INITIAL DECISION RELEASE NO. 141 ADMINISTRATIVE PROCEEDING FILE NO. 3-8966 UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Washington, D.C. ____________________________ In the Matter of : : INITIAL DECISION QUEST CAPITAL STRATEGIES, : April 12, 1999 INC., and DAVID CHEN YU : ____________________________ APPEARANCES: Wayne M. Carlin, Leslie Kazon, Anna T. Majewicz, and Caren N. Pennington for the Division of Enforcement, Securities and Exchange Commission Robert C. Rosen for Respondents BEFORE: Lillian A. McEwen, Administrative Law Judge SUMMARY Quest Capital Strategies, Inc., a registered broker-dealer and investment adviser, and David Chen Yu, Quest’s president, were charged with failing reasonably to supervise John Nakoski, a registered representative of Quest, with a view toward preventing his violations of the federal securities laws. This Initial Decision finds that Nakoski failed to register as an investment adviser, defrauded investors in violation of the Securities Act, Exchange Act, and Advisers Act, and violated certain custody and disclosure requirements of the Advisers Act. This Decision concludes that although Nakoski was subject to the supervision of Quest and Yu when he violated the federal securities laws, Respondents reasonably supervised him with a view to preventing his securities laws violations. This Decision orders that this proceeding against Respondents Quest Capital Strategies, Inc. and David Chen Yu be dismissed. INTRODUCTION Procedural Background The United States Securities and Exchange Commission (Commission) instituted these proceedings on February 29, 1996, pursuant to Sections 15(b) and 19(h) of the Securities Exchange Act of 1934 (Exchange Act) and Section 203(f) of the Investment Advisers Act of 1940 (Advisers Act). The Hearing I held a public hearing on August 20-23, 26-30, and September 3-4, 1996, in Los Angeles, California. The hearing record consists of the witnesses’ testimony and numerous exhibits. I admitted 190 exhibits from the Division of Enforcement (Division) into evidence and 121 exhibits from Respondents Quest Capital Strategies, Inc. (Quest) and David Chen Yu (collectively, Respondents).[1] Issues The Order Instituting Proceedings (OIP) alleges that from about August 1992 until August 1993, Quest, a registered broker- dealer and investment adviser, and Yu, its president and a compliance officer of the firm, failed reasonably to supervise John Nakoski, a registered representative, with a view toward preventing his violations of Section 17(a) of the Securities Act of 1933 (Securities Act), Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Sections 203(a) and 206(1), (2), and (4) of the Advisers Act and Rules 206(4)-2 and 206(4)-4 thereunder. (OIP at 2.) If I conclude that the allegations in the OIP are true, I must then determine what, if any, remedial sanctions are appropriate in the public interest against Quest pursuant to Sections 15(b), 19(h), and 21B of the Exchange Act and against Yu pursuant to Sections 15(b), 19(h), and 21B of the Exchange Act and Sections 203(f) and 203(i) of the Advisers Act. (OIP at 3.) After the hearing the Division filed Proposed Findings of Fact and Conclusions of Law, its Post-Hearing Memorandum in Support of Proposed Findings of Fact and Conclusions of Law, and its Reply to Respondents’ Proposed Findings of Fact and Conclusions of Law. Respondents filed Proposed Findings of Fact and Conclusions of Law, their Post-Trial Brief, Reply Proposed Conclusions of Law, and their Post-Trial Reply Brief. FINDINGS OF FACT I based the findings and conclusions herein on the entire record and on the demeanor of the witnesses who testified at the hearing. I applied preponderance of the evidence as the applicable standard of proof. See Steadman v. SEC, 450 U.S. 91 (1981). I considered and rejected all arguments and proposed findings and conclusions that are inconsistent with this decision. I find that the Division has not proved that Quest and Yu violated the federal securities laws as alleged in the OIP. Respondents Quest Capital Strategies, Inc. and David Chen Yu Yu was born in Canton, China in 1948. (Tr. 1572.) He graduated from a high school in Hong Kong and attended Pace University in New York (Pace). (Tr. 1572.) After Yu graduated from Pace he sold real estate in New York. (Tr. 1573.) Yu moved to California and sold option contracts for First Commodity of Boston from December 1978 to August 1979. (Tr. 1057, 1573.) Subsequently, he sold life insurance for John Hancock Life Insurance Company (John Hancock) and other life insurance companies. (Tr. 1573-74.) Yu founded Quest Capital Strategies in 1983 after his life insurance sales production slowed, became a Certified Financial Planner in 1984, and briefly provided financial planning services through the firm. (Tr. 1575.) Yu obtained his Series 7 license in January 1984. (Tr. 1576.) Quest, based in Laguna Nigel, California, has been registered with the Commission as a broker-dealer and investment adviser since 1985. (Tr. 1004, 1576.) By the end of 1992, Quest employed 250 registered representatives and had two branch offices. (Div. Ex. 170-102.) By the end of 1994, Quest had expanded to nine branch offices and 392 registered representatives. (Div. Ex. 170-102.) Presently, Quest has four branch offices and employs 700 registered representatives throughout the United States. (Tr. 2127.) The vast majority of Quest’s registered representatives work out of their homes and sell securities part time without on-site supervision, trading for their own accounts and for the accounts of their relatives and friends. (Tr. 1006, 1008, 2128, 2130.) Yu is presently the sole owner of Quest and has been its president since its incorporation. (Tr. 870, 1001, 1010.) He holds a Series 4 registered options principal license, a Series 6 investment company variable contracts license, a Series 7 general securities representative license, a Series 24 general securities principal license, a Series 27 financial operations principal license, and a Series 63 state law license. (Tr. 1127-28.) Quest Capital Investments, Inc. (Quest Investments) is a business related to Quest and is owned by Yu’s wife. (Tr. 1001- 02.) Since about 1987, Quest Investments has sold self-study materials (for the Series 7 examination) which Yu developed. (Tr. 1001-02, 1602-03.) With the assistance of outside authors, Quest Investments regularly updates the materials, which are sold throughout the United States. (Tr. 1602-03.) Quest recruits many of its registered representatives from purchasers of the Quest Investments materials who pass the Series 7 examination. (Tr. 1002.) Quest characterizes its registered representatives as "independent contractors" and appears to operate franchises. (Div. Ex. 1-89; Tr. 1562.) Its registered representatives are paid entirely by commission, with the firm deducting clearing costs, administrative expenses, and headquarters overhead from the gross commissions its registered representatives generate. (Resp. Ex. 118; Tr. 1006.) The registered representatives and branch offices are responsible for paying their own expenses, which may include office rental, telephone, postage, and registration and licensing fees. (Div. Ex. 1-89; Resp. Ex. 118; Tr. 1008.) Furthermore, Quest does not own any equity in its branch offices and allows its registered representatives to conduct other business activities if they submit their business proposals to the firm for approval. (Resp. Ex. 118; Div. Ex. 25- 75; Tr. 1008, 1755-58.) During the period at issue, Yu served as the firm’s chief compliance officer, setting the direction, tone, and requirements for Quest’s compliance policy. (Tr. 1045, 1111, 1609-12.) Yu’s duties included supervision of Quest’s registered representatives. (Tr. 1026.) In the fall of 1992, Quest also employed David Mahler, a part-time compliance officer, who assisted Yu. (Tr. 1026, 1048-49, 1739.) Quest also employed full-time supervisors who were responsible for the daily supervision of the firm’s registered representatives. (Tr. 1026.) Quest’s Compliance Practices and Procedures Since his creation of the broker-dealer, Yu has consistently refined and augmented the firm’s compliance and supervisory procedures. (Tr. 1611, 1614.) These procedures include background investigations, written agreements, comprehensive manuals, correspondence oversight, advertising oversight, compliance obligation reminders, annual meetings, inspections, and a computerized system which monitors all trades before their execution. Quest conducts background investigations of prospective registered representatives and does not hire applicants with an adverse criminal or regulatory history. (Tr. 914, 1564.) It also requires its registered representatives to execute an independent contractor’s agreement, which prohibits registered representatives from engaging in certain activities. (Div. Ex. 1-89.) By signing the agreement, a registered representative agrees to sell "only those securities permitted to be sold under the limitations or restrictions of any license issued to the contractor by Regulators . . . ." (Div. Ex. 1-89.) Any conduct that violates Quest’s procedures is considered a breach of the independent contractor agreement. (Div. Ex. 1-89.) Quest distributes compliance and procedures manuals to each of its registered representatives. (Tr. 1613.) The manuals are updated regularly, and the ones Quest distributed to its registered representatives in 1992 and 1993 provided specific guidance on a wide range of topics. (Tr. 1611, 1613.) Specifically, the manuals informed the firm’s registered representatives that they were prohibited from engaging in the following activities: borrowing money from a client; engaging in private securities transactions apart from their employment with Quest, absent prior approval; engaging in money-raising programs; guaranteeing the present or future value of a price of any security; accepting customer checks made payable to the representative; selling unsuitable securities to its customers; and advertising without approval by Quest. (Resp. Exs. 8-545 at 6, 7, 15, 17; 9-547 at 5, 6, 14, 16; 10-548 at 7, 14, 22, 24.) Quest also requires its registered representatives and its branch offices to submit all advertising and correspondence to a compliance officer at the firm’s headquarters for compliance review before it is used. (Tr. 875.) The company also regularly conducts compliance reviews of the proposed advertisements and correspondence and it does not approve advertisements that use the words "guarantee," "warranting," or "backed by." (Resp. Exs. 6-543A at 16; 33-591, 59-666; Tr. 878-79.) Quest’s registered representatives place their trades through the firm’s traders at its California headquarters. (Tr. 873, 1673.) A computerized compliance system developed by Yu known as Computerized Transactions Tracking Accounting and Compliance System (COMREC) analyzes each trade before it is executed. (Resp. Ex. 74-623; Tr. 1462-65, 1705-06, 2192-93.) COMREC screens each trade for many factors, including customer suitability, broker licensing, and account trading restrictions. (Resp. Ex. 74-623; Tr. 1687-98, 1700-06.) COMREC ensures that Quest does not execute trades that do not meet the firm’s compliance criteria. (Tr. 1700-06.) During 1992 and 1993, Quest allowed its brokers to trade with other firms so long as they sent account statements to headquarters. (Tr. 1054.) Mark Stuart, the trading supervisor at Quest, and occasionally Yu, examined these account statements. (Tr. 1054.) Stuart, a principal of the firm, holds a Series 24 license. (Tr. 1062.) Quest continuously reminds its registered representatives of their compliance obligations. For example, Quest requires its registered representatives to complete an annual compliance questionnaire. (Div. Ex. 26-80; Resp. Exs. 76, 77, 94-561; Tr. 2048-50.) By signing the questionnaire, the registered representatives certify that they have not accepted checks made payable to them directly, maintained securities accounts apart from their brokerage activities at Quest, engaged in money raising programs, or advertised without prior approval from a compliance officer. (Resp. Exs. 26-80, 64-672A, 76, 77.) Quest also requires its registered representatives to complete and sign a business activity report. (Resp. Ex. 11-59.) Their signature certifies they understand that the sale of any security unapproved by Quest is a violation of the National Association of Securities Dealers (NASD) Rules. (Resp. Ex. 11-59.) The annual questionnaire and the business activity report remind the registered representatives of Quest’s policies and are a means of determining whether the registered representatives are complying with them. (Tr. 1039-40, 1734, 1973-74.) In addition, Quest requires its registered representatives to attend at least one of the firm’s annual meetings. (Resp. Exs. 3-541, 4-542, 5-543, 6- 543A, 7-544, 8-545, 9-547, 10-542, 75.) The annual meetings include presentations about compliance issues. (Tr. 1612.) Quest also reviews the outside business activities of its registered representatives. (Resp. Exs. 24-574, 25-575.) John Nakoski’s Underlying Violations Background John Nakoski earned a bachelor’s degree in computer engineering from the Rochester Institute of Technology and a master’s degree in computer engineering from Syracuse University. (Tr. 285.) Nakoski worked for Taylor Instruments before joining IBM in Kingston, New York. (Tr. 285.) In 1988, after reading an advertisement in Investor’s Daily about Quest Investments’ Series 7 home study course, Nakoski ordered the material and passed the Series 7 examination. (Tr. 287.) Nakoski applied to become a Quest registered representative shortly after he had passed the Series 7 examination. (Tr. 287.) Quest hired the twenty-seven year old Nakoski in 1988, when his Form U-4 application did not reveal any adverse regulatory, criminal, or financial history. (Resp. Ex. 2-502; Tr. 287, 914.) Nakoski received Quest’s procedures manual and additional telephonic instruction from Yu and Mahler. (Tr. 288, 290, 294, 611; Resp. Ex. 3-541.) He also signed Quest’s independent contractor’s agreement wherein he certified that he had read and consented to abide by the provisions of the agreement and the procedures manual. (Div. Ex. 1-89.) Nakoski left IBM voluntarily in July 1992 to become a full- time broker at Quest. (Tr. 295.) At the time IBM offered its employees a lump sum payment if they voluntarily left their jobs and retired early. (Tr. 295.) Yu believed that Nakoski had received a substantial lump sum payment from IBM, which he also believed that Nakoski used later to open commodities trading accounts with other firms. (Tr. 1059.) After Nakoski passed the Series 24 exam, he opened Nakoski Investment Management, Inc. (NIM), a Quest branch office in Kingston, New York. (Tr. 295, 299.) There, Nakoski employed a secretary, Doreen Arensen, who later became an investor in Nakoski’s illegal venture. (Tr. 1136.) A sign outside of NIM identified it and its affiliation with Quest. (Tr. 1138.) Nakoski generated more commissions than the average Quest registered representative. (Div. Ex. 167-287; Resp. Ex. 109-622; Tr. 1722.) In 1992 and 1993, NIM was one of two Quest branch offices and was its only branch office with more than one registered representative. (Div. Ex. 170-102; Tr. 1004-06.) By the end of 1992 Nakoski had employed four registered representatives and he had employed nine by the end of 1993. (Div. Ex. 170-102; Tr. 1007.) In 1993 Yu invited Nakoski to speak at Quest’s annual East Coast convention. (Tr. 1014-15; Div. Ex. 36-100.) Yu billed Nakoski’s presentation as "How I recruited and established a very successful branch office in record time by using Quest Capital’s recruiting system." (Tr. 1014-15; Div. Ex. 36-100.) Nakoski was not a disciplinary problem at Quest. (Tr. 914.) Prior to the period at issue, Nakoski had been the subject of only one customer complaint, about the way that Nakoski handled an account. (Tr. 1722, 1763.) Nakoski spoke to the customer and the customer wrote Yu and explained that the matter had been resolved to his satisfaction. (Tr. 1722.) Nakoski’s Solicitation of Funds From January 1992 through August 1993 Nakoski solicited and obtained funds from the public through instruments he described as "fixed income loan agreements" (loan agreements), although he was not registered with the Commission as an investment adviser. Nakoski induced thirty-six individuals to provide him with a total of approximately $450,000. (Div. Exs. 41-150, 44-151 through 149-256, 165-146, 166-148; Tr. 482.) Twenty of these thirty-six individuals had brokerage accounts with Quest. (Div. Ex. 165-146.) From 1989 through 1993 Nakoski taught three courses at Ulster County Community College on investing titled "monthly income from stock options," "unlocking the mystery of the stock market," and "how to invest in futures." (Tr. 308; Div. Ex. 7-21.) During at least one of the courses, Nakoski discussed the loan agreements and distributed blank loan agreements. (Tr. 694-95, 702; Div. Ex. 155-1.) He also held investment seminars at the Holiday Inn in Kingston, New York, and at the Ramada Inn in Poughkeepsie, New York. (Tr. 310-11; Div. Exs. 8-17, 9-19.) In addition, he made presentations at NIM, which he described as "chalk-talks," that were open to the public. (Tr. 314-15.) The chalk-talks and the seminars had three purposes: to raise money pursuant to the loan agreement, to attract brokerage business, and to recruit registered representatives. (Tr. 311-12, 316.) At both the seminars and the chalk-talks Nakoski discussed the loan agreements and compared them to other investment products. (Tr. 314, 338, 705.) He also distributed brochures promoting the loan agreements at the presentations. (Tr. 317-18, 323, 326, 701-04, 1154-55.) Nakoski advertised the loan agreements in newspaper ads, and on a roadside billboard, located on Route 28, a road leading into Kingston, New York. (Tr. 300, 304, 336-37.) The billboard remained there from July 1992 until June 1993. (Tr. 538.) He also mailed at least 1,000 brochures, and he kept loan agreement materials in the NIM reception area. (Tr. 323-28, 1147, 1151-52; Div. Exs. 2-11, 3-6, 4-7, 5-8, 6-9, 11-16, 12-13, 13-14, 14-24.) Nakoski promised: a two percent commission for referrals; a twelve or fifteen percent annual return with guaranteed principal and interest; and withdrawal of funds at anytime without penalty. (Div. Exs. 16-3, 155-1, 178-5, 11-16, 12-13, 13-14, 18-39; Tr. 300, 343.) The loan agreement itself, signed by Nakoski, stated: "My money is 100% PRINCIPAL GUARANTEED and the INTEREST IS ALSO GUARANTEED by the full faith and credit of Nakoski Investment Management and by John Nakoski personally." (Div. Exs. 16-3, 155-1, 178-5; Tr. 333-34.) The loan agreements disclosed that Nakoski would invest the money in his business and in the manner he deemed best. (Div. Exs. 16-3, 155-1, 178-5.) Nakoski presented the loan agreements as one of several investment products available through NIM. (Tr. 324-25, 1160- 61.) Several of the documents Nakoski utilized when promoting or executing the loan agreements referred to "investing" and "investors." (Div. Exs. 3-6, 4-7, 5-8, 6-9, 11-16, 12-13, 17- 31.) Nakoski orally compared the loan agreements to other types of investments. (Tr. 314, 702-03.) Some of his brochures and advertisements also compared the loan agreements to other investment products. (Div. Ex. 13-14.) As a result, several investors viewed the loan agreements as investments. (Tr. 560- 61, 725, 1174.) The promotional materials, monthly statements he sent to the loan agreement investors, and at least one version of the loan agreement referred to NIM and Nakoski’s association with a broker-dealer. (Div. Exs. 11-16, 12-13, 17-31, 19-49, 154-48, 156-47, 178-5, 180-50.) At the college courses, seminars, and chalk-talks, Nakoski discussed investment strategies and stated that selling covered call options involved less risk than buying them. (Tr. 313-14, 338-39, 694, 699, 705.) Nakoski did not discuss the risks of investing in futures with all the investors. (Tr. 479-80, 561.) Nakoski endorsed selling covered call options and declared that by selling them an investor could earn a return of two percent each month, or twenty-four percent annually. (Tr. 313, 339-40, 479, 694, 700-06.) Nakoski informed investors that he could produce a twenty-four percent annual return by selling stock options with the loan agreement funds. (Tr. 696, 714, 1172; Div. Ex. 12-13.) Investors believed that Nakoski would invest the loan agreement funds in stock options. (Tr. 700-01, 1171.) He explained to many of them that he would retain the difference between what he could earn and the fifteen or twelve percent return he guaranteed them as profit. (Tr. 714, 1172.) However, some investors received little or no explanation of what Nakoski would do with their money. (Tr. 340, 524, 555.) Nakoski failed to disclose that he was investing some of the loan agreement funds in futures and futures options. (Tr. 475, 561, 712, 1172.) Furthermore he concealed from investors the substantial losses he sustained while trading futures and futures options. (Tr. 472, 481-82, 526-28, 562, 712, 1172-73.) Nonetheless, Nakoski always presented the loan agreements as safe investments, writing to one investor that the loan agreements involved "no risk" and recommending them to another investor who wanted a "very safe" investment for her children’s college money. (Tr. 349, 550-51; Div. Ex. 20-26.) Nakoski’s Use of the Loan Agreement Funds Nakoski initially kept the loan agreements in his apartment. (Tr. 640.) Later, Arensen kept copies of the loan agreements in her desk. (Tr. 640.) Nakoski used some of the money he raised from the loan agreements to finance the expenses of his branch office. (Tr. 389.) He invested some of the remaining funds in futures and futures options. (Tr. 389.) Investors in the loan agreements were instructed by Nakoski to make their checks payable to NIM instead of Quest. (Tr. 389.) Nakoski eventually opened approximately nine different commodities accounts in his own name. (Tr. 392-94, 400-03, 409-18; Div. Exs. 29-262, 39- 298.) Because the commodities firms would not accept the checks payable to NIM, Nakoski first deposited the checks into his personal checking accounts. (Tr. 389-93.) He then deposited investor funds into his commodities accounts by writing personal checks. (Tr. 390-93.) Each month Nakoski mailed investors a false statement for their loan agreement accounts reflecting the amount of their investment and the interest they had accrued. (Tr. 341-46, 555; Div. Exs. 17-31, 18-39, 19-49, 154-48.) Nakoski made payments to some of the loan agreement investors, while also accepting additional funds from new investors. (Tr. 542.) Eventually Nakoski lost several hundred thousand dollars through investments in futures and futures options. (Tr. 427, 542.) The monthly statements Nakoski mailed to investors did not indicate that Nakoski had sustained these substantial losses. (Tr. 555-56, 713.) Nakoski kept the false monthly statements in a bank safety deposit box. (Tr. 641.) Nakoski stopped soliciting funds in August 1993 because of his losses. (Tr. 426.) Nonetheless, some papers related to the loan agreements remained at NIM until October 1993. (Tr. 425.) At or about this time Nakoski instructed Arensen to destroy all forms in the office that had the word "guarantee" on them. (Tr. 1143.) The New York Attorney General’s Office removed all remaining records pertaining to the loan agreements later that month pursuant to subpoena. (Tr. 425.) On July 29, 1994, Nakoski filed for bankruptcy[2] and he resigned from Quest in August. (Div. Ex. 152-53; Tr. 531.) On June 12, 1995, Nakoski consented, without admitting or denying any wrongdoing, to the entry of a Final Judgment of Permanent Injunction, enjoining him from future violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Sections 203(a) and 206(1), (2), and (4) of the Advisers Act and Rules 206(4)-2 and 206(4)-4 thereunder.[3] (Tr. 533; Div. Ex. 153-58.) Nakoski also consented, without admitting or denying any wrongdoing, to the entry of an Order by the Commission barring him from association with any broker, dealer, investment company, investment adviser, or municipal securities dealer.[4] (Tr. 533; Div. Ex. 181-59.) In February 1996, Nakoski pled guilty to New York state criminal charges arising from his conduct with respect to the loan agreements. (Tr. 540.) In connection with the criminal proceeding, Nakoski pays restitution to the investors in the loan agreements. (Tr. 542.) Nakoski "emphatically" attempted to keep his loan agreement activities separate from his brokerage activities at Quest. (Tr. 637-38.) Nakoski never told Respondents that he had actually obtained money pursuant to the loan agreements. (Tr. 638, 646-47.) He acknowledged that Yu repeatedly told him that Quest did not permit him to borrow money without the firm’s approval and he knew that Quest did not permit its brokers to transact business in unregistered securities. (Tr. 640-41.) Supervision of Nakoski On August 7, 1992, Nakoski telephoned Yu and informed him that a Commission representative wanted to question him about an advertisement he was running in the Woodstock Times. (Tr. 871, 1723.) Nakoski told Yu that the advertisement was for a personal loan and that the representative from the Commission stated that he could not advertise the loan and securities in the same advertisement. (Tr. 350.) Yu advised Nakoski that Quest did not allow its registered representatives to borrow money from their customers or to borrow money without the firm’s approval. (Tr. 1723.) Yu asked Nakoski if he had actually borrowed any money. (Tr. 872, 1723.) Nakoski falsely replied that he had not. (Tr. 872, 1723.) Yu ordered Nakoski to refrain from borrowing money without the firm’s approval. (Tr. 1723-24.) He also instructed Nakoski to submit all of his advertisements to Quest for compliance approval. (Tr. 1723-24.) Nakoski agreed not to borrow any money and promised to submit his advertisements for compliance approval in the future. (Tr. 1724.) Yu then told Nakoski to provide him with a written explanation of why he advertised for the loan. (Tr. 871, 1724.) Yu also instructed Nakoski to cooperate with the Commission and told him they would discuss the matter after Nakoski had met with the Commission representatives. (Tr. 351, 872, 885, 1724, 1752) Nakoski faxed his explanation to Yu later that same day. (Div. Ex. 21-61; Tr. 352, 354-55, 876, 1724.) Yu received and read Nakoski’s fax in which Nakoski explained that he was trying to "[b]orrow money for [him]self to help . . . set up a branch office so [he] could devote his full-time to being a stockbroker for Quest Capital." (Tr. 876-77; Div. Ex. 21-61.) He attached a copy of the newspaper advertisement and loan agreement to the fax. (Tr. 352, 876; Div. Ex. 21-61.) The advertisement declared, "INVESTORS: Earn 12% Guaranteed Interest on your money. $5,000 minimum, no fees, no penalty for early withdrawal . . ." and advised the reader to "CALL . . . FOR FREE BROCHURES." (Div. Ex. 21-61 at 2.) The "12% Fixed Income Loan Agreement" disclosed that Nakoski would invest the funds "in the manner he deem[ed] best" and it could be filled out and returned to NIM with a check. (Div. Ex. 21-61 at 3.) It read, "I agree to lend the initial amount of $______ to Nakoski Investment Management" and notified potential investors that they could "lend additional amounts at any time by sending another check . . . ." (Div. Ex. 21-61 at 3.) Neither the advertisement nor the loan agreement mentioned or referred to Quest. (Div. Ex. 21-61.) Prior to August 7, 1992, Respondents were unaware of Nakoski’s efforts to borrow money. (Tr. 1722-23.) After Yu read the fax his main concern was that Nakoski had advertised without Quest’s approval. (Tr. 1725.) Immediately thereafter Yu consulted the NASD manual and his research indicated that the NASD did not prohibit registered representatives from obtaining personal loans. (Tr. 1725.) However, Quest’s compliance manual did prohibit its registered representatives from borrowing without firm approval. (Tr. 873.) Yu had promulgated this policy because he believed that if a registered representative borrowed money from a customer it could create various conflicts of interest. (Tr. 873.) On August 10, 1992, two Division representatives from the New York Regional Office of the Commission met with Nakoski. (Div. Ex. 22-62; Tr. 356.) They arrived at NIM unannounced and instructed Nakoski to furnish them with copies of his bank account statements. (Tr. 355-56.) Derek Burke (Burke), an attorney with the Division, was one of the representatives. (Tr. 355-56.) During the meeting they warned Nakoski that he might be acting as an investment adviser because he charged variable commission rates for his brokerage services. (Tr. 357.) They also warned him that the loan agreements might be considered unregistered securities. (Tr. 357.) Burke and the other representative took copies of Nakoski’s bank records with them when they left and stated they would send him a letter explaining their concerns in detail. (Tr. 357.) Although the Commission representatives asked Nakoski if he had raised any money pursuant to the loan agreements he did not tell them that he had already raised $90,000. (Tr. 644.) After Burke and the other Commission representative left NIM, Nakoski called Yu and told him about the meeting, but not about the funds that he had raised. (Tr. 357-58.) After some discussion, Yu concluded that Nakoski did not have to register as an investment adviser. (Tr. 358.) Yu explained to Nakoski again that he could not borrow money from his customers and that he must get all of his advertising approved by Quest before he used it. (Tr. 358, 362, 886.) Nakoski agreed to follow Yu’s instructions. (Tr. 886, 889-90.) Yu stated that they would discuss the matter further after Nakoski received the Division’s letter. (Tr. 359.) Through this and subsequent conversations with Nakoski, Yu learned that Burke and the other representative from the Division had searched the NIM office for advertising pertaining to the loan agreements. (Tr. 889.) Yu also knew that they had asked Nakoski whether he had borrowed any money and that Nakoski had responded that he had not. (Tr. 889-90.) Yu repeatedly advised Nakoski that he could not solicit loans without Quest’s approval. (Tr. 872, 886, 889-90, 901-02, 1724.) Nakoski falsely assured Yu that he would not borrow any money. (Tr. 884, 889-90.) Approximately one week later, on August 24, 1992, Yu met with Nakoski at a Quest annual meeting in New Haven, Connecticut. (Tr. 1018-19; Div. Ex. 25-75.) Yu had previously instructed Nakoski to bring all the files in his office to the meeting. (Tr. 1043-44, 1726, 1773.) Nakoski brought his Quest customer files, correspondence files, and advertisement files. (Tr. 1043.) He did not bring copies of the loan advertisements or his loan agreement files with him. (Tr. 1043.) Yu reviewed Nakoski’s files for approximately two hours. (Tr. 1773.) Nakoski falsely certified orally and in writing that he had not raised any funds pursuant to the loan agreements, that he had stopped advertising them, and that he understood that he was not allowed to engage in any outside business without the firm’s approval. (Tr. 1753-59.) On August 31, 1992, Burke sent Nakoski a letter that memorialized their meeting at NIM. (Div. Ex. 22-62.) Nakoski forwarded a copy of Burke’s letter to Yu. (Tr. 900.) Burke’s letter stated, "It is our understanding that NIM has solicited funds pursuant to the ‘loan agreement.’ It is also our understanding that NIM has not received any funds pursuant to the ‘loan agreement’ and further that NIM has decided not to continue to solicit funds by means of the ‘loan agreement.’" (Div. Ex. 22-62.) The letter recited the representatives’ concerns that Nakoski might be acting as an unregistered investment adviser, that the loan agreements might be unregistered securities, and that Nakoski might be using potentially misleading advertising and sales materials in connection with the loan agreements. (Div. Ex. 22-62.) The letter advised Nakoski to "examine NIM’s practices and in conjunction with Quest and legal counsel determine whether NIM is in compliance with the investment adviser registration requirement." (Div. Ex. 22-62.) The letter made a similar recommendation regarding the loan agreements, stating, "We recommend that you review with legal counsel any additional ‘loan instruments’ issued by NIM to the public to determine whether it falls within the statutory definition of a security." (Div. Ex. 22-62.) Burke also indicated in the letter that the advertisements and sales materials for the loan agreements "lacked certain information" and could "confuse and mislead investors." (Div. Ex. 22-62.) In this regard, the letter quoted one of Nakoski’s brochures that contained the word "guarantee." (Div. Ex. 22-62.) The letter explained that the use of the term "guarantee" could "be misleading or confusing" and that "at a minimum, the guarantor should be identified and a meaningful description of its ability to satisfy the obligation should be identified." (Div. Ex. 22-62.) After receiving and reading a copy of the Division’s letter, Yu discussed the merits of the Division’s allegations with Nakoski. (Tr. 895-96.) Once again Yu instructed Nakoski to submit any advertising he wanted to use to Quest for approval. (Tr. 362, 899-900.) He also directed Nakoski to refrain from borrowing any money and to send him a copy of his reply to the Division’s letter. (Tr. 362, 900.) Nakoski responded to Burke’s August 31 correspondence by a September 24, 1992, letter responding to the issues raised by the Division. (Div. Ex. 23- 63.) To support his position that he was not an investment adviser Nakoski provided the Division with a detailed explanation of the variable commission rate he charged and information regarding the practices of other brokerage firms. (Div. Ex. 23- 63.) Nakoski also informed the Division that he had canceled the advertisement soliciting funds pursuant to the loan agreements on August 11. (Div. Ex. 23-63.) He stated that he replaced the advertisement with "a modified advertisement that offer[ed] only stock brokerage services, [and] no solicitation of investment funds." (Div. Ex. 23-63.) Nakoski attached a copy of the revised advertisement to his letter. (Div. Ex. 23-63.) The attached advertisement pertained only to NIM’s brokerage services. (Div. Ex. 23-63.) In addition, Nakoski assured the Division that he no longer used the brochure mentioned in Burke’s letter and he promised that he would send "all future advertisements" to the Quest home office for review by Quest’s compliance department. (Div. Ex. 23-63.) Nakoski knew that Burke’s statement in the August 31, 1992, letter that Nakoski had not raised any funds was false, but he intentionally failed to advise the Division, or Yu, of the fact. (Tr. 645.) Nakoski stated in his letter to the Division that he might desire to borrow money in the future to finance NIM. (Div. Ex. 23-63.) In this respect, he enclosed a revised copy of the loan agreement. (Div. Ex. 23-63.) Nakoski indicated the loan agreement had been modified "to indicate that the term of any loans would be nine months or less, to further stress that the loan would be a loan and not an investment security, and to further clarify that the funds would be used for the operation of my branch office and would be repaid from the profits of the business and not by any particular investment." (Div. Ex. 23- 63.) The Division referred to these factors when it explained the legal basis for its position that the loan agreements might be unregistered securities. (Div. Ex. 22-62.) Nakoski faxed Yu a copy of his response to the Division. (Tr. 366.) Yu received and read it. (Tr. 908.) Yu interpreted the Nakoski response as an effort to clarify the Commission’s position with respect to Nakoski’s ability to borrow money. (Tr. 986.) Yu believed that even if the Commission allowed Nakoski to obtain personal loans that Nakoski would still seek Respondents’ approval before attempting to do so. (Tr. 987.) However, after Nakoski forwarded his response to Yu he continued to solicit funds pursuant to the revised loan agreement. (Tr. 372.) Yu expected the Division to respond to Nakoski’s August 31 letter. (Tr. 914-15, 1786.) Yu therefore called the Division in October 1992 to determine the status of their investigation of Nakoski. (Tr. 916, 1787.) Burke informed Yu that the Division was closing its investigation. (Tr. 918, 1788.) On November 4, 1992, Edward Newton of the NASD sent Yu a letter about a billboard advertisement that had been "recently" brought to the attention of the NASD’s advertising department. (Div. Ex. 162-65.) Newton’s letter stated that a billboard "appear[ed] to offer an investment which can ‘earn 12% interest . . . with no penalty for early withdrawal.’" (Div. Ex. 162-65.) Although the NASD’s letter which Yu read had referred to a photograph, the photograph was not enclosed as an attachment. (Div. Ex. 162-65; Tr. 988, 1790.) Yu did not call the NASD and request a copy of the photograph. (Tr. 995-96.) Yu believed that the billboard described in the NASD’s letter related to the same activity that the Commission had investigated. (Tr. 996, 1791.) Consequently, when Yu replied to the NASD on November 17, 1992, he enclosed Burke’s August 31 letter to Nakoski and Nakoski’s September 24 letter to the Division. (Tr. 996; Div. Ex. 163-66.) The NASD responded to Yu by letter dated December 1, 1992. (Div. Ex. 164-47.) The letter stated, "We appreciate your prompt and thorough response." (Div. Ex. 164-47.) It also notified the Respondents that the matter would be forwarded to the NASD’s New York District Office for whatever action it deemed appropriate. (Div. Ex. 164-47.) The NASD also stated, "We will apprise you of the results of any further investigation by the District." (Div. Ex. 164-47.) The NASD never contacted the Respondents again. (Tr. 798.) Later that month, Nakoski forwarded the text of a local television commercial (which did not mention the loan agreements) to the Quest home office for review and approval in accordance with the firm’s policies. (Resp. Ex. 12-516; Tr. 630.) On or about October 21, 1992, Yu approved Nakoski’s request to open a personal commodities account at First Commercial Financial Group, Inc. (Tr. 1055; Div. Ex. 171-70.) Yu did not elect to receive duplicate account statements because the NASD did not require brokerage firms to review them. (Tr. 1056; Div. Ex. 171-70.) Yu believed that Nakoski planned to invest his own money. (Tr. 1058.) On July 1, 1993, Yu elected to receive copies of Nakoski’s account statements from First Commercial Financial Group. (Tr. 1061; Div. Ex. 172-72.) The duplicate account statements were placed in Stuart’s box; he reviewed them at his discretion. (Tr. 1062-63.) Respondents were also aware that Nakoski was trading in at least two other personal commodities accounts. (Div. Exs. 27-268, 174-69, 175-286.) Nakoski suffered losses in the commodities accounts known to Quest. (Div. Exs. 159-258, 160-259.) Nakoski had approximately 16 customers on August 31, 1992, and 34 by November 30. (Tr. 1096; Div. Ex. 176.) No one from Quest ever contacted any of Nakoski’s customers to determine whether they had loaned Nakoski money or whether Nakoski had ceased soliciting loans or guaranteeing rates of return. (Tr. 1086-93.) On the other hand, Quest received no customer complaints about Nakoski or his loan agreement activities, and no Nakoski customers filed claims against Nakoski or Quest until at or about the time that Nakoski left Quest in August 1994. (Tr. 1723, 1763, 1766-68.) Dick Muller and Scott Sutton, Quest registered representatives who worked at NIM, referred loan agreement investors to Nakoski in exchange for a commission. (Tr. 524, 1734.) Arensen, Nakoski’s secretary, and Sutton invested in the loan agreements. (Tr. 1171; Div. Ex. 165-46.) Yu met personally with Muller in 1992 and 1993. (Tr. 1735-36.) In 1992 Yu questioned Muller about his money raising activities. (Tr. 1734- 38.) In 1993 Yu met with Muller again, as well as individually with other registered representatives at NIM, and asked them whether they had raised any money for other people or borrowed any money. (Tr. 1734-38) Muller falsely stated to Yu, and certified in his 1992 and 1993 annual questionnaires, that he had not engaged in any money raising programs unapproved by Quest. (Resp. Exs. 76, 77; Tr. 1735.) In 1994, Yu specifically discussed Nakoski’s loan agreement activities with Muller and the other registered representatives at NIM. (Tr. 1130-31, 1734, 1971) In 1994 and 1995, Muller falsely denied having any knowledge of Nakoski’s loan agreement activities. (Tr. 1737, 1971.) The remaining registered representatives at NIM did not offer Yu any information about Nakoski’s loan agreements. (Tr. 1729-37, 1971.) On August 8, 1993, Yu met with Nakoski at a Quest annual convention in White Plains, New York. (Tr. 1796; Resp. Ex. 13- 76.) At the meeting Nakoski turned in his annual questionnaire wherein he certified falsely that all his advertising was approved by a compliance officer and that he "kn[e]w that [he] [could] not sell any money raising programs without the Compliance officer’s written approval." (Resp. Ex. 77; Tr. 1797.) The other registered representatives at NIM turned in their annual questionnaires as well. (Tr. 1797-98; Resp. Ex. 77.) They also certified that they knew that they could not sell any money raising programs without compliance approval. (Tr. 1797-98; Resp. Ex. 77.) Yu conducted an inspection of NIM on August 9, 1993, the day after the annual convention. (Tr. 1108, 1796.) His inspection lasted approximately one hour. (Tr. 1110.) Yu examined the literature on the walls at NIM, asked Nakoski questions, and inspected at random several of Nakoski’s customer files and the available correspondence and advertising files. (Tr. 1111-20, 1122-23, 1126; Div. Ex. 24-77.) Yu did not see anything in the NIM reception area regarding the loans. (Tr. 1120-21.) Yu also reviewed Nakoski’s handwritten daily blotter and the blotter on his computer. (Tr. 1125.) Although Nakoski kept a record of all his Quest trades on the computer blotter, Yu told Nakoski that it was not in the format Quest wanted and instructed him to provide all of the information on his handwritten daily blotter. (Tr. 1125-26.) During the inspection Nakoski falsely stated that he had never raised any money pursuant to the loan agreements and that he had not solicited any loans since 1992. (Tr. 1127.) He further falsely informed Yu that he had pre-cleared all of his advertising with the home-office. (Tr. 1129.) When Yu asked Nakoski for documents Nakoski did not give him the loan agreement file in Arensen’s desk or any other loan agreement files. (Tr. 641.) CONCLUSIONS OF LAW From approximately August 1992 until August 1993, Nakoski, a registered representative of Quest, willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and Sections 203(a) and 206(1), (2), and (4) of the Advisers Act and Rules 206(4)-2 and 206(4)-4 thereunder. Nakoski violated the federal securities laws through his pattern of misrepresentations, unauthorized trading, and theft, described in the preceding section. Of course, the instant case raises issues mainly as they pertain to Respondents. Section 15(b)(4)(E) of the Exchange Act provides for the imposition of a sanction against a broker or dealer who: has failed reasonably to supervise, with a view to preventing violations of the provisions of such statutes, rules and regulations, another person who commits such a violation, if such other person is subject to his supervision. For the purpose of this subparagraph (E) no person shall be deemed to have failed reasonably to supervise any other person, if - (i) there have been established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect, insofar as practicable, any such violation by such other person, and (ii) such person has reasonably discharged the duties and obligations incumbent upon him by reason of such procedures and system without reasonable cause to believe that such procedures and system were not being complied with. Section 15(b)(6) of the Exchange Act, incorporating Section 15(b)(4)(E) by reference, authorizes the Commission to impose sanctions for deficient supervision on individuals associated with broker-dealers. Section 203(f) of the Advisers Act authorizes the Commission to sanction any person associated with an investment adviser for failure to supervise (incorporating by reference Section 203(3)(5)).[5] Yu was a person associated with Quest, a broker-dealer and investment adviser. Nakoski was subject to Yu’s supervision and Yu reasonably supervised him. Finally, procedures and systems at Quest would reasonably have prevented and detected Nakoski’s violations, and Yu had reasonable cause to believe that Nakoski had complied with those procedures and systems. Nakoski Violated the Securities Laws. Since the liability of the Respondents is predicated upon the existence of an underlying primary violation, I must first address the Division’s allegations pertaining to Nakoski. The Division alleges and has proved that Nakoski violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Sections 203(a) and 206(1), (2), and (4) of the Advisers Act and Rules 206 (4)-2 and 206(4)-4 thereunder. Nakoski acted as an investment adviser and violated Section 203(a) of the Advisers Act because he failed to register as an investment adviser. Section 202(a)(11) of the Advisers Act broadly defines an "investment adviser" as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as a part of a regular business, issues or promulgates analyses or reports concerning securities." Section 202(a)(11)(C) excludes from the definition of investment adviser any broker-dealer whose performance of investment advisory services is solely incidental to the conduct of his business as a broker-dealer and who does not receive "special compensation" for providing investment advice. Nakoski clearly provided investment advice to prospective and actual loan agreement investors by regularly advising them about the comparative merits of the loan agreements and other investment products. Furthermore, Nakoski regularly provided investment advice to his investors regarding the degree of risk involved in investing in the loan agreements. Nakoski did not receive a separate adviser’s fee for his advice. Instead he purported to retain as profit the difference between the interest he guaranteed to investors and the return he would secure by investing their funds. The phrase "special compensation," found in the Section 202(a)(11)(C), is not defined in the Advisers Act. The Commission has defined special compensation as "compensation to the broker-dealer in excess of that which he would be paid for providing a broker or dealer service alone." Investment Advisers Act of 1940, Release No. 626 (April 27, 1978); see, American Capital Fin. Servs. (Robert S. Strevell), SEC No-Action Letter, 1985 WL 54220 (pub. avail. April 29, 1985.) The remuneration Nakoski purportedly received is not the type of compensation received by a broker-dealer in the ordinary course of his brokerage business, i.e., a commission, and therefore constitutes "special compensation." Id. Accordingly, I conclude that Nakoski acted as an investment adviser in respect to his loan agreement activities and cannot rely on the Section 202(a)(11)(C) exemption. Section 203 of the Advisers Act makes it unlawful for any investment adviser to make use of the mails or the instrumentalities of interstate commerce in connection with his business as an investment adviser unless he is registered with the Commission or subject to an exemption. Nakoski violated Section 203 of the Advisers Act because he acted as an investment adviser, did not qualify for an exemption, and failed to register as required. Consequently, the antifraud and custody and disclosure provisions of the Advisers Act apply to Nakoski’s conduct. [6] Nakoski violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 206(1) and (2) of the Advisers Act. Section 17(a) of the Securities Act makes it unlawful, in the offer or sale of securities, (1) to employ any device, scheme or artifice to defraud, or (2) to obtain money or property by means of any untrue statement of material fact or any omission to state a material fact necessary to make the statements made, in light of the circumstances in which they were made, not misleading, or (3) to engage in any transaction, practice, or course of business that operates as a fraud or deceit upon a purchaser. Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful to employ any device, scheme or artifice to defraud in connection with the purchase or sale[7] of securities. Section 206(1) of the Advisers Act makes it unlawful for an investment adviser to employ any device, scheme or artifice to defraud any client or prospective client. Section 206(2) makes it unlawful for an investment adviser to engage in any transaction, practice, or course of business that operates as a fraud or deceit upon any client. Investment advisers are fiduciaries and, as such, have "an affirmative duty of good faith, and full and fair disclosure of all material facts" to their clients. SEC v. Capital Gains Research Bureau, 375 U.S. 180, 194 (1963). The jurisdictional components of the antifraud provisions are interpreted broadly. In this regard, it is sufficient that Nakoski mailed brochures promoting the loan agreements to the public. See SEC v. Softpoint, 958 F. Supp. 846, 861 (S.D.N.Y. 1997), aff’d, 159 F.3d 1348 (2d Cir. 1998) (unpublished table decision). The loan agreements are notes or evidence of indebtedness. A note is a written promise to pay a specified amount to a certain entity on demand or on a specified date. See John Downes & Jordan Elliot Goodman, Barron’s Dictionary of Finance and Investment Terms, 376 (4th ed. 1995). In order to determine that the note is a security, I applied the "family resemblance" test enunciated in Reves v. Ernst & Young, 494 U.S. 56 (1990). Under the test, every note is presumed to be a security. Stoiber v. SEC, 161 F.3d 745, 748-49 (D.C. Cir. 1998). This presumption may be rebutted by a showing, with reference to four factors, that the note bears a strong resemblance to one of the instruments found in a judicially created list of non-securities. Reves, 494 U.S. at 67. These categories include: notes delivered in consumer financing; notes secured by a mortgage on a home; short- term notes secured by a lien on a small business or some of its assets; notes evidencing a "character" loan to a bank customer; short-term notes secured by an assignment of accounts receivable; a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if it is collateralized); and notes evidencing loans by commercial banks for current operations. Stoiber, 161 F.3d at 749. If the note in question does not bear a strong resemblance to any of these categories of non-securities, the next step is to decide whether another category should be added to the list by examining the same four factors. Reves, 494 U.S. at 67. I conclude that the instrument in the instant case bears no resemblance to the list of non-securities. The four factors are: the motivation of the buyer and seller for entering the transaction; the plan of distribution; the reasonable expectations of the investing public; and whether there are any risk reducing factors that would make application of the securities laws unnecessary. Reves, 494 U.S. at 66. All four factors support a finding that the loan agreements are securities. With respect to the first factor "if the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a ‘security.’" Id. Nakoski used the loan agreements to raise capital for the general use of NIM and to finance his commodities investments; his customers provided him with funds because they expected profits in the form of high interest rates. Stoiber, 161 F.3d at 749. The second factor also supports the finding that the loan agreements are securities. Nakoski promoted the loan agreements as investments and solicited a broad segment of the general public to invest in them. Reves, 494 U.S. at 68 (citing Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985)). As to the reasonable expectations of the investing public, Nakoski’s customers viewed the loan agreements as investments, the "fundamental essence" of a security. Id. at 68-69; SEC v. Reynolds Enters., 952 F.2d 1125, 1131 (9th Cir. 1991). Finally, no regulatory scheme exists that reduces the risk of the loan agreements thereby making the application of the securities laws unnecessary. Reves, 494 U.S. at 67. Having applied the family resemblance test, I find that the loan agreements do not resemble any of the categories of instruments that are considered non- securities and the four factors do not suggest that they should be added to the list. Therefore, I conclude that the loan agreements are securities. The Division proved by a preponderance of the evidence that Nakoski misled investors as to material facts. To be actionable under the antifraud provisions of the Securities Act, Exchange Act, and Advisers Act, a misrepresented or omitted fact must be material to an investor’s decision. Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988). A fact is material if there is a substantial likelihood that a reasonable investor would consider it important. Id. at 231-32. In order to fulfill this materiality requirement "there must be a substantial likelihood that the disclosure of the omitted fact would have been, viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available." Id.; TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). Nakoski’s false statements and omissions concerning the use of the investors’ funds, the safety of investing in the loan agreements, and the losses he sustained while trading futures and futures options would be important to reasonable investors, and thus material within the meaning of the securities laws. The Division also proved that Nakoski acted with the requisite degree of culpability. Scienter is required to establish violations of Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 206(1) of the Advisers Act. Aaron v. SEC, 446 U.S. 680, 697, 701-02 (1980); Steadman v. SEC, 603 F.2d 1126, 1131-34 (5th Cir. 1979). Scienter refers to a "mental state embracing intent to deceive, manipulate, or defraud." Aaron, 446 U.S. at 686 n.5 (quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976)). A showing of knowing or reckless conduct can satisfy the scienter element of Section 17(a)(1), Rule 10b-5, and Section 206(1). Steadman, 603 F.2d at 1134; Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990); David Disner, 63 SEC Docket 2246, 2254 n.20 (Feb. 4, 1997). Reckless conduct is conduct that is "‘highly unreasonable’ and which represents ‘an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.’" Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978) (quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977)). Proof of scienter is not required to establish a violation of Sections 17(a)(2) and (3) of the Securities Act or Section 206(2) of the Advisers Act. Aaron, 446 U.S. at 701-02; SEC v. Steadman, 967 F.2d 636, 643 n.5 (D.C. Cir. 1992); Capital Gains Research, 375 U.S. at 195. Negligence alone is sufficient to establish the violations. Aaron, 446 U.S. at 701-02; Capital Gains Research, 375 U.S. at 195. Nakoski knew that he was investing the loan agreement funds in highly speculative futures and futures options. He also knew that this type of investing involved a higher degree of risk than the strategy he led investors to believe he would employ. In addition, Nakoski knew that he was suffering considerable losses while investing in futures and futures options. Nakoski knowingly failed to inform investors of material facts by misrepresenting the nature of his trading, his trading strategy, and the safety of the loan agreements. Furthermore, Nakoski knowingly failed to inform investors about the considerable losses he incurred. Therefore, I conclude that Nakoski acted with scienter. Nakoski violated Section 17(a), Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 206 of the Advisers Act. Nakoski violated Section 206(4) of the Advisers Act and Rule 206(4) thereunder. Section 206(4) of the Adviser’s Act makes it unlawful for an investment adviser to engage in any act, practice, or course of business that is fraudulent, deceptive or manipulative. Rule 206(4)-2, promulgated pursuant to Section 206(4), imposes several obligations on investment advisers who maintain custody and possession of their clients’ funds. In pertinent part, Rule 206(4)-2(a)(2) requires investment advisers to establish separate trust accounts for the funds of his clients that are in his custody and possession in a bank. Nakoski commingled the loan agreement funds in his personal checking accounts. Rule 206(4)-2(a)(4) requires investment advisers to send to each of their clients, at least once every three months, an itemized statement showing the funds in their custody and possession and all debits, credits and transactions. Although Nakoski sent investors a monthly statement, it falsely indicated the amount of interest they had accrued, and he never forwarded them an itemized report of all the transactions involving their funds. By engaging in the aforementioned conduct, Nakoski violated Section 206(4) of the Advisers Act and Rules 206(4)- 2(a)(2) and 206(4)-2(a)(4) promulgated thereunder. Section 206 of the Advisers Act requires an investment adviser to disclose certain enumerated facts to his actual and potential clients. Capital Gains Research, 375 U.S. at 197-98. Section 206(4) and Rule 206(4)-4(a)(1) thereunder make it a fraudulent, deceptive, or manipulative act, practice, or course of business if an investment adviser fails to disclose all material facts with respect to a financial condition of the adviser that is reasonably likely to impair his ability to meet contractual commitments to clients, if he has discretionary authority over his clients’ funds. The losses Nakoski sustained investing in futures and futures options placed him in a precarious financial condition that ultimately resulted in his inability to fulfill the terms of the loan agreements. By failing to disclose this condition to actual and potential investors he violated Section 206(4) of the Advisers Act and Rule 206(4)-4(a)(1) thereunder. Nakoski Was Subject to Respondents’ Supervision. From approximately August 1992 through August 1993, Nakoski was subject to the supervision of Yu and Quest. The president of a broker-dealer bears ultimate responsibility for compliance "unless and until he reasonably delegates particular functions to another person in the firm. . . ." Sheldon v. SEC, 45 F.3d 1515, 1517 (11th Cir. 1995) (quoting Universal Heritage Invs. Corp., 47 S.E.C. 839, 845 (1982)); Consolidated Inv. Servs., 61 SEC Docket 20, 31 & cases cited in n.30 (Jan. 5, 1996) (hereinafter "CIS"); Thomas F. White, 51 S.E.C. 1194, 1197 (1994). As president of Quest, Yu was responsible for ensuring that the firm’s registered representatives were supervised properly. Although Quest employed other supervisors and compliance personnel, Yu did not delegate the responsibility of supervising Nakoski to anyone else at the firm. Yu’s actions are imputed to Quest because he is the firm’s owner and president. See CIS, 61 SEC Docket at 31. Respondents Reasonably Supervised Nakoski. While subject to Respondents’ supervision, Nakoski violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Sections 203(a) and 206(1), (2), and (4) of the Advisers Act, and Rules 206(4)-2 and 206(4)-4. The only remaining inquiry is whether Quest and Yu failed reasonably to supervise Nakoski with a view toward preventing his securities laws violations. Section 15(b)(4)(E) of the Exchange Act and Section 203(e)(6) of the Advisers Act authorize the Commission to sanction a broker-dealer or investment adviser if that broker-dealer or investment adviser fails "reasonably to supervise, with a view to preventing violations of [the securities laws], another person who commits such a violation, if such other person is subject to its supervision." Sections 15(b)(6) of the Exchange Act and Section 203(f) of the Advisers Act provide for sanctions against individuals associated with an investment adviser for the same conduct. A broker-dealer, investment adviser, or person associated with either has a statutory defense if it can be demonstrated that (1) there have been established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect, insofar as practicable, any such violation by such other person, and (2) such person has reasonably discharged the duties and obligations incumbent upon him by reason of such procedures and system without reasonable cause to believe that such procedures and system were not being complied with. The Commission has consistently stressed that the duty to supervise is a critical component of the federal regulatory scheme and that substantial and affirmative responsibilities are placed on those who have a duty to supervise. See Mabon, Nugent & Co., 47 S.E.C. 862, 866-67 (1983); John H. Gutfreund, 51 S.E.C. 93, 108 (Dec. 3, 1992). However, the Commission’s "decisions have been careful not to substitute the knowledge, gleaned with hindsight, of actual wrongdoing by someone under a supervisor’s control for an assessment of whether the supervisor’s conduct was proper under the circumstances." James H. Thornton, Exchange Act Rel. No. 41007 (February 1, 1999) (concurring opinion of Commissioner Unger) (citing Louis R. Trujillo, 50 S.E.C. 1106 (1989)). Accordingly, the ultimate issue in this case is not whether Yu "was a model supervisor, but whether his supervision was reasonable under all the attendant circumstances." Arthur J. Huff, 50 S.E.C. 524, 528-29 & n.7 (Mar. 28, 1991). Supervisors have an obligation to respond vigorously and with the utmost vigilance to indications of irregularity. CIS, 61 SEC Docket at 29 (footnote omitted); Edwin Kantor, 51 S.E.C. 440, 446-47 (May 20, 1993). A supervisor cannot ignore or disregard "red flags" and must "act decisively to detect and prevent" improper activity. Kantor, 51 S.E.C. at 447; William L. Vieira, 49 S.E.C. 1091, 1097 (Feb. 28, 1989). Indications of wrongdoing demand inquiry as well as adequate follow-up and review. Kantor, 51 S.E.C. 447. In the instant case, the responsibility to supervise was diligently exercised. The compliance system I have described in the Findings of Fact would reasonably be expected to prevent and detect the violations of Nakoski. When Yu learned of Nakoski’s solicitation of loans, his response was immediate and reasonable. Yu insisted that Nakoski describe his actions in writing. He then instructed Nakoski to keep him informed about the Division’s investigation and to cooperate with the Commission. Yu also sought verbal assurances from Nakoski that he would cease soliciting loans and stop advertising the loan agreements. Subsequently, he consulted the NASD manual to ascertain whether there was a regulatory prohibition against personal loans. At the hearing, the Division’s own expert, David Powell, conceded that Yu’s initial response was "appropriate" and in accordance with industry practice. (Tr. 1341.) Yu’s activities were consistent with Quest’s compliance procedures and were reasonable. In deciding how to handle the situation, Yu took Nakoski’s background into consideration. In this respect, I credit the testimony of Respondents’ expert, Irving Einhorn, who stated that it was "consistent with the standards and practice of the securities industry for a supervisor, knowing all that Mr. Yu knew in August 1992, to consider Nakoski’s personal background in determining the response to the situation at hand." (Tr. 1822.) Unlike the supervisors of the registered representatives in CIS , Thornton , Vieira, and Albert V. O’Neal, 51 S.E.C. 1128 (May 26, 1994), Yu was not confronted with an employee with a disciplinary history. When Yu learned of Nakoski’s loan solicitation activities he knew that Nakoski’s Form U-4 did not indicate any adverse financial, criminal, or regulatory history. He also knew that Nakoski had an exemplary disciplinary record as a registered representative. Nakoski repeatedly falsely assured Yu that he had not borrowed any money and that he had stopped soliciting loans. Powell, the Division’s expert, testified that it was insufficient for Yu to be satisfied with Nakoski’s assurances that he had not obtained any loans and would stop advertising the loan agreements. Despite the Division’s arguments to the contrary, Yu did not simply rely on Nakoski’s unverified assurances. See Gutfreund, 51 S.E.C. at 108 (footnote omitted). Nakoski’s representations were corroborated over the course of the period at issue. The Division’s letter of August 31, 1992, which Yu read, stated, "It is our understanding that NIM has solicited funds pursuant to the ‘loan agreement.’ It is also our understanding that NIM has not received any funds pursuant to the ‘loan agreement’ and further that NIM has decided not to continue to solicit funds by means of the ‘loan agreement.’" With regard to the Division’s statements I credit the testimony of Respondent’s expert, Lee Pickard, who stated, "The letter was something that Yu could consider as a very strong factor in terms of what further measures he needed to take as a supervisor." (Tr. 2062.) Furthermore, when Yu contacted the Commission in order to learn the status of the Nakoski inquiry he was informed that the Division had closed its investigation. The NASD never contacted the Respondents after it stated that it would "apprise" them of the results of any further investigation it conducted. The Division’s letter, Burke’s representations, and the NASD’s silence, were all factors that Yu could reasonably consider in determining how to supervise Nakoski. In addition, throughout the period at issue Nakoski appeared to be cooperating with Yu’s supervisory efforts. His cooperative and responsive attitude bolstered his credibility. The Division asserts that a broker-dealer must be particularly vigilant with respect to supervising registered representatives located in distant offices. The Commission has stated that, "The need for central control increases, not decreases, as branch offices become more numerous, dispersed and distant." Shearson, Hamill & Co., 42 S.E.C. 811, 843 (Nov. 12, 1965). However, Yu’s supervision was direct and undiluted; he conducted an adequate "follow-up" of Nakoski’s loan solicitation efforts under the circumstances. He actively supervised Nakoski for the entire period at issue, notwithstanding the distance between NIM and Quest’s headquarters. In this regard, after the Commission representatives visited NIM, Yu discussed the concerns they raised with Nakoski. Within a week of learning about the loan agreements, Yu met face-to-face with Nakoski and inspected his files and records. Consistent with his earlier admonishment, Yu instructed Nakoski not to borrow any money and to have all of his advertising pre-approved by Quest’s compliance department. Yu then required Nakoski to fill out and sign an annual questionnaire wherein he certified that he had not engaged in any money raising programs unapproved by Quest. Immediately after receiving the Division’s letter of August 31, 1992, Yu again discussed the Division’s concerns with Nakoski. Yu instructed Nakoski to reply to the Division’s letter and to forward him a copy of his reply. When the Division did not respond to Nakoski’s reply, Yu called Burke to ascertain the status of the Division’s investigation. Yu also cooperated with the NASD. He promptly responded to its letter of November 4, 1992. Yu also conducted a physical inspection of NIM on August 9, 1993. He examined Nakoski’s files and daily trade blotters and found no evidence of the loan agreements, which Nakoski had hidden. Nakoski’s scheme included the solicitation of funds for personal loans, not for investment in Quest approved securities. The safeguards imbedded in the Quest computer programming would not allow Nakoski to siphon client funds for his own discretionary spending and investment. His scheme also included the cooperation and corruption of at least two employees in the branch office. Thus, they assisted the wrongdoing by creating and hiding a second set of books and files and by identifying potential victims. Because the Quest system did not allow embezzlement of client funds, Nakoski was forced to funnel new investor money into his personal account in order to carry out his plan to defraud the public. Indeed, his conduct was so egregious that Nakoski is now a convicted criminal. Like the salesmen in White, and in Huff, Nakoski launched a complex plan to circumvent reasonable controls that were instituted by the broker-dealer. His false advertisement, selling away, corruption of employees, conversion of client funds, and deception in the face of investigation and physical confrontation constitute extraordinary, criminal conduct. At the hearing, Nakoski testified and presented himself as a young, articulate, smart, choir-boy type person who denied any wrongdoing. These qualities must have been a factor in the abandonment of the investigations by the Division and the NASD. Yu and Quest could not reasonably be expected to supervise such a person in a business context so as to prevent the conduct that is revealed by the facts. The Division makes much of the possibility that a close examination of all the papers in the branch office, an effort to corroborate the salesman’s representations, and a thorough interrogation of all the investors would have thwarted the incipient scheme. Powell, the Division’s expert, testified that pursuant to industry standards and practices Yu should have performed a more timely inspection of NIM after learning of Nakoski’s efforts to solicit loans and should have contacted Quest’s clients. However, viewing the events from the perspective of a reasonable supervisor, I must conclude that neither Quest nor Yu had good reasons to take additional steps against the salesman. Yu had no reason to suspect that Nakoski had hidden unregistered securities in his secretary’s desk; no reason to conclude that Nakoski had received investor funds that were not accounted for; no reason to subject Quest investors to unsolicited inquiries; and no reason to view his trusted salesman as a criminal. Nakoski was reasonably supervised within the meaning of Section 15(b)(4)(E) and 15(b)(6) of the Exchange Act and Sections 203(e)(6) and 203(f) of the Advisers Act. Therefore, the proceeding must be dismissed. CERTIFICATION OF THE RECORD Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b)(1998), I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on April 17, 1997. ORDER Based on the findings and conclusions set forth above, IT IS ORDERED that this proceeding against Respondent Quest Capital Strategies, Inc. and Respondent David Chen Yu be, and it hereby is, dismissed. This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360 (1998). Pursuant to that rule, a petition for review of this initial decision may be filed within 21 days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within 21 days after service of the initial decision upon such party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the initial decision shall not become final as to that party. ______________________________ Lillian A. McEwen Administrative Law Judge **FOOTNOTES** [1]: Citations to the exhibits offered by the Division and the Respondent, and to the transcript of the hearing, will be noted as "Div. Ex. ___," "Resp. Ex. ___," and "Tr. ___," respectively. [2]: In re John Nakoski, No. 94-31555 (JEB) (Bankr. S.D.N.Y.) [3]: SEC v. Nakoski, 95 Civ. 0738 (RSP) (N.D.N.Y). [4]: John T. Nakoski, 59 SEC Docket 2336 (July 10, 1995). [5]: Effective April 9, 1997, Section 203(e)(4) of the Adviser’s Act was redesignated as Section 203(e)(5), Section 203(e)(5) of the Advisers Act was redesignated Section 203(e)(6), and Section 203(f) was amended to reflect the changes in numbering. [6]: Section 206 of the Advisers Act applies to any investment adviser, whether registered with the Commission or not. See Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 16 n.6 (1979). [7]: The phrases "in the offer or sale of securities" and "in connection with the purchase or sale of any security," as used in Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act respectively, are used interchangeably. See United States v. Naftalin, 441 U.S. 768, 773 n.4 (1979). 1