Schneider v. Kan. Sec. Comm'r

• Decision Date: 02 June 2017
• Docket Number: No. 115,383,115,383
• Citation: 54 Kan.App.2d 122,397 P.3d 1227
• Parties: Mark R. SCHNEIDER, Appellant, v. The KANSAS SECURITIES COMMISSIONER, Appellee.
• Court: Kansas Court of Appeals

54 Kan.App.2d 122

397 P.3d 1227

Mark R. SCHNEIDER, Appellant,

v.The KANSAS SECURITIES COMMISSIONER, Appellee.

No. 115,383

Court of Appeals of Kansas.

Opinion filed June 2, 2017

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...