appellate court to grant relief if the agency erroneously
interpreted or applied the law.
For support, Schneider first points to the fact that the initial notice of the
Commissioner's intent to impose administrative sanctions refers to language in FINRA
Notice 09-31. But the initial notice also contains several references to the Kansas
standards as set out in K.S.A. 17-12a412 and K.A.R. 81-14-5, especially in the sections
setting forth the Commissioner's allegations that Schneider breached his fiduciary duty
and made unsuitable recommendations. The record supports the Commissioner's position
that the agency recognized and understood the legal standard under Kansas law.
Second, Schneider complains that the Commissioner's expert, Duval, pointed to
FINRA Notice 09-31 and testified that nontraditional ETFs are categorically unsuitable
for retail investors planning to hold them for longer than one trading session. Duval
testified that inverse and leveraged ETFs will necessarily erode and lose money as a
result of the constant leveraging trap. But Duval made it clear that he was relying on
various sources in reaching his opinion that holding this type of investment for more than
1 day constituted a misuse of the investment product. Duval testified that his opinion was
shared by others:
19
"Q. And you're saying it's a misuse of the investment product to hold these
investments for more than one day?
"A. Yes. And it's not just me. It's FINRA. It's the SEC. It's the New York Stock
Exchange. It's a million academics and a million people in the popular press, the financial
press."
Third, Schneider complains that "the Agency's Final Order finds '. . . an
investment adviser representative exercising his discretion in utilizing and holding Non-
Traditional ETFs for a period longer than one day would constitute a breach of the
investment adviser representative's fiduciary duty.'" Schneider makes no further comment
about this third point, but he is apparently challenging this finding by the Commissioner.
But when the Commissioner's order is read in context, the record shows that this was not
a conclusion made by the Commissioner, but rather a finding of fact regarding an opinion
testified to by Duval. We find the Commissioner's statement accurately reflects Duval's
testimony.
Schneider refers to his fourth point as his most important point. He claims that
Duval did not use the Kansas Regulation as the standard to determine whether the
investment was suitable by analyzing whether Schneider had reasonable grounds to make
the investment. He complains that Duval did not do a "customer specific suitability
analysis" for Mary Lou before reaching his conclusion. But it was not Duval's burden to
apply the Kansas legal standard. That obligation fell on the district court and the
Commissioner. In fact, an expert should not testify as to a legal conclusion, as that is a
role left to the tribunal. See Puckett v. Mt. Carmel Regional Med. Center, 290 Kan. 406,
445, 228 P.3d 1048 (2010). Duval's testimony merely provided a piece of evidence for
the Commissioner to rely on in reaching the legal conclusion of whether the collective
evidence met the legal standards as provided in K.A.R. 81-14-5(c) and (d).
20
Schneider claims that his four points lead to the conclusion that the Commissioner
applied the 1-day standard in FINRA Notice 09-31 "without nuance or discretion" and
treated the standard as having the effect of law in concluding that violation of this
standard proved a breach of a fiduciary duty.
Schneider points to two other administrative actions in which the Commissioner
also applied the same legal standard and reached similar conclusions. In In the Matter of
Cornerstone Securities, LLC and Russell Fieger, Docket No. 13E023, the Commissioner
concluded that the respondent breached his fiduciary duty as an investment adviser when
he placed assets in leveraged and inverse ETFs and held them for periods longer than 1
day. And in In the Matter of Perkins, Smart & Boyd, Inc., Docket No. 13E014, the
stipulation for consent order cited FINRA Notice 09-31 and found that inverse leveraged
ETF funds were held for more than 1 day. In Perkins, the Commissioner used this
stipulation as a basis for an administrative order sanctioning the respondent. Schneider
claims this is evidence that the Commissioner erroneously invoked the FINRA standard
rather than analyzing the conduct at issue under the Kansas legal standard.
We find the record controverts Schneider's conclusion that the Commissioner and
the district court applied the incorrect legal standard. We find no indication that the
Commissioner adopted FINRA Notice 09-31 as a governing legal standard.
Beginning with the notice of intent to seek sanctions, the Commissioner alleged
violations of K.A.R. 81-14-5(d)(1) (unsuitable recommendations) and K.A.R. 81-14-5(c)
(breaches of fiduciary duty). Next, in the prehearing questionnaire, the Commissioner
clearly indicated the alleged violations were of K.A.R. 81-14-5(d)(1) and K.A.R. 81-14-
5(c). And in the final order, the Commissioner clearly identifies that correct legal
standard under the Kansas regulations. See K.S.A. 17-12a412(d)(13); K.A.R. 81-14-5(c)
(breach of fiduciary duty); and K.A.R. 81-14-5(d) (unsuitable recommendations). The
21
orders clearly show that FINRA Notice 09-31 and Duval's testimony regarding the
information contained therein was merely some of the evidence considered and not the
legal standard relied on by the Commissioner.
The Commissioner found that Schneider violated K.S.A. 17-12a412(d)(13) by
making unsuitable recommendations and breaching his fiduciary duty to Mary Lou. The
Commissioner specifically found that no evidence was presented to show that Mary Lou
was anything other than a retail investor or to show that nontraditional ETFs would be a
suitable investment and that using them contrary to the prospectuses would be suitable.
Schneider presented no testimony or evidence in support of his position on appeal that the
investments were reasonable based on Mary Lou's expectation of becoming financially
independent through her investments.
In the conclusion of the order, the Commissioner explicitly indicated an
understanding that the mere finding that an investment was made contrary to the
information in FINRA Notice 09-31 was not the sole or controlling determination. The
Commissioner found there was no evidence that the ETFs would have been a suitable
investment for Mary Lou. Accordingly, there is no evidence to show that Schneider had a
reasonable basis for believing the investments were suitable. We reject Schneider's claim
that the Commissioner and the district court applied the incorrect legal standard in
reaching their conclusions.
Did the Commissioner comply with general legal principles concerning the Rules and
Regulations Filing Act and administrative adjudications?
Although his next argument is unclear, Schneider seems to assert that the
Commissioner violated the Rules and Regulations Filing Act, K.S.A. 2016 Supp. 77-415
et seq., by adopting FINRA Notice 09-31 as a standard of general application having the
22
effect of law. Our interpretation of Schneider's argument is based on the fact that he relies
on Bruns v. Kansas State Bd. of Technical Professions, 255 Kan. 728, 733-37, 877 P.2d
391 (1994), which is a decision dealing with the Filing Act. At the district court level,
Schneider relied on Bruns, and the district court also assumed Schneider was asserting a
violation of the Filing Act.
Schneider argues that by using FINRA Notice 09-31 as the legal standard to
determine whether Schneider violated the Kanas Securities Act, the Commissioner
engaged in rulemaking by ad hoc adjudication contrary to the requirements of the Filing
Act. Schneider claims that the erroneous adoption of FINRA Notice 09-31 as the legal
standard constituted an arbitrary, capricious, and unreasonable action by the
Commissioner. K.S.A. 2016 Supp. 77-621(c)(8) requires an appellate court to grant relief
if the agency's action is unreasonable, arbitrary, or capricious.
K.S.A. 77-425 states, in relevant part: "Any rule and regulation not filed and
published as required by this act shall be of no force or effect." In addition, "any standard,
requirement or other policy of general application may be given binding legal effect only
if it has complied with the requirements of the rules and regulations filing act." K.S.A.
2016 Supp. 77-415(b)(1).
A rule or regulation is defined by the Filing Act as "a standard, requirement or
other policy of general application that has the force and effect of law, including
amendments or revocations thereof, issued or adopted by a state agency to implement or
interpret legislation." K.S.A. 2016 Supp. 77-415(c)(4).
As a general principle of administrative law, agency decisions must be based on
known rules and standards applicable under the facts presented. "The requirement for
filing and publishing rules and regulations is primarily one of dissemination of
23
information. Members of the public, and others affected thereby, should not be subjected
to agency rules and regulations whose existence is known only by agency personnel."
Clark v. Ivy, 240 Kan. 195, 206, 727 P.2d 493 (1986). When an administrative agency
arbitrarily applies a rule that is not embodied in the statutes or published as a rule or
regulation, a respondent to an agency action is deprived of fair notice and due process.
See Bruns, 255 Kan. at 737.
The Bruns court referred to the following factors to determine whether a policy is
a rule or regulation under the Filing Act: (1) the agency did not exercise any discretion in
applying the written policy; (2) the rule had general application to those having to do
business with the agency; and (3) the agency treats its internal policy as having the effect
of law. 255 Kan. at 733-34.
In Bruns, the Kansas State Board of Technical Professionals relied on a written
internal policy of the agency in denying an engineer's application for licensure as a
professional engineer by state reciprocity. But the written policy—which denied
reciprocity if the applicant had allowed his or her license to expire in the state of original
licensure—was not published or filed as an administrative regulation. The governing
statute contained no such restriction. Under these circumstances, the Kansas Supreme
Court found that the engineer was not given proper notice of the agency's requirements
for licensure, and the internal policy was void under the Filing Act. The court focused on
the agency's treatment of the policy as binding without discretion. 255 Kan. at 736-37.
The holding in Bruns is easily distinguished from the present case, as there is no
allegation in this case that the Commissioner sought to enforce an unpublished internal
policy of the agency. Schneider acknowledges that FINRA Notice 09-31 "merely
provides interpretive guidance" to those who recommend and sell leveraged and inverse
24
ETFs. As explained earlier, the Commissioner used the FINRA notice as evidence of
misconduct, not the binding standard by which conduct must be judged.
In American Trust Administrators, Inc. v. Kansas Insurance Dept., 273 Kan. 694,
44 P.3d 1253 (2002), the American Trust Administrators sought to gain the Kansas
Insurance Commissioner's approval for its stop-loss insurance policy. The Insurance
Commissioner refused approval of the insurance policy on the basis of a bulletin which
had been published by the Office of the Insurance Commissioner and which contained
specific criteria for the sale of stop-loss insurance. On appeal, the American Trust
Administrators challenged the Commissioner's refusal to approve its policy because the
bulletin relied on by the Commissioner constituted a rule or regulation which had not
been properly published and filed under the Filing Act. The Kansas Supreme Court held
that there was no indication that the Commissioner exercised its discretion when it
refused to approve the stop-loss insurance policy based on language in the bulletin. As
such, the bulletin was a regulation under the Filing Act and the decision was void. 273
Kan. at 703.
Our present case is also distinguishable from American Trust. There, the bulletin
relied on by the Commissioner was a document containing criteria specifically issued by
the Insurance Commissioner, and there is no evidence that discretion was exercised in its
application. But in this case, FINRA Notice 09-31 was not used as binding legal authority
to be applied without discretion. Rather, it was merely used as evidence in the
Commissioner's exercise of discretion.
Schneider also relies on In re Tax Appeal of Wedge Log-Tech, 48 Kan. App. 2d
804, 300 P.3d 1105 (2013). In that case, the County appealed from the Court of Tax
Appeals' order granting the taxpayer's application for an exemption from ad valorem
taxation. The exemption was based on the finding that wireline equipment was excluded
25
from taxation under the category of commercial and industrial machinery under K.S.A.
2012 Supp. 79-223(b). The County argued that the Court of Tax Appeals (COTA) should
depart from the historical treatment of this equipment as exempt and take the position that
the equipment should be classified with mineral leasehold interests because it is
intrinsically related to the oil and gas industry. 48 Kan. App. 2d at 805. This court found
that it is the role of the legislature, not the County or COTA, to implement a shift in tax
policy. 48 Kan. App. 2d at 816.
Our present case is different from In re Wedge Log-Tech. Schneider asserts that by
relying on FINRA Notice 09-31, the Commissioner "announced, interpreted, and applied
a standard of general application arbitrarily and without notice, and thereby engaged in
rulemaking by ad hoc adjudication." But there is no indication here that the
Commissioner attempted to implement a shift in the governing legal standard or engage
in rulemaking. The information admitted into evidence regarding FINRA Notice 09-31
was merely provided as evidence, not as the Commissioner's policy or the governing
legal standard. The Commissioner was not asserting a new position or agency regulation
when it relied in part on the information contained within FINRA Notice 09-31.
The Commissioner cites Hemphill v. Kansas Dept. of Revenue, 270 Kan. 83, 11
P.3d 1165 (2000), as support for the principle that the use of an industry standard as
evidence to prove an element of a published statute or regulation does not violate the
Filing Act. In Hemphill, the drivers sought judicial review of the administrative
suspension of their drivers' licenses for failure of a breath test. The statute governing
administrative suspensions for failure of a breath test required that the testing procedures
used were in accordance with the requirements set out by the Kansas Department of
Health and Environment. KDHE had adopted a regulation which stated that breathalyzer
testing equipment "'shall be operated strictly according to description provided by the
manufacturer and approved by the department of health and environment.'" 270 Kan. at
26
86. Relying on Bruns, the drivers argued that because the manufacturer's instructions
were not filed as rules and regulations, they had no force and effect under the Filing Act.
Hemphill, 270 Kan. at 86. Our Supreme Court rejected this argument, holding that the
manufacturer's manual was merely used as evidence to show compliance with the
regulation and was not a rule or regulation under the Filing Act. 270 Kan. at 87.
The Commissioner persuasively compares the information contained in FINRA
Notice 09-31 to the manufacturer's instructions in Hemphill because FINRA Notice 09-31
was used as evidence and not as a rule or regulation requiring absolute compliance.
Unlike in American Trust and Bruns, in which the agency policies in question were
treated as binding legal authority, FINRA Notice 09-31 was used merely as evidence to
prove violations of K.S.A. 17-12a412(d)(13), K.A.R. 81-14-5(d)(1), and K.A.R. 81-14-
5(c).
As a final note, Schneider suggests that Duval's testimony provides no basis for
the conclusions set out by the Commissioner in the final order because his testimony did
not address known industry rules and standards contained in the laws of Kansas. See
Pfannenstiel v. Osborne Publishing Co., 939 F. Supp. 1497, 1504 (D. Kan. 1996)
(holding expert testimony inadmissible because it was based on expert's own definition of
reckless disregard rather than the appropriate legal standard); Jones v. Hittle Service, Inc.,
219 Kan. 627, 633-34, 549 P.2d 1383 (1976) (expert testimony not substantial evidence
because it did not follow universally accepted standards).
But Schneider fails to point to anything in the record or explain how Duval's
testimony contradicted the appropriate legal standards. Schneider did not object to
Duval's testimony on this basis, and Schneider has not shown that Duval's testimony did
not comply with the Kansas regulations and standards.
27
At the hearing, Duval clearly indicated that FINRA Notice 09-31 did not impose a
categorical prohibition against using nontraditional ETFs for retail investors, noting
instead that
"it could be appropriate in very very narrow circumstances. I wouldn't categorically say
that it's just unsuitable for every retail investor. If you had a retail investor who wanted to
speculate and was willing to lose big sums of money with this, that might be appropriate,
if somebody wanted to hedge a portfolio for one day, it might be appropriate there. But,
by and large, these are unsuitable for almost all retail investors."
Duval did not rely solely on FINRA Notice 09-13 in forming his opinions. He
referred to investor alerts issued by the SEC, the New York Stock Exchange, and other
academic literature from economists and finance professionals warning against holding
these investments for more than 1 day.
The ALJ also treated FINRA Notice 09-31 as evidence, referring to it under the
factual findings. But FINRA Notice 09-31 was not relied on in the ALJ's conclusions of
law and discussion. Instead, the ALJ found that Schneider did not have a reasonable basis
to believe that the nontraditional ETFs were suitable for Mary Lou. Nothing in the ALJ's
order suggests that it adopted the FINRA Notice 09-31 as a standard of general
applicability.
Likewise, in the Commissioner's memorandum filed after the hearing, the
Commissioner merely relied on FINRA Notice 09-31 as evidence and does not suggest
that the FINRA Notice provided imposed a binding legal standard in Kansas.
Schneider raised his concern to the district court that FINRA Notice 09-31 was
treated as a standard of general applicability. He complained that "the ALJ based his
28
entire decision on the premise that FINRA Regulatory Notice 09-31 governed the
advisory activities that are the subject of this disciplinary action, and he determined that
this guidance imposed a categorical prohibition on the use of non-traditional ETFs for
retail investors such as Mrs. Silverman." Schneider claimed it was legal error for the ALJ
to treat FINRA Notice 09-31 "as the governing legal authority" in the case. And in oral
argument, Schneider again raised his concerns. In response, the agency reiterated to the
Commissioner that it was not the agency's position that FINRA Notice 09-31 should be
treated as a standard of general applicability. Rather, the agency indicated that it was
relying on FINRA Notice 09-31 as evidence that investing in nontraditional ETFs was
unsuitable for Mary Lou.
Counsel for the Commissioner asserted:
"Just to clarify, it was not the staff's position at hearing or any time during the
course of this proceeding that [Notice 09-31] provided a categorical prohibition against
using these products either for retail investors or for using them in a manner outside of
the prospectus.
"What we were simply trying to show, and which we did show, and which the
Presiding Officer found to be credible was the FINRA notice to members, in addition to
Mr. Duval's testimony and substantial amounts of literature discussing non-traditional
ETF's, simply state that it is not typical for retail investors. That's what the notice to
members says. That's what Mr. Duval said.
"Mr. Duval did not say that there was a categorical prohibition on using them for
retail investors. He says that there was just a tendency for that product to be unsuitable.
And why is that? Because non-traditional ETF's are speculative. They are a speculative
product.
"And that's what is essentially the nub of this case, whether or not the product
itself was suitable, given the circumstances for Mrs. Silverman and Mr. Schneider's
ability to use those products in a manner which—which addresses the complexity of the
product as is reflected in the industry literature and the notice to members."
29
The Commissioner specifically addressed Schneider's claim that FINRA Notice
09-31 was erroneously adopted by the ALJ as a standard of general applicability:
"Respondent argues that the ALJ incorrectly found that FINRA Regulatory
Notice 09-31 ('Notice') governed the advisory activities of respondent in this matter and
determined that the Notice imposed a categorical prohibition on the use of non-traditional
ETFs for retail investors such as Mrs. Silverman. However, nowhere in the Initial Order
did the ALJ find that FINRA Regulatory Notice 09-31 was a governing document or
anything other than regulatory guidance. The Notice did, however, serve as substantial
competent evidence of industry standards regarding the use of non-traditional ETFs and
the risks inherent in using such products. The ALJ did not find that the Notice imposed a
categorical prohibition on the use of non-traditional ETFs for a certain class of investors
but rather that the Respondent's actions and knowledge level, when compared with the
recommended actions and requisite knowledge level suggested in FINRA Notice 09-31,
demonstrated that the Respondent: '1) was not nearly as knowledgeable as he should
have been regarding the product; 2) disregarded accepted industry practice in how the
product was to be used; 3) ignored regulatory guidance; 4) failed to trade the product as
intended; 5) failed to monitor the investments appropriately; and [6]) lost Silverman a
significant sum of money as a result.
"In sum, the record supports the ALJ's evidentiary findings that the Respondent's
disregard of the guidance in FINRA Notice 09-31 factually demonstrated, in part, that the
Respondent did not have a reasonable basis to believe the Non-Traditional ETFs were
suitable for Silverman."
The Commissioner made clear that FINRA Notice 09-31 was used merely as
evidence. The Commissioner noted that the standard of review was governed by K.S.A.
77-527 and that review of the ALJ's conclusions of law was de novo. The Commissioner
thus made an independent determination that Schneider violated K.S.A. 17-
12a412(d)(13), K.A.R. 81-14-5(d)(1), and K.A.R. 81-14-5(c). As such, unlike cases
where the policy in question was treated as binding legal authority, we find the
30
Commissioner did not adopt FINRA Notice 09-31 as a regulation but treated it merely as
evidence. We conclude Schneider has failed to show a violation of the Filing Act.
Did the Commissioner violate the nondelegation doctrine in applying FINRA Notice 09-
31 to determine whether Schneider violated the Kansas Securities Act?
Schneider contends that the district court and the Commissioner violated the
nondelegation doctrine by relying on FINRA Notice 09-31 as the sole legal authority to
justify sanctions against Schneider. Because FINRA is a private entity that acts as a self-
regulatory organization for broker-dealers, Schneider claims that the Commissioner's
reliance on the notice constituted a "cession of governmental authority to a private entity
in violation of the non-delegation doctrine." By violating the nondelegation doctrine,
Schneider complains the Commissioner's actions were arbitrary, capricious, and
unreasonable. K.S.A. 2016 Supp. 77-621(c)(8) requires us to grant relief if the agency's
action is otherwise unreasonable, arbitrary, or capricious.
The nondelegation doctrine prohibits the delegation of governmental power to
unelected and politically unaccountable bodies. The nondelegation doctrine "flows from
the separation of powers principles embodied in Art. 2, § 1 of the Kansas Constitution,
which provides that '[t]he legislative power of this state shall be vested in a house of
representatives and senate.'" Blue Cross & Blue Shield of Kansas, Inc. v. Praeger, 276
Kan. 232, 276, 75 P.3d 226 (2003).
Under the nondelegation doctrine, State agencies may not delegate their power to
make obligatory rules to private individuals or nongovernmental entities. Sedlak v. Dick,
256 Kan. 779, Syl. ¶ 1, 887 P.2d 1119 (1995); see State v. Crawford, 104 Kan. 141, 177
P. 360 (1919) (the unlawful delegation of legislative power is contrary to the public
policy expressed in the Constitution). The legislature may enact general statutes and grant
31
state agencies discretionary authority to fill in the details, but legislative powers may not
be delegated to nongovernmental associations or groups. See State ex rel. Board of
Healing Arts v. Beyrle, 269 Kan. 616, 629-30, 7 P.3d 1194 (2000); Gumbhir v. Kansas
State Bd. of Pharmacy, 228 Kan. 579, 581-82, 618 P.2d 837 (1980).
Schneider relies on State v. Ribadeneira, 15 Kan. App. 2d 734, 817 P.2d 1105
(1991). But the facts in this case are completely different. In Ribadeneira, the defendant's
convictions of two counts of securities fraud were reversed based on this court's ruling
that the district court committed reversible error by instructing the jury that the failure of
the defendant to comply with the provisions of a federal securities regulation was a
fraudulent and deceptive practice as a matter of law. This was in error because Kansas
had not adopted the federal securities regulations cited in the jury instruction.
Ribadeneira is a criminal case having to do with erroneous jury instructions. We find no
evidence that the Commissioner in our present case delegated to FINRA the task of
setting the legal standard for the conduct of an investment adviser in Kansas.
Are the Commissioner's factual findings supported by substantial competent evidence?
Finally, Schneider claims that the Commissioner's determination that he violated
the Kansas Uniform Securities Act is not supported by substantial competent evidence
when viewed in light of the record as a whole. Schneider asserts the record does not
contain substantial competent evidence that he lacked a reasonable basis for finding the
investments were suitable for Mary Lou or that he breached his fiduciary duty to his
client.
K.S.A. 2016 Supp. 77-621(c)(7) allows us to grant relief if the agency action is
based on a determination of fact, made or implied by the agency, that is not supported by
evidence that is substantial when viewed in the light of the record as a whole. After being
32
amended in 2009, K.S.A. 77-621 now defines "in light of the record as a whole" to
include the evidence both supporting and detracting from an agency's finding. We must
now determine whether the evidence supporting the agency's factual findings is
substantial when considered in light of all the evidence. K.S.A. 2016 Supp. 77-621(d);
Redd v. Kansas Truck Center, 291 Kan. 176, 183, 239 P.3d 66 (2010). Substantial
competent evidence possesses both relevance and substance and provides a substantial
basis of fact from which the issues can be reasonably determined. Frick Farm Properties
v. Kansas Dept. of Agriculture, 289 Kan. 690, 709, 216 P.3d 170 (2009).
The Commissioner alleged that Schneider engaged in dishonest or unethical
practices under the Kansas Uniform Securities Act by making unsuitable investments for
Mary Lou and, in turn, breaching his fiduciary duty to her.
K.S.A. 17-12a412(d)(13) provides that Schneider may be disciplined if the
Commissioner finds that Schneider "has engaged in dishonest or unethical practices in
the securities . . . business within the previous 10 years." And K.A.R. 81-14-5(d)(1) states
that dishonest or unethical practices under K.S.A. 17-12a412(d)(13) include
"[recommending] to any client . . . the purchase, sale, or exchange of any security without
reasonable grounds to believe that the recommendation is suitable for the client on the
basis of information furnished by the client after reasonable inquiry concerning the
client's investment objectives, financial situation and needs, and any other information
known by the . . . investment adviser representative."
K.A.R. 81-14-5(d)(1) provides the standard for determining dishonest or unethical
practices based on suitability:
"Unsuitable recommendations. An investment adviser or investment adviser
representative shall not recommend to any client to whom investment supervisory,
33
management, or consulting services are provided the purchase, sale, or exchange of any
security without reasonable grounds to believe that the recommendation is suitable for the
client on the basis of information furnished by the client after reasonable inquiry
concerning the client's investment objectives, financial situation and needs, and any other
information known by the investment adviser or investment adviser representative."
Under K.A.R. 81-14-5(c), "[a]n investment adviser or investment adviser
representative is a fiduciary and shall act primarily for the benefit of its client." In
addition, "dishonest or unethical practices" also includes breaching fiduciary duties to a
client. K.A.R. 81-14-5(c).
Schneider claims that the investment was suitable for Mary Lou. He asserts that he
showed that his investment decisions were suitable under the circumstances, and he
demonstrated a firm understanding of the terms, features, design, risks, and rewards of
the investments. Schneider contends he was aware that at the end of each trading day, he
should position the portfolio so that its exposure to the benchmark index was consistent
with the fund's objective. Schneider claims he closely monitored the correlation between
the values of the ETF funds and the underlying index on a daily basis to determine if the
correlation became distorted. He asserts he demonstrated that he understood Mary Lou's
financial status, tax status, and investment objectives, conducted extensive due diligence,
and monitored the investments with reasonable frequency consistent with his
discretionary authority.
Schneider points to the financial plan he put together for Mary Lou, as well as a
discussion of her investment goals. He recognized that he identified that Mary Lou's total
risk exposure was a relatively conservative 2.4 on a scale of 1 to 10. He explained how he
monitored the nontraditional ETF investments, even though he held them for more than a
day. Schneider's explanation for Mary Lou's investment losses was that the market went
34
against both Schneider's and Mary Lou's reasonable expectations. He disputes that the
losses were due to the constant leveraging trap. He claims that the evidence does not
show that he breached his fiduciary duty to Mary Lou or that he failed to act ethically and
honestly.
Schneider also points to weaknesses in Duval's testimony, noting that Duval did
not perform an individual analysis of Mary Lou's portfolio to determine whether
Schneider provided an unsuitable recommendation. Schneider claims that this was a fatal
flaw because K.A.R. 81-14-5(d)(1) plainly makes customer-specific factors part of the
suitability analysis under the Kansas Uniform Securities Act.
In considering the record as a whole under K.S.A. 2016 Supp. 77-621, the court
must "(1) review evidence both supporting and contradicting the agency's findings; (2)
examine the presiding officer's credibility determination, if any; and (3) review the
agency's explanation as to why the evidence supports its findings. [Citations omitted.]"
Williams v. Petromark Drilling, 299 Kan. 792, 795, 326 P.3d 1057 (2014). We "cannot
reweigh the evidence or make our own independent review of the facts," but must
determine whether the agency's decision has been so undermined by cross-examination or
other evidence that it is insufficient to support its decision. Moore v. Venture
Corporation, 51 Kan. App. 2d 132, 137, 343 P.3d 114 (2015).
The Commissioner points to the following uncontroverted evidence in support of
its conclusion that Schneider violated K.S.A. 17-12a412(d)(13), K.A.R. 81-14-5(d)(1),
and K.A.R. 81-14-5(c):
 Mary Lou was a retail investor.
 Schneider liquidated positions held in Mary Lou's accounts and began
purchasing nontraditional ETFs.
35
 The prospectuses for the nontraditional ETFs, including FINRA Notice 09-
31, concurred that nontraditional ETFs are typically unsuitable for retail
investors, especially when the investments are held for more than 1 day and
during volatile market conditions.
 Schneider did not advise Mary Lou that he was going to invest in
nontraditional ETFs on her behalf.
 Schneider did not advise Mary Lou of the risks associated with investing in
nontraditional ETFs.
 Schneider held various nontraditional ETFs for periods exceeding 1 day,
even for over 180 days, in all instances contrary to the prospectuses for the
products and other industry literature.
 Schneider initially placed a series of stop-losses on the nontraditional ETFs,
but when they were continually triggered, Schneider placed larger stop-
losses until he eventually lifted them altogether.
 Schneider believed there was no difference in the level of care between
nontraditional ETFs and other products, indicating that nontraditional ETFs
have no inherent risks beyond the market itself.
 Schneider placed nearly all of his 160 retail clients in nontraditional ETFs.
 There is no indication that Mary Lou was an atypical retail investor such
that nontraditional ETFs would be a suitable investment for her.
 Between June 2010 and January 2011, Schneider's investments in
nontraditional ETFs on Mary Lou's behalf lost over $90,000, or roughly 20
percent of the value of her account.
Duval testified that Schneider's conduct violated the standards in K.A.R. 81-14-
5(d)(1) and K.A.R. 81-14-5(c). Duval relied on the legal standards provided in the
administrative regulations, and not FINRA Notice 09-31, in reaching his conclusions.
36
Duval testified that nontraditional ETFs are distinct from traditional ETFs because
they require that the leverage ratio be constant. Those investing in nontraditional ETFs
must rebalance their portfolio every day. Industry literature refers to this daily
rebalancing as the constant leverage trap. Duval used an example from his own published
article to show how the constant leverage trap causes nontraditional ETFs to lose value
when held for longer than 1 day, even if the underlying index ends at the same level. This
constant leveraging causes nontraditional ETFs to lose value in every type of market
environment with the possible exception of a market declining day after day. The effects
of constant leveraging are more pronounced in a volatile market. Nontraditional ETFs are
considered "speculative" investments.
Because Duval believed that nontraditional ETFs were unsuitable for Mary Lou at
the time they were purchased, Duval did not analyze what portion of Mary Lou's losses
were caused by constant leveraging as opposed to changes in the market. Duval
unequivocally testified that nontraditional ETFs were not suitable investments for Mary
Lou. Duval said that investing in nontraditional ETFs for more than 1 day is unsuitable
for the average retail investor. Investing in nontraditional ETFs for more than 1 day is
contrary to the prospectuses because the investments are speculative and because of the
constant leveraging.
Duval testified that if an investment adviser intended to use nontraditional ETFs in
a manner not prescribed by the prospectus, it is a breach of fiduciary duty to fail to
explain the products and their associated risks to the client, especially if the investments
are made under discretionary authority. Duval further testified that an investment adviser
breaches his or her fiduciary duty by failing to inform a growth and income client that he
is investing in speculative products such as nontraditional ETFs, even if in conformity of
the prospectuses.
37
The Commissioner concluded that Duval was credible, noting that his testimony
was not substantially undermined by cross-examination or other evidence. Duval stated
that regardless of the market conditions, if an investor remains in the position longer than
1 day, there will be a loss due to the constant leverage trap. He testified that "you
definitely do not want to buy this and hold it because the price is going to go down. And
the only variable is how fast it's going to go down." Duval's testimony about the constant
leverage trap was corroborated by FINRA Notice 09-31 and other industry literature
introduced into evidence.
Duval explained how losses result from the constant leverage trap, stating,
"the longer you hold it, the longer the constant leverage trap works. As I also said, the
longer you hold it, the more you're exposed to your bets. In this case, no doubt the bet
was completely wrong. So Mr. Schneider is holding on to wrong bets longer and longer.
And as they work against him, yeah, the positions have bigger and bigger losses. And the
constant leverage trap works against him at the same time."
Schneider's claim that Duval offered no opinion with respect to customer-specific
suitability is contradicted by the record. Duval was questioned about Mary Lou's
investments:
"Q. You stated that you reviewed the account statements of Mary Lou Silverman. Is that
correct?
"A. That's correct.
"Q. And you reviewed the holdings that Mr. Schneider had put Mary Lou in with respect
to nontraditional ETFs. Is that correct?
"A. Yes.
"Q. Did you have an opportunity to analyze those statements?
"A. Yes.
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"Q. And did you reach any conclusions as to the appropriateness of the use of those
products in Mary Lou's accounts?
"A. Yes.
"Q. And what was your conclusion on that?
"A. Well, by and large, many of these leveraged and inverse ETFs were held for long
time periods. Certainly much longer than a day and, most of them, much longer than 30
days. And this is contrary to how they're supposed to be used. And that puts them, in my
mind, squarely in an unsuitable category because they were used against the way they
were designed."
Duval concluded that those nontraditional ETFs were not suitable investments for Mary
Lou.
Finally, Schneider attacks the sufficiency of the evidence that he breached his
fiduciary duties. He argues that the Commissioner had to show that he had scienter to
support a finding that he breached his fiduciary duties. But scienter is not required to
prove a breach of fiduciary duty. The requirements of a claim of breach of fiduciary duty
are existence of a duty, breach of that duty, and damages resulting from the breach.
Horosko v. Jones, No. 91,375, 2004 WL 2926665, at *1 (Kan. 2004) (unpublished
opinion). In the careless management of an investment and failing to keep the client
advised regarding the status of investment, there is no scienter requirement to establish a
breach of fiduciary duty. See Gochnauer v. A.G. Edwards & Sons, Inc., 810 F.2d 1042,
1048-50 (11th Cir. 1987) (breach of fiduciary duty does not require showing of scienter
or bad faith); Dunn v. A.G. Edwards & Sons, Inc., No. 96,669, 2007 WL 2767997, at *6
(Kan. App. 2007) (unpublished opinion). Scienter is not required to establish a breach of
fiduciary duty.
Duval testified that it would be a breach of fiduciary duty to fail to explain
nontraditional ETFs to a client before investing in the product. Duval stated:
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"If you're an investment adviser, obviously you're a fiduciary. You're charged with
looking after the client, putting their interests first. And you're going to use an investment
product in a way that it's not designed to be used. And there's warnings all over the place
in the prospectus by the people who designed the investment stating this. If you're going
to do that, then you would have to, in my opinion, really you would have to paper the file,
tell the people, document it, get the people to sign, get the clients to sign something. And
in my mind, you would also have to put forth some kind of rationale of why you're going
to do that and why it makes sense and have a clear line of sight to some way of making
money that way."
In addition, Duval said it would be a breach of fiduciary duty not to tell a client
whose stated objectives were growth and income that they were using speculative
instruments. According to Duval, it is unethical to deliberately or ignorantly misuse the
investment product. In turn, holding ETFs for more than 1 day constitutes a dishonest or
unethical practice and a breach of fiduciary duty.
Schneider admitted that he did not explain to Mary Lou the risks associated with
the nontraditional ETFs. Schneider also showed a lack of understanding of how
nontraditional ETFs differed from other equity products, demonstrating a lack of
understanding of the product. When Schneider was asked what the term "constant
leveraging trap" referred to, he first stated: "I think I have an idea. But I'm not going to
share it because I'm not sure exactly where we're going with this." But when pressed by
the ALJ to answer if he knew what the term meant, Schneider changed his answer to no:
"Q. So you do or you do not know what a constant leverage trap is? What the term
means?
"A. Not in the context you're asking it. No.
"Q. I'm not asking it in any context?
"A. Let's make it, no.
"Q. Other than the context of this proceeding?
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"A. Make it no.
"Q. Excuse me. You're talking over me.
"A. We'll make it no.
"Q. You do not know?
"A. Okay. No."
As Duval testified, investing in nontraditional ETFs without adequately understanding
the particular risks is a breach of fiduciary duty.
We conclude there is substantial competent evidence to support the
Commissioner's findings when viewed in light of the record as a whole. A combination of
Duval's testimony, Schneider's testimony, Mary Lou's testimony, and the exhibits
admitted at the hearing show that Schneider did not have reasonable grounds to believe
that the investment strategy was suitable for Mary Lou's assets and further breached his
fiduciary duty to her as his client.
Affirmed.
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