Report under Section 21(a) of the Exchange Act

 Attorney's Conduct in Issuing an Opinion Letter Without Conducting An Inquiry Of Underlying Facts Failed to Comport With Applicable Standards of Conduct, Exchange Act Release No. 17831 (June 1, 1981).

Introduction

After consideration by the Commission of the role of the lawyer who represented an underwriter in the public offering of certain industrial revenue bonds, the Commission has determined, in the exercise of its prosecutorial discretion, not to institute an enforcement proceeding against that person, charging aiding and abetting of violations of antifraud provisions of the federal securities laws.ⁿ¹ This decision not to bring an enforcement action is not based on any conclusion that the lawyer's conduct was even arguably acceptable; to the contrary, the Commission believes that the lawyer failed to carry out his professional obligations under the circumstances described below and, as a result, facilitated violations of the securities laws.ⁿ² The Commission has taken into account certain other factors, including his unfamiliarity with the federal securities laws and the fact that he relied, in a manner inappropriate under the circumstances, upon bond counsel, an experienced securities lawyer. The Commission believes, however, that the public and the bar should be apprised of the conduct of the lawyer in this case and of the Commission's views as to the responsibilities of lawyers who render opinions in connection with securities transactions which affect public investors.

The Facts

In 1977, William M. Gotten, an attorney in Memphis, Tennessee, rendered an opinion, as counsel for an underwriter, in connection with the offer and sale of industrial revenue bonds not required to be registered pursuant to the Securities Act of 1933. The opinion letter, which was drafted for Mr. Gotten's signature by bond counsel in the transaction, falsely stated that the offering circular did not "omit to state a material fact necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading".

Unlike many other industrial bond offerings which are intended to provide funds for the construction of new facilities, the offering in this case was for the purpose of acquiring an existing hospital, which had operated for several years. While the offering circular contained projections of revenues, expenses and earnings, it contained no financial information about the past operations of the hospital. This operating history reflected adversely upon the possibility of future profitable operations and drew into serious question the ability of the issuer to service the debt being issued.

For five years prior to the offering, net income ranged from a loss to a $48,000 profit during a time when the hospital had no mortgage indebtedness or other debt service. Interest expense alone for the first five years of the bond sale was to average about $155,000 per year, or in excess of $100,000 more than the hospital had ever made as profit in the preceding 5 year period. Under a new management company which had operated the hospital during the year immediately preceding the bond offering, with no debt to service, a net profit from operations was realized of only $24,000. Debt service on the new bonds thus required more than $158,000, or an amount equivalent to more than 600% of the hospital's profits during the previous year. This information, clearly both relevant and material to the reasonableness of the income projections, was not disclosed.

Mr. Gotten read the offering circular prior to rendering his opinion. And, although the opinion letter states that the signator has not independently checked or verified most of the material statements in the offering circular, Mr. Gotten, who knew that the issuer was a going concern that had been in operation for a number of years, signed and issued the opinion letter without questioning the omission from the offering circular of financial statements concerning the issuer's prior operating history, reviewing any documents as to the financial status of the issuer, or making inquiry as to results of the operations of prior years.ⁿ³ This inquiry was totally inadequate and facilitated the bond closing and the bond sales to the public.

The nature of services performed by lawyers in connection with securities transactions frequently involves the rendering of opinions concerning compliance by their clients with the federal securities laws. This is so because legal opinions are often essential to the completion of the transactions, and the parties and the investing public look to the opinion as the authoritative statement that the matters opined upon are in order. The importance of the role of counsel who render legal opinions in this context has prompted the bar to establish professional standards for lawyers who provide them. The American Bar Association's Committee on Ethics and Professional Responsibility, for example, has addressed the duties of counsel who render securities law opinions in Formal Opinion 335, 60 A.B.A. Jour. 488 (1974).

Formal Opinion 335 relates to opinions written as the basis for transactions involving sales of unregistered securities and establishes that, as a matter of professional standards, a lawyer must make a preliminary inquiry of the client as to the relevant facts before rendering an opinion as to compliance with the federal securities laws. When the facts obtained from the client appear incomplete or inconsistent with facts known to the lawyer, or are otherwise suspect, the lawyer must make further inquiry. ⁿ⁴

And, if after such further inquiry, the lawyer is not satisfied as to all the relevant facts, he should refuse to render an opinion. ⁿ⁵

In addition, Canon 6 of the Model Code of Professional Responsibility of the American Bar Association requires that a lawyer represent his client competently. And Disciplinary Rule 6-101(A) expressly mandates that an attorney shall not handle a legal matter which he knows or should know he is not competent to handle, without associating himself with a lawyer who is competent to handle it, and shall not handle a legal matter without preparation adequate in the circumstances.

The smooth functioning of the securities markets will be subject to serious disruption if the public cannot safely rely on the expertise proffered by lawyers rendering their opinions. Unless lawyers carefully and competently ascertain the relevant facts, and make a reasonable inquiry of their clients to obtain facts not within their personal knowledge, their opinions may facilitate fraudulent transactions in securities. This is so particularly as the investing public looks to the lawyer's opinion as a safeguard against violations of the federal securities laws. As stated by the United States Court of Appeals for the Second Circuit in Securities and Exchange Commission v. Spectrum, Ltd., 489 F.2d 535 (2d Cir. 1973), in discussing the conduct of an attorney who, without conducting any inquiry into the underlying facts, issued a false opinion letter that unregistered shares could be sold without registration, "the preparation of an opinion letter is too essential and the reliance of the public too high to permit due diligence to be cast aside in the name of convenience." ⁿ⁶

And see Securities and Exchange Commission v. Universal Major Industries, Corp., 546 F.2d 1044 (2d Cir. 1976), cert. denied, 434 U.S. 834 (1977) (opinion that securities could be sold without registration); Securities and Exchange Commission v. Frank, 388 F.2d 486 (2d Cr. 1968) (failure of lawyer in drafting a prospectus to make inquiry beyond the facts supplied to him by his client, facts which even a laymen would know were false);

United States v. Crosby, 294 F.2d 928 (2d Cir. 1961) (opinion that unregistered stock was freely transferable); Escott v. Barchris Construction Co., 283 F. Supp 642 (S.D.N.Y. 1968) (failure to investigate the accuracy of registration statement signed by the attorney); cf. Securities and Exchange Commission v. Coven, 581 F.2d 1020 (2d Cir. 1978), cert. denied, 440 U.S. 590 (1979) (letter representing that a sufficient number of shares had been sold to facilitate the closing of an "all or nothing" offering); Securities and Exchange Commission v. Manor Nursing Centers, Inc., 458 F.2d 1082 (2d Cir. 1972) (failure to correct a misleading prospectus).

The Commission has also stated,

"if an attorney furnishes an opinion based solely on hypothetical facts which he has made no effort to verify, and if he knows that his opinion will be relied upon as the basis for a substantial distribution of unregistered securities, a serious question arises as to the propriety of his professional conduct."

Securities Act Release No. 4445 (Securities Exchange Act Release No. 6721), published on February 2, 1962 (cited with approval by the Commission is Securities Act Release No. 5168, July 7, 1971). ⁿ⁷

Conclusion

Under the circumstances described above concerning Mr. Gotten's conduct in rendering an opinion letter, and based on the standards of conduct articulated above, the Commission believes that Mr. Gotten's conduct, without having conducted any inquiry of his client as to the underlying facts on which his opinion was predicated, failed to satisfy applicable standards.

By the Commission.

Footnotes

-[n1]-The Commission is issuing this Report in accordance with its authority under Section 21(a) of the Securities Exchange Act. For further information concerning the related civil action filed against others, see Litigation Release No. 9366.

-[n2]-Ibid.

-[n3]-In that letter, Mr. Gotten also opined that the bonds were exempt from registration with the Commission under the Securities Act and that compliance with the Trust Indenture Act was not required. Although these opinions turned out to be correct, Mr. Gotten had made no attempt to ascertain their applicability or accuracy; instead he relied upon the representations of, among others, the underwriter and bond counsel.

-[n4]-Guidance as to when further inquiry is appropriate is provided in Formal Opinion 335, which states: "* * * the lawyer should, in the first instance, make inquiry of his client as to the relevant facts and receive answers. If any of the alleged facts, or the alleged facts taken as a whole, are incomplete in a material respect; or are suspect, or are inconsistent; or either on their face or on the basis of other known facts are open to question, the lawyer should make further inquiry." 60 A.B.A. Jour. at 489.

-[n5]-Again, guidance is provided in Formal Opinion 335, which cautions: "Where the lawyer concludes that further inquiry of a reasonable nature would not give him sufficient confidence as to all the relevant facts, or for any other reason he does not make the appropriate further inquiries, he should refuse to give an opinion." Id.

-[n6]-See also United States v. Benjamin, 328 F.2d 854, 863 (2d Cir. 1964) involving an opinion that certain securities were exempt from registration under Section 3(a)(1) of the Securities Act: "In our complex society . . . the lawyer's opinion can be [an] instrument for inflicting pecuniary loss more potent than the chisel or the crowbar. * * * Congress could not have intended that men holding themselves out as members of these ancient professions [the accounting and legal professions] should be able to escape criminal liability on a plea of ignorance when they have shut their eyes to what was plainly to be seen or have represented a knowledge they knew they did not possess."

-[n7]-In Release No. 4445, the Commission noted the practice of dealers, when attempting to obtain an exemption under Section 4(1) of the Securities Act, of submitting representations to a lawyer that the sellers of the securities did not hold any of those positions that would render the exemption unavailable. The release stated that a lawyer's opinion based on hypothetical facts would be worthless if the facts were not accurate or if the vital facts were not considered. The release further expounded on the duties of responsible counsel to the effect that "it is the practice of responsible counsel not to furnish an opinion * * * unless such counsel have themselves carefully examined all of the relevant circumstances * * *." Id.

To Contents   

Injunctive Proceedings

SEC v. Calhoun County Medical Facility, Inc., et al., Civ. Action No. WC-81-61 WK-P (N.D. Miss.), Litigation Release No. 9366 (June 1, 1981) (settled final order).

See "Obligated Persons" section.

To Contents   

SEC v. Haswell, Civ. Action No. CIV-77-0408-B, 1977 U.S. Dist. LEXIS 13396 (W.D. Okla. Oct. 19, 1977).

OPINION: BOHANON, District Judge: This action, filed pursuant to the provisions of Section 20(b) of the Securities Act of 1933 (the 1933 Act) and Section 21(e) of the Securities Exchange Act of 1934 (the 1934 Exchange Act), is brought by the Securities and Exchange Commission (the Commission) against the defendant, Andrew J. Haswell, Jr., (Haswell) seeking to enjoin him temporarily and permanently from violating in the future the provisions of Sections 5(a), 5(c) and 17(a) of the 1933 Act and the provisions of Section 10(b) of the 1934 Exchange Act and Rule 10b-5 thereunder. The Commission's application for a temporary injunction was earlier withdrawn by the Commission after a hearing was held and the Commission took evidence of Haswell by written interrogatories.

The Commission's application for a permanent injunction against defendant Haswell came on for hearing and trial on September 8 and 9, 1977. The Commission appeared by its counsel of record, Thomas Allen Moon and Raymond L. Betts, Jr. Haswell appeared by his counsel of record, Robert C. Bailey and Thomas J. Kenan. Both sides announced that they were ready for trial. Evidence was introduced at the conclusion of which both sides rested.

The plaintiff requested additional time in which to examine the evidence and to submit final argument by brief. The Court granted such request. Both sides then submitted briefs. Oral argument was heard on October 12, 1977.

The Court now having heard the testimony, considered all the evidence and briefs and heard argument, and having considered the entire record in these proceedings, finds and concludes as follows:

Midwestern Oklahoma Development Authority (MODA) is a development authority organized in November, 1969, under the laws of the State of Oklahoma. MODA was organized after the United States Department of the Air Force closed its Air Force base near Clinton and Burns Flats, Oklahoma. MODA was organized for the purpose of attracting industry to use the facilities at the closed Air Force base in an effort to buoy the local economy, which suffered as a result of the loss of the Air Force facilities in the cities. MODA was organized at the specific recommendation of the Department of Defense, Office of Economic Adjustment, which recommendation pointed out that an organization such as MODA could offer financing through the issuance of tax exempt industrial revenue bonds. It is not contended that the desire for economic adjustment gave anyone the right to violate any statute or any Securities and Exchange Commission regulations.

Pursuant to these governmental recommendations, MODA was organized and has sold several industrial development bond issues to various underwriters, with the hope of providing jobs for the unemployed in the area. Haswell has acted as bond counsel to MODA. He has issued his bond opinion with respect to the legality of certain of the bond issues and the tax exempt status of the interest to be paid on such bonds. This proceeding involves three of such bond issues, all occurring in 1972. The first of these bond issues was the Western States Plastics bond issue. The second was the Lee and Hodges bond issue. The third was the Harper Industries Series A and Series B bond issue, of which issue Haswell acted as bond counsel only for the Series B bonds.

The Commission contends that in 1972 Haswell violated Section 17(a) of the 1933 Act and Section 10(b) of the 1934 Exchange Act and Rule 10b-5 thereunder by (1) issuing bond opinions with respect to the Western States Plastics and the Lee and Hodges bond issues when Haswell was on notice of fraud likely to be committed by the sellers of such bonds and (2) with respect to the Harper Industries bond issue, by preparing and assembling a false and misleading offering circular and (3) misrepresenting the tax exempt status of the Western States Plastics and the Lee and Hodges bond issues in his bond opinions with respect to such two issues. The Commission contends that Haswell violated Section 5(a) and 5(c) of the 1933 Act by issuing false bond opinions for the Western States and the Lee and Hodges bond issues and by preparing an offering circular for the Harper bond issue, all of which in the view of the Commission misrepresented that the interest on the bonds for each respective issue was tax exempt.

Haswell denies that any of his bond opinions regarding the tax exempt status of the interest on the bonds was in error. In the alternative, he argues that should it eventually be held that any of his bond opinions in fact was in error, that his opinions were nevertheless made with due care and in good faith and without negligence, recklessness or any intent to defraud.

With respect to one category of bonds, the Harper Industries Class A bonds, Haswell was not the bond counsel. However, Haswell did assemble the offering circular with respect to such bond issue. The offering circular noted that the Series A bond counsel, another attorney, was of the opinion that the interest to be earned on such bonds would be tax exempt. The Commission contends that such bond opinion was in error and that Haswell was on notice of facts sufficient to cause him, an attorney, to doubt the validity of the other attorney's bond opinion. The Commission contends that by assembling the offering circular that referred to such other attorney's bond opinion, Haswell violated the antifraud provisions of the securities laws.

As of this date, none of Haswell's bond opinions in question in this proceeding has been challenged by the Treasury Department or any other governmental agency charged with the enforcement of the Internal Revenue Code save and except the Commission in these proceedings.

With respect to the Western States and Lee and Hodges bond issues, the Commission contends that Haswell delivered his bond opinion to the underwriter when he had become aware of the existence of a significant danger that the underwriter would use false and misleading sales materials in marketing these bond issues. The Commission contends that, under these circumstances, Haswell should have withheld his bond opinions and thereby refrained from assisting the underwriters. This alleged violation of Haswell is not dependent upon the imposition of an affirmative duty on his part to inquire and discover fraud but is based upon the premise that he has an obligation not to assist, knowingly or recklessly, in the perpetration of a fraud.

After weighing the evidence, the Court is unable to conclude that Haswell or any other reasonable person would have been put on notice that a fraud was to be perpetrated by the underwriters. The Commission's evidence, with respect both to the Western States and the Lee and Hodges bond issues, primarily depends in each instance upon the fact that the underwriter showed to Haswell a few-page, sketchy, document entitled "Preliminary Statement" which set forth a few of the terms of the proposed offerings, which documents were not only misleading with respect to the facts but were obviously full of omissions of material facts. However, these documents were exhibited to Haswell prior to any negotiations having occurred between the underwriter, MODA, and the lessee companies, prior to any decisions having been made with respect to the structuring of the bond issues, prior to any instruments having been drafted of the underlying security documents and other documents and prior in fact to any deal having been struck or decision made by MODA to even authorize the bond issues. The documents relied upon by the Commission were hardly more than negotiating documents prepared by the underwriter at a time when the decisions had not yet been made and the information was not in existence in order to prepare a proper offering circular.

The evidence is that Haswell, who prepared most of the underlying documents, delivered copies of these documents to the underwriter in order that the underwriter could prepare its own proper circular.

He did not negotiate the terms of the issues nor assume the responsibilities of the issuer, underwriter or sales agent, other than to act as bond counsel in issuing his opinion hereinbefore referred to and as a lawyer merely placing in legal form the agreements of other parties to the transaction.

At the closing of the two bond issues, when Haswell delivered his bond opinions, the trustee bank delivered the bonds, and the underwriter delivered the money, Haswell did not insists upon viewing the underwriter's final form of the offering circular. It is this event -- or, rather nonevent -- that is seized upon by the Commission and characterized by the Commission as the violation of the antifraud provisions of the federal securities laws.

This Court cannot agree with such an extreme characterization of Haswell's failure to insist upon viewing the underwriter's final form of the offering circular. It may be that a more careful attorney would have insisted upon this. But in order to find that Haswell violated Section 17(a) of the 1933 Act and Section 10(b) of the 1934 Exchange Act and Rule 10b-5 thereunder, it is necessary that this Court find that Haswell's conduct amounted to either fraudulent conduct or conduct so reckless that it was an extreme departure from the standards of ordinary care, conduct which presented a danger of misleading buyers that was either known to Haswell or was so obvious that he must have been aware of it. There is no credible evidence to support such a finding.

With respect to the Harper bond issue, the Commission does not challenge Haswell's bond opinion issued with respect to the Series B bonds. The Commission does contend that another attorney, a Kansas attorney, issued a false opinion with respect to the Harper Series A bonds. In a most convoluted argument, the Commission contents that, since Haswell prepared portions of the Harper offering circular which contained allusions to the bond opinion by the Kansas attorney, Haswell violated the antifraud provisions of the federal securities laws since he was on notice of facts and knew enough law to be charged with the knowledge that the Kansas bond attorney's opinion was wrong.

The Court finds that the evidence does not support a finding that Haswell was sufficiently on notice of any irregularities as to "second guess" the Kansas attorney. Matters of Kansas law were involved, since the security for the Harpers Series A bonds was property located in Kansas. The status of Treasury Regulations concerning such exempt bond issues was not settled at the time of this bond opinion. The argument of the Commission depends upon refinements in the Treasury Regulations that were not even proposed until 1975, and Haswell issued his bond opinions in 1972.

The Commission next contends that Haswell, in his preparation of the Harper offering circular, omitted to include certain information that the Commission believes should have been provided to make more meaningful certain financial projections involving the establishment of a salt and pepper shaker units assembly line and information concerning the costs of a patent.

The evidence shows that the portion of the offering circular containing financial projections was prepared by other persons but was assembled into the offering circular by Haswell. Admittedly, it does not contain the omitted matters deemed by the Commission to have been necessary to have been included. It is not necessary for this Court to find whether or not the omitted matter was material and should have been included in the offering circular. There is no credible evidence to support a finding that the omission of these matters was the result of any fraudulent or reckless behavior on the part of Haswell. It is clear that since Section 17(a) of the 1933 Act and Section 10(b) of the 1934 Exchange Act and Rule 10b-5 thereunder are fraud provisions, no violation of these provisions can occur unless the evidence supports a finding that Haswell's omissions were the result of fraudulent or culpably reckless behavior. There is clearly no credible evidence to support such a finding.

The Commission finally contends that Haswell "falsely" issued his bond opinions on the tax exempt status of the bonds in question. No credible evidence was introduced by the Commission to support its interpretation of the Internal Revenue Code and the Regulations issued thereunder. The evidence introduced was not convincing. Defendant Haswell's defense of the legality of his bond opinions, which were challenged solely with respect to aspects of the interpretation of the Internal Revenue Code, was most convincing to this Court with respect to the manner in which he arrived at his legal opinions. They were carefully considered opinions and, whether right or wrong, were made in utmost good faith. Whether right or wrong, the Treasury Department has never challenged any of his bond opinions in question in these proceedings.

The Court is not inclined to find that Haswell's bond opinions were erroneous and incorrect.

Haswell's opinions were neither negligently nor recklessly reached. Thus, even if his opinions were wrong, the resulting violations of the registration provisions of the securities laws were violations by the issuer and not by the issuer's attorney. Ultramares Corporation v. Touche, 174 N.E. 441 (N.Y. 1931) sets forth this principle and it in turn has been cited with approval in Ernst and Ernst v. Hochfelder, 425 U.S. 185 (1976) and Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).

After a careful review of the relevant statutes and case-law, the Court concludes that Congress created the Commission to enforce the provisions of the Securities and Exchange Act and to protect the public from the sale of fraudulent securities, and that agency has been seemingly amply funded and staffed to accomplish these ends. The alleged misconduct of which the Commission complains in this case could have been and should have been avoided by the enactment of regulations requiring disclosure in the initial offering of the initial discount rate as a percentage figure, and delineating those other economic factors underlying an issue which are material and subject to disclosure. The Commission should prospectively establish rules on these matters, by Congressional enactment where necessary, rather than defer action and then initiate enforcement procedures against attorneys who were forced to act in areas where no clear guidelines existed. The Commission's failure to seek creation of a well understood framework of disclosure principles as to longstanding problem areas fairly could be criticized as having contributed more to spectacular losses by investors in recent years than the actions of bond counsel, certainly Mr. Haswell included.

The Court concludes that Haswell has not violated the federal securities laws as charged. But even if Haswell had violated the federal securities laws, the permanent injunction sought by the Commission should be denied under the circumstances.

As delineated by the Court in Securities & Exchange Commission v. Manor Nursing Centers, Inc., 458 F. 2d 1082, 1100 (2nd Cir. 1972):

"The critical question for a district court in deciding whether to issue a permanent injunction in view of past violations is whether there is a reasonable likelihood that the wrong will be repeated."

Haswell has, in addition to the opinions rendered by him on the MODA bonds, issued many other opinions of similar nature since March of 1972, all of which were furnished to the Court by Haswell pursuant to written interrogatories served on him by the Commission, as well as produced by him at the time of trial at the request of the Commission.

The activities of Haswell complained of by the Commission occurred more than five years in the past. Since such time, Haswell has been counsel in dozens of bond issues, and there has been no showing of wrongdoing.

The Commission has found no fault nor alleged any violations with respect to any actions taken or bond opinions rendered by Haswell subsequent to July of 1972, neither in its pleadings nor evidence at trial.

Haswell has been employed by many prestigious underwriters issuers and public authorities. The Court has examined his work product over the last several years and finds it to be scholarly and of very high quality. There is clearly no evidence to support the inference. Urged by the Commission, that Haswell is likely to commit a future violation of the federal securities laws. The evidence is convincing to this Court that Haswell is a scholarly, ethical and cautious attorney and that he has been gravely damaged by the Commission's wrongful actions in this case.

IT IS, THEREFORE, ORDERED, based upon the foregoing, that the application of the Commission for a permanent injunction against Haswell be and the same is hereby denied.

For further information concerning (i) a related administrative proceeding involving Bullington-Schas, Tipton and Frost, see Securities Exchange Act Release No. 17832; and (ii) a Section 21(a) Report involving the role of underwriter's counsel, see Securities Exchange Act Release No. 17831.

To Contents   

SEC v. Washington County Utility District, et al., Civ. Action No. 2-77-15 (E.D. Tenn.), Litigation Release No. 7782 (February 15, 1977) (complaint); Litigation Release No. 7868 (April 14, 1977) (settled final order).

See "The Issuer" section.

To Contents   

SEC v. Reclamation District No. 2090, et al., Civ. Action No. C76-1231-SAW (N.D. Cal.), Litigation Release No. 7460, (June 22, 1976) (complaint).

See "The Issuer" section.

To Contents   

SEC v. Reclamation District No. 2090, et al., Litigation Release No. 7590 (September 28, 1976) (settled final order).

Gerald E. Boltz, Regional Administrator of the Los Angeles Regional Office, and Michael J. Stewart, Acting Associate Regional Administrator of the San Francisco Branch Office, announced that on September 1, 1976, the Honorable Robert H. Schnacke, United States District Judge for the Northern District of California, entered a Final Judgment of Permanent Injunction against Urban J. Schreiner of Atherton, California. The injunction proscribes violations of the anti-fraud provisions of the federal securities laws in connection with offers and sales of securities issued by Reclamation District No. 2090 ("the District") and any other security of any other issuer. Schreiner consented to the entry of the permanent injunction without admitting or denying the allegations of the Commission's complaint.

The Commission's complaint alleged that the defendants' conduct in violation of the anti-fraud provisions of the federal securities laws resulted in the sales of approximately $2.2 million of bond anticipation notes and negotiable promissory notes issued by the District to approximately 161 persons residing in at least twelve states.

To Contents   

Commission Orders – Settled Administrative Proceedings

In re Jean Costanza, Securities Act Release No. 7621, A.P. File No. 3-9799 (January 6, 1999).

I. The Securities and Exchange Commission ("Commission") deems it appropriate that a public cease-and-desist proceeding be and hereby is instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") against Jean Costanza ("Costanza").

II. In anticipation of the institution of this proceeding, Costanza has submitted an Offer of Settlement, which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and without admitting or denying the findings contained herein, except that Costanza admits the jurisdiction of the Commission over her and over the subject matter of this proceeding, Costanza, by her Offer of Settlement, consents to the entry of this Order Instituting a Public Cease-And-Desist Proceeding Pursuant to Section 8A of the Securities Act of 1933, Making Findings, and Imposing Cease-and-Desist Order ("Order") and to the entry of the findings and the cease-and-desist order set forth below.

Accordingly, IT IS HEREBY ORDERED that a proceeding pursuant to Section 8A of the Securities Act be, and hereby is, instituted.

III. On the basis of this Order and the Offer of Settlement submitted by Costanza, the Commission finds that: ¹

A. Respondent

Jean Costanza ("Costanza") was the issuer's bond counsel for eight note offerings (the "Note Offerings") related to the County of Orange ("Orange County" or the "County") Investment Pools (the "Pools") that raised a total of almost $1.425 billion. Costanza, as bond counsel, participated in preparing the official statements (the "Official Statements") for the Note Offerings and opined on the validity and tax-exempt status of the Note Offerings.

B. Facts

1. Introduction

Costanza was the bond counsel for the Note Offerings. The Official Statements for seven of the eight Note Offerings, which Costanza participated in drafting, omitted material facts about the Pools' investment strategy, the risks of that strategy, and the Pools' investment losses. Accurate and complete disclosure about the Pools was material to investors because these matters affected the issuers' ability to repay the Notes, as the funds pledged to repay the Notes were invested in the Pools and three of the offerings were conducted for the purpose of reinvesting the offering proceeds for profit. In addition, in two other Note Offerings, the Pools guaranteed repayment of the Notes.

In three of the Note Offerings, the Official Statements also omitted to disclose that the variable interest rate paid on the notes was subject to a 12% interest rate cap. The Official Statements represented that the Notes paid a variable interest rate but omitted to disclose that the interest rate would not exceed 12%. This interest rate cap was material to investors that had adopted policies against investing in securities with an interest rate cap.

The Official Statements for four Note Offerings that were tax-exempt (the "Tax-Exempt Offerings") also omitted to disclose information about the tax-exempt status. The Official Statement for each of these offerings represented that the interest on the notes would be tax-exempt. The Official Statement failed to disclose, however, that the issuer had improperly increased the size of the offering and, therefore, had jeopardized the tax-exempt status. Information about the tax-exempt status of the offering was material to investors because they would have wanted to know that their interest earnings might be taxable, thus reducing the earnings.

2. The Orange County Investment Pools

The Pools operated as an investment fund managed by the Orange County Treasurer-Tax Collector (the "Treasurer"), in which the County and various local governments or districts (the "Participants") deposited public funds. As of December 6, 1994, the Pools held approximately $7.6 billion in Participant deposits, which the County had leveraged to an investment portfolio with a book value of over $20.6 billion.

a. The Pools' Investment Strategy

From at least April 1992 until December 1994, the Treasurer's investment strategy for the Pools involved: (1) using a high degree of leverage by obtaining funds through reverse repurchase agreements on a short-term basis (less than 180 days); and (2) investing the Participants' deposits and funds obtained through reverse repurchase agreements in debt securities (issued by the United States Treasury, United States government sponsored enterprises, and highly-rated banks and corporations) with a maturity of two to five years, many of which were derivative securities. The Pools' investment return was to result principally from the interest received on the securities in the Pools. Leverage enabled the Pools to purchase more securities with the anticipation of increasing interest income. This strategy was profitable as long as the Pools were able to maintain a positive spread between the long-term interest rate received on the securities and the short-term interest rate paid on the funds obtained through reverse repurchase agreements.

b. The Pools' Portfolio

During 1993 and 1994, the Treasurer, using reverse repurchase agreements, leveraged the Participants' deposits to amounts ranging from 158% to over 292%. As of the end of June 1994, the Pools held $19.8 billion in securities, with approximately $7.2 billion in Participant deposits and about $12.6 billion in reverse repurchase agreements, resulting in leverage of about 274%.

During 1993 and 1994, the amount of derivatives in the Pools' portfolio ranged from 27.6% to 42.2% of the portfolio. As of the end of June 1994, 38.2% of the Pools' securities were derivatives. Most of the Pools' derivative securities were inverse floaters, which paid interest rates inversely related to the prevailing interest rate. From January 1993 through November 1994, 24.89% to 39.84% of the Pools' portfolio consisted of inverse floaters. As of the end of June 1994, 35% of the Pools' portfolio was invested in inverse floaters. From January 1993 through November 1994, only 1.84% to 5.59% of the Pools' portfolio consisted of securities that paid interest rates directly related to the prevailing interest rate (variable rate securities) or securities that paid interest rates that rose at certain stated intervals to certain stated rates (step-up securities). As of the end of June 1994, about 3.17% of the Pools' portfolio was invested in variable and step-up securities.

c. The Pools' Sensitivity To Interest Rate Changes And The Rise In Interest Rates During 1994

The composition of the Pools' portfolio made it sensitive to interest rate changes. As interest rates rose, the market value of the Pools' securities fell, and the interest received on the Pools' inverse floaters also declined. Thus, the Treasurer's investment strategy was profitable so long as interest rates, including the cost of obtaining funds through reverse repurchase agreements, remained low, the market value of the Pools' securities did not decline, and the Pools had the ability to hold securities to maturity.

From April 1992 through 1993, U.S. interest rates remained low and relatively stable. Due to the low interest rates and the Pools' investment strategy, the Pools earned a relatively high yield of approximately 8%. Beginning in February 1994, interest rates began to rise. This rise in interest rates resulted in: (1) an increase in the cost of obtaining funds under reverse repurchase agreements; (2) a decrease in the interest income on inverse floaters; (3) a decrease in the market value of the Pools' debt securities; (4) collateral calls and reductions in amounts obtained under reverse repurchase agreements; and (5) a decrease in the Pools' yield.

d. Orange County's Bankruptcy

By early December 1994, the Pools had an unrealized decline in market value of about $1.5 billion. Shortly thereafter, on December 6, 1994, Orange County filed Chapter 9 bankruptcy petitions on behalf of itself and the Pools (the petition filed on behalf of the Pools was later dismissed). Between early December 1994 and January 20, 1995, the Pools' securities portfolio was liquidated, incurring a loss of almost $1.7 billion on the Participants' deposits of $7.6 billion, a 22.3% loss.

3. The Note Offerings

In July and August 1994, Costanza was the bond counsel for eight offerings of municipal securities conducted by Orange County, the Orange County Flood Control District (the "Flood Control District"), and the Placentia-Yorba Linda Unified School District ("Placentia USD") that raised a total of almost $1.425 billion. ²

a. The Taxable Note Offerings

Orange County, the Flood Control District, and Placentia USD raised $750 million through three offerings of taxable notes (the "Taxable Note Offerings") in 1994. The issuers conducted these offerings for the purpose of generating an anticipated profit by reinvesting the proceeds (together with funds equal to the estimated interest on the notes) in the Pools to earn an investment return that would be higher than the rate of interest payable to the Taxable Note investors. The issuers pledged these invested funds to secure repayment of the Taxable Notes, and, if the pledged funds were insufficient to pay principal and interest, the issuers would satisfy any deficiency with other moneys lawfully available to repay the notes in the respective issuer's general fund attributable to the fiscal year in which the notes were issued.

The County issued $600 million in notes (the "$600 Million Taxable Notes") on July 8, 1994, described in an Official Statement dated July 1, 1994. These notes earned a variable interest rate reset monthly at the one-month London Interbank Offered Rate ("LIBOR") not to exceed 12% per annum. The $600 Million Taxable Notes were originally due on July 10, 1995. On June 27, 1995, the County and the noteholders entered into Rollover Agreements under which the maturity of the notes was extended from July 10, 1995, to June 30, 1996, and the interest rate paid on the notes was increased. On June 12, 1996, as part of its emergence from bankruptcy, the County repaid the notes with a portion of the proceeds from another County municipal securities offering.

On August 2, 1994, the Flood Control District issued $100 million in notes (the "$100 Million Taxable Notes") described in an Official Statement dated July 27, 1994. These notes earned a variable interest rate reset monthly at the one-month LIBOR plus .03% not to exceed 12% per annum. The notes matured, and were repaid, on August 1, 1995.

On August 25, 1994, Placentia USD issued $50 million in notes (the "$50 Million Taxable Notes") described in an Official Statement dated August 19, 1994. The notes matured, and were repaid, on August 24, 1995.

b. The TRAN Offerings

In 1994, the County conducted two tax and revenue anticipation note ("TRAN") offerings (the "TRAN Offerings") that raised a total of $200 million to fund its expected cash flow deficits, as it received revenue infrequently throughout the fiscal year but had constant working capital expenses. The Official Statements for these offerings represented that: the County would pledge certain anticipated revenues to pay the notes' principal and interest; the revenue, when received, would be placed into a repayment account; the funds in the repayment account would be invested; and if the County lacked sufficient funds in the repayment account to repay the notes, the County would satisfy any deficiency from other moneys received or accrued during the fiscal year in which the notes were issued and lawfully available for repayment of the notes.

The County issued $169 million in TRANs (the "$169 Million TRANs") on July 5, 1994, described in an Official Statement dated June 27, 1994, and $31 million in tax-exempt TRANs (the "$31 Million TRANs") on August 11, 1994, described in an Official Statement dated August 5, 1994. The $169 Million TRANs and $31 Million TRANs were originally due on July 19, 1995 and August 10, 1995, respectively. On June 27, 1995, the County and the noteholders entered into Rollover Agreements under which the maturity of the TRANs was extended to June 30, 1996. On June 12, 1996, as part of its emergence from bankruptcy, the County repaid the TRANs with a portion of the proceeds from another County municipal securities offering.

c. The $299.66 Million Pooled TRAN Offering

On July 1, 1994, the County raised $299.66 million through an offering of tax-exempt TRANs (the "$299.66 Million Pooled TRAN Offering"). The notes matured, and were repaid, on July 28, 1995. As represented in the Official Statement dated June 7, 1994, the County used the offering proceeds to purchase $299.66 million in notes issued by the 27 school districts (the "School Districts"), which used the proceeds to fund their cash flow deficits. The Official Statement represented that to repay the notes, the County would deposit certain funds pledged by the School Districts into a repayment account which the County intended to invest in the Pools; in turn, the County intended to pledge those funds to repay the investors. The Pools also guaranteed repayment of the $299.66 Million Pooled TRANs through a Standby Note Repurchase Agreement, under which the County Treasurer, as fund manager of the Pools, agreed to purchase the School Districts' notes to the extent that the school districts did not meet their obligations of repayment.

d. The Teeter Note Offerings

In 1994, Orange County conducted two offerings of Teeter Notes (the "Teeter Note Offerings"). The purpose of these offerings was to fund the County's Teeter Plan, an alternate method of property tax distribution whereby the County pays local taxing entities (such as school districts) their share of property taxes upon levy rather than actual collection and the County then retains all property taxes, and the penalties and interest thereon, upon collection.

The first Teeter Note Offering was conducted on July 20, 1994, for $111 million (the "$111 Million Teeter Notes"). These notes were described in an Official Statement dated July 13, 1994. These notes earned a variable interest rate reset monthly at one-month LIBOR not to exceed 12% per annum. The second Teeter Note Offering was conducted on August 18, 1994, for $64 million (the "$64 Million Teeter Notes"). These notes were described in an Official Statement dated August 12, 1994. These notes earned a variable interest rate reset monthly at 70% of one-month LIBOR not to exceed 12% per annum. The $111 Million and $64 Million Teeter Notes matured, and were repaid, in part with proceeds from a June 30, 1995 Teeter bond offering.

The Official Statements for the Teeter Note Offerings represented that the County planned to deposit certain delinquent tax payments, penalties, and interest collections in accounts pledged to repay the Teeter Notes and to then invest those funds in the Pools. The Official Statements for the Teeter Note Offerings represented that the County anticipated that the funds in the repayment account would not be sufficient to pay the principal and interest on the Teeter Notes at maturity and that the County estimated that, at maturity of the Teeter Notes, approximately $70 million would be available in the repayment account to pay the principal and interest on the $175 million in Teeter Notes. The Official Statements further represented that this anticipated deficiency in the repayment account would be satisfied from moneys received under Standby Note Purchase Agreements, which agreements obligated the Treasurer (as "fund manager" of the Pools) to purchase the Teeter Notes, and from other moneys lawfully available to the County for repayment from revenues received or attributable to the fiscal year in which the notes were issued.

4. Costanza's Role in the Note Offerings

Costanza was bond counsel for the Note Offerings. As bond counsel, Costanza issued opinions regarding the legality and tax-exempt status of the Notes, prepared resolutions authorizing the issuance of the Notes, and coordinated the documents for closing the transaction. In seven of the Note Offerings (the $299.66 Million Pooled TRAN Offering excluded), Costanza also participated in drafting the Official Statements, including the disclosure concerning the Pools. ³ In fact, her contracts with the issuers of the Notes required that she assist in preparing and reviewing the Official Statements for the Note Offerings. Moreover, the officials of the County and Flood Control District would not sign the Official Statements without Costanza's approval of the Official Statements.

5. The Omissions And Costanza's Knowledge

a. The Pools⁴

(1) The Omissions

(a) The Pools' Investment Strategy

The disclosure in the Official Statements for the Note Offerings regarding the Pools' investment strategy was misleading because it failed to disclose material information, including: (1) the Pools' investment strategy was predicated upon the assumption that prevailing interest rates would remain at relatively low levels; (2) the Pools' use of leverage through reverse repurchase agreements was constant, high, and a major part of the Pools' investment strategy; and (3) the Pools had a substantial investment in derivative securities, particularly inverse floaters.

(b) The Risks Of The Pools' Investment Strategy

The disclosure in the Official Statements regarding the risks of the Pools' investment strategy was misleading because it omitted material information about the Pools' sensitivity to rises in interest rates. Specifically, the Official Statements failed to disclose that because of the Pools' high degree of leverage and substantial investment in inverse floaters, rising interest rates would have a negative effect on the Pools, including: (1) the Pools' cost of obtaining funds under reverse repurchase agreements would increase; (2) the Pools' interest income on the inverse floaters would decrease; (3) the Pools' securities would decline in market value; (4) as the value of the securities fell, the Pools would be subject to collateral calls and reductions in amounts obtained under reverse repurchase agreements; (5) the Pools' earnings would decrease; (6) the Pools would suffer losses of principal at certain interest rate levels; and (7) if the Pools' began to suffer lower earnings or losses of principal, certain Participants could withdraw their invested funds, leaving the County and other Participants such as the Flood Control District who were required to deposit their funds with the Treasurer to absorb any losses.

(c) The Pools' Investment Results

The disclosure in the Official Statements regarding the Pools' historic investment results was misleading because it omitted material information regarding the Pools' investment results during the first half of 1994 when interest rates were rising. Specifically, the Official Statements omitted to disclose that as a result of rising interest rates in 1994, the market value of the Pools' securities was declining, the Pools were subject to collateral calls and reductions in amounts obtained under reverse repurchase agreements, and the Pools' costs of obtaining funds under reverse repurchase agreements were increasing.

(2) Costanza's Knowledge About The Pools And Drafting Of The Official Statements

While preparing the Official Statements, Costanza received information concerning the Pools' investment strategy, the risks of that strategy, and the Pools' recent investment results. Costanza, however, did not assure that this information about the Pools was disclosed in the Official Statements.

(a) March 1994 Meetings

In late March 1994, Costanza and others participating in preparing the Official Statements for the Note Offerings, including the County's Assistant Treasurer and a representative from the County Counsel's Office, met with the rating agencies and two potential institutional investors in New York City to discuss the upcoming Note Offerings. During the meetings, the rating agencies and the potential investors questioned a County official about the Pools and the effect the recent rise in interest rates had had on the Pools. The official responded that the Pools used leverage through reverse repurchase agreements and invested in derivative securities, including inverse floaters.

(b) The Media Coverage Of the Pools

From January 31 through June 30, 1994, articles appeared in the media regarding the Pools. The articles reported that the Treasurer admitted that: he used reverse repurchase agreements to leverage the Pools' $7.5 billion in deposits to $19.5 billion in investments; 20% of the $19.5 billion portfolio was invested in derivative securities; his strategy was to borrow short-term and invest in medium-term securities; the value of the Pools' portfolio had "been hit by rising interest rates"; and as a result of rising interest rates and the declining market value of the Pools' securities, the County had recently experienced up to $300 million in collateral calls under reverse repurchase agreements. These articles also reported that many believed that the investment strategy was too risky for public funds and exposed the Pools to very large losses. Costanza knew that there were a number of articles about the Pools published in numerous newspapers and received from the County by facsimile some of the articles.

(c) May 1994 Telephone Call With A Rating Agency

On May 9, 1994, Costanza and other participants in the Note Offerings, including the County's Assistant Treasurer and a representative from the County Counsel's Office, discussed the Pools by telephone with one of the rating agencies. During the conversations, the rating agency asked a County official about the news articles concerning the Pools. One of the topics discussed during the telephone call was the Pools' sensitivity to changes in the interest rate. The County official told the rating agency that the Pools held floating rate notes to hedge against rises in interest rates and inverse floating rate notes to hedge against declines in interest rates and that, "as long as the movements didn't occur precipitously all at once," changes in the interest rate should not be a problem for the Pools. According to Costanza's notes, the County official stated in this regard:

"(The County official) expect(ed interest rates) to go up . . . 25 (basis points) . . .

If run through 700 m(illion) ((i)n addition to 1.5 B(illion)) -- what happens:

If i(nterest) rates go up 300 (basis points) DISASTER . . .

(Short term interest) rates go up 200 (basis points and) stay=danger! (If interest rates go up) 100 (basis points) collateral gone"

Another topic discussed during the telephone call was collateral calls suffered by the Pools as a result of recent rises in interest rates. In this regard, Costanza's notes of the conversation stated that the County official stated that the Pools had suffered a total of $300 million of collateral calls since January 1994, including $40 million dollars of collateral calls during April 1994. ⁵

(d) The Adoption Of, And Changes To, The Disclosure In A Prior Offering

As a result of the media coverage and the rating agency's questions regarding the Pools, one of the professionals participating in drafting the Official Statements obtained and reviewed a copy of the Official Statement for a 1993 taxable note offering conducted by another local government located in Southern California (the "Prior Offering"). The Official Statement for the Prior Offering contained disclosure regarding the issuer's investment pool (the "Prior Pool").

On June 17, 1994, the County, after consultation with Costanza and other professionals and County officials participating in drafting the Official Statements, determined to revise the disclosure about the Pools to be similar to the Prior Pool disclosure. Indeed, much of the disclosure in the Official Statements for the Note Offerings was copied directly from the Official Statement for the Prior Offering. The County, in consultation with Costanza and the others who participated in drafting the Official Statements, However, made some critical changes to the disclosure in the Prior Offering for use in the Note Offerings. The changes to the disclosure principally related to the Pools' reverse repurchase position and derivative holdings. Costanza was aware of these changes and did not object to them.

First, with respect to reverse repurchase agreements, both offerings stated that "(f)rom time to time" the pools engaged in reverse repurchase transactions. The Prior Offering, however, disclosed that the Prior Pool had engaged in no reverse repurchase agreements as of the end of the prior quarter and that the maximum amount of the Prior Pool's portfolio that could be pledged under reverse repurchase agreements was 25%. In contrast, the Note Offerings only disclosed that "a significant portion" of the Pools' securities were pledged under reverse repurchase agreements but did not disclose that the Pools were leveraged by about 274% and that the Pools' investment strategy was based on such leverage. Second, with respect to derivative investments, the Prior Offering specifically disclosed the dollar amount of derivative securities held by the pool and the structure of the derivatives. In contrast, the Note Offering only disclosed the Pools' investment in fixed and floating rate securities but did not specifically disclose the Pools' dollar investment in inverse floaters.

b. Omission Of The 12% Interest Rate Cap

The Official Statements for the $600 Million Taxable Note Offering, the $111 Million Teeter Note Offering, and the $100 Million Taxable Note Offering each represented that the notes paid a variable interest rate connected to the one-month LIBOR. These Official Statements, however, failed to disclose the fact that the notes contained a 12% cap on the maximum variable interest rate that would be paid by the issuer.

The existence of the 12% interest rate cap was material to the investors, even though LIBOR never reached 12% during the term of the Notes and the interest rate cap, therefore, never limited the interest rate paid to investors. Several investors had a policy against purchasing securities that had an interest rate cap and would not have purchased the notes had they known of the interest rate cap.

Costanza knew or should have known of the interest rate cap. The existence of this interest rate cap was stated in three documents relating to the issuance of these Notes: the resolutions of the Boards of Supervisors of Orange County and the Flood Control District authorizing the issuance of the notes; the issuers' certificates stating that the amount of the offering was in compliance with state law; and the sample notes. Costanza participated in preparing the resolutions and the sample notes expressly stating the interest rate cap. Costanza also received all of these documents as part of the official transcript for each of these offerings that was provided to all professionals participating in the offering. Despite this knowledge, Costanza failed to assure that the Official Statements for the three offerings disclosed the interest rate cap.

c. Omissions Concerning The Tax-Exempt Status Of The Notes

In 1994, the County conducted four tax-exempt offerings: the $169 Million TRAN Offering; the $31 Million TRAN Offering; the $299.66 Million Pooled TRAN; and the $64 Million Teeter Note Offering (collectively, the "Tax-Exempt Offerings"). In order for interest on the notes to be tax-exempt to the investors, however, the County and the School Districts that participated in the $299.66 Million Pooled TRAN were required to conduct the offerings in compliance with the Internal Revenue Code and Treasury Regulations. If they failed to comply with these provisions, the Internal Revenue Service (the "IRS") may deem the interest on the notes to be taxable and may then seek from the investors taxes on the interest earned on the arbitrage bonds. See Harbor Bancorp & Subsidiaries v. Commissioner of Internal Revenue, 115 F.3d 722 (9th Cir. 1997), cert. denied, 118 U.S. 1035 (1998).

Costanza advised the County and the School Districts to take certain actions that had the effect of improperly increasing the size of the Tax-Exempt Offerings. As a result, there was a risk that the IRS could declare that the investors were liable for taxes on the note interest. Costanza had notice that the County's and the School Districts' actions to increase the size of the Tax-Exempt Offerings did not comply with the Internal Revenue Code and Treasury Regulations and could jeopardize the tax-exempt status of the offerings.

In each of the Tax-Exempt Offerings, Costanza, as bond counsel, issued an opinion stating that the interest on the notes was exempt from federal income tax. She also participated in drafting the Official Statements for the Tax-Exempt Offerings, which represented that the interest on the notes was tax-exempt. Costanza, however, failed to disclose in the tax opinion or the Official Statements the material information that the County and the School Districts took certain actions that had the effect of improperly increasing the size of the Tax-Exempt Offerings and that, as a result, there was a risk that the IRS could declare that the investors were liable for taxes on the note interest.

C. Legal Discussion

1. Costanza Violated Sections 17(a)(2) And (3) Of The Securities Act In The Offer And Sale Of The Notes Sections 17(a)(2) and (3) of the Securities Act make it unlawful for any person, through the means or instruments of interstate commerce or the mails, in the offer or sale of any security:

(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or

(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Scienter is not required to prove violations of Sections 17(a)(2) or (3) of the Securities Act. Aaron v. SEC, 446 U.S. 680, 697 (1980). Violations of these sections may be established by showing negligence. SEC v. Hughes Capital Corp., 124 F.3d 449, 453-54 (3d Cir. 1997); SEC v. Steadman, 967 F.2d 636, 643 n.5 (D.C. Cir. 1992). Accordingly, Costanza, through negligent conduct, violated Sections 17(a)(2) and (3) of the Securities Act in the offer and sale of the Notes.

a. The Omissions Were Material

Information about the Pools, the interest rate cap, and the tax-exempt status of the offerings were material to the Note investors. Information is material if there is a substantial likelihood that a reasonable investor in making an investment decision would consider it as having significantly altered the total mix of information made available. See Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).

Accurate and complete disclosure about the Pools was material to investors because it affected the sources of repayment for the Notes. In particular, in all of the Note Offerings, the funds pledged to repay the securities were invested in the Pools, and, in the two of the Teeter Note Offerings, the Pools guaranteed repayment of the securities. Disclosure of the interest rate cap was material to investors that had adopted policies against investing in securities with an interest rate cap. Disclosure of the risk that the tax-exempt status of the Tax-Exempt Offerings had been jeopardized was material to investors as they could have been held liable for the unpaid taxes on the interest received.

b. Costanza Should Have Known That The Official Statements Were Materially Misleading

Costanza, as bond counsel for the Note Offerings, participated in drafting the disclosure in the Official Statements for the Note Offerings that omitted material information and issued the tax opinion for the Tax-Exempt Offerings. Costanza also knew or reasonably should have known material information about the Pools, the Notes' interest rate, and the tax-exempt status of the Tax-Exempt Offerings could have been jeopardized. From participating in preparing the Official Statements and issuing the tax opinion for the Tax-Exempt Offerings, Costanza reasonably should have known that the Official Statements omitted to disclose material information that she knew or reasonably should have known about the Pools, the Notes' interest rates, and the tax exempt status of the Tax-Exempt Offerings could have been jeopardized.

2. Conclusion

Accordingly, based on the foregoing, the Commission finds that Costanza violated Sections 17(a)(2) and (3) of the Securities Act.

IV. Costanza has submitted an Offer of Settlement in which, without admitting or denying the findings herein, she consents to the Commission's entry of this Order, which: (1) makes findings, as set forth above; and (2) orders Costanza to cease and desist from committing or causing any violations and any future violations of Sections 17(a)(2) and (3) of the Securities Act.

V. In view of the foregoing, the Commission deems it appropriate to accept the Offer of Settlement submitted by Costanza. Accordingly, IT IS HEREBY ORDERED that, pursuant to Section 8A of the Securities Act, Costanza shall, effective immediately, cease and desist from committing or causing any violation and any future violation of Sections 17(a)(2) and (3) of the Securities Act.

Footnotes

-[1]-The findings herein are made pursuant to Costanza's Offer of Settlement and are not binding on any other person or entity named as a respondent in this or any other proceeding.

-[2]-Orange County, the Flood Control District, and related parties previously settled enforcement proceedings relating to the Note Offerings. See SEC v. Citron , Civil Action No. SA CV 96-0074 (C.D. Cal. Jan. 24, 1996); In re County of Orange, California , Securities Act Rel. No. 7260 (Jan. 24, 1996).

-[3]-Other participants in the Note Offerings were County officials, the issuer's financial marketing specialist, the underwriter, and disclosure counsel.

-[4]-For purposes of this section, the terms "Note Offerings" and "Notes" shall exclude the $299.66 Million Pooled TRAN Offering.

-[5]-Both rating agencies gave each of the Note Offerings the highest ratings available for a municipal note offering.

To Contents   

SEC In re Thorn, Alvis, Welch, Inc., John E. Thorn, Jr., and Derryl W. Peden, A.P. File No. 3-8400 (June 23, 1994).

The Commission announced today the issuance of an order instituting public administrative and cease-and-desist proceedings pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b), 19(h) and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Thorn, Alvis, Welch, Inc. ("TAW"), a registered broker-dealer located in Jackson, Mississippi and John E. Thorn, Jr. ("Thorn"), the president of TAW, and cease-and-desist proceedings pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act against Derryl W. Peden ("Peden") of Jackson, Mississippi, bond counsel for TAW, alleging violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by TAW, Thorn and Peden, and violations by TAW, aided and abetted by Thorn, of Section 15B(c)(1) of the Exchange Act and Rule G-17 of the Municipal Securities Rulemaking Board ("MSRB").

According to the alleging order, from August 1992 through October 1993, TAW, as underwriter, raised approximately $20 million from hundreds of investors nationwide through seven nonrated municipal urban renewal revenue bond offerings ("TAW offerings") issued by Warren County or Hinds County, Mississippi. The bonds were sold as qualified tax exempt, private activity bonds pursuant to the Internal Revenue Code ("the Code"), and financed the purchase and rehabilitation of existing low-income housing projects.

Section 147(g) of the Code provides that no more than two percent of the proceeds of such offerings can be used to finance issuance costs such as bond counsel fees and the underwriter's spread. Section 142(a) of the Code provides that at least ninety-five percent of the bond proceeds must be used to provide the financed facility. According to the allegations in the order, TAW, through Thorn and Peden, devised a scheme which utilized sham transactions to conceal the fact that bond proceeds in excess of the amounts permitted by Sections 147(g) and 142(a) of the Code were used to pay issuance costs. Thorn and Peden, on behalf of TAW, prepared the Official Statements for the TAW offerings representing that the TAW offerings were financed by bond proceeds and a cash contribution from the developer of the underlying projects. The purported contribution by the developer was disclosed in the Official Statements and was calculated based solely on the amount required to cover issuance costs in excess of amounts permitted under the Code. The order alleges that cash purportedly contributed by the developer to the TAW offerings was not paid with the developer's funds, but rather exclusively with bond proceeds, which were routed through the developer by inflating his fee.

The order further alleges that TAW, through Thorn, failed to disclose that $88,500 in commissions were paid to related parties in connection with one of the TAW offerings.

The public administrative proceedings will determine whether remedial action under Sections 15(b) and 19(h) of the Exchange Act, entry of cease-and-desist orders under Section 8A of the Securities Act and Section 21C of the Exchange Act and the imposition of civil penalties under Section 21B of the Exchange Act are appropriate and in the public interest.

In the Matter of Thorn, Alvis, Welch, Inc., John E. Thorn, Jr., and Derryl W. Peden

Order instituting public proceedings and notice of hearing pursuant to Section 8A Of the Securities Act OF 1933, and Sections 15(b), 19(h) and 21C of The Securities Exchange Act of 1934

I. The Commission's public official files disclose that:

A. Thorn, Alvis, Welch, Inc. ("TAW") is a registered broker-dealer located in Jackson, Mississippi that has been registered with the Commission pursuant to Section 15(b) of the Securities Exchange Act of 1934 ("Exchange Act") since on or about March 10, 1977.

II. As a result of an investigation, the Division of Enforcement alleges that:

BACKGROUND

A. TAW's sole place of business is in Jackson, Mississippi.

B. John E. Thorn, Jr. ("Thorn") is a resident of Jackson, Mississippi and is president and director of TAW. Thorn has been a principal of TAW since its inception.

C. Thorn has been responsible for the underwriting and the trading of municipal bonds offered and sold by TAW. Thorn's underwriting responsibilities include, among other things, assisting in the preparation of Official Statements for various municipal bond offerings.

D. Derryl W. Peden ("Peden") resides in Jackson, Mississippi. He has been a licensed attorney with the State Bar of Mississippi since 1974. Peden served as bond counsel for seven municipal bond offerings that were underwritten and offered and sold by TAW.

E. Peden, assisted by Thorn, prepared the Official Statements for the seven municipal bond offerings that were underwritten and offered and sold by TAW from August 1992 through October 1993.

F. From August 1992 through October 1993, TAW, as underwriter, raised approximately $20 million from hundreds of investors nationwide, directly and through other broker-dealers, through seven, nonrated municipal urban renewal revenue bond offerings ("TAW offerings") issued by Warren County or Hinds County, Mississippi. The bonds were sold as qualified tax exempt, private activity bonds and financed the purchase and rehabilitation of existing low-income housing projects.

G. TAW, through Thorn and Peden, offered and sold the bonds to broker-dealers and to investors as qualified tax exempt, private activity bonds. Pursuant to Section 147(g) of the Internal Revenue Code ("Code"), no more than two percent of the bond proceeds could be used to finance issuance costs such as bond counsel fees and the under-writer's spread. Pursuant to Section 142(a) of the Code, at least ninety-five percent of the bond proceeds must be used to provide the financed facility. Failure to comply with either Section 147(g) or Section 142(a) of the Code would result in the bonds losing their tax exempt status.

H. TAW, through Thorn and Peden, devised a scheme which utilized sham transactions to conceal the fact that bond proceeds in excess of the amounts permitted by Sections 147(g) and 142(a) of the Code were used for issuance costs.

I. Thorn and Peden, on behalf of TAW, prepared the Official Statements for the TAW offerings which were distributed to investors, directly and through other broker-dealers, and represented in the official statements that the TAW offerings were financed by bond proceeds and a cash contribution from the developer of the underlying projects ("developer"). The contribution from the developer was disclosed in the Sources of Funds section of the Official Statements of the TAW offerings as a "Developer's Contribution." The amount described as a Developer's Contribution was determined by Peden and Thorn for each of the TAW offerings and was based solely on the amount required to cover issuance costs which exceeded two percent of the bond proceeds of the TAW offerings. The purported Developer's Contribution was at least five percent of the bond proceeds with regard to each TAW offering.

J. Cash purportedly contributed by the developer to the TAW offerings was not paid with the developer's funds, but rather exclusively with bond proceeds. Thorn and Peden informed the developer that it would be receiving bond proceeds, in addition to those contracted for by the developer in exchange for its services, for the sole purpose of paying issuance costs, including payments to TAW and to Peden, through a Developer's Contribution. At each bond closing, TAW, through Thorn and Peden, caused the trustee to disburse additional bond proceeds to the developer in an amount equal to the amount disclosed in the Official Statements as the Developer's Contribution. The additional bond proceeds disbursed to the developer were utilized by the developer solely to pay issuance costs exceeding two percent of the bond proceeds of the TAW offerings. The use of offering proceeds to pay the purported Developer's Contribution in each offering was not disclosed to investors or prospective investors.

K. The developer was willing to proceed with the underlying projects of the TAW offerings without being paid additional bond proceeds which were to be used to pay additional issuance costs. There was no consideration given nor was there bargaining by the developer for the additional bond proceeds that it received. Moreover, the developer did not make a cash contribution from its own funds to pay additional issuance costs of any of the underlying projects of the TAW offerings.

L. Recognizing the purported Developer's Contribution as bond proceeds, approximately 7 to 9.5% of the bond proceeds of each TAW offering were used to pay issuance costs, creating a substantial risk that the TAW offerings failed to comply with the requirements of Sections 147(g) and 142(a) of the Code and that, in fact, the bonds were not tax exempt as represented in the Official Statements. TAW, through Thorn and Peden, offered and sold the TAW offering bonds to investors and to other broker-dealers as tax exempt bonds. The risk that interest on the bonds might not be tax exempt was not disclosed to investors or prospective investors in the Official Statements or otherwise.

M. TAW, through Thorn, failed to disclose in the Application of Funds section of the Official Statement of the $1,375,000 Warren County, Mississippi Urban Renewal Revenue Bonds (Sherwood Garden Apartments Project) Series 1992 that $88,500 in commissions were paid to related parties in connection with the purchase of the underlying project.

N. TAW, through Thorn and others, continues to offer, buy, and sell bonds from the TAW offerings in the aftermarket as qualified tax exempt, private activity bonds without disclosure of the substantial risk that the bonds may not be tax exempt.

O. During the period from in or about August 1992 through at least February 1994, TAW, Thorn and Peden willfully violated Section 17(a)(1) of the Securities Act of 1933 ("Securities Act") by, directly and indirectly, using the means and instruments of transportation and communication in interstate commerce and the mails to employ devices, schemes, and artifices to defraud purchasers in the offer and sale of securities, as more particularly described in Paragraphs II.A. through II.N. above.

P. During the period from in or about August 1992 through at least February 1994, TAW, Thorn and Peden willfully violated Sections 17(a)(2) and 17(a)(3) of the Securities Act by, directly and indirectly, using the means and instruments of transportation and communication in interstate commerce and the mails to obtain money and property by means of untrue statements of material facts and omissions to state material facts necessary in order to make the statements, made in light of the circumstances under which they were made, not misleading, and to engage in transactions, practices, and a course of business which operated or would have operated as a fraud and deceit upon purchasers, in the offer and sale of securities, as more particularly described in Paragraphs II.A. through II.N. above.

Q. During the period from in or about August 1992 through at least February 1994, TAW, Thorn and Peden willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, by, directly and indirectly, using the means and instrumentalities of interstate commerce and the mails: (1) to employ devices, schemes and artifices to defraud, (2) to make untrue statements of material facts and to omit to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, and (3) to engage in acts, practices, and a course of business which operated or would have operated as a fraud and deceit upon persons, in connection with the purchase and sale of securities, as more particularly described in Paragraphs II.A. through II.N. above.

R. During the period from in or about August 1992 through at least February 1994, TAW willfully violated, and Thorn willfully aided and abetted violations of, Section 15B(c)(1) of the Exchange Act, and Rule G-17 of the Municipal Securities Rulemaking Board, by, in the conduct of the municipal securities business of TAW, not dealing fairly with other persons and engaging in deceptive, dishonest and unfair practices, as more particularly described in Paragraphs II.A. through II.N. above.

III. In view of the allegations made by the Division of Enforcement, the Commission deems it necessary and appropriate in the public interest and for the protection of investors that public proceedings be instituted to determine:

A. Whether the allegations set forth in Section II. hereof are true and in connection therewith to afford TAW, Thorn and Peden the opportunity to establish any defense to such allegations;

B. What, if any, remedial action is appropriate in the public interest against TAW and Thorn pursuant to Sections 15(b) and 19(h) of the Exchange Act;

C. Whether, pursuant to Section 18A of the Securities Act and Section 21C of the Exchange Act, TAW, Thorn and Peden should be ordered to cease and desist from committing or causing violations and future violations of the statutory provisions and rules specified in Section II. hereof, whether such order should require future compliance or steps to effect future compliance with such statutory provisions and rules, and whether such order should require disgorgement, including reasonable interest; and

D. Whether, pursuant to Section 21B of the Exchange Act, civil penalties should be imposed on TAW and Thorn.

IV. IT IS ORDERED that a public hearing for the purpose of taking evidence on the questions set forth in Section III. hereof be convened not earlier than thirty (30) days and not later than sixty (60) days from service of this Order, at a time and place to be fixed, and before an Administrative Law Judge to be designated by further order, as provided by Rule 6 of the Commission's Rules of Practice.

IT IS FURTHER ORDERED that each Respondent shall file an answer to the allegations contained in this Order within fifteen (15) days after service of this Order, as provided in Rule 7 of the Commission's Rules of Practice. If any Respondent fails to file the directed answer, or fails to appear at a hearing for which proper notice has been given, such Respondent shall be deemed in default and the proceeding may be determined against such Respondent upon consideration of this Order Instituting Proceedings, the allegations of which may be deemed to be true, as provided by Rules 6 and 7 of the Commission's Rules of Practice.

This Order shall be served upon Respondents by certified mail, forthwith.

To Contents   

In re Derryl W. Peden, Exchange Act Release No. 35045 (December 2, 1994).

I. In this proceeding ordered pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"),ⁿ¹ Respondent Derryl W. Peden ("Peden") has submitted an Offer of Settlement ("Offer") which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein, except as to the jurisdiction of the Commission over him and over the subject matter of this proceeding, which is admitted, Respondent Peden by his Offer consents to the entry of findings and cease-and-desist order set forth below.

II. On the basis of this Order, the Order Instituting Public Administrative and Cease-and-Desist Proceedings and the Offer, the Commission findsⁿ² that:

1. Peden resides in Jackson, Mississippi. He has been a licensed attorney with the State Bar of Mississippi since 1974. Peden served as bond counsel for seven nonrated municipal urban renewal revenue bond offerings that were underwritten and offered between August 1, 1992 and October 1993 ("the bond offerings").

2. Peden, assisted by others, prepared the Official Statements which were the primary disclosure documents used in the bond offerings.

3. The developer of the underlying projects ("the development company") is a real estate developer and general contractor. The development company served a multi-faceted role in each of the underlying projects, acting as Project Coordinator, General Contractor and Property Manager. As Project Coordinator, the development company located existing apartment complexes to be purchased for the projects, negotiated their purchase, determined what rehabilitation and construction had to be done, and did the feasibility analysis for each project.

4. Approximately $20 million was raised from hundreds of investors nationwide through the bond offerings. The bonds were sold as qualified tax exempt, private activity bonds and financed the purchase and rehabilitation of existing low-income housing projects.

5. The bonds were offered and sold to broker-dealers and to investors as qualified tax exempt, private activity bonds. Pursuant to Section 147(g) of the Internal Revenue Code ("Code"), no more than two percent of the bond proceeds could be used to finance issuance costs such as bond counsel fees and the underwriter's spread. Pursuant to Section 142(a) of the Code, at least ninety-five percent of the bond proceeds must be used to provide the financed facility. Failure to comply with either Section 147(g) or Section 142(a) of the Code could result in the bonds losing their tax exempt status.

6. The Official Statements prepared by Peden represented that the bond projects were financed by bond proceeds and a cash contribution from the development company. The contribution from the development company was disclosed in the Sources of Funds section of the Official Statements of the bond offerings as a "Developer's Contribution." The amount described as a Developer's Contribution was determined by Peden and others for each of the bond offerings and was based solely on the amount required to cover issuance costs which exceeded two percent of the bond proceeds of the bond offerings. The purported Developer's Contribution was more than five percent of the bond proceeds with regard to each of the bond offerings. The Developer's Contribution was not paid with separate funds from the development company, but was paid exclusively with funds received from the bond proceeds by the development company. The development company received bond proceeds, in addition to those required by the development company for construction in exchange for its services, for the purpose of making the Developer's Contribution. The Developer's Contribution was utilized in each of the bond offerings solely to pay issuance costs exceeding two percent of the bond proceeds. The use by the development company of funds received from offering proceeds to pay the purported Developer's Contribution in each offering was not disclosed to investors or prospective investors.

7. The manner in which proceeds derived from the bond offerings, in amounts equivalent to approximately seven to nine percent of the proceeds of each offering, were utilized to make the purported Developer's Contribution, created a risk that the bond offerings failed to comply with the requirements of Sections 147(g) and 142(a) of the Code and the risk that, in fact, interest payments on the bonds were not tax exempt as represented in the Official Statements, which risk was not disclosed in the Official Statements.

8. During the period from in or about August 1992 through at least October 1993, Peden willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by, directly and indirectly, using the means and instrumentalities of interstate commerce and the mails: (1) to employ devices, schemes and artifices to defraud; (2) to make untrue statements of material facts and to omit to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or (3) to engage in acts, practices, and a course of business which operated or would have operated as a fraud and deceit upon persons, in connection with the purchase and sale of securities, as more particularly described in paragraphs one through seven, above.

III. In view of the foregoing, it is in the public interest to impose the sanctions specified in the Offer.

Accordingly, IT IS ORDERED THAT Respondent Peden permanently cease and desist from committing or causing any violation or future violation of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

IT IS FURTHER ORDERED that Respondent Peden disgorge to the United States Treasury within thirty days of the entry of this Order $35,000. Such payment shall be (a) made by United States postal money order, certified check, bank cashier's check or bank money order; (b) made payable to the Securities and Exchange Commission; (c) hand-delivered to the Comptroller, Securities and Exchange Commission, 450 5th Street, N.W., Washington, D.C. 20549; and (d) submitted under a cover letter which identifies Peden as the respondent in these proceedings and the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to William P. Hicks, District Trial Counsel, Atlanta District Office, Securities and Exchange Commission, 3475 Lenox Road, N.E., Suite 1000, Atlanta, Georgia 30326-1232, within thirty (30) days from the entry of this Order.

Footnotes

-[n1]-The Order Instituting Public Administrative and Cease-and-Desist Proceedings in this matter was issued on June 23, 1994. See Exchange Act Release No. 34248.

-[n2]-The findings and conclusions herein and the entry of this Order are solely for the purpose of this proceeding and are applicable only to this respondent and shall not be binding on any other person or entity named in this or any other proceeding.

To Contents   

In re Jo M. Ferguson, Securities Act Release No. 5523, A.P. File No. 3-4528 (August 21, 1974).

Jo M. Ferguson, an attorney, has submitted an offer of settlement in connection with proceedings proposed to be instituted pursuant to Rule 2(e) of the Commission's Rules of Practice.ⁿ¹ Solely for the purpose of these proceedings, respondent consents to their institution and to the findings made herein, without admitting or denying those findings, and to the sanction imposed by this order.

Accordingly, IT IS ORDERED that proceedings pursuant to Rule 2(e) of the Commission's Rules of Practice be, and they hereby are, instituted against respondent.

On the basis of the offer of settlement, it is found that respondent was bond counsel and that in addition he assumed principal legal responsibility for reviewing a prospectus (or "official statement") used in the offer and sale through the mails of $4,425,000 in City of Covington Health Care Project revenue bonds, issued in 1972 to finance the construction of a nursing home in Covington, Kentucky. It is further found that while acting in this capacity, respondent willfully aided and abetted violations of Section 17(a) of the Securities Act and Section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder in that:

1. The prospectus failed to disclose that:

a. Senex Corporation, developer of the project, had entered into a contract with a local contractor to construct the nursing home for a contract price which was $650,000 less than the price for which it had negotiated and agreed with city officials to construct the facility;

b. The purportedly independent consultant who passed on the need for and feasibility of the project had an agreement to share 50 percent of the developer's profits;

c. Two feasibility consultants, one of which had been specifically hired to render an opinion about the project, had rendered reports bearing unfavorably on the need for such a project;

d. The project's financial adviser, which received a fee of $135,000, was owned and controlled by the developer;

e. An independent securities dealer could not be found to underwrite the bonds; and

f. The financial adviser caused itself to be appointed underwriter for the issue.

2. Because of his review of the prospectus, his pre-existing relationship with the developer on other offerings of municipal bonds, and other factors which had come to his attention, respondent should have known, if he did not know, that the prospectus omitted material facts. ⁿ²

In determining to accept the offer of settlement, the Commission considered various mitigative factors, including the voluntary adoption by respondent and his firm of a number of corrective changes in the firm's procedures relative to municipal bonds, ⁿ³ and the fact that neither Ferguson nor his firm has been a respondent in prior Rule 2(e) proceedings or a defendant in an injunctive action brought by the Commission.

Accordingly, IT IS ORDERED that Jo M. Ferguson be, and he hereby is, censured.

For the Commission, by the Office of Opinions and Review, pursuant to delegated authority.

To Contents   

Underwriter's Counsel

Report under Section 21(a) of the Exchange Act

Attorney's Conduct in Issuing an Opinion Letter Without Conducting An Inquiry Of Underlying Facts Failed to Comport With Applicable Standards of Conduct, Exchange Act Release No. 17831 (June 1, 1981).

See "Bond Counsel" section.

To Contents   

Injunctive Proceedings

Securities and Exchange Commission v. Michael Goodman and Harold Tzinburg, Civ. Action No. 95CV 71563 (E.D. Mich.), Litigation Release No. 14471 (April 19, 1995) (settled injunctive order).

See "The Underwriter" section.

To Contents   

Securities and Exchange Commission v. Matthews & Wright Group, Inc., Matthews & Wright Inc., George W. Benoit, Arthur Abba Goldberg, Rodger J. Burns and Bernard M. Althoff, Civ. Action No. 89-2877 (S.D.N.Y), Litigation Release No. 12072 (April 27, 1989) (complaint).

See "The Underwriter" section.

To Contents   

Securities and Exchange Commission v. Matthews & Wright Group, Inc., Matthews & Wright Inc., George W. Benoit, Arthur Abba Goldberg, Rodger J. Burns and Bernard M. Althoff,, Litigation Release No. 12950 (August 22, 1991) (settled final order).

The Securities and Exchange Commission ("Commission") today announced that Bernard M. Althoff ("Althoff"), an attorney with a New York, New York law firm, consented to the entry of a final judgment of permanent injunction and other relief ("final judgment") with the United States District Court for the Southern District of New York. Under the terms of the settlement, Althoff consented, without admitting or denying the allegations of the Commission's Complaint, to the entry of a final judgment enjoining him against future violations of Section 17(a) of the Securities Act of 1933 ("Securities Act") and Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), and Rule 10b-5 promulgated thereunder. The final judgment also bars Althoff from appearing or practicing as an attorney before the Commission for a period of two years. The final judgment was entered with the Court on August 15, 1991.

The Complaint filed by the Commission in this matter on April 27, 1989 alleged violations by Matthews & Wright and certain of its officers of the antifraud provisions of the federal securities laws in connection with materially false and misleading statements and omissions in the offering documents for 22 issuances of $768 million worth of municipal bonds underwritten by Matthews & Wright on December 31, 1985.

The Complaint also alleged the use of false and misleading statements and omissions in the registration statement filed with the Commission in connection with an initial public offering of common stock by Matthews & Wright Group in August 1986. The Complaint alleges that Althoff served as counsel for Matthews & Wright Group during its initial public offering of common stock in August 1986. Althoff was alleged to have aided and abetted violations of the antifraud provisions of the Securities Act and Exchange Act relating to the failure of the August, 1986 Matthews & Wright Group registration statement to disclose the potential business and liability risks created by the questionable bond offerings of December 31, 1985 although he knew, or was reckless in not knowing, of the problems with the offerings. See Litigation Release 12072, April 27, 1989.

To Contents   

Trustee

Injunctive Proceedings

Securities and Exchange Commission v. Robert D. Gersh, Boston Municipal Securities, Inc., and Devonshire Escrow and Transfer Corp., Civ. Action No. 95-12580 (RCL) (D. Mass.), Litigation Release No. 14742 (November 30, 1995) (complaint); Litigation Release No. 15310 (March 31, 1997) (settled final order).

See 'The Issuer' section.

To Contents   

Accountant/Auditor

Commission Orders – Settled Administrative Proceedings

In the Matter of Ronald Blaine., Securities Act Release No. 7224, Exchange Act Release No. 36277, AAE Release No. 717, A.P. File No. 3-8828 (September 26, 1995).

I. The Commission deems it appropriate and in the public interest that public administrative proceedings be instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Ronald Blaine ("Blaine").

In anticipation of the institution of these administrative proceedings, Blaine has submitted an Offer of Settlement which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceeding brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to jurisdiction, which is admitted, Blaine consents to the entry of this Order Instituting Proceedings pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, Making Findings and Imposing a Cease and Desist Order.

Accordingly, it is ordered that proceedings pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act be, and hereby are, instituted.

II. On the basis of this Order and the Offer of Settlement submitted by Blaine, the Commission makes the following findingsⁿ¹:

Entity Involved

A. First Humanics Corp. ("First Humanics" or "the company"), a not-for-profit corporation, was in the business of acquiring, renovating and operating nursing homes. From 1984 through 1989, First Humanics renovated and operated 21 nursing homes acquired through 21 separate offerings totaling approximately $82 million in publicly sold municipal and corporate bonds. On October 15, 1987, the Economic Development Corporation of the City of Detroit, Michigan, for the benefit of First Humanics, acquired the Medicos Recovery Care Center (Medicos) through the issuance of $6,955,000 in tax-exempt bonds. This was First Humanics' last offering.

Respondent

B. Blaine was the engagement partner for First Humanics' auditor, Clifton Gunderson & Co. (Clifton). As such, Blaine was primarily responsible for auditing First Humanics' 1986 financial statements which were included as an appendix to the Medicos offering circular. This was Clifton's and Blaine's first engagement with First Humanics.

Background

C. In connection with each offering, First Humanics contracted to purchase a particular nursing home. To finance the purchase, the Company arranged for a municipality to issue tax-free municipal bonds. However, the Company remained liable for all payments to bondholders. To finance the issuance costs on certain of the above offerings, the Company also issued a modest amount of corporate bonds in conjunction with the tax-exempt bonds. Again, the Company was liable for all payments to bondholders.

D. Each prospective nursing home was initially located by Lee F. Sutliffe (Sutliffe), the undisclosed control person of First Humanics and the undisclosed promoter of First Humanics' offerings. If he decided the nursing home was acceptable for acquisition, the First Humanics Board of Directors then typically voted to acquire the facility. Subsequent to the Board's approval, Sutliffe initiated the offering process, through which First Humanics obtained the necessary funds to purchase the nursing home. In connection therewith, Sutliffe coordinated the offering process and received an acquisition fee of between $100,000 to $300,000 from each offering.

E. As part of each offering, an offering circular was also prepared with the assistance of company counsel and underwriter's counsel. The offering circular typically contained sections describing First Humanics, the nursing home to be acquired, the bonds, sources and uses of bond proceeds, risk factors and, as appendices, the Company's audited financial statements, and a feasibility study containing forecasts (prepared by other accounting firms). The primary purpose of the offering circular was to provide the investing public with all material facts pertaining to the offering.

F. At each bond closing, the municipal issuer sold the bonds to an underwriter who, in turn, re-sold them to the investing public through various retail broker-dealers. Upon receiving the bond proceeds from the underwriter, the municipal issuer either lent such proceeds to First Humanics so that the Company could purchase the nursing home, or the issuer purchased the nursing home and leased it back to the Company. A certain amount of bond proceeds were also set aside as working capital for the benefit of First Humanics.

G. Upon closing, First Humanics assumed the municipal issuer's repayment obligation to the bondholders. First Humanics was then required to make monthly bond payments to an indenture trustee sufficient for the trustee to meet semi-annual interest payments to the bondholders. At all times, however, effective control of the nursing homes remained with First Humanics. Pursuant to various bond and trust indentures, the Company was also required to allocate a certain amount of the offering proceeds to a debt service reserve fund. The debt service reserve fund was used to offset any insufficiencies in funds available for the semi-annual interest payments to bondholders. However, the Company was required to pay back any monies withdrawn from this account.

H. In addition to his promoting activities, Sutliffe also exercised considerable control over First Humanics. In fact, First Humanics' officers and Board of Directors allowed him to dictate virtually all significant First Humanics' decisions. Sutliffe also served on various First Humanics advisory sub-committees, including a management advisory sub-committee. As such, he was involved in the day-to-day operations of the nursing homes.

I. Revenues from First Humanics' nursing homes were generally paid directly to the company and, from 1984 on, First Humanics freely and openly commingled virtually all such revenues in a central bank account located in Dixon, Illinois (Dixon account). First Humanics then used the revenues from any one nursing home to pay the expenses of other nursing homes, as the need arose. Each nursing home's expenses were paid according to the urgency of the bill and not limited by the amount of revenue generated by the particular nursing home. From 1986 onward, however, most of the nursing homes failed to generate an amount of revenues sufficient to meet their own expenses. As a result, commingling became essential to the operation and survival of First Humanics. Consequently, the success or failure of any one nursing home was thereby dependent upon the success or failure of all other nursing homes. Thus, each municipal offering was, in fact, a de facto investment into First Humanics and its existing nursing homes.

J. Nonetheless, First Humanics experienced severe financial problems. As a result, Sutliffe began contributing large portions of his acquisition fees to First Humanics. During the 1986 calendar year alone, Sutliffe contributed approximately $840,000. Despite these contributions, First Humanics became late in its required monthly bond payments to the offering trustees for certain bond issues. Therefore, First Humanics (through the trustees) began using the funds from some of these delinquent nursing homes' debt service reserve accounts to offset the insufficiencies. Although First Humanics was required to pay back monies withdrawn from such accounts, these payments were often late and insufficient. First Humanics reported a $1.5 million loss for its fiscal year ended November 30, 1986, even including Sutliffe's contributions.

K. Despite First Humanics' financial problems, in early 1987, Sutliffe directed First Humanics to acquire Medicos. In connection therewith, he arranged to have the City of Detroit issue $6,955,000 in tax-exempt bonds. He also directed the Board of Directors to issue $530,000 in taxable bonds to cover the issuance expenses. Both series of bonds were issued pursuant to one offering circular.

L. The Medicos offering closed on October 15, 1987 and the municipal and corporate bonds were sold to the public through underwriters and various broker-dealers. However, the Medicos offering circular misrepresented and omitted to disclose numerous material facts including the commingling of revenues and the resulting interdependence of First Humanics' nursing homes, and Sutliffe's role as promoter and control person of First Humanics.

First Humanics' Audited Financial Statements

M. Attached to the Medicos offering circular as an appendix was First Humanics' 1986 financial statements, including supplemental nursing home schedules, audited by Clifton. Blaine, as the engagement partner, was primarily responsible for the audit of these financial statements. As such, he became aware of First Humanics' deteriorating financial condition, large and increasing losses, commingling and First Humanics' failure to pay back certain debt service reserve funds. However, First Humanics' 1986 audited financial statements failed to disclose the full impact and significance of these conditions and, therefore, the statements did not comply with the disclosure requirements of Generally Accepted Accounting Principles (GAAP). Nonetheless, Blaine permitted these audited financial statements to be included in the Medicos offering circular.

N. Specifically, although Blaine was aware of the commingling of nursing home revenues in the Dixon account and that, in many instances, individual nursing home expenses exceeded revenues, a complete disclosure was not made. Instead, the amount by which each nursing home's expenditures exceeded its revenues was characterized as a "bank overdraft." It was Blaine's decision to use that term. The bank overdraft entries made it appear that each nursing home had a separate bank account and was independent of the other nursing homes. In essence, the bank overdraft entries thereby created the impression that although certain nursing homes were experiencing financial difficulties, these problems were isolated and, therefore, unconnected to the remaining profitable nursing homes. Thus, Medicos investors were led to believe that the financial problems of the existing nursing homes were not necessarily pertinent to their ability to receive interest payments from Medicos.

O. In addition, Blaine knew that indenture trustees for at least two of the bond issues had used debt service reserve funds to pay bondholders. Blaine was also aware that First Humanics had failed to make the required payments to replenish at least one of the funds. In fact, that particular debt service reserve fund had not been repaid by the time the audited financial statements were issued. Such a failure to restore a debt service reserve fund could have constituted an event of default under the underlying bond indenture. Specifically, under the provisions of the First Humanics bond indentures, the bonds became callable upon First Humanics' failure to meet the provision requiring it to make consecutive monthly payments to replenish the debt service reserve fund after monies were withdrawn. When there is such a violation of a provision of a debt agreement for a long-term obligation (e.g., First Humanics municipal and corporate bonds) which, when not cured within a specified grace period, causes the long term obligation to become callable, GAAP requires the callable obligation to be classified as a current liability.ⁿ²Although the obligation need not be classified as a current liability if it is probable that the debtor will cure the violation, the underlying circumstances must still be disclosed. Blaine, however, did not question the classification of First Humanics' bonds in the 1986 audited financial statements as long term obligations. Further, even if it were probable that First Humanics would have cured the depletion of the debt service reserve fund, Blaine should have requested that disclosures of the underlying circumstances be made. No additional disclosure was made.

P. Finally, Blaine should have been aware of, or should have taken steps to more fully investigate, Sutliffe's role in First Humanics' management. "During the course of an audit, the auditor should be aware of the possible existence of material related party transactions that could affect the financial statements and of ... management control relationships."ⁿ³ In addition, the auditor should obtain an understanding of management responsibilities and the relationship of each component to the total entity.ⁿ⁴ There were a number of events that should have put Blaine on notice of Sutliffe's role. First and foremost was Sutliffe's substantial and continuing contributions to First Humanics. In addition, Clifton's files contained copies of minutes of First Humanics Board of Directors meetings, one of which showed Sutliffe as a member of the management executive advisory committee, and the rest of which showed his attendance at other Board meetings. In fact, Sutliffe was present at the one Board meeting that Blaine attended. In his role, Sutliffe clearly exercised significant influence over the management and operating policies of First Humanics.ⁿ⁵ Under GAAP, the transactions between First Humanics and its management (such as Sutliffe's contributions) should have been disclosed as material related party transactions. ⁿ⁶ Thus, First Humanics' 1986 audited financial statements should have included disclosures describing the nature of Sutliffe's relationship with First Humanics and a description of his contributions. ⁿ⁷ However, no such disclosures were made. Blaine did not exercise the requisite due professional care in not making the necessary inquiries to obtain an adequate understanding of Sutliffe's role in the affairs of First Humanics.

Q. Respondent Blaine caused violations of Section 17(a) of the Securities Act due to an act or omission Blaine knew or should have known would contribute to a violation of Section 17(a) of the Securities Act in that he, in the offer or sale of certain securities, namely Medicos municipal bonds and First Humanics corporate bonds described in paragraphs III.B.1. (a) and (k) above, by use of the means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly, caused the: employing of devices, schemes or artifices to defraud; obtaining of money or property by means of untrue statements of material facts or omissions to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or engaging in transactions, practices or courses of business which operated as a fraud or deceit upon purchasers or prospective purchasers. As part of the aforesaid conduct, Respondent, by allowing First Humanics' 1986 financial statements to be included in the Medicos offering circular, caused misrepresentations and omissions of material fact to be made to purchasers and prospective purchasers concerning, among other things, the commingling of revenues and the resulting interdependence of First Humanics' nursing homes, Sutliffe's role and control, and First Humanics' failure to replenish its debt service reserve fund.

R. Respondent Blaine caused violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder due to an act or omission Blaine knew or should have known would contribute to a violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder in that he, in connection with the purchase or sale of certain securities, namely Medicos municipal bonds and First Humanics corporate bonds described in paragraphs III.B.1. (a) and (k) above, by use of the means or instrumentalities of interstate commerce or by the use of the mails, directly or indirectly, caused the: employing of devices, schemes or artifices to defraud; making of untrue statements of material facts or omissions to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or engaging in acts, practices or courses of business which operated as a fraud or deceit. As part of the aforesaid conduct, Respondent, by allowing First Humanics' 1986 financial statements to be included in the Medicos offering circular, caused misrepresentations and omissions of material facts to be made to purchasers and sellers concerning, among other things, the commingling of revenues and the resulting interdependence of First Humanics' nursing homes, Sutliffe's role and control, and First Humanics' failure to replenish its debt service reserve fund.

III. In view of the foregoing, it is in the public interest to impose the sanctions agreed to in the Offer of Settlement.

Accordingly, IT IS HEREBY ORDERED THAT, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, Ronald Blaine cease and desist from committing or causing any violation, and committing or causing any future violation, of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

Footnotes

-[n1]-The findings herein are made pursuant to Blaine's Offer of Settlement and are not binding on any other person or entity named as a respondent in this or any other proceedings.

-[n2]-FAS 79, P 5

-[n3]-AICPA, Codification of Statements on Auditing Standards, AU Section 334.04 (effective after September 30, 1983).

-[n4]-Id. At AU Section 334.05.

-[n5]-SFAS 57, P24(f).

-[n6]-SFAS 57, P 1

-[n7]-SFAS 57, P 2

To Contents   

Consultants

Injunctive Proceedings

SEC v. A. L. Busby, et al. Civ. Action No. C-79-2442-M (W.D. Tenn.), Litigation Release No. 8812 (July 5, 1979) (settled final order).

Jule B. Greene, Administrator of the Atlanta Regional Office of the Securities and Exchange Commission, announced that on June 20, 1979, the Honorable Robert M. McRae, Jr., United States District Judge for the Western District of Tennessee, at Memphis, entered an order permanently enjoining A. L. Busby, individually and d/b/a ALB Company and Busby Oil Company, and Steven Grimes, individually and d/b/a Dal-Tex Supply of Tennessee, Inc., of East Tawakoni, Texas, Gayle I. Malone of Trenton and Richard T. Heagy, individually and d/b/a the Atlantic Company and Standard Reports, and Hagen H. Peters of Memphis, Tennessee, from further violations of anti-fraud provisions of the Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange Act").

The Commission's complaint alleged violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder in the offer and sale of $4.6 million in revenue bonds issued by the Gibson County Municipal Water District of Gibson County, Tennessee. The complaint alleged, among other things, that investors were not told that Busby, doing business as ALB Company, had an arrangement with the Water District to provide "advisory" services at a fee equal to 2% of the aggregate principal amount of the bond issues. The complaint also alleged that investors in the District's revenue bonds were not informed of the effects of using lower grade pipe to construct a portion of the water system, the number of customers to be served by the water system, the adequacy of funds to complete the water system, or the relationship of Busby to various construction companies and materials suppliers dealing with the District.

The defendants consented to entry of the order without admitting or denying the allegations in the complaint.

To Contents   

SEC v. The Senex Corporation, et al., Civ. Action No. 7453 (E.D. Ky.), Litigation Release No. 6451 (July 24, 1974) (complaint); 399 F. Supp. 497 (E.D. Ky. 1975); Litigation Release No. 6769 (March 5, 1975) (settled final orders); Litigation Release No. 8651 (January 23, 1979) (settled final orders).

See "Obligated Persons" section.

To Contents   

Commission Orders – Settled Administrative Proceedings

In re County of Nevada, City of Ione, Wasco Public Financing Authority, Virginia Horler and William McKay, Securities Act Release No. 7503, Exchange Act Release No. 39612, A.P. File No. 3-9542 (February 2, 1998).

See "The Issuer" section.

To Contents   

In re William McKay, Securities Act Release No. 7536, Exchange Act Release No. 40225, A.P. File No. 3-9542, (July 17, 1998).

I. The Securities and Exchange Commission ("Commission") has previously instituted a cease-and-desist proceeding pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against William McKay ("McKay" or "Respondent").ⁿ¹ McKay subsequently has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept.

II. Solely for the purpose of this proceeding and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein, except that McKay admits the jurisdiction of the Commission over him and over the subject matter of this proceeding, McKay consents to the issuance of this Order Making Findings and Imposing a Cease-and-Desist Order ("Order") and to the entry of the findings and the imposition of the relief set forth below.

III. On the basis of this Order and McKay's Offer, the Commission finds").ⁿ² the following:

A. Respondent

William McKay ("McKay"), age 69, resides in Sacramento, California, and is a real estate appraiser who does business under the name McKay & Associates.

B. Background

1. On December 20, 1990, the County of Nevadaⁿ³ issued $9.07 million in Series E-1990 Special Tax, Community Facilities District 1990-1 Bonds ("the Nevada bonds") pursuant to the California Mello-Roos Community Facilities Act of 1982, Cal. Gov. Code §§ 53311, et seq. (the "Mello-Roos Act").ⁿ⁴ On February 14, 1991, the City of Ioneⁿ⁵ issued $7.5 million in Special Tax Bonds, Community Facilities District No. 1989-2, Series 1991 ("the Ione CFD 89-2 bonds"), and on May 28, 1991, the City of Ione issued $6.55 million in Special Tax Bonds, Community Facilities District No. 1989-1, Series 1991 ("the Ione CFD 89-1 bonds"), both pursuant to the Mello-Roos Act.

The Mello-Roos Bond Act

2. The Mello-Roos Act authorizes municipalities to organize community facilities districts ("CFDs") to finance the building of infrastructure.

3. Mello-Roos bonds are paid off through special taxes levied on the property being developed. The bonds are not personal debts of the landowners or general obligations of the issuing municipality. Because they are paid off using future real property tax levies, the bonds' financial attractiveness depends upon the underlying value of the land being developed, the contemplated improvements to the land and the developer's ability to carry out the contemplated improvements.

Nature of the Value-to-Lien Ratio for a Mello-Roos Bond Financing

4. The value of the land being developed in relation to the amount of bond debt against the land constitutes the value-to-lien ratio. To determine the value of the land, a real estate appraisal is normally performed. Investors rely on the "value-to-lien" ratio to measure the creditworthiness of Mello-Roos bonds because land-secured municipal debt is often sold without a credit rating. If there is a default on a Mello-Roos bond, the issuer will foreclose on the tax lien and use the proceeds to bring the bonds current or possibly pay off the bonds to the extent funds are available to do so. Alternatively, the issuer will attempt to sell the property to another developer who will complete the project.

5. Adequate land values offer the best assurance that bondholders will receive principal and interest payments. A high value-to-lien ratio usually provides greater safety for the investor and leads to a lower interest rate for the issuer. In California during the relevant time period, a 3-to-1 value-to-lien ratio was normally required to complete a Mello-Roos bond offering.

6. The "value" securing a bond issue. and therefore the risk to investors, must be accurately disclosed in Official Statements. Otherwise, no investor can really assess the true level of risk.

C. The Nevada County Bond Offering

Formation of the Wildwood Estates District

1. Located within Nevada County is a contiguous, undeveloped, 286-acre parcel which became known as "Wildwood Estates" and which had been owned by a bankrupt entity. In early 1990, a developer purchased -- subject to final bankruptcy court approval -- Wildwood Estates for $1.98 million using funds raised through four limited partnerships.

2. To finance the development of the property, the developer requested financial assistance from the County of Nevada ("Nevada" or the "County). In February 1990, Nevada initiated the process to issue Mello-Roos bonds to finance the construction of the public improvements for Wildwood Estates. On March 20, 1990, the County Board of Supervisors ("Board") considered an application by the developer to form the Wildwood Estates Community Facilities District ("Nevada County CFD") in accordance with the Mello-Roos Act. The developer presented to the Board a three-page appraisal summary prepared by a Member of the Appraisal Institute ("MAI") valuing the property at $28 million after final completion.

McKay is Retained to Appraise Wildwood Estates

3. On March 23, 1990, the underwriter solicited proposals for the appraisal of Wildwood Estates. The appraisal was required to determine the value-to-lien ratio. Of the five appraisers solicited, two did not respond, one replied that it could not submit a bid within the time allowed, one bid $20,000 and McKay bid $4,000. At the time, McKay was already working with the underwriter on the City of Ione bond offerings (discussed below).

4. McKay was not an MAI, but he had a fee-splitting arrangement with an appraiser who was an MAI. Under this arrangement, the MAI co-signed the appraisal reports in exchange for a 10 percent cut of McKay's fees. In a letter providing McKay instructions for the appraisal, the underwriter stated that McKay should provide three separate values for the property: the "as is" value, the "bulk sale" value and the "project build-out" value. The underwriter specifically instructed McKay that the value of certain improvements (roads, utilities, recreation and other facilities) should not be included in the appraisal because these improvements would not be funded with Mello-Roos bonds.

5. On June 6, 1990, McKay prepared a two-page "preliminary appraisal," in which he valued the property based on three separate sets of assumptions. The first assumed that the property was developed as 396 single family lots, with a 22-acre parcel in the center of the project left undeveloped. The second assumed that the property was developed as 396 single family lots with the 22 acre parcel subdivided into 45 additional single family lots. The third assumed that the property was developed as 396 single family lots with the 22 acre parcel developed as 175 townhouses.

6. On June 23, 1990, McKay issued a 60-page appraisal report for Wildwood Estates. His report incorporated the same three assumptions, and the build-out values remained substantially the same. In this appraisal, McKay found values ranging from $2.98 million to $38 million. McKay also prepared a 14-page summary to be included in the Official Statement to be provided to investors. The summary appraisal only contained the three highest values, ranging from approximately $32 million to $38 million. McKay knew the summary would be included in the Official Statement and relied upon by investors to measure the security of the bonds.

The Official Statement Contains Material Misrepresentations and Omissions

7. The Nevada County Official Statement represented that the build-out value of Wildwood Estates (the estimated value for all the lots after completion of the infrastructure if sold individually to builders or homeowners) was $35,280,000. This representation was important to investors because it indicated that there would likely be adequate security in the event property owners failed to pay the special taxes needed for making principal and interest payments to the bondholders.

8. The $35,280,000 figure in the Official Statement was materially overstated by at least $4 million because it was based on the inclusion of 45 single family lots to be located on a 22-acre parcel in Wildwood Estates when, in fact, the developer had not sought -- and never received -- approval to develop that parcel into 45 single family lots. McKay also assigned a per lot value almost $10,000 higher for these 45 lots than the average value for the approved 384 lots. Without the additional $4 million, the Nevada County Bonds would not have met a 3-to-1 value-to-lien ratio (after the County issued the additional $2 million in taxable bonds necessary to complete the project) Additionally, without a clear and viable plan to develop the 22-acre parcel, the Mello-Roos tax liens against that parcel would go unpaid unless Wildwood Corp. was willing and able to pay the taxes.

9. The Nevada County Official Statement falsely stated that all comparables were cash sales when in fact some of the comparables were only listing prices. McKay's full 60-page appraisal, which the County received, disclosed the basis for his comparables. The full appraisal was not distributed to the bond investors; instead, they received a 14-page summary, which excluded this information, and had to request copies of the full appraisal from the County, the County's financial adviser, or the underwriter.

10. The Nevada County Official Statement failed to disclose that, in addition to the appraised build-out value of $35,280,000 represented in the Official Statement, the land had also been appraised using other methods of valuation which resulted in substantially lower appraised values which did not meet the 3-to-1 ratio.

D. The two City of Ione Bond Offerings

1. The City of Ione ("Ione") wanted to finance the infrastructure for a 460-acre real estate development project called Castle Oaks Country Club Estates ("Castle Oaks"), consisting of a residential subdivision, a golf course, and other recreational and commercial uses. The underwriter recommended that Ione issue two series of Mello-Roos bonds to finance the infrastructure. The first series, Ione CFD-1, was to be used to finance the development of the Castle Oaks golf course, which was to be owned by Ione, but leased to a private, for-profit operator. Because that lease arrangement would prevent that series of Mello-Roos bonds from being tax free, the Ione CFD-1 offering was delayed for several months. The second series, Ione CFD-2, was to be used to develop certain infrastructure at Castle Oaks. Because of the delay in issuing the Ione CFD-1 bonds, the Ione CFD-2 bonds were actually issued first.

2. On February 14, 1991, the Ione issued $7.5 million in Ione CFD-2 bonds under the Mello-Roos Act After the Ione CFD-2 bonds were issued, Ione noticed that the tentative map had not been drawn in conformity with the minimum lot size requirement set forth in the Development Agreement between Ione and the developer. When the lot size was recalculated, the development had only 584 single family lots rather than 667 as originally calculated.

3. On June 6, 1991, in a separate underwriting, Ione issued $6.55 million of Ione CFD-1 bonds under the Mello-Roos Act. The Ione CFD-1 Official Statement represented that the build-out value of the Castle Oaks Project was $44,906,000, an amount that appeared to satisfy the 3-to-1 value-to-lien ratio for the $14.05 million in total bonds (CFD-2 and CFD-1) then issued. The value was based on an appraisal prepared by McKay.

4. This representation was false and misleading. The $44,906,000 appraisal was almost $3 million higher than an appraisal prepared the previous year, despite the fact that in the one year intervening period the number of single family lots in the project had been reduced from 667 to 584 and real estate values in California had declined. In addition, the $44,906,000 appraisal was based on the assumption that part of the land would be developed into 90 high-density single family lots. That assumption, however, was not part of the developer's immediate plans, did not meet the required minimum square foot requirements, had not been approved, and lacked any apparent market.

5. McKay improperly disregarded the developments as planned, and instead included in his appraisal the value of improvements which were not planned, approved or financed.

E. McKay committed or caused the violation of Antifraud Provisions of the Federal Securities Laws

1. McKay's misrepresentations were material. As discussed in Section III.B. above, the value of the underlying property is the key measure of the creditworthiness of a land-secured financing. The lower the value the greater the risk inherent in the bonds. In both the Nevada and Ione CFD-1 offerings, McKay's appraisals led bond holders to falsely believe that their investments were adequately secured by the value of the real estate securing the bonds.

2. McKay's misrepresentations were "in connection with" and "in the offer or sale" of the Nevada and Ione bonds. All were designed to induce investors to purchase the Nevada and Ione CFD-1 bond issues. There was a causal nexus between the statements made and investors' decisions to buy the bonds.

3. McKay knew or recklessly disregarded the fact that the Nevada County and Ione CFD-1 Official Statements contained material misrepresentations and omissions.

4. McKay obtained money or property by means of material misstatements or omissions and engaged in a transaction, practice or course of business which operated as a fraud or deceit upon the purchasers of the Nevada and Ione CFD-1 bonds.

5. Based on the foregoing, the Commission finds that McKay committed or caused the violation of Sections 17(a)(1), (2) and (3) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

IV. Accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act and Section 21G of the Exchange Act, that McKay cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

Footnotes

-[n1]-The commission instituted the cease -and-desist proceedings on February 2, 1998. See Securities Act Rel No. 7503; Securities Exchange Act Rel No., 39612.

-[n2]- The findings herein are made pursuant to McKay's Offer and are not binding on any other person or entity in this or any other proceedings.

-[n3]-Nevada County is a political division and legal subdivision of the State of California.

-[n4]-See Article 1, Chapter 2.5, Division 2, Title 5 of the California Government Code ( 53311, et seq.)

-[n5]-The City of Ione is a political division and legal subdivision of the State of California.

To Contents   

In re Dwight Allen, Securities Act Release No. 7456, Exchange Act Release No. 39122, A.P. File No. 3-9430 (September 24, 1997).

I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that a cease-and-desist proceeding be, and hereby is, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Dwight Allen ("Allen" or "Respondent") violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

II. In anticipation of the institution of this proceeding, Allen has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein, except that Respondent admits the jurisdiction of the Commission over him and over the subject matter of this proceeding, Allen consents to the issuance of this Order Instituting Cease-and-Desist Proceeding Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order ("Order") and to the entry of the findings and the imposition of the relief set forth below.

III. On the basis of this Order and Respondent's Offer, the Commission finds¹ the following:

A. The Respondent

Dwight Allen, 51 years old, resides in Greenbrae, California. He is a certified public accountant who operates a sole proprietorship called Allen & Co. located in San Francisco, California. Allen served as the "Independent Financial Consultant" to the Wasco and Avenal Public Financing Authorities for their purchases of City of Ione Community Facilities District 1989-1 Special Tax Bonds.

B. Background

1. The Relevant Bond Legislation

a. The Marks-Roos Bond Act

The California Marks-Roos Local Bond Pool Act of 1985 ("Marks-Roos ct")² permits municipalities to organize "public financing authorities" ("PFAs") that sell bonds to the general public in order to create pools of monies which are, in turn, used to buy bonds, notes and other obligations of other public entities. Marks-Roos bonds are payable from the principal and interest of the local obligations purchased with the pool's proceeds.

Funds raised in a Marks-Roos offering must be used within a certain amount of time to purchase other local obligations. Under Section 149(f) of the Internal Revenue Code, a pooled financing is tax exempt only if the issuer reasonably expects that 95 percent of the net proceeds of the bond pool will be used within three years of the date of issuance. For this reason, bond pools generally require that all funds not applied within three years of issuance be returned to investors.

On June 1, 1989, the Avenal Public Financing Authority ("Avenal") issued $11 million in municipal bonds under the Marks-Roos Act. On September 20, 1989, the Wasco Public Financing Authority ("Wasco") issued $35 million in bonds under the Marks-Roos Act.³ The Wasco and Avenal Indentures of Trust ("Indentures") both contained a three year limitation on the placement of funds ("the origination period") and required that all funds not used within the origination period be repaid to investors.

b. The Mello-Roos Bond Act

The California Mello-Roos Community Facilities Act of 1982 ("Mello-Roos Act")⁴ authorizes cities, special districts, joint power authorities and other municipal corporations to organize community facilities districts ("CFDs") for the purpose of financing the building of infrastructure. CFDs are empowered to issue bonds secured by special taxes to finance both localized improvements such as streets and sewers, and more regional facilities, such as schools and freeway exchanges. However, the vast majority of CFDs are formed to finance the public infrastructure of real estate developments. Mello-Roos bonds are payable from special taxes levied on the property to be developed. The Mello-Roos bonds are not personal debts of the landowners or general obligations of the municipalities.

On May 28, 1991, the City of Ione issued $6.55 million in Special Tax, Community Facilities District 1989-1 Series 1991 Bonds ("the Ione CFD 89-1 bonds") pursuant to the Mello-Roos Act. ⁵

2. The Value-to-Lien Ratio for a Land-Secured Financing

The relationship between the value of the land and the amount of bond debt is referred to as the value-to-lien ratio. The land is not collateral in the sense that a default on the bonds results in the transfer of title to bondholders. Rather, adequate land values offer the best assurance that bondholders will receive principal and interest payments because, if necessary, the issuer can foreclose on the tax lien and the proceeds from the sale of the delinquent properties can be used to bring the bonds current and repay the bondholders. Special tax liens have no intrinsic value without adequate property values to support them.

Because a substantial portion of California land-secured municipal debt is sold without a credit rating, investors have relied on the value-to-lien ratio to measure the creditworthiness of a land-secured financing. The higher the ratio the lower the degree of risk to the investor and the lower the borrowing cost to the issuer in the form of a lower interest rate on the issue. In California, a 3 to 1 value-to-lien ratio served as the informal standard for a number of years. The belief was that a value-to-lien ratio of 3 to 1 offered a sufficient cushion against declines in land value as well as some protection against the uncertainties of the appraisal process itself.

The Wasco and Avenal Indentures of Trust required that a local obligation had to have a value-to-lien ratio of at least 3 to 1, a requirement the Indentures referred to as the "minimum credit requirement." To satisfy the Wasco and Avenal PFA minimum credit requirement, "the current market value of the land and improvements subject to the lien of such issue . . . , as determined by an appraisal rendered by an MAI certified real estate appraiser selected by the Authority" had to be three times the value of the special tax liens.

3. The Role of the Independent Financial Consultant

The Wasco and Avenal Indentures also required that the Authorities retain an Independent Financial Consultant to verify that a project had a value-to-lien ratio of at least 3 to 1. A local obligation could not be acquired by the Authorities without a certificate from the Independent Financial Consultant stating that the "minimum credit requirement" had been met.

An Independent Financial Consultant was defined in the Indentures as "any financial consultant or firm of such financial consultants appointed by the Authority and who, or each of whom: (a) is judged by the Authority to have experience with respect to the financing of public capital improvement projects; (b) is in fact independent and not under the domination of the Authority; (c) does not have any substantial interest, direct or indirect, with the Authority, other than as Original Purchaser; and (d) is not connected with the Authority as an officer or employee of the Authority, but who may be regularly retained to make reports to the Authority."

C. Facts

1. Limitations on the Local Obligations Wasco and Avenal Could Purchase

The Avenal and Wasco Official Statements disclosed that the bond pools had been established for the express purpose of acquiring the specific projects identified in the Official Statements. The Official Statements stated that if for some reason the money was not used for those specific projects, other public agencies could join the Authorities and participate in the bond pools, as long as their bonds satisfied the minimum credit requirement and other requirements.

2. Allen Represents that the Ione CFD 89-1 Bonds Satisfy the Minimum Credit Requirement

As of June 1991, a number of the specific projects identified in the Avenal and Wasco Official Statements had not been funded by the Authorities. As a result, the Avenal and Wasco PFAs both had millions of dollars in uncommitted funds that had to be used to acquire other projects or returned to investors upon the expiration of the three year origination period. The underwriter recommended that the Authorities consider purchasing the Ione CFD 89-1 bonds that it was then underwriting.

Based on the underwriter's recommendation, the Authorities retained Allen to act as their Independent Financial Consultant in connection with their purchases of the Ione bonds. Allen testified that he was not familiar in detail with the Marks-Roos or Mello-Roos Bond Acts. His prior experience in municipal finance was limited to verifying calculations regarding debt service coverage of bond financing. He had no experience reviewing appraisals for public capital improvement projects. Allen never spoke with anyone from the Avenal or Wasco PFAs.

Allen received the Wasco and Avenal Official Statements which contained the definitions of "minimum credit requirement" before preparing his opinion letters. He received and relied on excerpts of the Wasco and Avenal Indentures (namely, Sections 1.02, 3.05, and 3.06).

In order to prepare his June 7 and 11, 1991 opinion letters, Allen also received and relied on a May 1, 1991, appraisal which had been prepared for Ione. Avenal and Wasco had not contracted to have an appraisal prepared. The appraisal found three values for the property: raw land was $1,380,000; bulk sale value was $27,957,000; and project build out value was $44,906,000. In order to satisfy the minimum credit requirement, the "current market value of the land and improvements" had to be at least $42.15 million. The special tax liens on the property were to total $14.05 million. The raw land and bulk sale values were too low. The project build out value did not reflect the current market value, as it was an estimate of what the land might sell for once the infrastructure was completed. Allen conceded in testimony that without the built out improvements, the current market value of the property was not three times the value of the bonds. This assumes the current market value meant what the property could sell for on the May 1, 1991, appraisal date.

Allen signed two opinion letters to the Wasco and Avenal PFAs, respectively, on June 7 and 11, 1991, which stated in part: We have read Section 3.05, Section 3.06, Section 1.02 (regarding the content of this opinion) and the related definitions thereto of the Indenture of Trust. . . . We have read the terms and conditions of the Local Obligation and are qualified to render the opinion set forth below. We have made or caused to be made such examinations as is necessary to enable us to express an informed opinion with respect to the subject matter herein contained. In our opinion, the provisions of said Section 3.05 of the Indenture have been complied with.

Based on the foregoing, we express the following opinion:

The Local Obligation satisfies the Minimum Credit Requirements as required by Section 3.05(a) and as defined in the Indenture. The MAI certified real restate appraisal reflects a value of approximately 3.2 times the aggregate of Special Tax Bonds issued under the authority of the CFD 1989-1 and CFD 1989-2.

The determined value of the land and improvements is based upon the appraised build-out value as defined in the certified appraisal.

The Ione CFD 89-1 bonds did not satisfy the Indenture's requirements because the current market value of the land and improvements securing the bonds was less than $42.15 million, or three times $14.05 million.

In October 1994, the Ione CFD stopped paying principal and interest on the bonds and the City of Ione declared a default. In December 1995, the bonds were brought current through the sale of the property to an investment group.

D. Findings

During the offer and sale of the Ione CFD 89-1 bonds, Allen made representations that were false to the Wasco and Avenal PFAs. As discussed above, in his Independent Financial Consultant Certificates, Allen represented that the Ione bonds satisfied the minimum credit requirement of the Indentures.

The misrepresentations were material. The minimum credit requirement was intended to measure the creditworthiness of the bonds and to limit the risk being assumed by the Authorities and their bondholders.

The misrepresentations were "in connection with" and "in the offer or sale" of the Ione bonds.

Allen acted with scienter. Given that Allen relied solely on the appraisal to determine the current market value of the property, his conduct was reckless.

Based on the foregoing, and the Offer submitted by Respondent, the Commission finds that Allen violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

IV. Accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that Allen cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

Footnotes

-[n1]-The findings herein are made pursuant to Respondent's Offer and are not binding on any other person or entity in this or any other proceedings.

-[n2]-See Article 4, Chapter 5, Division 7 Title 1 of the California Government Code (____ 6500, et seq.)

-[n3]-The Cities of Avenal and Wasco are both located in the State of California.

-[n4]-See Article 1, Chapter 2.5, Division 2, Title 5 of the California Government Code (__ 53311, et. Seq.)

-[n5]-The City of Ione is a political division and legal subdivision of the State of Califronia. On February 7, 1991, Ione also issued $7.5 million in Special Tax, Community Facilities District 1989-2, Series 1991 Bonds pursuant to the Mello-Roos Act.

To Contents   

In re Richard Milbrodt, Securities Act Release No. 7455, Exchange Act Release No. 39121, A.P. File No. 3-9429 (September 24, 1997).

I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that a cease-and-desist proceeding be, and hereby is, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Richard Milbrodt ("Milbrodt" or "Respondent") violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

II. In anticipation of the institution of this proceeding, Milbrodt has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings contained herein, except that Respondent admits the jurisdiction of the Commission over him and over the subject matter of this proceeding, Milbrodt consents to the issuance of this Order Instituting Cease-and-Desist Proceeding Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order ("Order") and to the entry of the findings and the imposition of the relief set forth below.

III. On the basis of this Order and Respondent's Offer, the Commission findsⁿ¹ the following:

A. The Respondent

Richard Milbrodt, 64 years old, resides in Sacramento, California. He provides financial consulting services to municipalities under the name Administrative Budget Counseling. Milbrodt served as the "Independent Financial Consultant" to the Wasco and Avenal Public Financing Authorities for their purchases of Nevada County Series E-1990 Special Tax Bonds.

B. Background

1. The Relevant Bond Legislation

a. The Marks-Roos Bond Act

The California Marks-Roos Local Bond Pool Act of 1985 ("Marks-Roos Act")ⁿ² permits municipalities to organize "public financing authorities" ("PFAs") that sell bonds to the general public in order to create pools of monies which are, in turn, used to buy bonds, notes and other obligations of other public entities. Marks-Roos bonds are payable from the principal and interest of the local obligations purchased with the pool's proceeds.

Funds raised in a Marks-Roos offering must be used within a certain amount of time to purchase other local obligations. Under Section 149(f) of the Internal Revenue Code, a pooled financing is tax exempt only if the issuer reasonably expects that 95 percent of the net proceeds of the bond pool will be used within three years of the date of issuance. For this reason, bond pools generally require that all funds not applied within three years of issuance be returned to investors.

On June 1, 1989, the Avenal Public Financing Authority ("Avenal") issued $11 million in municipal bonds under the Marks-Roos Act. On September 20, 1989, the Wasco Public Financing Authority ("Wasco") issued $35 million in bonds under the Marks-Roos Act.ⁿ³ The Wasco and Avenal Indentures of Trust ("Indentures") both contained a three year limitation ("the origination period") on the placement of funds and required that all funds not used within the origination period be repaid to investors.

b. The Mello-Roos Bond Act

The California Mello-Roos Community Facilities Act of 1982 ("Mello-Roos Act")ⁿ⁴ authorizes cities, special districts, joint power authorities and other municipal corporations to organize community facilities districts ("CFDs") for the purpose of financing the building of infrastructure. Unlike public financing authorities, CFDs are formed for funding purposes only and are governed by the legislative bodies which authorize their formation. CFDs are empowered to issue bonds secured by special taxes to finance both localized improvements such as streets and sewers, and more regional facilities, such as schools and freeway exchanges. However, the vast majority of CFDs are formed to finance the public infrastructure of real estate developments. Mello-Roos bonds are payable from special taxes levied on the property to be developed. The Mello-Roos bonds are not personal debts of the landowners or general obligations of the municipalities.

On December 20, 1990, the County of Nevadaⁿ⁵ issued $9.07 million in Series E-1990 Special Tax, Community Facilities District 1990-1 Bonds ("the Nevada bonds") pursuant to the Mello-Roos Act.

2. The Value-to-Lien Ratio for a Land-Secured Financing

The relationship between the value of the land and the amount of bond debt is referred to as the value-to-lien ratio. The land is not collateral in the sense that a default on the bonds results in the transfer of title to bondholders. Rather, adequate land values offer the best assurance that bondholders will receive principal and interest payments because, if necessary, the issuer can foreclose on the tax lien and the proceeds from the sale of the delinquent properties can be used to bring the bonds current and repay the bondholders. Special tax liens have no intrinsic value without adequate property values to support them.

Because a substantial portion of California land-secured municipal debt is sold without a credit rating, investors have relied on the value-to-lien ratio to measure the creditworthiness of a land-secured financing. The higher the ratio the lower the degree of risk to the investor and the lower the borrowing cost to the issuer in the form of a lower interest rate on the issue. In California, a 3 to 1 value-to-lien ratio served as the informal standard for a number of years. The belief was that a value-to-lien ratio of 3 to 1 offered a sufficient cushion against declines in land value as well as some protection against the uncertainties of the appraisal process itself. ⁿ⁶

The "value" of the land for the purposes of the value-to-lien ratio can be measured in different ways. The Wasco and Avenal Indentures mandated that a project had to have a value-to-lien ratio of at least 3 to 1 as appraised by a member of the Appraisal Institute ("MAI") selected by the Authorities. Furthermore, the 3 to 1 ratio was based on the "current market value of the land and improvements subject to the lien" divided by the total amount of public debt secured by liens against the property. This requirement was defined in the Indentures as the "minimum credit requirement."

3. The Role of the Independent Financial Consultant

To ensure that the "minimum credit requirement" was satisfied, the Wasco and Avenal Indentures required that the Authorities retain an Independent Financial Consultant to verify that a project had a value-to-lien ratio of at least 3 to 1. A local obligation could not be acquired by the Authorities without a certificate from the Independent Financial Consultant stating that the "minimum credit requirement" had been met.

An Independent Financial Consultant was defined in the Indentures as "any financial consultant or firm of such financial consultants appointed by the Authority and who, or each of whom: (a) is judged by the Authority to have experience with respect to the financing of public capital improvement projects; (b) is in fact independent and not under the domination of the Authority; (c) does not have any substantial interest, direct or indirect, with the Authority, other than as Original Purchaser; and (d) is not connected with the Authority as an officer or employee of the Authority, but who may be regularly retained to make reports to the Authority."

C. Facts

1. Limitations on the Local Obligations Wasco and Avenal Could Purchase

The Avenal and Wasco Official Statements disclosed that the bond pools had been established for the express purpose of acquiring the specific projects identified in the Official Statements. While the Official Statements stated that Wasco and Avenal intended to and reasonably expected to purchase these projects, they noted that there could be no guarantee that any of the specified projects would be constructed and, if so, acquired by the Authorities. In such an event, they disclosed that the bond pools had been designed to allow other public agencies to join the Authorities and participate in the bond pools, as long as their bonds satisfied the minimum credit requirement, in addition to other requirements.

2. Milbrodt Represents that the Nevada Bonds Satisfy the Minimum Credit Requirement

As of December 1990, a number of the specific projects identified in the Avenal and Wasco Official Statements had not been funded by the Authorities. As a result, Avenal and Wasco both had millions of dollars in uncommitted funds in their bond pools that had to be used to acquire other projects or returned to investors prior to the expiration of the origination period. The underwriter of the Wasco and Avenal bonds recommended that the Authorities consider purchasing some of the Nevada bonds, which it also was underwriting.

Upon the underwriter's recommendation, the Authorities retained Milbrodt to act as their Independent Financial Consultant in connection with their purchases of the Nevada bonds. Milbrodt testified that he did not read the Indentures and that he was unaware of the Indentures' "minimum credit requirement." Milbrodt also testified that he did not read the Nevada Official Statement before rendering an opinion and did not know that the Nevada CFD had issued $9 million in bonds. Notwithstanding, Milbrodt issued separate certificates to Avenal and Wasco in which he represented that "we have read the terms and conditions of the Local Obligation and are qualified to render the opinion set forth below" that "the Local Obligation satisfies the Minimum Credit Requirements provided in the Indenture." After Milbrodt issued his certificates, Avenal purchased $1 million and Wasco purchased $3.5 of the Nevada bonds.

Milbrodt's certificates were false and misleading. To satisfy the "minimum credit requirement" specified in the Indentures, the land and improvements securing the Nevada bonds had to have a "current market value" that was three times the value of the special tax liens, as determined by a certified MAI appraiser selected by the Authorities. The Nevada bonds did not satisfy these requirements because the current market of value of the land and improvements was far less than three times the principal amount of the bonds.ⁿ⁷ Milbrodt had no evidence that the current market value of the property securing the Nevada bonds was anything close to that amount. In addition, the Authorities had not retained their own MAIs to appraise the property securing the Nevada bonds.

In December 1994, the Nevada CFD stopped paying principal and interest on the bonds and the County declared a default. In February 1996, the bonds were brought current through the sale of a portion of the property securing the bonds. The reserve fund, however, was not replenished. The Nevada CFD will not be able to make future principal and interest payments on the bonds unless there are additional sales of the remaining real estate securing the bonds.

D. Findings

During the offer and sale of the Nevada bonds, Milbrodt made misrepresentations to Wasco and Avenal. As discussed above, in his Independent Financial Consultant Certificates, Milbrodt falsely represented that the Nevada bonds satisfied the "minimum credit requirements" of the Indentures. As a result, Avenal and Wasco were deceived into purchasing the Nevada bonds in violation of the undertakings contained in their Indentures.

The misrepresentations were material. As discussed above, the "minimum credit requirement" was intended to measure the creditworthiness of the bonds and to limit the risk being assumed by the Authorities and their bondholders. Milbrodt's misrepresentations led the Authorities to falsely believe that the Nevada bonds were adequately secured and that the level of risk was appropriate.

The misrepresentations were "in connection with" and "in the offer or sale" of the Nevada bonds. All were designed to induce the Authorities to purchase the Nevada bonds. There was a causal nexus between Milbrodt's misrepresentations and Avenal and Wasco's decisions to purchase the bonds.

Milbrodt acted with scienter. Given that Milbrodt testified that he never received copies of the Indentures, issued his certificates without viewing the minimum credit requirement, did not know the amount of bonds issued by the Nevada CFD, yet certified that the Nevada bonds satisfied the minimum credit requirement, his conduct, at a minimum, was reckless.

Based on the foregoing, and the Offer submitted by Respondent, the Commission finds that Milbrodt violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

IV. Accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that Milbrodt cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.

Footnotes

-[n1]-The findings herein are made pursuant to Respondent's Offer and are not binding on any other person or entity in this or any other proceedings.

-[n2]-See Article 4, Chapter 5, Division 7 Title 1 of the California Government Code (____ 6500, et seq.)

-[n3]-The Cities of Avenal and Wasco are both located in the State of California.

-[n4]-See Article 1, Chapter 2.5, Dvision 2, Title 5 of the California Government Code (__ 53311, et. Seq.)

-[n5]-Nevada County is a political division and legal subdivision of the State of California.

-[n6]-In 1994, the 3 to 1 standard was enacted as state law to address investor concerns arising from the collapse in real estate values in many CFDs during the early 1990s.

-[n7]-In January 1990, the developer of the Nevada project purchased the property for $1,980,000. In a June 23, 1990 appraisal of the property, the appraiser selected by the underwriter valued the raw land at $2,980,000.

To Contents