Federal Court Sustains Failure To Supervise Penalty

December 5, 2013

In Matthew Collins v. Securities And Exchange Commission (United States Court of Appeals, Sixth Circuit, District of Columbia, 2-1241, November 26, 2013), we are presented with the appeal by Matthew J. Collins from a Securities And Exchange Commission ("SEC") finding that he had failed to supervise a subordinate, who violated various securities laws. Among the sanctions imposed by the SEC against Collins were:
  • a Bar from associating with any broker, dealer, or investment adviser with the proviso that he may apply to become so associated in a non-supervisory capacity after two years; 
  • a cease-and-desist order; 
  • a $2,915 disgorgement, plus $1,324.74 in prejudgment interest; and
  • a $310,000 civil monetary penalty. 
Although Collins did not challenge the SEC's factual findings on appeal to the federal Circuit Court, he did assert that the civil penalty was excessive and constituted an arbitrary and capricious act in violation of the Eighth Amendment.

READ This SEC Background
A Career Brown-out

In 2001, Collins arrived at Prime Capital Services. Eric Brown was associated with Prime Capital from 1998 until March 2006, and during that time he was one of the firm's top producers, selling, among other financial products, variable annuities ("VAs"). Because Collins had not previously sold variable annuities, Brown purportedly taught the supervisor about VAs and how to sell them. 

In December 2002, Prime Capital assigned Collins to be Brown's supervisor. Oddly, the firm did not begin training Collins to be a supervisor until several months after he began an supervising Brown. As to the quality of that training, the SEC Opinion asserts that Collins acknowledged it as "lacking."

In recent years, securities industry regulators have gone after VA sales with a vengeance -- and, frankly, with much justification.  This has been an area ripe with fraud and targeting far too many senior citizens.  The SEC's February 27, 2012, Opinion at pages 5-6 explains that:

The securities at issue in this matter were all variable annuities. A variable annuity is a hybrid security and life insurance product. It is a contract between an investor and an insurance company in which the investor agrees to make a lump-sum payment or a series of payments in exchange for a regular stream of payments or a lump-sum payment in the future. Variable annuities generally offer investors a range of investment options (typically mutual funds that invest in stocks, bonds, and money market instruments), and the value of variable annuities depends on the performance of the underlying investments. Income and investment gains from variable annuities are generally tax-deferred and, when withdrawn, are taxed at ordinary income tax rates.

Variable annuities generally offer a "death benefit," which provides that, if the investor dies before receiving payments from the insurance company, the investor's stated beneficiaries are guaranteed to receive a specified amount (typically at least the amount of the investor's payments to the insurance company less accumulated withdrawals). Variable annuities also generally assess surrender charges if the investor withdraws money during the early years of the investment, although contracts will often allow an investor to withdraw a certain amount of his or her account without paying a surrender charge. Variable annuities also generally contain a "freelook" period of ten or more days after the initial investment, during which investors can terminate the contract without incurring a surrender charge.

Variable annuities generally contain a "mortality and expense risk" charge to compensate the insurance company for the insurance risk that the company assumes under the annuity contract. In addition, investors in variable annuities can often obtain certain optional features (such as a stepped-up death benefit, guaranteed minimum income benefit, long-term care insurance, and up-front bonus credits) at specified charges.

Insurance companies pay broker-dealers a commission for selling variable annuities. The amount of the commission depends on the insurance company, the relationship between the broker-dealer and the insurance company, the type of annuity sold, and how much money the customer invested. Commissions can be paid in full at the time of sale, over the life of the contract, or for another defined period.

December 2003 Revocation

In August 2003, the Florida Department of Financial Services filed an administrative complaint against Brown that alleged, in part, that he had improperly guaranteed certain customers a 6 to 8% return on their investments. Following, Brown's failure to respond, Florida revoked his insurance license in December 2003. 

What He Knew . . . Or Should Have?

As to supervisor Collins' awareness of the Florida revocation and the underlying issues, the Opinion concedes that "Brown lied to Collins about the nature of the administrative sanction, suggesting that it related to a "mishap with the state of Massachusetts," and that it was "no big deal." 

When compliance and regulatory staff investigate possible instances of failed supervision; however, such an inquiry is rarely satisfied by the disclosure that a supervised individual lied to a supervisor or had engaged in a cover-up. Typically, the investigation tries to determine whether the supervisor was on notice of potential misconduct and, thereafter, took appropriate steps to gather information about the circumstances.  

The SEC concluded that Collins had failed to personally investigate the circumstances of the Florida revocation and had permitted Brown to continue to market variable annuities. Moreover, the SEC found that even though Collins had eventually learned of the revocation of Brown's license in February 2004, the supervisor still did not constrain Brown's VA marketing activities; in fact, Collins allowed Brown to continue marketing variable annuities. 

A Reversal Of Misfortune

Florida throws us a curve, which breaks sharply, and we wind up whiffing because in April 2004 -- some four months after that state had revoked Brown's license when he failed to contest the state's August 2003 charges --Florida reinstated Brown's license pending his appeal of the 2003 revocation.  You got that?  First the state revoked Brown's license and then, pending his appeal, unrevoked it; however, the state conditioned the reinstatement of the license upon prohibitions against Brown marketing annuities to individual 65 and older who were not then clients. 

SIDE BAR: Hmmmm . . . so the December 2003 revocation is lifted in April 2004 pending Brown's appeal.  Which sort of suggests that Florida wasn't so troubled by Brown's alleged misconduct and gave him some benefit of the doubt. Should Collins' supervision of Brown have taken that factor into account?  Keep in mind that Collins was unaware of the December 2003 revocation until February 2004. However, by that later date, he was finally on notice of the state's concerns and actions.

The Name Game

Notwithstanding the explicit prohibition against marketing annuities to non-client senior citizens, Brown continued to market annuities to the proscribed population. For example, Collins permitted Brown to discuss VAs at public seminars and to sell them to customers. In what now comes off as horrifically misguided conduct, Collins tried to conceal Brown's marketing efforts by improperly substituting his name for that of Brown as the representative of record for the subject annuities sales. I mean, seriously?  Yeah, Collins was certainly on point when he characterized his training as a supervisor as "lacking."

In contravention to the marketing restrictions imposed appeal of the Florida license revocation, the SEC found that Brown had, in fact, sold VAs to five elderly customers. Of those five customers:
  • one withdrew from the investment without penalty or other expense;
  • two suffered no financial loss other than commissions paid to Collins; however, 
  • two customers incurred over $60,000 in total withdrawal penalties from Brown's unauthorized transfers of funds from their pre-existing investments plus the further $459,000 loss of appreciation of those prior investments. 
During the SEC proceedings, substantial evidence was presented to suggest that Brown was the servicing registered representative - highlighted by testimony of customers who stated that they had virtually no interaction with Collins. In fact, an internal review by Prime Capital characterized Collins as demonstrating a  "complete lack of supervision." 

Settling Up

In January 2006, Brown settled Florida's complaint against him by agreeing to a consent order, pursuant to which his license to sell insurance was permanently revoked and he agreed to pay restitution to the complaining customers in amounts ranging from approximately $14,000 to $84,000.

Following a Florida investigation into the customers' complaints, Collins paid a $5,000 fine and accepted a one-year probation on his insurance license.  Separately, Prime Capital settled an NASD complaint with a payment of $125,000, towards which Collins contributed $25,000.


In June 2009, the SEC instituted antifraud proceedings against Brown, Collins and other employees of Prime Capital.  As detailed in the Court's Opinion:

[I]ronically, the Commission absolved Collins of one charge of which the ALJ had found him liable, and lowered the "tier" of punishment, yet imposed a much heavier civil penalty. The ALJ found him liable as a primary violator of the antifraud provisions, but the Commission reversed that finding. On the substantive charge of failing "reasonably to supervise" Brown under Exchange Act §§ 15(b)(4)(E) and 15(b)(6)(A), the ALJ and the Commission agreed. Those sections create liability for a supervisor when his inadequate supervision is coupled with a violation by his supervisee. . .
. . .
The ALJ found that Collins's acts satisfied the third-tier criteria, and imposed a single such penalty of $130,000. The Commission found that Collins was properly subject only to second-tier penalties. But it treated each of the five relevant sales as "distinct and separate" acts or omissions, resulting in five penalties aggregating $310,000. SEC Opinion at *60. It also ordered him to disgorge $2,915, the total commissions on sales to two customers; it excused any disgorgement of the commissions (slightly exceeding $2000) paid by the two customers whose NASD claim Prime Capital had settled for $125,000, including $25,000 from Collins.

Notwithstanding the concession as to the "primary violator" issue, the SEC's Opinion at page 17presented a strongly worded condemnation of Collins' conduct as a supervisor:

Collins was responsible for supervising only one person: Brown. In fact, Collins and Brown were, for a time, the only two employees in the Delray office. Yet, as Prime Capital's own review of Collins accurately concluded, "there was [a] complete lack of supervision . . . by Matt Collins" over Brown. The Firm's records, for example, showed that customer documents, and in some cases entire files, were missing (which Collins acknowledged made an adequate review of Brown's sales impossible), and the Firm's branch reviews found "no evidence" of any supervisory review over certain of Brown's transactions.

Even more egregiously, when Brown told Collins of a "mishap" with his Massachusetts insurance license, Collins did nothing, accepting Brown's claim that it "was no big deal." When Collins later learned that, in fact, Florida had suspended Brown's license for making material misstatements and executing an unauthorized transaction, Collins still did nothing. And when Collins learned that Florida reinstated Brown's license with restrictions, he again did nothing. Collins not only allowed Brown to continue selling variable annuities to new customers in violation of Florida's prohibition, he also actively facilitated Brown's continued sales by falsely stating on customer account forms that he, and not Brown, was the customers' registered representative. Collins also continued to defer to Brown, relying entirely on Brown's word, for instance, that Bogan's son had signed a document authorizing a transfer in Bogan's son's account.27

As a result, Collins's supervision of Brown was not just inadequate, but entirely absent. Collins himself admitted that his supervision of Brown was deficient and that he lacked the training and documents to review Brown adequately. We thus find that Collins failed to exercise reasonable supervision with a view to preventing Brown's antifraud violations.

6th Circuit Appeal

In his appeal to the Sixth Circuit, Collins challenges the SEC's Order on the grounds that it was an abuse of discretion to impose the $310,000 civil penalty, and that the penalty violated the Excessive Fines Clause of the Eighth Amendment.  Pointedly, Collins argued that the $310,000 penalty was arbitrary or capricious because it was an unexplained departure from the SEC's practice of linking a civil penalty more closely with the disgorgement amount. As such, the penalty imposed against Collins constituted a whopping 100 times multiple of the $3,915 disgorgement. 

Not A Foolish Consistency

After due consideration of the contested penalty, the Court affirmed the SEC. The Opinion explains that for a court:

[N]ot to require uniformity or "mechanical formulae" is not the same as for it to be oblivious to history and precedent. Review for whether an agency's sanction is "arbitrary or capricious" requires consideration of whether the sanction is out of line with the agency's decisions in other cases. Friedman v. Sebelius, 686 F.3d 813, 827-28 (D.C. Cir. 2012).

Recognizing this, we nonetheless find that the penalty's relation to disgorgement does not render it arbitrary or capricious. First, the $2,915 disgorgement imposed directly on Collins understates his full disgorgement responsibility, as he was excused disgorgement of slightly more than $2000 in commissions because of the $25,000 he had contributed to settlement of the NASD complaint brought by the customers involved.

Second, disgorgement obviously doesn't fully capture the "harm" side of the proportionality test that Collins's reply brief invites us to consider-"proportionality between the gain or injury and the penalties exacted." Full indicia of the injury inflicted by Collins and Brown, for example, include the entire $125,000 paid to settle the NASD complaint, of which Collins paid only $25,000.

Third, the statute seems to demand that the Commission look beyond harm to victims or gains enjoyed by perpetrators. It lists harm to other persons as only one of five specific factors (plus the catch-all reference to "such other matters as justice may require"). In that context, the relation between the civil penalty and disgorgement (and other measures of injury) is informative, particularly in comparison with other cases,but hardly decisive.

Looking more broadly, the Commission noted in its opinion, for instance, that Collins's violation was "egregious," and that he "displayed a blatant failure to deal fairly with elderly, unsophisticated customers and exhibited a clear disregard for . . . customers' interests." SEC Opinion at *59-60. This conclusion rested, in part, on the fact that Collins falsified documents and otherwise failed completely to supervise Brown, "creat[ing] an environment where Brown could defraud his clients with impunity." Id. at *42. And the Commission quite properly invoked the statutory interest in deterrence.