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Schneider v. The Kansas Securities Commissioner

Court of Appeals of Kansas

June 2, 2017

Mark R. Schneider, Appellant,
v.
The Kansas Securities Commissioner, Appellee.

         SYALLABUS

         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.

         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 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."

         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.

         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. 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.

          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. 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%.

         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.

         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 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 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 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."

         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, ...


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