Timothy Michael McGinn (CRD #813935, Registered Principal, Schenectady, New York) and David Lee Smith (CRD #427284, Registered Principal, Saratoga Springs, New York)

were barred from association with any FINRA member in any capacity. The sanctions were based on findings that Smith misused investor funds when he sold approximately $89 million in income notes issued by four limited liability companies he controlled.

David Smith told the investors that the Income Note LLCs would place their funds in a broad array of public and private investments. Contrary to Smith’s representations, he diverted most of the invested funds for the benefit of business entities that he and McGinn owned or in which they had a financial interest. Smith also loaned approximately $590,000 of funds directly to himself. The findings also stated that Smith made misrepresentations and omissions of material facts relating to the Income Note LLCs when he recommended to investors that they participate in the private offerings and purchase the income notes.

Additionly, to falsely representing that the Income Note LLCs would place their funds in private and public investments, Smith stated that the member firm would charge an annual 2 percent commission or fee. In actuality, the proceeds of the investments were diverted to entities McGinn and Smith owned, which were illiquid and in poor financial condition with little or no revenues, and the firm charged recurring annual commissions or fees amounting to approximately 8 percent of the investors’ purchases. Smith failed to inform investors that the Income Note LLCs would invest in, and make loans to, entities in which he and McGinn maintained a financial interest, and that the majority of the funds would be invested in illiquid, non-public companies.

These findings also included that Smith directed the sales efforts by which customers purchased the Income Note LLCs. The notes were not registered with the SEC and were not eligible for exemption from registration, but the offerings falsely claimed to be exempt from the registration requirement pursuant to Rule 506 of the Securities Act of 1933, Regulation D.

Also, FINRA found that Smith sent letters to income note investors containing material misrepresentations and omissions concerning their investments. One letter informed certain Income Note LLCs holders that their annual interest rates of return would bereduced because of market conditions, and Smith falsely represented that the firm would suspend further collection of fees from the Income Note LLCs but it continued to collect them, totaling approximately $6.7 million. Another letter informed all Income Note LLC holders that they would be unable to redeem notes on a particular day because of conditions in financial credit markets and the resultant liquidity crises. Smith also falsely represented that the firm would forfeit all annual fees and commissions in order to improve the liquidity of the Income Note LLCs, but it continued to charge fees and commissions.

Present in both letters, Smith failed to disclose to the note holders that the poor financial condition of the Income Note LLCs was caused in part by his decision to lend or invest most of the investors’ funds in illiquid entities that he and McGinn owned and controlled, had few or no revenues, and were in financial distress. FINRA also found that the firm, through Smith, failed to establish and maintain a supervisory system, and failed to establish, maintain and enforce WSPs reasonably designed to achieve compliance with the applicable FINRA rules and securities laws related to suitability, disclosure and verification of investor accreditation status.

FINRA reports that for approximately five years, the firm’s principal source of revenues was from private placements, including the Income Note LLCs. The subscription contracts potential investors submitted in income note offerings were inadequate because they did not contain information about the investors’ liquid net worth, but the firm relied on them to review and approve individual investments; many investor documents were incomplete, and many were altered after they were submitted by the investors to make it appear that the investors had a higher net worth and qualified as accredited investors.

The firm did not have, and Smith did not implement, procedures for reviewing customer documents reasonably designed to allow the firm to identify any potential alterations and to take appropriate action, and did not have a procedure for spot-checking customer documents and contacting customers directly to ascertain if the documents were accurate.

Despite the fact that the PPM for the income notes and subscription agreements provided that only accredited investors would be eligible to invest, Smith approved and accepted investments from approximately 250 non-accredited investors.

FINRA found that McGinn and Smith provided false documents to FINRA in response to requests for information relating to loans from certain business entities they controlled.

McGinn and Smith submitted copies of promissory notes relating to the loans, dated to appear that they had been previously signed; each note contained a certification attesting that it had been executed and delivered on the date specified. The certifications were false, as McGinn, Smith and a registered representative actually prepared, dated and signed the notes after the FINRA request for documents.

 (FINRA Case #2009017984501)

This article was obtained from FINRA’s website’s Disciplinary Actions of December 2011.

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Bruce Kelly writes in a Sept. 13th, 2011, article in InvestmentNews.com that a broker-dealer who sold millions of dollars of failed private placements reached a $200,000 settlement with the Financial Industry Regulatory Authority Inc. last month, with the money going to the investors.

In a Finra letter of acceptance, waiver and consent, Capital Financial Services Inc. of Minot, N.D., “failed to have reasonable grounds to believe that private placements offered by Medical Capital Holdings Inc. and Provident Royalties LLC, pursuant to Regulation D, were suitable for any customer.”

Capital Financial Services Inc., also “failed to conduct adequate due diligence” on the two series of offerings and to put in place a supervisory system to achieve compliance when selling the private placements, according to the Finra letter. The firm has 332 affiliated registered representatives. John Carlson is the firm’s president.

The InvestmentNews.com article goes on to say that Capital Financial has recently drawn attention for its due-diligence policies. In April, the Securities and Exchange Commission alleged that Capital Financial’s due diligence on Provident Royalties private placements fell short, and the firm “never conducted independent verification of any of the offering materials provided by Provident.” The status of that case is still pending, according to the firm’s profile on Finra’s BrokerCheck system.

Those potential problems, according to Finra, included a custodian’s refusing to hold the MedCap notes, a clearing firm’s valuing the notes at zero on client account statements; the firm’s receiving two third-party due-diligence reports that highlighted Medical Capital’s recent failure to pay interest and a communication from a another third-party due-diligence analyst who indicated that MedCap executives weren’t allowing the analyst access to all its records.

Kelly writes that according to the SEC, the firm’s brokers sold $63 million of Provident Royalties preferred stock from 2006 to 2009. The Finra action focuses on 36 Capital Financial brokers who sold $11.8 million of MedCap notes in 2008 and 2009, allegedly after several “red flags” were raised about those notes.

Also stated was another alleged shortcoming of Capital Financial, was its failure to look at the financial records of Medical Capital and Provident Royalties. The firm “never obtained financial information about MedCap and its offerings from independent sources, such as audited financial statements,” according to the Finra letter, which uses similar language regarding sales of Provident Royalties.

By Sept. 1, the firm was to pay $80,000 to the court-appointed receiver for Medical Capital and $120,000 to the court-appointed receiver for Provident Royalties.

The firm consented to the Finra action without admitting to or denying its findings.

Securities Attorney, Lars Soreide, of Soreide Law Group, PLLC, has represented clients nationwide. If you feel you have become a victim of Capital Financial Services, Inc., call a Securities Arbitration Lawyer for a free consultation on how to potentially recover your losses.  To speak with an attorney, call 888-760-6552, or visit www.securitieslawyer.com

Soreide Law Group, PLLC., representing investors nationwide before FINRA  the Financial Industry Regulatory Authority.

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