Municipal Bond Participants - Failure to Supervise
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U.S. Securities and Exchange Commission

Municipal Bond Participants:
Failure to Supervise

Commission Orders Settled Administrative Proceedings

In re Brian M. Cohen, Exchange Act Release No. 40450, A.P. File No. 3-9708 (September 18, 1998).

I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest to institute public administrative proceedings pursuant to Sections 15(b) and 19(h) of the Securities Exchange Act of 1934 ("Exchange Act") against Respondent Brian M. Cohen ("Cohen" or "Respondent").

II. In anticipation of the institution of these proceedings, Cohen has submitted an Offer of Settlement ("Offer") which the Commission has determined to accept. Solely for the purpose of these proceedings 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 as to the jurisdiction of the Commission over Respondent and over the subject matter of this proceeding, and except as to paragraphs III.A. and III.B. below, which are admitted, Respondent Cohen, by his Offer, consents to the entry of findings and remedial sanctions set forth below.

Accordingly, it is ordered that proceedings pursuant to Sections 15(b) and 19(h) of the Exchange Act be, and, they hereby are, instituted.

III. On the basis of this Order Instituting Administrative Proceedings Pursuant To Sections 15(b) and 19(h) of the Securities Exchange Act of 1934, Making Findings and Imposing Remedial Sanctions ("Order") and Respondent's Offer, the Commission finds n1 that:

A. First Montauk Securities Corp. ("First Montauk") is, and at all relevant times was, a broker-dealer registered with the Commission, with approximately 125 branch offices and 75 offices of supervisory jurisdiction.

B. Cohen at all relevant times was a registered principal of First Montauk in its main office in Red Bank, New Jersey. Cohen is a resident of Tom's River, New Jersey.

C. First Montauk's Houston office was opened by certain individuals with prior experience trading government securities (hereafter the "Houston traders") in October 1990. The Houston office was established to sell fixed-income products, primarily REMICs and other mortgage-backed securities, to institutional clients. Prior to the opening of the Houston office, fixed-income products were a minor part of the First Montauk's business, and the firm had relatively few institutional clients. By opening the Houston branch to sell REMICs and other mortgage-backed securities, First Montauk was expanding into an area in which the firm previously had very limited experience. The Houston office was one of only three First Montauk branches that was allowed to execute their own trades. This distinct trading activity required stringent home office supervision, but First Montauk did not have procedures in place to review the Houston office's trading activity.

D. Cohen, at all relevant times a principal in First Montauk's main office in New Jersey, by reason of his greater experience in mortgage-backed securities, was delegated responsibility for supervising certain of the Houston office's operations, including the branch's trading activity.

E. At all relevant times, the Houston office had the authority to execute riskless principal transactions. The procedure required the Houston traders, who directed the Houston office's activities, to arrange and confirm both sides of each transaction, and then call the details directly in to Cohen in New Jersey. Cohen then would write an order ticket for each transaction, and provide that information to First Montauk's clearing firm.

Parking, Excessive Markups and Net Capital and Books and Records Violations

F. First Montauk did not allow the Houston office to hold positions in securities unless they received approval from the main office. In order to circumvent Respondent First Montauk's restriction on holding positions, the Houston traders engaged in a parking scheme which enabled them to purchase bonds and secretly hold them "off their books," while still maintaining control of the securities. From October 1992 through March 1994, the Houston traders parked government agency securities on at least seventeen occasions, including every month from March 1993 through March 1994.

G. The parking scheme was conceived and carried out by the Houston traders in the following manner. Whenever the Houston traders wanted to park securities, they entered into an arrangement with two other broker dealers (Dealers One and Two) whereby First Montauk would sell the bonds to Dealer One for settlement that month. Dealer One would then sell the bonds to Dealer Two for a fraction higher than it had purchased them from First Montauk. The Houston traders then caused First Montauk to repurchase the bonds from Dealer Two for settlement the next month, with Dealer Two earning a small profit on the transaction. The Houston traders used the time between settlement dates to find a customer for the bonds. The parking scheme essentially allowed the Houston traders an extra month to find a customer for securities over which they maintained control.

H. Each time the Houston traders executed a parking transaction, they filled out tickets for the sale and the repurchase from the other dealers. These trades were then called in to Cohen in New Jersey, who wrote tickets for processing by First Montauk's clearing agent. Cohen never saw the order tickets which were prepared in the Houston office. For each of the parking transactions, however, one or more of the order tickets written by Cohen contained trade dates different than the trade dates on the Houston tickets. These order tickets depicted each of the parking transactions as two separate riskless principal trades, thereby enabling the scheme to go undetected.

I. On at least seven occasions, the Houston traders used the parking scheme to manipulate the price of certain government agency securities and conceal from First Montauk and others undisclosed excessive markups charged to First Montauk customers. The excessive markups on the seven transactions alone amounted to approximately $1.85 million, of which approximately $1.66 million was paid directly to the Houston traders, while the remainder, less clearing fees, was retained by First Montauk.

J. In those instances, the Houston traders purchased bonds and marked them up significantly on the sale to Dealer One. Dealer One then marked up the securities another 1/32 or 2/32 when selling them to Dealer Two. The Houston traders would then mark up the securities another 4% 5% when selling them to First Montauk customers.

K. As a result, the Houston traders violated Section 17(a) of the Securities Act of 1933 ("Securities Act") and Section 10(b) of the Exchange Act and Rule 10b-5, thereunder.

L. In response to regulatory inquires in April 1994, the firm undertook an investigation of trading activity in the Houston office.

M. As a result of the parking scheme carried out by the Houston traders, the Houston traders aided and abetted First Montauk's violations of Sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5 and 17a-11, thereunder, by causing the firm to maintain inaccurate books and records, insofar as, the firm's books and records did not reflect the liabilities arising from the Houston traders' commitments to repurchase the securities involved, and contained incorrect valuations of the firm's positions. This conduct also caused the firm to compute its net capital inaccurately.

N. The parking scheme of the Houston traders also caused First Montauk to file inaccurate FOCUS reports with the NASD, thereby presenting to regulators a misleading picture of the firm's net worth. Furthermore, the Houston trader's scheme caused First Montauk to fail to disclose to the Commission that the firm was in net capital violation on numerous occasions.n2

Cohen's Failure to Supervise

O. Cohen failed reasonably to supervise the trading activity of the Houston branch office, which was subject to his supervision. Cohen wrote the order ticket for each transaction executed by the Houston office. Despite his responsibility for supervising the trading activity of the Houston office, Cohen failed to check the accuracy of the information he was given, failed to review the Houston office's trade blotter, failed to review the monthly or quarterly trade run or the proprietary trading account, and otherwise failed to perform a review. If he had conducted such reviews of the office's activity, he would have discovered the unusual trading patterns. Cohen also failed to act in response to other red flags. By July 1993, for example, the Houston office had repeatedly asked for permission to engage in "repurchase" transactions with other dealers and had, in fact, engaged in transactions of nearly identical blocks of bonds on numerous occasions. Despite this notice, Cohen failed to conduct a review calculated to prevent the parking scheme from continuing for another eight months.

P. Cohen also failed to perform compliance exams in accordance with First Montauk's own procedures. First Montauk's procedures state that someone from First Montauk's main office shall conduct a branch office examination at least once annually. Cohen, however, allegedly performed only one examination during the violative period. Moreover, when Cohen did perform a branch office examination, he failed to review the Houston office's trading operations.

Q. As a result of the conduct described above, Cohen failed reasonably to supervise the Houston traders who were subject to his supervision within the meaning of Section 15(b) of the Exchange Act with a view to preventing their violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5, thereunder, and their aiding and abetting violations of 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5 and 17a-11, thereunder.

IV. In view of the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer submitted by Cohen and impose the sanctions specified therein.

Accordingly, IT IS ORDERED that:

A. Cohen be, and hereby is, suspended from association with any broker or dealer for a period of four (4) months, effective on the second Monday following entry of this Order. Cohen shall provide an affidavit of compliance to the Securities and Exchange Commission, Southeast Regional Office, 1401 Brickell Avenue, Suite 200, Miami, FL 33131, within ten (10) days following the suspension period stating that he has complied fully with the terms of the suspension.

B. IT IS FURTHER ORDERED that following the period of his suspension from association, Cohen be; and hereby is, barred from association in a supervisory capacity with any broker or dealer with a right to reapply after one year to become so associated with the appropriate self-regulatory organization or, where there is none, to the Commission.

C. IT IS FURTHER ORDERED Cohen shall, within thirty (30) days of the entry of the Order, pay a civil money penalty in the amount of $5,000 to the United States Treasury. 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 or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312; and (D) submitted under cover letter that identifies Cohen as a Respondent in these proceedings, the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to David Nelson, Southeast Regional Office, Securities and Exchange Commission, 1401 Brickell Avenue, Suite 200, Miami, FL 33131.

By the Commission.

Footnotes

-[n1]- The findings contained in the Order are not binding on any other person or entity in this or any other proceeding.

-[n2]- On June 25, 1997, the Commission issued an Order, by consent, which found that First Montauk: (a) violated Sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5 and 17a-11; (b) ordered First Montauk to cease-and-desist from committing and/or causing any violation or future violation of the aforementioned sections and rules, and (c) found that First Montauk failed reasonably to supervise one or more individuals subject to its supervision within the meaning of Section 15(b) of the Exchange Act. First Montauk was also ordered to comply with various undertakings, pay disgorgement and prejudgment interest and a civil penalty.

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Administrative Proceedings Commission Decisions

In re Sheldon, et al., Exchange Act Release No. 31475, A.P. File No. 3-6626 (November 18, 1992).

See "Sales Practices" section.

In re Boettcher and Company, Exchange Act Release No. 8393, A.P. File No. 3-544 (August 30, 1968).

See "The Underwriter" section.

In re CS First Boston Corp., Jerry L. Nowlin and Douglas J. Montague, Securities Act Release No. 7498, Exchange Act Release No. 39595, A.P. File No. 3-9535 (January 29, 1998).

See "The Underwriters" section.

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In re Christopher LaPorte and Government Securities Corporation, Exchange Act Release No. 39171, A.P. File No. 3-9472 (September 30, 1997).

I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public proceedings be, and hereby are, instituted, pursuant to Sections 15(b) and 19(h) of the Securities Exchange Act of 1934 ("Exchange Act") against Christopher LaPorte ("LaPorte") and Government Securities Corporation ("GSC").

In anticipation of the institution of these proceedings, LaPorte and GSC have submitted an Offer of Settlement to the Commission, which the Commission has determined to accept. Solely for the purposes of this proceeding and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. 201.1 et seq., and, without admitting or denying the findings contained herein, except those contained in paragraphs II. A. and B., which are admitted, LaPorte and GSC consent to the issuance of this Order Instituting Proceedings, Making Findings, and Imposing Remedial Sanctions, and to the entry of the findings and the Order set forth below.

Accordingly, IT IS ORDERED that administrative proceedings pursuant to Sections 15(b) and 19(h) of the Exchange Act be, and hereby are, instituted against Christopher LaPorte and Government Securities Corporation.

II. On the basis of this Order and the Offer submitted by LaPorte and GSC the Commission findsn1 that:

A. LaPorte is a resident of Houston, Texas, and was a founder, director, president and a registered general securities principal of GSC, a broker-dealer registered with the Commission.

B. GSC (File No. 8-36869), formerly Government Securities Corporation of Texas, has been registered with the Commission as a broker-dealer since July 25, 1987. GSC, located in Houston, is owned by GSC Group, Inc., a holding company whose majority shareholder is Christopher LaPorte.

C. During the period from at least March 1989 through March 1993, three of GSC's registered representatives (other than LaPorte) and two other GSC employees willfully violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder while engaged in offering and selling to public clients certain collateralized mortgage obligation securities ("CMOs"). These CMOs were sold to public clients, including municipalities and state educational institutions, whose investment objectives stressed safety of principal, liquidity, market stability, short maturities and low risk. GSC, through its representatives, sold these clients Interest Only strips ("IOs"), Inverse IOs, and Inverse Floater CMOs. IOs and Inverse IOs are highly sensitive to changes in interest rates and prepayment speeds, and thus subject investors to risks, including loss of principal, market, extension and liquidity risks. Although Inverse Floaters provide guaranteed return of principal, these instruments are extremely sensitive to changes in interest rates and prepayment speeds and thus subject investors to various risks, including market, extension and liquidity risks.

D. To induce the public clients to purchase high-risk CMOs, three of GSC's registered representatives and two other employees made various misrepresentations and omissions to them, including the following:

1. misrepresenting the high-risk CMOs as suitable investments which were consistent with clients' objectives of safety of principal, liquidity, market stability, short duration and low risk;

2. referring to the high-risk CMOs as "Fannie Mae," "Freddie Mac," or "FNMA" securities, while omitting to disclose that the instruments were volatile CMO tranches;

3. misrepresenting the IOs and Inverse IOs as government guaranteed and that their principal was fully protected;

4. failing to disclose that the IOs and Inverse IOs carry an inherent risk of loss of principal and illiquidity;

5. failing to disclose that the market value and yield of the IOs and Inverse IOs are highly sensitive to changes in interest rates and prepayment speeds;

6. guaranteeing one public client that the client "would not lose a dime" on the Inverse IOs;

7. failing to disclose that the characteristics of the Inverse Floaters, including duration and yield, were highly sensitive to changes in interest rates;

8. failing to disclose that the Inverse Floaters were subject to extension risk of as much as 30 years;

E. In March 1994, one of the GSC registered representatives and two other GSC employees induced a public client to enter into an adjusted trade, pursuant to which GSC purchased from the client, at above-market prices, three conservative securities and sold to the public client, through numerous oral and written misrepresentations, an Inverse Floater at an undisclosed markup of more than 10 percent above market value ("March Swap").

F. One of the employees involved in the conduct set forth in Paragraphs II. C. through E. was barred by the Commission from being associated with any registered broker or dealer with the right, after one year, to reapply to become associated with a broker-dealer as a supervised employee in a non-supervisory capacity. As a consequence, he was subject to a statutory disqualification from exercising supervisory responsibility over GSC's sales personnel. In violation of Section 15(b) (6) (B) (i) of the Exchange Act, he became Sales Manager of GSC and, in 1993, he accepted a promotion to the position of Executive Vice President and Managing Director of GSC. In these positions, he was the person chiefly responsible for supervising GSC registered representatives.

III. A. GSC and LaPorte failed reasonably to supervise GSC representatives and other employees, who were subject to their supervision, within the meaning of Section 15(b) (4) of the Exchange Act, with a view toward preventing the violations described in Paragraphs II. C. through F. by the representatives of the federal securities laws, in that:

1. GSC written supervisory policies failed to designate a particular partner, officer or manager with overall supervisory responsibility and failed to provide adequate written guidance concerning responsibility for enforcing various policies and procedures, with the result that GSC supervisors often assumed that one of the other supervisors had responsibility for enforcing various policies and procedures;

2. GSC had inadequate procedures for monitoring accounts to detect unsuitable transactions;

3. GSC's policies and procedures were inadequate to control or monitor the quality of written and oral disclosure to clients concerning the characteristics and risks of CMOs.

4. LaPorte appointed a statutorily disqualified individual to act as the person chiefly responsible for supervising registered representatives. GSC and LaPorte permitted that statutorily disqualified individual to act in this capacity with nearly unfettered discretion, even though GSC and LaPorte were aware that the employee was statutorily disqualified. Moreover, GSC and LaPorte represented in an application filed with the NASD that the employee would have no supervisory duties, and agreed to provide the employee with adequate supervision. The statutorily disqualified individual was one of the GSC employees who engaged in the conduct that was violative of the federal securities laws delineated in Paragraphs II. C. through E.

5. There were ample "red flags" which were sufficient to alert LaPorte and GSC that GSC's compliance and supervisory policies were inadequate and to place any reasonable supervisor on notice of the possibility of violations of the federal securities laws. These "red flags" included, but were not limited to, the following:

a. LaPorte was aware throughout the relevant period that GSC registered representatives were offering and selling IOs, Inverse IOs, and Inverse Floaters to public clients with conservative investment objectives;

b. LaPorte was warned on several occasions by other GSC employees that the mortgage derivative securities being sold to public clients appeared to be inconsistent with the investment policies and objectives specifically delineated by these clients in written investment policies or account opening forms and were also inconsistent with certain internal GSC policies;

c. LaPorte was repeatedly warned by other GSC employees that there were unusually high concentrations of high-risk CMOs in the accounts of public clients;

d. LaPorte was aware that one of the registered representatives had repeated disagreements with one of GSC's department heads about how to present the characteristics of mortgage derivative securities in written documents;

e. LaPorte was informed, prior to the settlement of the March swap, about serious questions concerning the terms of the transaction and the oral and written representations made to the client, but did not take reasonable steps to make certain that the trade comported with the federal securities laws.

IV. As set forth in Paragraph II. F. and Paragraph III. A. 4., GSC willfully n2 violated Section 15(b) (6) (B) (ii) by permitting a statutorily disqualified individual to become and remain associated with GSC in contravention of his disqualification.

V. In view of the foregoing, the Commission deems it appropriate and in the public interest to impose the sanctions that are set forth in the Offer submitted by LaPorte and GSC.

Accordingly, IT IS ORDERED that:

A. LaPorte be, and hereby is, suspended from association with any broker, dealer, municipal securities dealer, investment adviser or investment company for a period of 12 months, effective on the second Monday following the entry of this Order. LaPorte agrees to deliver an affidavit of compliance to the Securities and Exchange Commission, Fort Worth District Office, 801 Cherry Street, Suite 1900, Fort Worth, Texas 76102, within ten (10) days following the suspension period stating that he has complied fully with the terms of the suspension; and

B. LaPorte be, and hereby is, barred from association in a supervisory capacity with any broker, dealer, investment company, investment adviser or municipal securities dealer; provided that after a period of three years LaPorte may make application to reapply to the appropriate self-regulatory organization, and where there is none, to the Commission; and

C. LaPorte shall, within 21 days of the entry of this Order, pay a civil money penalty in the amount of $50,000.00 to the United States Treasury. 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 or mailed to the Comptroller, Securities and Exchange Commission, 6432 General Green Way, Stop 0-3, Alexandria, Virginia 22312; and (D) submitted under cover letter that identifies LaPorte as a 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 Harold F. Degenhardt, the District Administrator of the Fort Worth District Office, Securities and Exchange Commission, 801 Cherry Street, Suite 1900, Fort Worth, Texas 76102; and

D. GSC shall comply with its undertaking to file a Form BDW to withdraw its registration as a broker-dealer within 21 days of the date of the Order; and

E. GSC shall, within 21 days of the entry of this Order, pay a civil money penalty in the amount of $200,000.00 to the United States Treasury. 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 or mailed to the Comptroller, Securities and Exchange Commission, 6432 General Green Way, Stop 0-3, Alexandria, Virginia 22312; and (D) submitted under cover letter that identifies GSC as a 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 Harold F. Degenhardt, the District Administrator of the Fort Worth District Office, Securities and Exchange Commission, 801 Cherry Street, Suite 1900, Fort Worth, Texas 76102.

By the Commission.

Footnotes

-[n1]- The findings herein are not binding on anyone other than Respondents.

-[n2]-In applying the term "willful" in Commission administrative proceedings instituted pursuant to Sections 15(b), 15B, 15C, 17A, 19(h) and 21B of the Securities Exchange Act, Section 9 of the Investment Company Act, and section 203 of the Investment Advisers Act, the Commission evaluates on a case-by-case basis whether the respondent knew or reasonably should have known under the particular facts and circumstances that his conduct was improper. In this case, as in all Commission administrative proceedings charging a willful violation under these statutory provisions, the Commission applies this standard to persons -- specifically, securities industry professionals -- who are directly subject to Commission jurisdiction and who have a responsibility to understand their duties to the investing public and to comply with the applicable rules and regulations which govern their behavior.

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In re Smith Barney, Inc., Exchange Act Release No. 39118, A.P. File No. 3-9426 (September 23, 1997).

See "The Underwriter Section" section.

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In re First Montauk Securities Corp., Exchange Act Release No. 38775, A.P. File No. 3-9342 (June 25, 1997).

I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest to institute public administrative and cease-and-desist proceedings pursuant to Sections 15(b), 19(h) and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Respondent First Montauk Securities Corp. ("First Montauk" or "Respondent").

II. In anticipation of the institution of these proceedings, Respondent First Montauk has submitted an Offer of Settlement ("Offer") to the Commission, 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 Respondent and over the subject matter of this proceeding and except as to Section III.A. below, which is admitted, Respondent First Montauk, by its Offer, consents to the entry of findings, remedial sanctions and cease-and-desist order set forth below.

Accordingly, IT IS ORDERED that proceedings pursuant to Sections 15(b), 19(h) and 21C of the Exchange Act be, and, they hereby are, instituted.

III. On the basis of this Order and the Offer submitted by Respondent First Montauk, the Commission finds n1 that:

A. First Montauk is, and at all relevant times was, a broker-dealer registered with the Commission, with approximately 125 branch offices and 75 offices of supervisory jurisdiction.

B. First Montauk employed at all relevant times, a registered principal in its main office in Red Bank, New Jersey ("the Supervisor").

C. First Montauk's Houston office was opened by certain individuals with prior experience trading government securities (hereafter the "Houston traders") in October 1990. The Houston office was established to sell fixed-income products, primarily REMICs and other mortgage-backed securities, to institutional clients. Prior to the opening of the Houston office, fixed-income products were a minor part of the First Montauk's business, and the firm had relatively few institutional clients. By opening the Houston branch to sell REMICs and other mortgage-backed securities, First Montauk was expanding into an area in which the firm previously had very limited experience. The Houston office was one of only three First Montauk branches that was allowed to execute its own trades. This distinct trading activity required stringent home office supervision, but First Montauk did not have procedures in place to review the Houston office's trading activity.

D. First Montauk did not effectively designate any one individual in the Houston office to supervise sales practices on a day to day basis. Among other things, the firm failed to require the Houston office to assign an individual with responsibility for supervising daily sales practices. The Supervisor, at all relevant times a principal in First Montauk's main office in New Jersey, by reason of his greater experience in mortgage-backed securities, was delegated responsibility for supervising certain of the Houston office's operations, including the branch's trading activity.

E. At all relevant times, the Houston office had the authority to execute riskless principal transactions. The procedure required the Houston traders, who directed the Houston office's activities, to arrange and confirm both sides of each transaction, and then call the details directly in to the Supervisor in New Jersey. The Supervisor then would write an order ticket for each transaction and provide that information to First Montauk's clearing firm.

Parking, Excessive Markups and Net Capital and Books and Records Violations

F. First Montauk did not allow the Houston office to hold positions in securities unless it received approval from the main office. In order to circumvent First Montauk's restriction on holding positions, the Houston traders engaged in a parking scheme which enabled them to purchase bonds and secretly hold them "off their books," while still maintaining control of the securities. From October 1992 through March 1994, the Houston traders parked government agency securities on at least seventeen occasions, including every month from March 1993 through March 1994.

G. The parking scheme was conceived and carried out by the Houston traders in the following manner. Whenever the Houston traders wanted to park securities, they entered into an arrangement with two other broker dealers (Dealers One and Two) whereby First Montauk would sell the bonds to Dealer One for settlement that month. Dealer One would then sell the bonds to Dealer Two for a fraction higher than it had purchased them from First Montauk. The Houston traders then caused First Montauk to repurchase the bonds from Dealer Two for settlement the next month, with Dealer Two earning a small profit on the transaction. The Houston traders used the time between settlement dates to find a customer for the bonds. The parking scheme essentially allowed the Houston traders an extra month to find a customer for securities over which they maintained control.

H. Each time the Houston traders executed a parking transaction, they filled out tickets for the sale and the repurchase from the other dealers. These trades were then called in to the Supervisor in New Jersey, who wrote tickets for processing by First Montauk's clearing agent. The Supervisor never saw the order tickets which were prepared in the Houston office. For each of the parking transactions, however, one or more of the order tickets written by the Supervisor contained trade dates different than the trade dates on the Houston tickets. These order tickets depicted each of the parking transactions as two separate riskless principal trades, thereby enabling the scheme to go undetected.

I. On at least seven occasions, the Houston traders used the parking scheme to manipulate the price of certain government agency securities and conceal from First Montauk and others undisclosed excessive markups charged to First Montauk customers. The excessive markups on the seven transactions alone amounted to approximately $1.85 million, of which approximately $1.66 million was paid directly to the Houston traders, while the remainder, less clearing fees, was retained by First Montauk.

J. In those instances, the Houston traders purchased bonds and marked them up significantly on the sale to Dealer One. Dealer One then marked up the securities another 1/32 or 2/32 when selling them to Dealer Two. The Houston traders would then mark up the securities another 4% 5% when selling them to First Montauk customers.

K. In response to regulatory inquiries in April 1994, the firm undertook an investigation of trading activity in the Houston office. After that date, there were no further trades in furtherance of the parking scheme described above.

L. As a result of the parking scheme carried out by the Houston traders, First Montauk failed to maintain accurate books and records, insofar as, among other things, the firm's books and records did not reflect the liabilities arising from the Houston traders' commitments to repurchase the securities involved, and contained incorrect valuations of the firm's positions. This conduct also caused the firm to compute its net capital inaccurately.

M. Proper recordation by the Houston traders of these transactions on First Montauk's books and records would have adversely affected Respondent First Montauk's computation of net capital and, in some instances, resulted in undisclosed net capital deficiencies.

N. The parking scheme of the Houston traders also caused First Montauk to file inaccurate FOCUS reports with the National Association of Securities Dealers, Inc., thereby presenting to regulators a misleading picture of the firm's net worth. Furthermore, the Houston trader's scheme caused First Montauk to fail to disclose to the Commission that the firm was in net capital violation on numerous occasions.

Misrepresentations to Escambia County, Florida

O. Escambia County (the "county") began doing business with the Houston office of First Montauk and one of the office's registered representatives ("RR") in December 1990. In connection with the offer and sale of certain complex mortgage-backed derivative securities known as REMICs, the RR misrepresented information regarding the risks of these securities. The RR also made misrepresentations regarding, among other things, the returns that the county would receive.

First Montauk's Failure to Supervise

P. First Montauk's compliance procedures were inadequate to detect the parking scheme. There was no system of follow up and review to determine if the supervisory responsibilities delegated to the Supervisor were being diligently exercised. There also was no specific procedure for anyone to review the activity in the proprietary trading account or the trade blotter for the Houston office. Such a review, on either a monthly or quarterly basis, might well have alerted the firm to the Houston office's parking scheme, its books and records violations and its net capital deficiencies.

Q. Additionally, First Montauk had inadequate procedures for conducting compliance audits. No guidance is given in First Montauk's compliance manual as to how to perform audits, nor was the Supervisor given any training. There was no specific procedure to review the branch's trade blotter, or even to determine if the branch kept one, despite the fact that the firm's compliance manual requires that every office maintain a blotter. There also were no procedures for the examiner to review any of the Houston office's records (i.e. broker's books or trade tickets). Proper procedures would have alerted the Supervisor to the parking scheme being carried out in the Houston office and the resulting excessive markups.

R. In addition to having inadequate compliance and review procedures as detailed above, First Montauk failed to effectively designate a supervisor for the Houston branch office, allowing inadequate supervision of the office's daily sales practices. Among other things, the firm failed to require the Houston office to assign an individual with responsibility for supervising daily sales practices.

Violations

S. As a result of the conduct described above, First Montauk willfully violated Sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5 and 17a-11.

T. As a result of the conduct described above, First Montauk failed reasonably to supervise one or more individuals subject to its supervision within the meaning of Section 15(b) of the Exchange Act.

IV. In view of the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer submitted by First Montauk and impose the sanctions specified therein.

Accordingly, IT IS ORDERED that:

A. Pursuant to Section 21C of the Exchange Act, First Montauk is ordered to cease and desist from committing and/or causing to commit any violation or future violation of Section 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5, and 17a-11;

B. First Montauk shall be, and hereby is, censured;

C. First Montauk shall comply with the undertakings described below:

1. First Montauk undertakes that, within thirty (30) days of the entry of the Order, First Montauk will supplement its compliance and supervisory policies and procedures to address those deficiencies raised in sections III.P. III.R. above, relating to the firm's affiliate program and the supervision of the firm's branch offices by the main office.

2. First Montauk undertakes to maintain the modified supervisory and compliance policies and procedures, as well as existing supervisory and compliance policies and procedures, except as they may be inconsistent with, or superseded by, any new policies or procedures adopted in accordance with Paragraph C.3. below;

3. First Montauk undertakes to retain, within sixty (60) days of the date of the Order, at First Montauk's expense, an Independent Consultant ("Consultant"), not unacceptable to the Commission's staff, to conduct a review of, and to report and make recommendations as to First Montauk's supervisory and compliance policies and procedures, particularly those subject matters and areas of First Montauk's operations discussed in sections III.P. III.R. above, relating to the firm's affiliate program and the supervision of the firm's branch offices by the main office.

4. First Montauk undertakes to cooperate fully with the Consultant in this review, including making such non-privileged records available, as the Consultant may reasonably request; and by permitting and requiring First Montauk's employees and agents to supply such non-privileged information as the Consultant may request for the Consultant's review.

5. At the conclusion of such review, which in no event shall be more than 120 days after the date of the retention of the Consultant, the Consultant shall submit to First Montauk a draft report ("Draft Report") which shall address the adequacy of First Montauk's policies and procedures to detect and prevent federal securities laws violations of the nature involved in this matter and shall include the Consultant's recommendations therein.

6. Within forty-five (45) days of transmittal of the Consultant's Draft Report, First Montauk shall in writing advise the Consultant of any recommendation which First Montauk has determined to accept and of any recommendation which First Montauk has determined to reject. With respect to any recommendation of the Consultant which First Montauk has rejected, First Montauk will select and set forth an alternative policy or procedure designed to achieve the same objective or purpose. With respect to the latter, First Montauk and the Consultant shall then attempt in good faith to reach agreement on any policy or procedure as to which there is a dispute.

7. Within ninety (90) days after transmittal of the Consultant's Draft Report, First Montauk shall in writing advise the Consultant of any recommendation which First Montauk and the Consultant have agreed upon and which First Montauk has determined to accept. In the event the Consultant and First Montauk are unable to agree on an alternative proposal, First Montauk shall abide by the recommendation of the Consultant.

8. The Consultant shall complete the aforementioned reviews and submit a written final report ("Final Report") thereon to First Montauk and to the Commission's staff within 330 days after the date of the Order. The Final Report shall describe the efforts undertaken by the Consultant to review First Montauk's supervisory and compliance policies and procedures, shall set forth the Consultant's recommendations, and shall specify those recommendations which have been accepted by First Montauk and those recommendations as to which there has been agreement as to an alternative policy or procedure. The Final Report shall set forth the alternative policy or procedure selected by First Montauk and agreed to by the Consultant.

9. Within sixty (60) days of transmittal of the Consultant's Final Report, First Montauk undertakes to adopt and implement all of the Consultant's recommendations or alternative policies or procedures which have been agreed upon in the Final Report.

10. Within ninety (90) days of transmittal of the Consultant's Final Report, First Montauk shall submit to the Commission's staff an Affidavit of Compliance setting forth the details of its implementation of the recommendations and accepted alternative policies or procedures contained in the Consultant's Final Report and all other undertakings set forth in Section IV. herein. For good cause shown, the Commission's staff may extend any of the procedural dates set forth above, provided that the Affidavit of Compliance is received within eighteen (18) months from the date of entry of the Order.

11. To ensure the independence of the Consultant, First Montauk: (i) shall not have the authority to terminate the Consultant, without the prior written approval of the staff of the Southeast Regional Office; (ii) shall compensate the Consultant, and persons engaged to assist the Consultant, for services rendered pursuant to this Order at their reasonable and customary rates; (iii) shall not, without prior written consent of the staff of the Southeast Regional Office, enter into any legal, business, or other financial relationship with the Consultant, any firm with which he or she is affiliated or of which he or she is a member, or any person engaged to assist the Consultant in the performance of his or her duties under this Order, during the period of their engagements and for a period of two years following the completion of their duties described in this Order; and (iv) shall not be in and shall not have an attorney-client relationship with the Consultant and shall not seek to invoke the attorney-client or any other doctrine or privilege to prevent the Consultant from transmitting any information, reports, or documents to the Commission or its staff.

D. First Montauk shall pay to the Commission, within 30 business days after the entry of the Order, (i) disgorgement in the amount of $175,458; (ii) prejudgment interest in the amount of $51,584; and (iii) a civil money penalty in the amount of $50,000. 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 Fifth Street, N.W., Washington, D.C. 20549, Mail Stop 0-3; and (d) submitted under cover letter which identifies First Montauk as a respondent in this proceeding, the file number of this proceeding, a copy of which cover letter and money order or check shall be sent to David Nelson, Southeast Regional Office, Securities and Exchange Commission, 1401 Brickell Avenue, Suite 200, Miami, FL 33131.

By the Commission.

Footnotes

-[n1]- The findings herein are made pursuant to Respondent First Montauk's Offer and are not binding on any other person or entity named as a Respondent in this or any other proceeding.

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Reinvestment of Proceeds

Injunctive Proceedings

Securities and Exchange Commission v. Rauscher Pierce Refsnes, Inc. and James R. Feltham, Civ. Action No. CV-98-0027 PHX ROS (D. Ariz.), Litigation Release No. 15613 (January 8, 1998) (complaint).

The Securities and Exchange Commission today filed a civil fraud action against Rauscher Pierce Refsnes, Inc. and its former Senior Vice President, James R. Feltham, in the United States District Court for the District of Arizona. The Commission's complaint alleges that Rauscher and Feltham defrauded their financial advisory client, the State of Arizona Department of Administration ("DOA" or the "State"), in connection with DOA's issuance of $129,640,000 of Series 1992B Refunding Certificates of Participation (the "1992B COPs"). As part of the 1992B COPs offering, the defendants allegedly sold certain United States Treasury securities (the "escrow securities") to the State at above-market prices. According to the complaint, inflating the escrow securities' prices reduced the yields on those securities and enabled Rauscher to make illegal profits at the expense of the federal government while purporting to comply with the federal tax laws governing the 1992B COPs offering, a practice commonly referred to as "yield burning." Rauscher allegedly took an undisclosed $707,037 profit on its sales to DOA. The complaint further alleges that Rauscher and Feltham failed to inform their client of this profit or that any of the sales prices of the escrow securities had been inflated. Instead, Rauscher and Feltham issued a materially false tax certification (the "Certification") in connection with the sale of the escrow securities which falsely stated that Rauscher's sale prices for the escrow securities equaled their "fair market value," that Rauscher's sale of the securities was an "arm's length transaction," and that Rauscher had priced the escrow securities without regard to the yield of those securities.

The Commission's complaint further charges that the State's ability to successfully market the 1992B COPs depended on the securities' tax-exempt status under federal law, and that the defendants' alleged overcharges in violation of applicable tax laws and regulations jeopardized the tax-exempt status of the 1992B COPs.

According to the complaint, Rauscher and Feltham charged DOA a fraudulent and excessive undisclosed markup on the escrow securities, in that the prices charged DOA for such securities were not reasonably related to prevailing market prices, and Rauscher's $707,037 profit from the sale of such securities was unreasonable in light of the circumstances surrounding the sale.

Finally, the complaint alleges that in their capacities as financial adviser and investment adviser to DOA, Rauscher and Feltham owed DOA fiduciary duties to provide DOA with complete information and unbiased advice and assistance in all aspects of the 1992B COPs offering. The defendants allegedly violated these duties by failing to disclose the conflict of interest inherent in their selling DOA the escrow securities as principal from Rauscher's own account and taking the secret $707,037 profit while at the same time purporting to give DOA independent investment advice.

The complaint requests the Court to enjoin Rauscher from violating the antifraud provisions of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1), (2), (3) of the Investment Advisers Act of 1940; to enjoin Feltham from violating Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder; and to enjoin Feltham from aiding and abetting violations of Sections 206(1), (2), and (3) of the Investment Advisers Act of 1940.

The complaint further requests the Court to order Rauscher and Feltham to disgorge the profits from their illegal conduct and to impose civil monetary penalties against them.

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SEC v. Rauscher Pierce Refsnes, Inc., James R. Feltham and Dain Rauscher Inc., 1998 U.S. Dist. LEXIS 13164 (August 24, 1998).

Opinion By: Rosyln O. Silver

Opinion: Amended Order

Background

In 1988, the Department of Administration of the State of Arizona (the "DOA") issued $121,830,000 of tax-exempt certificates of participation (the "1988 COPs") to finance the construction of six state buildings. The 1988 COPs could not be redeemed until July of 1998, and bore an average interest rate of 7.55%. In 1990, Defendant Rauscher Pierce Refsnes, Inc.n1 ("Rauscher") became the financial adviser to the DOA for lease purchases and bond transactions. Rauscher's contract was renewed by the DOA in 1991 and 1992. By 1992, interest rates had fallen well below the 7.55% the state was paying on its 1988 COPs, and Defendants recommended that the DOA take advantage of this situation by advance refunding the 1988 COPs. (Compl. P 14.) Defendants advised the DOA to issue new tax-exempt municipal securities (the "1992B COPs") bearing a lower interest rate than that of the 1988 COPs, and invest the proceeds into United States Treasury securities, to be held in an escrow account and used to make debt service payments on the 1988 COPs until they were redeemed in 1998. Id. In addition to providing the DOA with advice on the 1992B COPs offering, Defendants assigned themselves the responsibility of selling the DOA the United States Treasury securities it would buy with the proceeds from the 1992B COPs bond offering. Id. P 18.

On June 10, 1992, the underwriters of the 1992 offering priced the 1992B COPs. On that same day, Defendants purchased a portfolio of Treasury securities and priced them for delivery on June 16, 1992. Id. P 19. On June 16, 1992, the bond offering closed with the DOA issuing $129,640,000 of the 1992B COPs. The proceeds from the sale were turned over to an escrow trustee who then bought the Defendants' portfolio of United States Treasury securities. Id. Plaintiff, the Securities Exchange Commission (the "SEC"), filed a lawsuit against Defendants on January 8, 1998, alleging that during their participation in the 1992B COPs offering, Defendants violated federal securities laws by making materially false and misleading statements in connection with the sale of securities, by omitting to disclose material information that they were under a duty to disclose, and by charging their client excessive markups. Plaintiff requests that this Court order Defendants to return the profits from their allegedly illegal conduct, impose civil penalties upon Defendants, and enjoin Defendants from violating the securities laws in the future. On March 31, 1998, Defendants James Feltham and Dain Rauscher filed motions to dismiss the Amended Complaint (hereinafter "Complaint") in its entirety, pursuant to Rule 12(b) (6) for failure to state a claim upon which relief can be granted.

On August 7, 1998, the Court conducted oral argument and took the matter under advisement. The Court has resolved to deny Defendants' motions to dismiss, but also to allow Plaintiff to allege with particularity the market standard.

Legal Standard

The Ninth Circuit Court of Appeals has held that "the conditions that must be met before a motion may be granted under Fed. R. Civ. P. 12(b) (6) are quite strict." Church of Scientology of California v. Flynn, 744 F.2d 694, 695-96 (9th Cir. 1984). This Court may only dismiss the Complaint if "it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Id. at 696 (quoting Conley v. Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957)). In considering a motion to dismiss, this Court must take "as true the facts alleged in the complaint . . . drawing all reasonable inferences in the plaintiff's favor." Jackson Nat'l Life Ins. Co. v. Merrill Lynch Co., 32 F.3d 697, 699-700 (2d Cir. 1994).

Discussion

Plaintiff argues that it has adequately stated three claims in its Complaint. First, Plaintiff asserts that Defendants violated Section 17(a) of the Securities Act of 1933, 15 U.S.C. 77q(a) n2; Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78j(b), and Rule 10b-5 thereunder, 17 C.F.R. 240.10b-5n3; and Sections 206(1), (2), and (3) of the Investment Advisers Act of 1940, 15 U.S.C. 80b-6n4; by making false and misleading statements in the tax compliance certificate they issued to the DOA's bond counsel. Second, Plaintiff asserts that Defendants violated the aforementioned statutes by failing to disclose material information concerning their sale of Treasury securities to their client the DOA. Third, Plaintiff contends that Defendants violated the aforementioned statutes by failing to disclose that they were charging the DOA excessive markups on the Treasury securities they sold them. Defendants contend that Plaintiff has pled no facts in support of its allegations, and therefore, this Court must dismiss each claim pursuant to Rule 12(b) (6) for failure to state a claim. Each of Plaintiff's claims will be examined in turn.

A. Plaintiff's Claim of False and Misleading Statements

In order for Plaintiff to succeed in proving a claim of securities fraud, Plaintiff must prove that "(1) in connection with the purchase or sale of a security; (2) the defendant acting with scientern5; (3) made a material misrepresentation . . . ." Grandon v. Merrill Lynch & Co., Inc., 147 F.3d 184, 1998 U.S. App. LEXIS 13027, at *8, 1998 WL 321695, at *3 (2d Cir. 1998). Because Plaintiff's claim involves fraud, Rule 9(b) requires that "the circumstances constituting fraud or mistake, shall be stated with particularity." Fed. R. Civ. P. 9(b). This requirement of particularity "usually requires the claimant to allege at a minimum the identity of the person who made the fraudulent statement, the time, place, and content of the misrepresentation, the resulting injury, and the method by which the misrepresentation was communicated." 2 James Wm. Moore, Moore's Federal Practice 9.03[1][b] (3d ed. 1998). In addition to these minimum requirements, the Ninth Circuit has held that in order to satisfy Rule 9(b) in a securities fraud case:

plaintiff must set forth more than the neutral facts necessary to identify the transaction. The plaintiff must set forth what is false or misleading about a statement, and why it is false. In other words, the plaintiff must set forth an explanation as to why the statement or omission complained of was false or misleading.

In Re Glenfed, Inc., Secs. Litig., 42 F.3d 1541, 1548 (9th Cir. 1994) (en banc). The Ninth Circuit has explained that "a pleading is sufficient under Rule 9(b) if it identifies the circumstances of the alleged fraud so that the defendant can prepare an adequate answer." Kaplan v. Rose, 49 F.3d 1363, 1370 (9th Cir. 1994); see also Warshaw v. Xoma Corp., 74 F.3d 955, 960 (9th Cir. 1996).

There can be no question that Plaintiff has met the minimum requirements for pleading fraud. n6 The only remaining question is whether Plaintiff has adequately explained what is false about each of Defendants' statements. Plaintiff argues that its complaint adequately explains which statements were false and the reasons why each was false or misleading. Defendants argue that Plaintiff's complaint is insufficient because Plaintiff cites no facts and relies entirely on conclusory allegations of fraud to explain why Defendants' statements are false.n7 Plaintiff is only required to identify which of Defendants' statements are false or misleading, and explain why those statements were false or misleading when they were made. Plaintiff has met the burden.

Plaintiff contends that Defendants' statement that the sale of the escrow securities "was an arm's length transaction" is false and misleading because Defendants were involved on both sides of the transaction. (Compl. P 33.) Plaintiff alleges that Defendants recommended to the DOA that they buy securities, and then sold the DOA the securities they recommended it buy. Id. P 18. Plaintiff alleges that it was impossible for Defendants to truthfully state in the Certificate that the transaction was made at arm's length in light of Defendants' fiduciary relationship with the DOA and their undisclosed material financial interest in the sale of the securities. Id. P 33. Defendants argue that the statement was not false because the sale was conducted at arm's length, meaning the sale was between a willing buyer and a willing seller. (Rauscher Reply at 22.) Defendants further contend that Plaintiff's allegation that a financial adviser cannot enter into an "arm's length" transaction with an issuer client for tax purposes is contrary to the SEC and IRS regulations that existed in 1992, which allowed interested sellers to state that they sold securities in an arm's length transaction. (Rauscher Reply at 16-17.) These arguments go to Plaintiff's ultimate ability to prove this allegation, they do not establish that Plaintiff cannot, as a matter of law, prove that the statement was misleading or false.

Plaintiff's second allegation is that Defendants' statement that the escrow securities were priced "without regard to any amount paid to reduce the yield" and that "the price was no higher than the price Rauscher would have charged any other customer . . . in a transaction in which the yield on the [escrow securities] was not subject to any limitation" is false. (Compl. P 34.) Plaintiff contends that this statement is false because at the time Rauscher priced the escrow securities it knew or should have known that a positive arbitrage situation existed and priced the securities in part on the amount of the yield that was available to be burned. Id. In essence, Plaintiff alleges that Defendants did charge the DOA a higher price than they would have charged other customers because they knew the yield could be burned, and that Defendant did burn the yield.n8 Defendants argue that this charge is merely a legal conclusion couched as a factual allegation, but Plaintiff has clearly identified why the statement is false.

The other way to circumvent the yield restrictions is through the practice known as yield burning. Yield burning occurs when a seller excessively increases the price an issuer pays for securities. Id. at 4. By adding unjustified markups to the price of advance refunding escrow securities, the refunding escrow's yield is artificially depressed below what it would have been had the securities been fairly priced. Id. In other words, the yield has been burned, and the broker has cheated the Treasury out of the arbitrage profit the municipalities would have had to pay to the Treasury, had the securities been fairly priced. Id.

Plaintiff's third allegation is that Defendants' statement that the escrow securities were priced "at fair market value" is false. Id. P 32. Plaintiff contends that the statement is false because the securities were sold to the DOA at prices that exceeded "the mean of the bid and offered prices for those securities on an established market." Id. Plaintiff also contends that the statement is false because the securities were sold to the DOA at prices above the market price. Id. Plaintiff contends that if a firm charges a buyer a price higher than the market price, that firm can only claim that they sold the securities at fair market value, if the transaction was made at "arm's length without regard to any amount paid to reduce the yield on the obligation." Id. PP 17, 32. Plaintiff contends that Defendants' statement is false because Defendants charged a price above the market price in a transaction that was not made at arm's length without regard to any amount paid to reduce the yield on the obligation. Id. Defendants contend that the statement was not false because they were not issuing an opinion regarding whether the 1992B COPs would be tax exempt. (Rauscher Mot. at 24.) Defendants further contend that Treasury regulations defined "market price" as: (1) the actual price paid for the securities, if the securities are purchased in "an arm's length transaction without regard to any amount paid to reduce the yield"; or (2) the mean and bid offered prices published by appropriate publications on an established market price. Id. at 25. Plaintiff does not contend that only one definition of market value can apply; but that Defendants meet neither definition. (Compl. PP 17, 32.)

While Defendants have raised doubts concerning Plaintiff's ability to ultimately prove that a material misrepresentation was made, Defendants have not proved that Plaintiff cannot, as a matter of law, state a claim for misrepresentation under the Securities Act of 1933, 15 U.S.C. 77q(a); the Securities Exchange Act of 1934, 15 U.S.C. 78j(b), and Rule 10b-5 thereunder, 17 C.F.R. 240.10b-5; and 206(1), (2), and (3) of the Investment Advisers Act of 1940, 15 U.S.C. 80b-6.

B. Plaintiff's Omission Claim Based on Fiduciary Duty

For Plaintiff to succeed in proving an omissions claim Plaintiff must prove that "(1) in connection with the purchase or sale of a security; (2) the defendant acting with scienter n9; (3) made . . . (where there exists a duty to speak) a material omission." Grandon, 147 F.3d 184, 1998 U.S. App. LEXIS 13027, 1998 WL 321695, at *3. Plaintiff's omission claim must also be pleaded with "particularity." Fed. R. Civ. P. 9(b). In addition to these requirements, Plaintiff must also establish that Defendants had an affirmative duty to disclose the disputed information. The Supreme Court held in Basic Inc. v. Levinson, 485 U.S. 224, 239 n.17, 99 L. Ed. 2d 194, 108 S. Ct. 978 (1988), that "silence, absent a duty to disclose, is not misleading under Rule 10b-5." Even if the information that was not disclosed is deemed to be material, "there is no liability under Rule 10b-5 unless there is a duty to disclose it." Glazer v. Formica Corp., 964 F.2d 149, 156 (2d Cir. 1992).

Plaintiff alleges that Defendants had a fiduciary relationship with the DOA which arose from their contract with the DOA, their relationship with the DOA, or both. (Compl. PP 25, 26.) Plaintiff further alleges that Defendants' fiduciary relationship imposed a duty upon them to disclose all information material to the 1992 COPs issue, including all facts material to the DOA's purchase of the escrow securities. Id. P 27. Plaintiff contends that Defendants failed to disclose prior to the closing of the 1992B COPs offering that: (1) Rauscher would act as principal for its own account in selling the escrow securities to DOA; (2) Rauscher would make a substantial profit from the sale; (3) the amount of the undisclosed profit; (4) the escrow could be purchased for a lower price from other dealers; (5) the prices DOA was charged exceeded the mean of the bid and offered prices for the securities on an established market; and (6) the profit received by Rauscher could jeopardize the tax exempt status of the 1992B COPs. Id. P 28. Plaintiff asserts that these were material omissions that Defendants made knowingly, recklessly, or negligently. Id. Defendants deny that they had any statutory, regulatory, or fiduciary duty to disclose any of the aforementioned information to the DOA. (Rauscher Mot. at 13-20.) Accordingly, Defendants argue that Plaintiff's omissions claim must be dismissed because, even if the aforementioned information was material, they had no duty to disclose it to the DOA.

The Supreme Court has held that parties have a duty of disclosure to one another when a fiduciary or agency relationship exists, or when circumstances exist such that one party has placed trust and confidence in the other. See Chiarella v. United States, 445 U.S. 222, 232, 63 L. Ed. 2d 348, 100 S. Ct. 1108 (1980). The Ninth Circuit has held that in order to determine whether a party has a duty to disclose, a court must examine: (1) the relationship of the parties, (2) their relative access to information, (3) the benefit that the defendant derives from the relationship, (4) the defendant's awareness that the plaintiff was relying upon the relationship in making his investment decision, and (5) the defendant's activity in initiating the transaction. See Jett v. Sunderman, 840 F.2d 1487, 1493 (9th Cir. 1988). As part of the inquiry required by Jett, a court must look to Arizona law to determine if the relationship between the parties creates a fiduciary duty. Arizona courts have held that a fiduciary duty exists when there is a "great intimacy, disclosure of secrets, entrusting of power, and superiority of position in the case of the representative," and that "to establish a fiduciary (confidential) relationship there must be something approximating business agency, professional relationship, or family tie." Rhoads v. Harvey Publications, Inc., 145 Ariz. 142, 700 P.2d 840, 847 (Ariz. Ct. App. 1984). The Arizona Supreme Court has held that a confidential relationship exists between a client and his or her financial adviser when there is an imbalance of knowledge so that the client relies heavily on the adviser for advice. See Stewart v. Phoenix Nat'l Bank, 49 Ariz. 34, 64 P.2d 101, 106 (Ariz. 1937) (holding that a confidential relationship existed when the bank had acted as the plaintiff's financial adviser for many years and he relied upon the bank's advice). Arizona and federal courts are in agreement that generally the question of whether a fiduciary relationship exists is a question of fact. See Rhoads, 700 P.2d at 846; Firestone v. Firestone, 316 U.S. App. D.C. 152, 76 F.3d 1205, 1211 (D.C. Cir. 1996). In Rhoads, the Arizona Court of Appeals held that the question of whether a confidential relationship exists is a question of fact "provided there is sufficient evidence to submit the issue." 700 P.2d at 846. In Firestone, the D.C. Circuit held that the "existence of a fiduciary relationship is a fact-intensive question involving a searching inquiry into the nature of the relationship, the promises made, the type of services or advice given and the legitimate expectations of the parties." 76 F.3d at 1211. While Defendants raise questions concerning Plaintiff's ability to ultimately prove their material omissions claim, this Court finds that Plaintiff has alleged enough facts to state an omissions claim.

Plaintiff alleges that Defendants' financial advisory contract with the DOA created a fiduciary relationship between Defendants and the DOA. (Compl. P 25.) Plaintiff contends that the contract required Defendants to provide advice and assistance in all aspects of the issuance of the 1992B COPs. Id. Plaintiff further contends that the contract explicitly stated that the DOA would pay no expense for Defendants' services other than a financial advisory fee of $71,856 for the 1992B COP offering. Id. P 13.

Defendants deny that their contract with the DOA created a fiduciary relationship. Defendants contend that there was no fiduciary relationship between the parties because the express terms of the contract provided that each party would "act in its individual capacity and not as an agent of the other." (Rauscher Mot. at 17.) Defendants claim that this case is indistinguishable from Gateway Technologies, Inc. v. MCI Telecommunications Corp., 64 F.3d 993, 1000 (5th Cir. 1995), where the court found that contractual language similar to that found in Defendants' contract precluded a finding of fiduciary duty. Gateway is distinguishable. The contract in Gateway specifically stated that "each party shall act as an independent contractor and not as an agent for, partner of, joint venturer with the other party. The parties create no other relationship outside of that contemplated by the terms of the subcontract." Id. at 1000 (emphasis added). Further, the Fifth Circuit found, based on the relationship of the parties and the unambiguous language of the contract, "the parties intended no formal relationship which would impose fiduciary duties on MCI." Id. A close examination of the contract between the DOA and Defendants indicates that ambiguities exist, and that the contract could have created a fiduciary relationship despite the above language. Under the "Standard Terms and Conditions" portion of the contract, the contract states that "each party will act in its individual capacity and not as an agent, employee, partner, joint venturer, or associate of the other." (Rauscher Mot. Ex. A at 26.) However, "Part Two" of the contract, specifically discusses Rauscher's duties as financial adviser, states that Rauscher will "provide advice and assistance in all aspects of the lease purchase process." Id. at 13.

Defendants further argue that in addition to the contract, the confirmation forms they sent to the DOA also establish that Defendants were not acting as the DOA's agents but as principals on their own account. n10 Defendants cite Press v. Chemical Inv. Serv. Corp., 988 F. Supp. 375, 382 (S.D.N.Y. 1997) as allegedly controlling. Press involved a one time transaction where Mr. Press bought a U.S. Treasury bill worth roughly $100,000 from Chemical Investment Securities. Id. at 378. Further, the confirmation form sent by the defendant, the only contract between the parties, specifically stated that it was acting as principal. Id. at 379. In addition, the court found that Press had pleaded no facts and made only conclusory allegations to support the claim that the defendants were acting as his agent. Id. at 381. Based on those facts, the court concluded that when a confirmation form clearly establishes that no fiduciary relationship exists, a court may reject a party's conclusory allegations that such a relationship exists. n11 Id. at 382. In the instant case, Plaintiff has alleged facts to support its allegation that a fiduciary duty exists based on the contract. In addition to the contract, the parties had an ongoing business relationship which may have required Defendants to disclose, prior to the closing of the deal, that they were acting as principal in the sale of the securities. Because of the significant factual differences between Press and the instant case, this Court is not persuaded that Press controls the instant case. Assuming that the contract did not create a fiduciary relationship, contractual language does not preclude a finding that the parties' relationship gave rise to a confidential or fiduciary relationship. See Gateway, 64 F.3d at 1000 (finding that even though the contract did not create a fiduciary duty, the relationship between the parties could create such a duty).

Plaintiff alleges that Defendants' relationship gave rise to a fiduciary relationship that imposed duties on Defendants both during the issuance of the bonds and the sale of the securities. Plaintiff alleges that as DOA's financial adviser in connection with the 1992B COPs offering, Defendants assumed substantial responsibility for structuring the offering, preparing the necessary documentation, and advising the DOA regarding the allocation and investment of issue proceeds. (Compl. P 18.) Plaintiff alleges that only Rauscher had access to information concerning the prices it paid for the securities and the profit it reaped. Id. P 21. Plaintiff contends that Defendants derived substantial benefits from its relationship with the DOA. Id. P 22. Plaintiff alleges that Defendants made $707,037 on the sale of the treasury securities, in addition to their $71,856 adviser fee, and that Feltham personally made over $100,000 on the deal. Id. Plaintiff further contends that Defendants knew, or should have known, that the DOA personnel responsible for the 1992B COPs offering were inexperienced with advance refunding transactions and relied heavily on their advice. Id. P 31. As a result of their contractual duties, and the reliance of the DOA on Defendants, Plaintiff contends that Defendants had a fiduciary duty to provide the DOA with complete information and unbiased advice and assistance in all aspects of the 1992 COPs offering including the purchase of the escrow securities. Id. P 4. Plaintiff has clearly pled enough facts to satisfy the state and federal standards for determining the existence of a fiduciary relationship.

Defendants argue that even if they had a fiduciary relationship with the DOA during the 1992B COPs offering, that fiduciary duty did not extend to the separate and independent transaction of providing the DOA with the United States Treasury securities for its escrow account. Defendants contend that they made it obvious to the DOA that they were not acting as a fiduciary in the sale of the securities by disclosing on the confirmation forms that they were acting as a "dealer" in "an arm's length transaction." (Rauscher Mot. at 18.) In essence, Defendants argue that they had no duty to disclose their markup on the sale of the Treasury securities to the DOA because it was a completely independent transaction from the DOA's 1992B COPs offering. Defendants contend that because they had no duty to disclose during the second transaction, United States v. Cochran, 109 F.3d 660 (10th Cir. 1997) controls. In Cochran, the Tenth Circuit found that the absence of a "duty to disclose" was dispositive in a case involving fraud in a municipal securities transaction. Id. at 667.

Defendants' reliance on Cochran is misplaced because the facts of Cochran are distinguishable from those in the instant case.n12 First, Cochran was not acting as an investment advisor to his client, but merely as a underwriter for the bond offering. Id. at 662. Second, Cochran's client understood that underwriting the bond offering was a separate transaction from defendant's work brokering the guaranteed investment contract. Id. at 666. Third, the bond offering had already closed before the defendant brokered the guaranteed investment contract. Id. Fourth, the plaintiffs did not rely upon the defendant to advise or evaluate the guaranteed investment contract. Id. Finally, the plaintiffs admitted that Mr. Cochran did not have a fiduciary duty with them during the second transaction of negotiating the guaranteed investment contract. Id. In the instant case, Plaintiff has alleged that Defendants recommended that the DOA issue bonds in order to buy securities, they helped the DOA in all aspects of their bond offering, and, finally, they sold the DOA, after locking out all competitors, the securities at an undisclosed markup.

Whether these were indeed two separate and distinct transactions, and whether Defendants had a fiduciary duty during the sale of the securities are both questions of fact that cannot be resolved in a motion to dismiss. Further, even if Defendants are correct in asserting that their fiduciary relationship did not extend to the sale of the securities, the existence of a fiduciary relationship during the bond offering may have required them to disclose the markup information to the DOA when they notified the DOA that they would be providing the securities. See Rhoads, 700 P.2d at 845 (holding "where a relation of trust and confidence exists between two parties so that one of them places peculiar reliance in the trustworthiness of another, the latter is under a duty to make a full and truthful disclosure of all material facts and is liable for misrepresentation or concealment").

Finally, Defendants argue that the SEC and Municipal Securities Rulemaking Board ("MSRB") rules and regulations determine whether a duty to disclose existed. Defendants contend that under SEC and MSRB rules they had no statutory or regulatory duty to disclose information to the DOA regarding the markups. Defendants argue that they had no duty to disclose the markup under Rule 10b-10 because Rule 10b-10 does not apply to the sale of equity securities. (Rauscher Mot. at 14.) Defendants further contend that they had no duty to disclose the markup under MSRB Rule G-23, because Rule G-23 only imposes disclosure requirements on financial advisers when they purchase securities from their clients, not when they sell securities to their clients. Id. Defendants assert that in 1992, MSRB Rule G-23 did not even suggest that a financial adviser was required to make any specific disclosures when selling securities to an issuer. (Rauscher Reply at 10.) Defendants further contend that the absence of a full disclosure requirement in MSRB Rule G-23 can only be premised on the MSRB's view that no fiduciary relationship exists between a financial adviser and an issuer. Id. at 11. Defendants further assert that MSRB Rule G-23 establishes that an issuer and financial advisor may act as principals in relation to each other in transactions associated with an issuance so long as the financial adviser discloses its status as principal. Id.

Plaintiff does not contend that Defendants did not comply with these rules. Further, even if Defendants did comply fully with MSRB and SEC Rules, courts have held that "a broker-dealer's compliance with the disclosure requirements of Rule 10b-10 does not, as a matter of law, shield it from possible liability under Rule 10b-5." Ettinger v. Merrill Lynch, Pierce, Fenner & Smith, Inc, 835 F.2d 1031, 1036 (3d Cir. 1987) (emphasis added).

C. Plaintiff's Omission Claim Based on Excessive Markups

Plaintiff asserts that Defendants had a duty to disclose the markups because the markups were excessive. Plaintiff contends that the undisclosed markups charged by Defendants were excessive (1) in light of the circumstances surrounding the sale, and (2) because they were not reasonably related to prevailing market prices. (Compl. P 1.) Plaintiff alleges that Defendants had a duty to disclose the markups because the prices they charged were excessive in light of: (1) the existence of a fiduciary relationship; (2) the fact that Rauscher never considered or approached any other firm about providing the securities through competitive bid or negotiation; (3) the fact that Defendants assigned themselves the job of selling the securities despite an offer by the Office of the Treasurer of the State of Arizona to supply the securities; and (4) the fact that Defendants did not disclose, until after the deal had closed, that they would purchase the securities as principal for their own account. Id. P 18. Plaintiff also alleges that Defendants had a duty to disclose the markups because they knew, or should have known, that the prices were excessive because they were not reasonably related to prevailing market prices. Id. Plaintiff alleges that Defendants made an undisclosed profit of $707,037 on the sale of their securities to the DOA. Id. Plaintiff further alleges that Defendants sold the DOA thirteen different securities with markups ranging from .0236% to .7333%, with the average markup for the entire deal being .55%. Id. P 20. Finally, Plaintiff asserts that the average markup charged by dealers-brokers in sales of Treasury securities comparable to those at issue in the instant case range from zero to 2/32 (or .06%).n13 (Resp. at 28.)

Defendants, once again, contend that Plaintiff's complaint has not met the particularity requirements of Rule 9(b). Defendants contend that under the holding of Christidis v. First Pennsylvania Mortgage Trust, 717 F.2d 96, 100 (3d Cir. 1983) and Glenfed, 42 F.3d at 1549, Plaintiff must show how Defendants' actions were inconsistent with reasonable practices. Defendants would be correct if Plaintiff was asserting that a fraudulent statement about the markup had been made, Plaintiff, however, is asserting that Defendants made no statement about the markup at all. In Christidis and Glenfed, the courts addressed statements made by banks in which they estimated loan loss reserves. In both cases, the plaintiffs were alleging that statements concerning loan loss reserves were fraudulent because they were different from later statements made by the bank that contained revised loan loss figures. See Christidis, 717 F.2d at 98; Glenfed, 42 F.3d at 1543. In Glenfed, the court held "both the valuation of assets and the setting of loan loss reserves are based on flexible accounting concepts . . . plaintiff must set forth facts demonstrating why the difference between the earlier and the later statements is not merely the difference between two permissible judgements, but rather the result of falsehood." 42 F.3d at 1549. In Christidis, the court held that estimates of loan loss reserves "could be fraudulent only if, when they were established, the responsible parties knew or should have known that they were derived in a manner inconsistent with reasonable accounting practices. What those practices were and how they were departed from is nowhere set forth." 717 F.2d at 99. Because Plaintiff is asserting an omission claim, those cases do not apply. Taking all these allegations as true, and drawing all inferences in favor of Plaintiff, Plaintiff has clearly met the requirements of Rule 9(b).

Plaintiff must first establish that Defendants had an affirmative duty to disclose the markup. There can be no question that broker-dealers have an obligation under federal securities laws to disclose markups that may be deemed excessive. See SEC v. Feminella, 947 F. Supp. 722, 729 (S.D.N.Y. 1996). This duty arises because there is an implied representation by broker-dealers when they hang out their shingle to do business that they are charging their customers securities prices that are reasonably related to the prices charged in an open and competitive market. See Charles Hughes & Co. v. SEC, 139 F.2d 434, 437 (2d Cir. 1943). Broker-dealers that do not disclose that they are charging excessive markups are committing fraud. See SEC v. First Jersey, 101 F.3d 1450, 1469 (2d Cir. 1996). Thus, Defendants had a duty to disclose their markup only if it was excessive. Defendants contend that Plaintiff cannot establish a duty to disclose because the markup they charged was not excessive as a matter of law.

Plaintiff contends that the reasonableness of a markup can be determined only on the basis of the individual facts of each case. Plaintiff contends that case law has held that in order to determine whether a markup is excessive, a fact finder must assess all the relevant facts and circumstances of the transaction including: (1) the industry practice regarding the range of appropriate markups on a security in comparable transactions; (2) the availability of the security; (3) the total amount of money involved in the transaction; (4) the nature of the broker-dealer's business and the pattern of its markups; (5) the unit price of the security; (6) the nature of the services that the brokerage firm provides to the customer; and (7) the extent to which the broker-dealer was at risk in the transaction. See Feminella, 947 F. Supp. at 729. Plaintiff contends that because the determination of excessiveness depends so heavily on an extensive factual inquiry, it cannot be resolved on a motion to dismiss. In support, Plaintiff cites to Feminella where the court held:

Given the fact-specific nature of the inquiry, it is clear that there is no single, fixed definition of what constitutes an excessive markup for all transactions. Rather, the fact finder must determine whether, under all the circumstances of the transaction, the price charged for the security was reasonably related to the prevailing market price. This determination cannot reasonably be made upon a motion to dismiss. Id.

The complex nature of a securities transaction generally makes it impossible in a motion to dismiss for a court to find that a markup is or is not excessive as a matter of law. This Court, however, rejects Plaintiff's position that excessiveness can never be determined in a motion to dismiss. As Defendants correctly point out in their motion, the SEC's position is contrary to the case law which has held that some markups are either so excessive, or so minimal, that they do not need to be heard by a fact-finder at trial. See Press, 988 F. Supp. at 385 (holding that as a matter of law that a markup of 1/6 of one percent was not excessive); Grandon, 147 F.3d 184, 1998 U.S. App. LEXIS 13027, 1998 WL 321695, at *9 (holding that "we anticipate that in some cases a trial court, as a matter of law, properly may conclude that a plaintiff has failed to state a claim that the markups were excessive"). While this Court agrees that it can determine whether markups are excessive as a matter of law, it is unable to rule that the markups charged by Defendants on these motions to dismiss were not excessive as a matter of law.

Defendants basically assert that a safe harbor exists in securities law that allows for markups of 5% or below. (Rauscher Mot. at 8.) Defendants contend that, in addition to the general 5% markup policy that the National Association of Securities Dealers (the "NASD") has created for debt securities, the SEC has also provided specific guidance for broker-dealers of zero-coupon bonds. n14 Id. at 9. Defendants contend that in the Zero-Coupon Release, the SEC recognized that the industry practice was to charge markups of up to 3.5%. Id. Defendants further contend that while the SEC recognized that markups of one percent could be excessive, the clear implication of the Release was that a markup of less than one percent on the purchase price was not excessive. Id. Defendants contend that because their average markup of .55% was at the low end of the range of markups allowed under the NASD's 5% policy and the guidelines for zero-coupon securities, their markups were not excessive as a matter of law.

Defendants assert that courts have recognized that the 5% policy and the guidelines in the Zero-Coupon Release clearly foreclose this Court from finding that the .55% markup they charged in this case is excessive. Id. at 9-10. In support, Defendants rely heavily on the holding in Press. In Press, the plaintiff asserted that the defendant had charged an excessive undisclosed markup of 1/6 of one percent on a six-month Treasury bill in violation of Rule 10b-5. 988 F. Supp. at 385. In making its decision, the court relied heavily on the Zero-Coupon Release. Id. In reaching its decision that the markup was not excessive, the court stated that "simply put, the markup is indisputably at the extreme low end of what the SEC considers to be acceptable. . . . More specifically, no authority of which this court has been advised involves a markup even remotely as small as 1/6 of a percent markup at issue in this case." Id. at 385-86. In the court's opinion "'excessiveness' appears not to become a consideration in debt-security cases until markups reach the three to three and one-half percent range." Id. at 386. Finally, Defendants contend that Plaintiff cannot, just as the plaintiff in Press could not, cite to any authority that has held that a markup under the 3.5% threshold set in the Zero-Coupon Release is excessive.n15 (Rauscher Mot. at 10.)

Defendants' argument is that the NASD and the SEC guidelines have produced a safe harbor, such that a court can rule, without taking into consideration the circumstances surrounding the deal, that a markup was not excessive simply because it fell below a certain percentage is not supported by the case law. While neither the SEC nor the MSRB has adopted a numerical standard for excessiveness, "the SEC has consistently held, that in sales of equities, undisclosed markups of more than 10% above the prevailing market price violate securities law." Bank of Lexington, 959 F.2d at 606. The Commission has also "consistently . . . taken the position that mark-ups on debt securities . . . generally are expected to be lower than mark-ups on equity securities." Id.; see also SEC v. Charles A. Morris & Assoc., Inc., 386 F. Supp. 1327, 1334 (W.D. Tenn. 1973). The NASD has taken the position that a markup on securities in excess of 5% is generally excessive. See Lehl v. SEC, 90 F.3d 1483, 1487 (10th Cir. 1996). While the SEC and NASD have been willing to set a ceiling for markups, they have refused to set a floor, below which a markup can never be found excessive. The NASD has consistently stated, and courts have consistently held, that the five percent policy is not a rule, but merely a guideline. See Samuel B. Franklin & Co. v. SEC, 290 F.2d 719, 725 (9th Cir. 1961); Lehl, 90 F.3d at 1487; Bank of Lexington, 959 F.2d at 613. In Lehl, the Court explained that:

The NASD cautioned . . . that the 5% policy 'is a guide--not a rule'; that a mark-up pattern of 5% or even less may be considered unfair or unreasonable; and that in the case of certain low-priced securities, such as those selling below $10.00, a somewhat higher percentage may sometimes be justified.

90 F.3d at 1488 n.4. In other words, excessiveness depends on the circumstances surrounding the deal as well as the percentage charged. For this reason, the SEC has held that markups below five percent can be excessive. See In Re Investment Planning, Inc., 1993 WL 289728, at *2 (holding that markups on municipal bonds between 4 and 5.99% were excessive); and In Re Lehman Bros., Inc., 1996 WL 519914, at *5 (holding that markups of 3.5 to 4.7% were excessive). The SEC's Zero-Coupon Release did not eliminate the need for a court to examine a markup in light of the circumstances surrounding a transaction; it merely lowered the ceiling for acceptable markups on debt securities. n161987 WL 133877, at *15576. While Defendants correctly note that the markups they charged were towards the low end of the range listed in the Zero Coupon Release, that fact alone does not mean that their markups were not excessive. The Zero Coupon Release simply indicates that the industry practice in 1992 was to charge markups from 3 1/2 percent to 1/32 of one percent, depending on maturity, order size, and availability. Id. In other words, under some circumstances, markups as high as 3 1/2% may not be excessive, but under other circumstances markups above 1/32 of one percent may be excessive. Defendants' argument that the Zero Coupon Release clearly implied that markups below one percent could not be excessive is not persuasive. The relevant portion of the Release states:

the commission has become aware of the practice of a number of broker-dealers of charging a percentage mark-up based on the face amount of a zero-coupon security for all maturities, a pricing practice often employed in the market for conventional coupon bonds. Although this percentage may be as low as 1% of the face amount, such pricing can result in a mark-up that is excessive relative to the prevailing market price because zero-coupon bonds trade at a deep discount.

Id. at *15577 (emphasis added). There is no support in the Release for Defendants' argument that the SEC was setting one percent as a safe harbor. In fact, when the Release is read in its entirety, the exact opposite conclusion is reached. The SEC warned that a markup on zero-coupon bonds as low as one percent could be excessive because there was a practice among some brokers of charging a one percent markup. Id. There is simply no indication in the Release that the SEC was definitively stating that a markup below one percent could not also be excessive.

Defendants' argument that Press controls this case is also not persuasive. Press involved a one time transaction in which Mr. Press bought a "straight" U.S. Treasury bill worth roughly $100, 000 from Chemical Investment Securities. 988 F. Supp. at 378. The defendant charged a markup of 1/6 of 1% on the transaction. Id. The confirmation form sent by the defendant, the only contract between the parties, specifically stated that it was acting as principal. Id. Finally, the court found that "Press provided no authority for his contention that 'the industry spread' for such a markup is five times less than what the defendants charged." Id. In the instant case, Plaintiff alleges that a fiduciary duty and other circumstances surrounding the deal exist to make the markup excessive. Further, the majority of the securities sold to the DOA were zero-coupon bonds, not "straight" treasuries. In the Zero-Coupon release, the SEC warned broker-dealers that markups as low as 1% could be excessive on zero coupon securities, but made no such warning for straight treasuries.n17 1987 WL 133877, at *15577. Finally, the SEC has alleged that the markups typically charged for the refunding transactions at issue here range from zero to 2/32 of one percent (.06%). (Resp. at 28.)

In none of the cases cited by Defendants did a court rule that the markup was not excessive simply because the percentage charged was under the 5% guideline, or the guidelines of the Zero-Coupon Release. In Press, the court recognized that "the determination as to whether a given markup is or is not excessive depends on a range of factors." Id. In Banca Cremi, the Fourth Circuit Court of Appeals rejected the fraud claim not because the markup was not excessive, but because "a disclosed markup would not have mattered." Id. at 1037. Finally, in Bank of Lexington, the Sixth Circuit Court of Appeals upheld the district court's finding that the markups were not excessive because "the bank had failed to cite any evidence, besides the markup percentage, that Vining-Sparks had charged the bank an unfair price." 959 F.2d at 613.

Defendants are incorrect in stating that the SEC cannot cite to any authority that has held that a markup of less 3 1/2 percent may be excessive. The Commission held In Re Lehman Brothers, Inc., 1996 WL 519914, at *6, that markups ranging from 3.5% to 4.7% were excessive. Significantly, the Commission further held that of the approximately $1,390,000 of markups that Lehman Brothers had charged on the $38.5 million securities sale, "at least $1 million" of that was excessive. Id. The markup the SEC considered appropriate under the circumstances of the case turns out to be approximately 1.01%. Defendants contend that markup was still twice the average markup they charged the DOA. The "at least" language, however, indicates that the SEC was only offering an estimate, and that the proper markup in the case could have been much lower than one percent. Further, even if Plaintiff could not cite to a case where a court found that a markup of less than 3.5% was excessive, that does not mean that Defendants' markup was not excessive.

While Defendants' arguments raise questions concerning Plaintiff's ultimate ability to prove its omissions claim, they do not persuade this Court to rule as a matter of law that Plaintiff cannot prove that the markups were excessive under the circumstances surrounding the transaction or because they were above the prevailing market price, or both.

Defendants contend that even if the markups were excessive, they did not have fair notice in 1992 that markups of less than one percent could be excessive. Defendants contend that as late as 1993, the SEC recognized that its markup decisions had failed to give notice to the industry that markups of less than five percent were excessive. Defendants cite to In Re First Honolulu Securities, Inc., 51 S.E.C. 695, 1993 WL 380039, at *4 (Sept. 21, 1993), where the SEC held that "under all the circumstances before us here, however, it may not have been clear to applicants in 1990 that mark-ups on municipal securities of over four percent usually are unfair." Defendants further contend that in Platsis v. E.F. Hutton & Co., 946 F.2d 38, 41 (6th Cir. 1991) and Banca Cremi, 132 F.3d 1017 at 1037, courts have reached the same conclusion as the SEC in First Honolulu, that broker-dealers did not have notice that markups below five percent could be excessive.

Defendants contend that the lack of notice makes it impossible for Plaintiff to establish that Defendants acted with scienter.n18 In Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976), the Supreme Court defined scienter as "a mental state embracing intent to deceive, manipulate, or defraud." The Ninth Circuit Court of Appeals has held that in addition to knowing or intentional misconduct, recklessness may satisfy the element of scienter in a civil action for damages under Rule 10b-5. See Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990). The Ninth Circuit has held that:

Reckless conduct may be defined as a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.

Id. (quoting Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977), cert denied, 434 U.S. 875, 54 L. Ed. 2d 155, 98 S. Ct. 224, 98 S. Ct. 225 (1977)). Defendants contend that the most precise markup guidance available in June of 1992 was the SEC's Zero-Coupon Release and the NASD's 5% policy. (Rauscher Mot. at 12.) Defendants assert that because no guidance in 1992 even suggested that a markup of less than 1 percent could be fraudulent, their markups of .0266 to .73 of one percent could not have been excessive. Defendants contend that if they had no notice that their markups were excessive, then under no circumstance could their actions have been an extreme departure from the prevailing standards necessary to find scienter. Defendants also assert that the retroactive application of a new standard violates due process. Defendants contend that even if the SEC now considers markups in excess of .06 of one percent to be excessive, no one in the industry was on notice in 1992 that such standards would be applied rather than those in the Zero-Coupon Release. (Rauscher Reply at 7.)

Once again, Defendants' arguments raise questions of fact. At trial, or the summary judgement stage, Defendants may be able to argue that there was no industry practice of charging less than a one percent markup, that the industry had no notice that markups of less than one percent could be excessive, and that they did not have the necessary mental state to satisfy the scienter requirement; but, in this motion, those arguments are not well-taken. The cases cited by Defendants do no more than raise material issues of fact, they do not settle the issue. Plaintiff alleges that the industry practice was to charge between zero and 2/32 of one percent markup on transactions comparable to those at issue in this case. (Resp. at 28.) Plaintiff further alleges that the markups changed by Defendants ranged from .02 of one percent to .77 of one percent. (Compl. P 20.) These allegations, taken as true, could potentially allow a reasonable trier of fact to find that scienter existed.

Defendants' due process claim must also fail because Plaintiff asserts that in 1992 the industry standard was to charge between zero and 2/32 of one percent for transactions like the one in question. (Resp. at 28.) A new standard is not being applied retroactively; Plaintiff is asserting that the same standard has existed all along. If this standard did exist as Plaintiff alleges, then people within the industry obviously knew that the SEC could sue those broker-dealers who charged in excess of that standard, even if the SEC was not actively pursuing claims against those broker-dealers in 1992.

Finally, Defendants' argument that its markup practice was in line with industry practices, and therefore, it could not have violated the law was rejected by the court in Newton v. Merrill, Lynch, Pierce, Fenner & Smith, 135 F.3d 266, 273-74 (3d Cir. 1996). In that case, the Third Circuit Court of Appeals held:

In concluding as we do, we are not unmindful of the fact, deemed determinative by the district court, that execution of customer orders at the NBBO was a practice 'widely, if not almost universally followed' in the securities industry . . . . Under the district court's logic, a Section 10(b) defendant would be entitled to summary judgement even if it were her regular practice to knowingly violate the duty of best execution, so long as she could identify a sufficient number of other broker-dealers engaged in the same wrongful conduct to be able to argue in good faith that the underlying duty was 'ambiguous.' We cannot accept an analysis that would produce such a result. Even a universal industry practice may still be fraudulent.

Id. Accordingly, this Court finds that Plaintiff has met its burden under Rule 12 for its omission claim based on excessive markups.

D. Plaintiff's Claims Under the Investment Advisers Act of 1940

Plaintiff has alleged in all three of its claims that in addition to violating the Securities Act of 1933 and the Securities Exchange Act of 1934, Defendants also violated the Investment Advisers Act of 1940 ("the Act"), 15 U.S.C. 80b-6. Defendants contend that all three of Plaintiff's claims brought under the Act fail to state a claim that is actionable under the Act.

Defendants contend that the only basis for Plaintiff's allegations is the fact that Defendants are registered as investment advisers under the Act. (Rauscher Mot. at 28.) Defendants assert that registration as an investment adviser does not alone bring all of a broker-dealer's actions within the scope of the Act. Id. Accordingly, Defendants contend that the Act does not apply to the transactions at issue in this case for several reasons. First, Defendants assert that the Act's definition of an investment adviser specifically excludes those who provide advice with respect to debt obligations of, or guaranteed by, the United States. Id. Defendants argue that because the Complaint alleges that the securities they provided to the DOA were Treasury securities of the United States, they are not a financial adviser under the Act. Id. Second, Defendants contend that Plaintiff's allegation that they acted as an investment adviser in the sale of the securities is contrary to the other allegations in the Complaint, the terms of the contract, and the information contained in the confirmation forms. Defendants argue that these documents establish that Defendants were acting as a broker-dealer. Third, Defendants assert that even if the statutory exclusion did not apply, there is no authority for the proposition that a financial consultant who assists in the structuring and issuance of municipal bonds is subject to the Act. Id. Defendants further contend that in Dominion Resources, Inc., SEC No-Action Letter, 1985 WL 54428, at *6 (Aug. 24, 1985) and The Knight Group, SEC No-Action Letter, 1991 WL 251302, at *2-*3 (Nov. 13, 1991), the SEC held that firms that provide ancillary investment advice to state and local governments in the course of providing assistance in the issuance of bonds are not subject to the requirements of the Act. Id. Defendants assert that any advice they gave concerning a forward supply contract, or a guaranteed investment contract (GIC), or both, was ancillary advice regarding the "investment of temporarily idle proceeds of an issue" and, as such, is not "investment advice" subject to the Act. See The Knight Group, 1991 WL 251302, at 2-3. Finally, Defendants assert that a prerequisite of the Act is that there must be a charge for the investment advice, and in this case Defendants did not charge or receive compensation for their advice. (Rauscher Mot. at 29-30.)

Defendants' allegation that the only basis for Plaintiff's claims is the fact that Defendants are registered as investment advisers under the Act is incorrect. Plaintiff alleges that Defendants acted as an investment adviser, within the meaning of the Act, because in connection with the 1992B COPs offering, Defendants received a fee for their advice to the DOA concerning the availability of investing in, purchasing, or selling securities. (Compl. P 23.) Plaintiff alleges that in addition to selling the escrow securities to the DOA, Defendants advised the DOA to structure the defeasance escrow to include a forward supply contract. Id. Plaintiff also alleges that Defendants received a separate fee for acting as co-broker in the procurement and sale of a GIC. Id. Plaintiff has demonstrated in its allegations that it has relied upon more than the mere fact that Defendants are a registered financial adviser to assert their claims under the Act.

Defendants, however, are correct in stating that registration as an investment adviser under the Act does not alone bring all of a broker-dealer's action Party Fees i scope of the Act. In order to face liability under the Act, a defendant must first meet the Act's definition of an investment adviser. The Act defines an investment adviser as:

any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities . . . .

15 U.S.C. 80b-2(11). Plaintiff has alleged that Defendants, for compensation, advised them as to the advisability of investing in United States Treasury securities, a forward supply contract, and a GIC. (Compl. P 23.) Plaintiff has alleged enough facts to support its allegation that Defendants are an investment adviser under the Act. The only remaining question is whether Defendants meet one of the exclusions to this definition that has been created by SEC regulations or the Act itself.

Defendants are correct when they state that the Act's definition of investment adviser excludes those who provide advice with respect to debt obligations of the United States. The Act states that the definition of investment adviser excludes "any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct of indirect interest . . . ." 15 U.S.C. 80b-2(11) (E). The SEC, however, has consistently stated that this exception does not apply when an individual, in addition to providing advice on United States securities, gives advise on any other security that is not a United States' security. In J.Y. Bery Arbitrage Mgmt., Inc, SEC No-Action Letter, 1989 WL 246531, at *3 (Oct. 18, 1989), the SEC stated "you should note that if you provide advice as to any security other than a government security as provided in Section 202(a) (11) (E), you may not rely on this exception." See also Securities Counselors of Iowa, Inc., SEC No-Action Letter, 1989 WL 246135, at *5 (June 29, 1989). In this case, Plaintiff has alleged that in addition to advising the DOA to buy United States Treasuries, Defendants also advised them to invest in a forward supply contract and a GIC. (Compl. P 23.) Both the forward supply contract and the GIC are separate debt securities, and neither was issued or insured by the United States. Accordingly, Defendants do not come under the government securities exception.

Defendants' argument that it was clear from the contract and the confirmation forms that they were acting as a broker-dealer, and not a financial adviser, in the sale of the securities has already been found unpersuasive. Even assuming that Defendants were acting as a broker-dealer in the sale, the Act only excludes broker-dealers from the definition of an investment adviser when the "performance of such services (financial advising) is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor." 15 U.S.C. 80b-2(11) (C). Plaintiff has alleged that Defendants' advice was not incidental to, but central to the 1992B COPs offering. (Compl. P 14.) Plaintiff alleges that Defendants' advice included recommending which securities should comprise the escrow, that the escrow include a supply contract, what price the DOA should pay for the escrow securities, the amount of money the DOA should accept for the forward supply contract, and whether the reserve fund should be invested in a GIC. Even assuming that Defendants were acting as broker-dealer, the broker-dealer exclusion is inapplicable because based on these allegations, this Court cannot find that advice given was "solely incidental" to Defendants' broker-dealer business.

Defendants' argument that The Knight Group and Dominion Resources, Inc. No-Action Letters control this case is unpersuasive. Defendants seem to assert that these letters have established that a financial consultant who advises on municipal issues is never subject to the Act. This interpretation of the letters is unpersuasive. Neither letter states that financial advisers that provide advice to municipal issues are exempt from the Act. The Dominion Resources, Inc. letter comes the closest to supporting Defendants' position and it merely states that "the division of Investment Management ("IM") has asked us to inform you that, in general, IM does not interpret Section 202(a) (11) of the Investment Advisers Act of 1940 to apply to persons that advise issuers on how to structure their financing." 1985 WL 54428, at *6. The "in general" language clearly indicates that there is no rule that municipal finance advisers do not meet the definition of financial adviser under the Act. The letters simply held that the SEC would not take action against individuals that gave investment advice at the request of the issuer concerning idle proceeds from the offering. See The Knight Group, 1991 WL 251302, at *2 (stating that the SEC stated they would not seek action against the Knight Group if the advice was "requested by the issuer" and limited to "recommendations about investment of temporarily idle proceeds of an issuer pending their project use"); Dominion Resources, Inc., 1985 WL 54428, at *6 (stating that the SEC stated they would not take action against Dominion if they advised "without compensation and as an accommodation to the issued" and only made "recommendations about the investment of temporarily idle proceeds of an issue"). Defendants contend that any advice they gave concerning a forward supply contract, or a GIC, or both, concerning idle proceeds is contrary to the facts alleged by Plaintiff. As Plaintiff correctly points out, the whole purpose of issuing 1992B COPs was to raise proceeds which were sufficient, if properly invested, to defease the 1988 COPs and achieve savings for the State. Defendants' role was to insure that the proceeds of the offering were, in fact, properly invested. Plaintiff has alleged that Defendants recommended the various securities investments. Plaintiff has also alleged that Defendants charged a fee for their advice. Finally, Plaintiff has alleged that there were no idle proceeds to give advice on because the plan from the beginning was to invest the proceeds from the offering in United States Treasury securities, a GIC, and a forward supply contract. Based on the facts alleged by Plaintiff, Defendants cannot rely on The Knight Group and Dominion Resources, Inc., No-Action letters.

Finally, Defendants' allegation that they received no compensation for their advice is contrary to the facts alleged in the Complaint. Plaintiff alleges that Defendants received $71,840 as a financial advisory fee, over $700,000 for selling the escrow securities, and additional and separate compensation for its work in the procurement and sale of the GIC. (Compl. PP 13, 22, 23.) While some of Defendants' arguments appear to raise questions of fact, they do not prove Plaintiff cannot, as a matter of law, prove its claims under the Act.

Accordingly,

IT IS ORDERED that Plaintiff's Motion for leave to amend its Complaint to include allegations concerning the industry standard of markups is granted. Plaintiff has thirty days to file an Amended Complaint.

IT IS FURTHER ORDERED that Defendant James R. Feltham's Motion to Dismiss (Doc. # 9) is denied.

IT IS FURTHER ORDERED that Defendants Rauscher Pierce Refsnes, Inc.'s and Dain Rauscher Inc.'s Motion to Dismiss (Doc. # 11) is denied.

DATED this 24 day of August, 1998.

The Honorable Roslyn O. Silver

United States District Judge

Footnotes

-[n1]- Rauscher Pierce Refsnes, Inc., was a Delaware corporation with its principal place of business in Dallas, Texas. (Rauscher Mot. at 2.) On January 2, 1998, Rauscher merged with its sister company, Dain Bosworth Incorporated, to become Dain Rauscher. Id. Dain Rauscher then merged with a Minnesota corporation to become Dain Rauscher Incorporated. Id. James Feltham was the Senior Vice President at Rauscher's Phoenix office who supervised Rauscher's participation in the 1992B COPs offering. Id.

-[n2]- The relevant portion of 15 U.S.C. 77q states:

It shall be unlawful for any person in the offer or sale of any securities by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, directly or indirectly-

(1) to employ any device, scheme, or artifice to defraud, or

(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. 15 U.S.C. 77q(a) (1), (2), (3).

-[n3]- Rule 10b-5 states:

It shall be unlawful for any person directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national security exchanges

(1) to employ any device, scheme, or artifice to defraud, or

(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. 17 C.F.R. 240.10b-5.

-[n4]- The relevant portion of 15 U.S.C. 80b-6 provides:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly-

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;

(3) acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and the obtaining consent of the client to such transaction. The prohibitions of this paragraph shall not apply to any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction. 15 U.S.C. 80b-6(1), (2), (3).

-[n5]- The Supreme Court has held that scienter is a requirement for claims brought under Rule 10b-5 and 15 U.S.C. 77q(a) (1), but that no scienter requirement exists for claims brought under 15 U.S.C. 77q(a) (2), (3). Aaron v. SEC, 446 U.S. 680, 695-97, 64 L. Ed. 2d 611, 100 S. Ct. 1945 (1980). The Supreme Court has also held that no scienter requirement exists for claims brought under Section 206(2) of the Investment Advisers Act, 15 U.S.C. 80b-6(2). SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 195, 11 L. Ed. 2d 237, 84 S. Ct. 275 (1963). The Supreme Court has not determined whether scienter is required for claims brought under Section 206(1) of the Investment Advisers Act, 15 U.S.C. 80b-6(1), but lower courts have held that it is required. See SEC v. W. Steadman, 296 U.S. App. D.C. 269, 967 F.2d 636, 641 (D.C. Cir. 1992).

-[n6]- The Complaint clearly alleges three false or misleading statements were made in a Tax Certification Certificate (the "Certificate") issued by Rauscher on June 16, 1992, knowing that the DOA's bond counsel would rely on the Certificate in rendering its opinion on whether the interest paid on the 1992B COPs would be tax-exempt. (Compl. PP 30-31.)

-[n7]- In reality, Defendants' argument is that Plaintiff has not alleged enough facts, and that the facts that have been alleged cannot be proven. This argument is misplaced in a motion to dismiss. A court must take all of Plaintiff's allegations as true, and draw all reasonable inferences in Plaintiff's favor. Further, the Ninth Circuit has held that "in certain cases, . . . the requisite particularity might be supplied with great simplicity." Glenfed, 42 F.3d at 1548. The Ninth Circuit has indicated that securities fraud cases generally require a more detailed pleading because they: often involve some more or less catastrophic event occurring between the time the complained-of statement was made and the time a more sobering truth is revealed (precipitating a drop in stock price). Such events might include, for example, a general decline in the stock market, a decline in other markets affecting the company's product, a shift in consumer demand, the appearance of a new competition, or a major lawsuit. When such an event has occurred, it is clearly insufficient for plaintiffs to say that the later, sobering revelations make the earlier, cheerier statement a falsehood. Id. at 1548. This is not the type of securities fraud noted in Glenfed because there was no "intervening catastrophe between the time the complained-of statement was made and the time a more sobering truth was revealed." Id. Accordingly, this is a securities fraud case where particularity may be satisfied with fewer facts.

-[n8]- In a typical advance refunding transaction like the one in this case, the municipality issues a new offering of tax-exempt bonds to retire a pre-existing issue of bonds bearing higher interest rates. See In Re Meridian Securities, Inc., SEC File No. 3-9582, 1998 WL 195679, at *3. The proceeds of the new bond offering are then invested in Treasury securities. Id. Federal Tax laws restrict the yield that issuers can receive on these investments to the yield on the new offering of bonds. Id. If investments generate a yield that is greater than the yield on the new offering of bonds, an impermissible arbitrage profit is created. Id. Under those circumstances, the Internal Revenue Service (the "IRS") could declare the bonds taxable. Id. IRS regulations effectively require that arbitrage profit be reduced by investing a portion of the account in State and Local Government Series--customized securities issued by the Treasury at below market interest rates specifically for the purpose of allowing municipal issuers to comply with the IRS yield restrictions. Id.

-[n9]- See supra note 5.

-[n10]- Plaintiff did not refer to the confirmation forms in its complaint. Generally, a district court may not consider any material beyond the pleadings in a Rule 12(b) (6) motion. Hal Roach Studios, Inc. v. Richard Feiner & Co., 896 F.2d 1542, 1555 n.19 (9th Cir. 1990). The Ninth Circuit has held that "a document is not 'outside' the complaint, only when "the complaint specifically refers to the document and if its authenticity is not questioned." Branch v. Tunnell, 14 F.3d 449, 454 (9th Cir. 1994), cert. denied, 512 U.S. 1219, 114 S. Ct. 2704, 129 L. Ed. 2d 832 (1994). When matters outside the pleadings are presented to and not excluded by the court, a Rule 12(b) (6) motion is treated as one for summary judgment and disposed of as provided in Rule 56. This Court declines to convert this motion into a motion for summery judgment. Cortec Indus. Inc. v. Sum Holding L.P., 949 F.2d 42 (2d Cir. 1991) does not persuade this Court to consider the confirmation forms in this motion. In Cortec, the court held that "where plaintiff has actual notice of all the information in the movant's papers and has relied upon these documents in framing the complaint the necessity of translating a Rule 12(b) (6) motion into one under Rule 56 is largely dissipated." Id. at 48. In this case, Plaintiff did not rely on the confirmation forms to frame its Complaint. Further, in Cortec the plaintiff alleged that misrepresentations had been made in the forms, and then did not attach those forms to the complaint. Here, Plaintiff is not relying on the confirmation forms.

-[n11]- In addition to the reasons listed above the court in The Press also noted that "Press has commenced at least one other very similar securities class action in this District . . . alleging violations of Section 10b-10 and 10b-5, and state common law in connection with the sharing of certain fees between introducing and clerking brokers without disclosure to, or consent of, investors. Press's complaint in that case was dismissed in its entirety." 988 F. Supp. at 384. It appears the court in Press may have been influenced by the plaintiff's unwarranted persistence in litigating meritless claims.

-[n12]- The defendant, Mr. Cochran, was the head of an underwriting firm that participated in a bond offering for the Oklahoma City Airport Trust Authority. Cochran, 109 F.3d at 662. In addition to acting as underwriter for the offering, the defendant also brokered a collateralized guaranteed investment contract. Id. The defendant received an undisclosed fee of $489,241.09 for his work in the second transaction. Id.

-[n13]- Plaintiff suggested leave to amend its Complaint to include this allegation. Plaintiff's request will be granted because the particularity will assist in moving the litigation forward.

-[n14]- Zero-coupon securities are debt securities that do not pay interest to the holder periodically prior to maturity. Zero-Coupon Securities Release, No. 34-24368, 1987 WL 133877, at *15576 (Apr. 29, 1987). The majority of the securities Defendants sold to the DOA were zero-coupon securities.

-[n15]- In support of their position, Defendants cite to Banca Cremi, 132 F.3d 1017 at 1037 (holding that markups of 1.78% to 5.25% were not excessive); Bank of Lexington, 959 F.2d 606 at 614 (holding that a 5.02% markup on zero-coupon bonds was not excessive); In Re Investment Planning, Inc., 51 S.E.C. 592, 1993 SEC LEXIS 1897, 1993 WL 289728, at *2 (July 28, 1993) (holding that markups on municipal bonds between 4 and 5.99% were excessive); and In Re Lehman Bros., Inc., 62 S.E.C. 2195, 1996 SEC LEXIS 2453, 1996 WL 519914, at *5 (Sept. 12, 1996) (holding that markups of 3.5 to 4.7% were excessive).

-[n16]- In 1988, the SEC issued its Zero-Coupon Release in which it recognized that "as a general matter, common industry practice regarding mark-ups is to charge a mark-up over the prevailing inter-dealer market price of between 1/32% and 3 1/2% for conventional or 'straight' Treasuries depending on maturity, order size, and availability." 1997 WL 133877, at *15576.

-[n17]- In the Zero-Coupon Release, the SEC stated that "it is expected . . that percentage mark-ups on zero-coupon securities, as with other debt securities, usually will be smaller than those on equity securities." 1987 WL 133877, at *15577. The SEC also stated that markups as low as one percent on zero-coupon bonds could be excessive because "they trade at a deep discount." Id.

-[n18]- See supra note 7.

To Contents


Securities and Exchange Commission v. Robert M. Cochran, Michael B. Garrett and Randall W. Nelson, Civ. Action No. 95-1477T (W.D. Okla.), Litigation Release No. 14644 (September 20, 1995) consolidated with

Securities and Exchange Commission v. James V. Pannone and Sakura Global Capital, Inc., Civ. Action No. CIV98-146L (W.D. Okla.), Litigation Release No. 15630 (January 29, 1998) (complaint);

Securities and Exchange Commission v. Robert M. Cochran, Randall W. Nelson, James V. Pannone, Steven Strauss, and Sakura Global Capital, Inc., (Order granting in part and denying in part motions for summary judgment of defendants) (January 28, 1999); Litigation Release No. 16063 (February 17, 1999) (settled final orders).

See "The Underwriter".

To Contents


Administrative Proceedings Commission Decisions

In re Boettcher and Company, Exchange Act Release No. 8393, A.P. File No. 3-544 (August 30, 1968).

See "The Underwriter".

To Contents


Commission Orders Settled Administrative Proceedings

In re Lazard Freres & Co. LLC, Securities Act Release No. 7671, Exchange Act Release No. 41318, A.P. File No. 3-9880 (April 21, 1999).

See "The Financial Advisor".

To Contents


In re John E. Thorn Jr., and Thorn Welch & Co., Inc., Securities Act Release No. 7663, Exchange Act Release No. 41233, A.P. File Nos. 3-8400 and 3-9860 (March 31, 1999).

See "The Underwriter".

To Contents


In re Eugene J. Yelverton, Jr., Securities Act Release No. 7662, Exchange Act Release No. 41232, A.P. File No. 3-9859 (March 31, 1999).

See "The Underwriter".

To Contents


In re Kidder, Peabody & Co. Inc., Exchange Act Release No. 41224, A.P. File No. 3-9857 (March 30, 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 21C of the Securities Exchange Act of 1934 ("Exchange Act") to determine whether Kidder, Peabody & Co. Incorporated ("Kidder") violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

II. In anticipation of the institution of this proceeding, Kidder 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 it and over the subject matter of this proceeding, Kidder consents to the issuance of this Order Instituting Public Proceeding, Making Findings and Imposing a Cease-and-Desist Order and Disgorgement ("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 finds the following: n1

A. Respondent

Kidder, Peabody & Co. Incorporated was, at all relevant times, a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act. Kidder withdrew its registration by filing a Form BDW, which was effective January 1996.

B Other Relevant Entity

Tampa, Florida ("Tampa" or "City") is the largest municipality in the State of Florida. At all relevant times, the City was empowered to issue bonds and invest the bond proceeds in accordance with applicable laws and regulations.

C. Facts

This matter involves material misrepresentations by Kidder in connection with the purchase of an Escrow Reinvestment Agreement ("Agreement"); whereby Kidder was able to purchase the Agreement at less than fair market value. Kidder's purchase of the Agreement at less than fair market value had the effect of reducing--or "burning"--the yield on that Agreement, a form of "yield burning."

In December 1993, Kidder was the winning bidder for the right to enter into an Agreement awarded by the City. Kidder also had been responsible, along with another broker-dealer (referred to here as "BD-1"), for soliciting bids on the Agreement from others. During the bidding, an individual affiliated with BD-1 ("Registered Person") engaged in misconduct that caused two bidders (one of which was affiliated with the Registered Person), to submit artificially low bids. Kidder won the Agreement with a bid of $1.319 million, more than $3.0 million below what Kidder then believed the Agreement was worth.

In connection with the award of the Agreement, Kidder and BD-1 made certain representations to the City regarding the bidding process and the value of the Agreement. Kidder either knew or recklessly disregarded that these representations were false. In subsequent purchases and sales of securities under the Agreement, Kidder and BD-1 realized profits of nearly $3.5 million.

1. The City's Series 1991 Advance Refunding Bonds

In April 1991, the City issued its tax-exempt $138,610,000 Utilities Tax and Special Revenue Refunding Bonds, Series 1991 (the "Series 1991 Bonds"). The Series 1991 Bonds were advance refunding bonds, meaning that the City intended to use the proceeds to repay previously-issued bonds when those bonds became due and payable. Because the previously-issued bonds were not then due and payable, the City set up an escrow account to hold the proceeds from the Series 1991 Bonds.

The proceeds from the Series 1991 Bonds were invested in various federal government securities, which were chosen in amounts and for durations such that they matured as near as possible to the time the City would actually need the proceeds to repay the previously-issued bonds. However, in several instances, the federal government securities matured prior to the time the City actually needed the funds. These gaps, referred to as "float periods", ranged from 45 to 228 days.

Pursuant to certain provisions of the Internal Revenue Code ("IRC"), a municipal issuer of tax-exempt advance refunding bonds may invest the bond proceeds so long as the issuer does not earn an overall return on the proceeds materially higher than the yield on the underlying tax-exempt bonds. See 26 U.S.C. 148. These provisions are generally referred to as the "IRC arbitrage provisions." An issuer must either structure the escrow in compliance with these provisions or run the risk that the Internal Revenue Service will declare interest on the advance refunding bonds taxable. Id.

As originally structured, the overall yield to the City was below the maximum it could earn. Thus, an opportunity existed for the City to earn additional investment income if the City could find a proper vehicle through which to invest proceeds from the Series 1991 Bonds during some or all of the float periods in the escrow, so long as that additional income did not cause the overall yield on the escrow to exceed the maximum, which was 6.892697%.

2. The Proposal by Kidder and BD-1 to Restructure the Escrow for the Series 1991 Bonds

In late 1992, Kidder and BD-1 proposed that the City restructure the escrow for the Series 1991 Bonds. Kidder's primary representative in this matter was a then Senior Vice President in Kidder's Tampa office (the "Former Senior Vice President"). In his dealings with the City, the Registered Person presented himself as a representative of BD-1. Neither Kidder nor the Registered Person ever disclosed to the City that the Registered Person was also affiliated with a second broker-dealer (referred to here as "BD-2"). n2

The proposal Kidder and BD-1 eventually presented to the City focused on seven float periods in the escrow. Under the proposal, Kidder would make an initial cash payment to the City, and Kidder would obtain the right, at the outset of each float period, to sell to the escrow a federal government security that matured on or before the end of the float period, in an amount at least equal to the amount the City needed to meet its underlying repayment obligation. Kidder would then take the proceeds from the escrow that the City paid in exchange for the federal government security, reinvest those proceeds for the duration of the float period and retain for itself any reinvestment earnings. At the end of the float period, Kidder would retain both the principal amount of the proceeds and any reinvestment earnings, and the City would retain the initial cash payment and the government security provided by Kidder, which would mature as needed to meet the City's underlying repayment obligation.

The increase in the City's overall yield on the escrow from such a transaction is determined by the amount of the initial payment: the higher the payment, the higher the City's overall yield. Thus, the size of the initial payment the City could receive was limited by the requirement that the City's overall yield on the escrow not exceed the yield on the City's underlying tax-exempt bonds.

In a proposal dated January 11, 1993, Kidder and BD-1 proposed a transaction which would result in a payment to the City of $1,367,928.33. In this proposal, Kidder and BD-1 calculated that the effect of such a payment would be to increase the City's yield on the escrow to 6.892591%, just below the yield restriction of 6.892697%.

In late 1993, the City agreed to enter into an Escrow Reinvestment Agreement. However, IRC arbitrage provisions required that any payment to the City under the Agreement represent "fair market value" for the reinvestment rights transferred under the Agreement. 26 CFR 1.148-5(d) (6) (iii). One of the purposes of the fair market value requirement is to ensure that investment banks and others that enter into such agreements with yield-restricted escrow accounts do not artificially depress the yield to the municipality (and thus allow the municipality to appear to be in compliance with the IRC arbitrage provisions). Id. Such practices are commonly referred to as "yield burning."

Regulations under the IRC provided a safe harbor for determining the fair market value of an investment contract such as the Agreement. Among other things, the IRC regulations required that an issuer obtain bids for any such investment contract from at least three qualified bidders (i.e., bidders with no other financial interest in the transaction) and that the contract be awarded to the highest bidder. Id.

As a result, in December 1993 the City required that Kidder and BD-1 solicit bids on the Agreement from at least three bidders not otherwise involved in the escrow restructuring, to ensure that the initial payment the City received for the Agreement represented fair market value.

3. The Rigged Bidding on the Escrow Reinvestment Agreement

As noted above, in their January 11, 1993 proposal Kidder and BD-1 determined that the maximum initial payment the City could receive for an escrow restructuring without violating IRC yield restrictions was approximately $1.37 million. However, internal Kidder documents prepared by the Former Senior Vice President prior to bidding on the Agreement in late 1993 show that Kidder believed that the present value of the Agreement was between $4.34 million and $4.8 million, far above the maximum amount the City could receive. Kidder never disclosed its present value calculations to the City.

Kidder agreed to be jointly responsible, along with BD-1, for soliciting bids on the Agreement. The bidding produced bids from three entities, in addition to a bid from Kidder itself. At least two of the non-Kidder bids, which ranged from $1,205,000 to $1,301,550, were rigged. In one instance, the Registered Person provided false information to a bidder as to the amounts available for reinvestment and the duration of the float periods under the Agreement, which caused that bidder to submit an artificially low bid. In a second instance, the Registered Person (known to the City only as a representative of BD-1) solicited an artificially low bid from BD-2, without disclosing the fact that he was affiliated with BD-2 or that BD-2 had a written agreement to share with Kidder in any profits either party realized on an escrow restructuring transaction with the City. n3 As a result, Kidder was the high bidder for the Agreement at $1.319 million, more than $3.0 million below what Kidder then believed the Agreement was worth.

4. Misrepresentations by Kidder and BD-1 in the Representation Letter

With the bidding complete, the City awarded the Agreement to Kidder and held a closing on December 28, 1993. As part of the closing, Kidder and BD-1 each signed a letter (the "Representation Letter") which contained the following three representations, each of which was false.

The first representation was that the yield to the City on the Agreement. i.e. the initial payment to the City) was at least equal to the yields offered on similar obligations under similar agreements. This representation was false because, as internal Kidder documents show, Kidder believed the actual present value of the Agreement was at least $4.34 million, or $3.0 million more than Kidder's winning bid.

The second representation was that in soliciting the bids Kidder and BD-1 had not acted with an intent to reduce the resulting yield to the City. This representation was false because the Registered Person had obtained an artificially low bid from one bidder by providing that bidder with false information and had obtained a second artificially low bid from his affiliated company, BD-2.

The third representation was that Kidder and BD-1 had taken reasonable steps to obtain bids for the Agreement from at least three bidders not otherwise involved in the escrow restructuring. This representation was false because one of the bids the Registered Person obtained was from BD-2. Because it already had a profit-sharing agreement with Kidder concerning the transaction with the City, BD-2 was not a disinterested bidder.

The City's Special Tax Counsel drafted the Representation Letter and relied on each of these representations in rendering his opinion that entering into the Escrow Reinvestment Agreement would not jeopardize the tax-exempt status of the Series 1991 Bonds.

5. Profits to Kidder and BD-1 Resulting from the Fraudulent Escrow Reinvestment Agreement

The Agreement contemplated that Kidder would realize its profits over time; at the outset of each float period, Kidder would sell a security to the City in exchange for escrow proceeds, which Kidder would then reinvest for its own benefit. However, the Agreement included a second option which allowed Kidder to substitute securities for those in the escrow, and thus realize its profits sooner.

In February 1994, Kidder exercised this second option, which required the City to liquidate certain federal government securities then held in the escrow. The securities at issue were those which, had the City held them to maturity in the escrow, would have produced the proceeds scheduled to be available for reinvestment during each of the seven float periods covered by the Agreement. The market value of the securities the City liquidated was $142,089,275.40. Pursuant to the terms of the Agreement, Kidder then required the City to use those proceeds to purchase from Kidder a group of securities sufficient to meet the City's repayment obligations on its underlying tax-exempt bonds at the end of each of the seven float periods. The market value of the securities Kidder sold to the City was $137,494,667.37. The difference, approximately $4.6 million, was wired to Kidder by the City's escrow agent pursuant to the Agreement. Kidder also realized commissions of nearly $400,000 for the trades. Thus, the gross profits on the transaction were $4,992,072.72.

After deducting Kidder's initial payment to the City and other expenses, net profits on the transaction were $3,461,724.66. Of this amount, Kidder retained $1,676,673.08 and transferred the balance, or $1,785,051.58, to BD-1.

6. Kidder's Violations of Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder

In signing the Representation Letter, Kidder made material misrepresentations of fact in connection with the sale of securities to the City, in violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The first representation was that the yield i.e., the initial payment) to the City under the Agreement was at least equal to the yield on similar obligations under similar agreements. At the time it made this representation, Kidder knew that the present value of the Agreement was in excess of $4.34 million. Thus, Kidder knew that, absent the IRC-imposed restriction on the amount of the initial payment the City could receive, a willing buyer would have paid much more than Kidder's winning amount of $1.319 million for the right to enter into the Agreement. Because Kidder was aware of the significant disparity between the present value of the Agreement and the amount of its winning bid, Kidder either knew or recklessly disregarded the fact that this first representation was false.

The second representation was that the bids for the Agreement were not solicited with an intent to reduce the yield to the City. Kidder was reckless in making this representation because Kidder knew that its own winning bid was more than $3.0 million below what Kidder believed the Agreement was worth, and that the only reason Kidder had limited the size of its bid was to limit the yield to the City on the Agreement. The fact that Kidder relied on the Registered Person to solicit bids from other parties does not change this analysis, since any such bids were lower than Kidder's winning bid.

Similarly, Kidder was reckless in disregarding the falsity of the third representation--that Kidder and BD-1 had taken reasonable steps to obtain bids from at least three bidders not otherwise involved in the escrow restructuring. Had Kidder conducted even a minimal inquiry, it would have learned that one of the bids was from BD-2, with which Kidder already had an agreement to share profits from any escrow restructuring agreement with the City. Under these circumstances, Kidder was reckless in falsely representing that it had obtained bids from at least three bidders not otherwise involved in the escrow restructuring.

IV. On the basis of this Order and the Offer submitted by Respondent, the Commission finds that Kidder violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

V. Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that Kidder:

(1) cease and desist from committing or causing any violation and any future violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder;

(2) disgorge, within 30 days after the date of issuance of the Commission's Order, an amount equal to Kidder's wrongful profits of $1,676,673.08 plus prejudgment interest, computed and payable as follows:

(a) if paid by Kidder on or before March 31, 1999, a total amount of $2,466,657.34;

(b) if paid by Kidder after March 31, 1999, the amount of $2,466,657.34 plus interest to be accrued at an annual rate of 7.62%, compounded daily beginning April 1, 1999; and

(3) make the monetary payment called for in the Order by United States postal money order, certified check, bank cashier's check, or bank money order payable to the United States Treasury. Such payment shall be sent by certified mail to: Mr. Charles Anderson, Group Manager-Tax Exempt Bond Group, Southeast Key District Office (EP/EO), Department of the Treasury, Internal Revenue Service, 31 Hopkins Plaza, Room 1420, Baltimore, MD 21201, with a cover letter that identifies the payment as relating to the City of Tampa, Florida Utilities Tax and Special Revenue Refunding Bonds, Series 1991, and also identifies Kidder as the Respondent in the public proceeding instituted by the Order. A copy of the cover letter and the payment instrument shall simultaneously be sent to David B. Bayless, District Administrator, San Francisco District Office, Securities and Exchange Commission, 44 Montgomery Street, Suite 1100, San Francisco, California 94104.

By the Commission.

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Footnotes

-[n1]- The findings herein are made pursuant to Respondent's Offer and are not binding on anyone other than Respondent Kidder.

-[n2]- Kidder's relationship with the Registered Person was memorialized in a four-page agreement dated February 23, 1993. The agreement lists a number of pending escrow restructuring proposals (including the transaction with the City) and details the manner in which the parties would share any profits arising from the transactions. The Registered Person signed the agreement on behalf of BD-2.

-[n3]- Notwithstanding the fact that it agreed to be jointly responsible with BD-1 for the bidding process, Kidder took no part in preparing or distributing the bid solicitation forms, contacting potential bidders or reviewing the bids received.

To Contents


In re O'Brien Partners, Inc., Securities Act Release No. 7594, Investment Advisers Act Release No. 1772, A.P. File No. 3-9761 (October 27, 1998).

See "The Financial Advisor" section.

To Contents


In re Meridian Securities, Inc., and Corestates Capital Markets, Securities Act Release No. 7525, Exchange Act Release No. 39905, A.P. File No. 3-9582 (April 23, 1998).

See "The Underwriter" section.

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Reliance on Counsel

Federal Court

SEC v. Senex Corp., 399 F. Supp. 497 (E.D. KY. 1975).

See "Obligated Persons" section.

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Administrative Law Judge Decision

In the Matter of Thorn, Alvis, Welch, Inc., John E. Thorn, Jr., and Derryl W. Peden, 61 SEC Docket 2524 (May 2, 1996).

Text: Initial Decision

Before: Brenda P. Murray, Chief Administrative Law Judge

The Securities and Exchange Commission (Commission) initiated this proceeding on June 23, 1994, 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). The Order Instituting Proceedings charges that, from about August 1992 through at least February 1994, the respondents willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and that Thorn, Alvis, Welch, Inc. (TAW) willfully violated, and Mr. 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 (MSRB).

I held five days of hearing in Atlanta, Georgia, in January and February 1995 at which each side presented nine witnesses. n1 I allowed 157 exhibits into evidence: three from counsel, 87 exhibits by the Division of Enforcement (Division), and 67 by the respondents.n2 The parties filed consecutive briefs. I received the last brief on April 28, 1995. I deny respondents' single sentence request for oral argument received in April 1995 because they gave no reason why they needed another opportunity, in addition to briefs, to present arguments to me.

Respondents

TAW, a broker-dealer with a single office in Jackson, Mississippi, has been registered with the Commission, pursuant to Section 15(b) of the Exchange Act, since 1977. TAW specializes in municipal tax-exempt securities.

Mr. Thorn has owned a 25 percent interest in TAW since it was founded. He is a director and has been president of the firm for 18 years. He has degrees from Mississippi College and New Orleans Baptist Theological Seminary. Mr. Thorn is a registered municipal securities principal. He did not take an exam but was grandfathered in when TAW joined the National Association of Securities Dealers. Tr. 51-52. In a 30-year career in the securities industry, Mr. Thorn's activities have consisted almost entirely of selling and underwriting tax-exempt securities. Tr. 53, 55-57.

The Commission entered an Order Making Findings and Imposing a Cease and Desist Order Against Derryl W. Peden on December 2, 1994. 58 SEC Docket 0505 (1995).

Issues

Whether Respondents TAW and Mr. Thorn have willfully violated the antifraud provisions of the securities statutes, and either willfully violated or willfully aided and abetted violations of Rule G-17 of the MSRB, and Section 15B(c) (1) of the Exchange Act and, if they did so, (a) what remedial action is appropriate; (b) whether they should be ordered to cease and desist from committing or causing violations and future violations of the statute and rules thereunder; (c) whether they should be ordered to comply with the applicable laws and regulations in the future; (d) whether they should be ordered to disgorge amounts, including reasonable interest; and (e) whether civil penalties should be imposed.

Findings of Factn3

Reading this record is reminiscent of reading Alice in Wonderland in that things are not what they appear to be and, as Alice exclaimed, events get "Curiouser and curiouser!" n4

In the period August 1992 through October 1993, TAW was the underwriter on seven non-rated private activity urban renewal revenue bond offerings totaling almost $19.5 million by two Mississippi counties Warren or Hinds County.n5

Name of Project Face Value Date
Sherwood Garden Apartments $1,375,000 August 27, 1992
Northwest Plaza Apartments $950,000 January 21, 1993
Eden Point Apartments $2,470,000 March 26, 1993
The Pines $1,865,000 April 30, 1993
Northpark Apartments $625,000 May 15, 1993
Glen Oaks Apartments $4,050,000 July 28, 1993
The Lodge Apartments $7,950,000 October 20, 1993

Counsel Ex. 1 at 1-2.

These bonds were not registered with the Commission, pursuant to the exemption in Section 3(a) (2) of the Securities Act.

The same parties participated in each of the seven offerings. As noted, TAW was the underwriter. The Mitchell Company (Mitchell) of Mobile, Alabama, was the contractor, and the project manager after development was completed. Attorney Derryl W. Peden (Attorney Peden), who at the time had been counsel on about 90 percent of the tax-exempt, multi-housing bonds issued in Mississippi, was bond counsel and underwriter's counsel in the first two issues by Warren County, and was bond counsel in the next five issues by Hinds County.

Mitchell, which specialized in real estate development, is the largest of fourteen companies and partnerships known as the Mitchell Group which was run as one business enterprise.n6 Three officers of Mitchell Mr. Saint the president, Mr. Kelly the senior executive president, and Mr. Stefan the executive vice president owned 70 percent of the company, and the employee stock ownership plan owned the remaining 30 percent. In the period at issue here, these persons ran Mitchell under a contract to buy the company from the Resolution Trust Corporation (RTC). Tr. 387. The Mitchell Group is not a legal entity but a term used to refer to all the companies in which at least one of the three individual owners of Mitchell Mr. Saint, Mr. Kelly, and Mr. Stefan owns an interest. Tr. 351-52.

The material facts on all seven bond issues are sufficiently similar so that a detailed description of the first one, Sherwood Garden Apartment Project (Sherwood Garden Project, Sherwood Garden, project), is applicable to all seven situations. Counsel Ex. 1. The Sherwood Garden Project is a ninety-eight unit, garden-type apartment project, located in Vicksburg, Mississippi. Id. Mitchell learned of the property from a real estate broker in 1992. The owner, a financially distressed savings and loan association, had foreclosed on the property which was in disrepair. Local authorities would only grant a building permit on ninety-eight of the original 150 units, and required that the fifty-two units which had been flooded three times be demolished. Mitchell or Mr. Stefan and Mr. Saint took an option to buy the property. Compare Tr. 496-97; Tr. 2/9/95 at 10-14.

Each of the TAW offerings involved several legal documents. For Sherwood Garden, the legal documents are as follows:

1. The Official Statement for the bond issue dated August 27, 1992, was the disclosure document provided to prospective purchasers. Div. Ex. 1; Counsel Ex. 1 at 2.

2. The Agreement of Limited Partnership effective August 24, 1992, which created the limited partnership, Warren-Sherwood, Ltd., formed to own the Sherwood Garden Project, the subject of the bonds. n7 Div. Ex. 63C.

3. The Construction Management Contract between Warren-Sherwood, Ltd. and Mitchell dated August 23, 1992. Div. Ex. 63B.

4. The Memorandum of Agreement prepared by Attorney Peden to memorialize what occurred at the closing. Div. Ex. 63(a).n8 Div. Ex. 63C.

Attorney Wesch acted as counsel for Warren-Sherwood, Ltd. when it was negotiating a construction contract with Mitchell, his employer. Moreover, Attorney Wesch opined on August 27, 1992, that Warren-Sherwood, Ltd., owned by some of the same people who owned his employer, had validly executed the documents regarding the bonds at issue. Resp. Ex. 84D.

Mr. Thorn signed the Memorandum of Agreement for TAW and Warren-Sherwood, Ltd. Mr. Stefan signed the same document for Mitchell and Warren-Sherwood, Ltd.

Attorney Peden, in his capacity as bond counsel, opined that the bonds were tax-exempt and, in his capacity as underwriter's counsel, prepared with Mr. Thorn the Official Statement which made this representation.n9 Div. Ex. 63C.

Tr. 69-75. TAW sold these bonds to the public as qualified tax-exempt private activity bonds, and in doing so it used the mails and other means of interstate commerce.

The Official Statement for the Sherwood Garden bond issue, dated August 27, 1992, represented that:

1. Interest on the bonds is excludable from income for federal income tax purposes.

2. The bond proceeds are expected to be used primarily to provide the Issuer, Warren County, with funds to loan to the Developer to finance the acquisition, partial demolition, reconstruction, renovation, and expansion of an existing multifamily rental housing project located in an urban renewal area of the Issuer.

3. The Developer is Warren-Sherwood, Ltd., an Alabama limited partnership. The Developer's general partner is Disposition & Management, Inc., which is owned by Mitchell's President, John Saint, and Executive Vice-president, Chester J. Stefan. The Developer's limited partners include Mr. Stefan, Mr. Saint, Mr. Napper and Mr. Kelly, of Mitchell, and Mr. Thorn, Mr. Welch and Mr. Yelverton of TAW.

4. Mitchell, the Project Coordinator, General Contractor, and Property Manager, is a wholly-owned subsidiary of Altus Bank which has been placed under control of the RTC.

5. The contractor will guaranty the payment of a portion of the principal and interest on the bonds.

6. The construction contract will be a turnkey contract in the total amount of $686,000.n10 Div. Ex. 63C.

7. The source of funds are:

Bond principal $1,375,000
Premium $27,500
Interest earned $3,500
Developer's contribution $95,450
Total $1,501,450

8. One application of funds is a construction expenditure of $713,950.

9. The fair market value of the site is $525,000.

10. Mitchell will manage the project for an annual fee of 5 percent of gross rental income.

Div. Ex. 1.

Mitchell typically did not share ownership in renovated projects with others, i.e., engage in joint ventures. It agreed to jointly own these renovated projects with Mr. Thorn and others from TAW because TAW offered to arrange 100 percent financing, n11 which was not available from any other source, and Mr. Thorn required that he and others receive ownership in the projects. Tr. 356-57, 518-20; Tr. 2/9/95 at 16-17. As a result, certain owners and officers of TAW and Mitchell formed limited partnerships which became the owner/developer of each of the seven properties which were the subject of the bond offerings. Mr. Thorn signed the Agreement of Limited Partnership of Warren-Sherwood, Ltd. (limited partnership) on August 24, 1992. Div. Ex. 63(c).

As noted, the limited partners of Warren-Sherwood, Ltd. were John B. Saint, Chester J. Stefan, Gordon K. Napper, and Donald P. Kelly, Jr., from Mitchell, and Lonnie Joe Welch, Mr. Thorn, and E. J. Yelverton, Jr., from TAW. A limited partner's share of the profits, to be paid in cash quarterly, was in the same proportion as his ownership of the partnership. Div. Ex. 63C at 1-2. The limited partners' shares ranged from a low of 9.9 percent and a high of 19.8 percent. Mr. Thorn owned 19.8 percent of the project. Div. Ex. 1 at 8; 63C. The total capital contribution to the partnership was $2,000. The general partner paid $20. The limited partners contributed in a range between $198 and $396. Div. Ex. 63C, Schedule A.

Each of the Official Statements for the seven bond offerings listed a developer's contribution as a source of funds.

Developer's Project Percent of Contribution Offering Proceeds
Sherwood Garden 95,450 6.81
Northwest Plaza 72,500 7.48
Eden Point 144,229 5.69
The Pines 105,143 5.49
Northpark 48,144 7.50
Glen Oaks 242,450 5.99
The Lodge 404,662 5.09

Counsel Ex. 1 at 7.

The limited partnership agreement that created Warren-Sherwood, Ltd., dated August 24, 1992, directed the partnership to enter a construction contract with Mitchell for rehabilitation of the project for actual costs plus 10 percent. Tr. 729; Div. Ex. 63C at 12-13. This limited partnership agreement provided that Mitchelln12 would be paid property management fees not to exceed 5 percent of the gross collections from the project, and an incentive fee equal to 25 percent of the distributable cash for each quarter. Div. Ex. 63C at 13; Tr. 729. As I have noted, the Official Statement did not disclose that Mitchell would receive an incentive fee.

Also on August 24, 1992, Warren-Sherwood, Ltd. entered into a two page Construction Management Contract (construction contract) with Mitchell. Mr. Stefan signed for Warren-Sherwood, Ltd., as the executive vice president of Disposition & Management, Inc., the general partner, and Duke W. Miller signed for Mitchell as the vice president of Armay Development Corp., a general partner of Mitchell. Div. Ex. 63B. This contract provided that Mitchell would repair and rehabilitate the project for costs plus 10 percent, and that Mitchell was not responsible for cost overruns, insuring the project, plan errors, or existing code violations. Id.; Tr. 363-64, 438-48. The Official Statement did not disclose this information or that Mitchell would receive an incentive fee to manage the property of 25 percent of net revenues.

The construction contract was just one part of the overall compensation received by Mitchell and some of its officers and employees. Tr. 362-384, 451, 453, 735; Tr. 2/9/95 at 180-96; Div. Ex 113. At least thirty days before the bond closing, Mr. Stefan, representing Mitchell, and Mr. Thorn, representing TAW, agreed that the transaction would be financed 100 percent, and that Mitchell would do the work for:

1. hard construction costs plus 10 percent; Mitchell agreed on the sum of $429,855, which included the 10 percent return on hard costs, on a best efforts basis.n13 Div. Ex. 113; Tr. 390-92, 416, 435-47. Mitchell was not responsible for cost overruns, insuring the project, plan errors or code violations. n14

2. cost of the contractor's guaranty for payment of principal and interest on the bonds, i.e., $211,000 to purchase zero coupon or stripped Treasury bonds. If these securities were not needed to pay debt service over the 25 years the bonds were outstanding, they would revert to Mitchell. Div. Ex. 113; Tr. 381.

3. ownership interest in the project for certain officers and employees of Mitchell.

4. five percent of gross rents as a management fee when the project is rehabilitated.

5. twenty-five percent supplemental management fee, i.e., percentage of distributable cash as defined in the partnership agreement. Div. Ex. 63C at 2.

Attorney Peden maintained that Mr. Thorn and Mr. Stefan were still negotiating Mitchell's compensation when they participated in a phone call shortly before August 27, 1992, even though Mr. Stefan and Mr. Thorn agreed on Mitchell's compensation well before that conversation. Tr. 246.

Tr. 361-68, 383.

According to Mr. Stefan, Mitchell would not have agreed to just a construction contract for cost plus 10 percent. Mitchell viewed the various agreements as a compensation package. It expected to make a profit from each of the agreements. Tr. 453.

Mr. Stefan learned that Mitchell was expected to make a $95,450 developer's contribution when he saw a draft of the Official Statement and the Memorandum of Agreement shortly before the bond closing. Tr. 393-95, 403-05. He called Mr. Thorn and Attorney Peden and reminded them that they had consistently represented that Sherwood Garden would be financed 100 percent. Tr. 396-97. Attorney Peden and Mr. Thorn assured Mr. Stefan that Mitchell would not have to bring a check to the closing. n15

Respondents represent that Mitchell, the construction company, made the developer's contribution in all seven offerings. At the closing on August 27, 1992, Attorney Peden directed that Batesville Security Bank, trustee for the bond proceeds, disburse the following sums from the construction fund to escrow accounts of First American Title Insurance Company (First American) at Sunburst Bank: $525,000 for Warren-Sherwood, Ltd.'s. account for site purchase; $3,500 for First American's account for title insurance premium; $1,000 for the State of Mississippi for bond allocation fee; and $95,450 for Mitchell's account representing the contractor's initial draw. Counsel Ex. 1 at 7-8.

Additional disbursements from the construction fund were: $1,000 to Batesville Bank for trustee fee; $10,787 to Attorney Peden for bond counsel fee and expenses; $6,000 to Attorney Ken Harper for issuer's counsel fee; $10,263 to TAW for underwriter's fee; and $307,021 to Mitchell for the initial draw under the construction contract. Div. Ex. 46A. Attorney Peden directed First American to wire $83,237 of the $95,450 to TAW and the remaining $12,213 to Attorney Peden's law firm to pay issuance costs in excess of 2 percent of the offering. Tr. 410-420.

Attorney Peden had TAW, Warren-Sherwood, Ltd., and Mitchell sign a Memorandum of Agreement at the closing on August 27, 1992. n16 Div. Ex. 63A. It stated that Mitchell agreed to pay miscellaneous business expenses and obligations of the owner, Warren-Sherwood, Ltd., in consideration of being awarded the construction contract of $713,950; that payment of the expenses shall be a cost of the contractor in performing under its construction contract; and that the contractor was required to pay these costs under the contract. Mr. Stefan considered the Memorandum Agreement just another closing document, and he did not notify Mitchell's attorney that he had signed such a document or that Mitchell received $95,450 and used it to pay closing costs in excess of 2 percent. Tr. 427.

The Sherwood Garden offering raised $1,402,500. n17 Issuance costs of the offering totaled $124,500 or 8.88 percent of bond proceeds. n18 Div. Ex. 104. TAW received net underwriter's fees of $24,750. Counsel Ex. 1 at 12; Tr. 594. Attorney Peden and his law firm received $23,000 as bond counsel fees and expenses. Counsel Ex. 1 at 11; Div. Ex. 104.

TAW retained $117,376 of the total underwriting fees of $350,635 it received from the seven offerings. Counsel Exhibit 1 at 15. It disbursed $116,432 to Mr. Thorn and $116,827 to another TAW principal. Id.

Attorney Peden's law firm received a total of $152,161 from the TAW offerings. Id.

Findings of Law

Antifraud Provisions of the Securities Statutes and Regulations

It is well established that broker-dealers are subject to the same high standards when underwriting and trading municipal securities as when they underwrite and trade corporate securities. Walston & Co., Inc., 43 S.E.C. 508, 512 (1967). As the underwriter, TAW was required: to have a reasonable basis for recommending any municipal securities and its responsibility, in fulfilling that obligation, to review in a professional manner the accuracy of the offering statements with which it is associated.

An underwriter, whether of municipal or other securities, occupies a vital position in an offering. The underwriter stands between the issuer and the public purchasers, assisting the issuer in pricing and, at times, in structuring the financing and preparing disclosure documents. Most importantly, its role is to place the offered securities with public investors. By participating in an offering, an underwriter makes an implied recommendation about the securities. Because the underwriter holds itself out as a securities professional, and especially in light of its position vis-a-vis the issuer, this recommendation itself implies that the underwriter has a reasonable basis for belief in the truthfulness and completeness of the key representations made in any disclosure documents used in the offerings.

Release Requesting Comments on SEC Proposed Rule 15c2-12, 41 SEC Docket 1402, 1411 (1988). See Brown, Barton & Engel, 41 S.E.C. 59 (1962); The Richmond Corporation, 41 S.E.C. 398 (1963); Amos Treat & Co., Inc., 42 S.E.C. 99 (1964).

The expert testimony affirmed TAW's duty as the underwriter to have a reasonable basis for the truthfulness and completeness of the factual representations in the Official Statement. Tr. 803-06. This duty included undertaking a reasonable investigation of the facts behind the disclosure documents to make sure they were not misleading. Tr. 2/9/95 at 97-102.

Mr. Thorn and, through him, TAW willfully disseminated copies of the Official Statement, the disclosure document provided to prospective purchasers, which he knew or was reckless in not knowing contained material information that was false and misleading. Mr. Thorn acted with full knowledge of the facts and the responsibilities of an underwriter intending to deceive, manipulate and defraud investors. Aaron v. SEC, 446 U.S. 680, 686 n.5 (1980). Alternatively, if one accepted Mr. Thorn's claim that he did not know that certain material information was false, the evidence is overwhelming that he acted with extreme recklessness, i.e., a degree of negligence that was an extreme departure from ordinary care. SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992).

The Official Statement for the Sherwood Garden Project, which was similar to the other six offerings, was false and misleading in material respects by representing that:

1. interest on these bonds was tax-exempt;

2. a total of $1,500,000 was coming into the transaction, Tr. 798, and the owner/developer, Warren-Sherwood, Ltd., contributed $95,450 to the project, Tr. 796-98; Tr. 2/9/95 at 102-03;

3. $713,950 would be spent on construction, Tr. 796;

4. the construction contract was for a turnkey project so that the contractor was responsible for any cost overruns, Tr. 799-801;

5. the fair market value of the property was approximately $525,000; and

6. the contractor would furnish a guaranty on the payment of interest while the bonds were outstanding.

These representations were material because a reasonable person would consider the information important in deciding whether to invest in these securities. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 445 (1976); accord Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988).

1. Bonds are not tax-exempt.

Interest on these bonds is taxable because the transaction violated two provisions of the Internal Revenue Code which made them ineligible for tax-exempt status. Section 147(g) provides that "a private activity bond shall not be a qualified [tax exempt] bond if the issuance costs financed by the issue (of which such bond is a part) exceed 2 percent of the proceeds of the issue."n19 26 U.S.C. 147(g). Issuance costs include the cost of lawyers, underwriters, printers, and others concerned with issuance. Tr. 637. Section 142(a) provides that "the term 'exempt facility bond' means any bond issued as part of an issue 95 percent or more of the net proceeds of which are to be used to provide" the financed facility. 26 U.S.C. 142(a). n20 The term "provide" means a cost chargeable to the capital account of the facility such as the purchase, construction or rehabilitation cost. Tr. 636-37, 777. Issuance costs are not costs of providing the facility within the meaning of Section 142(a). Tr. 777.

As noted the developer was Warren-Sherwood, Ltd. There is not one shred of evidence that the parties ever considered that Warren-Sherwood, Ltd., which had a capitalization of $2,000, would make a developer's contribution of $95,450.

To accept respondents' position, you have to accept first that it was reasonable for them to describe in the Official Statement a contribution from Mitchell, the contractor, as a developer's contribution. Attorney Peden claimed that Mitchell was the developer because by industry custom the developer can be a party who advises the owner or does the development work for the owner. Tr. 317-21. I disagree. Mitchell was not the developer in these seven offerings. The Official Statement which Attorney Peden drafted designated Warren-Sherwood, Ltd. as the owner/developer. Two experts, Attorney N. Jerold Cohen for the Division and Attorney Margaret Joslin for respondents, thought Warren-Sherwood, Ltd. to be the developer based on their reading of the Official Statement. The drafter of the limited partnership agreement, Attorney Paul C. Wesch, considered Warren-Sherwood, Ltd. to be the developer. Tr. 659-60, 727-28; Tr. 2/9/95 at 102, 162.

Even if one excused as not misleading the Official Statement's misdescription of the developer, rather than the contractor, as the source of the contribution to pay issuance cost in excess of 2 percent, n21 the evidence leaves no doubt that Mitchell agreed to do all the work in connection with Sherwood Garden for consideration which did not include the $95,450 developer's contribution. Speaking on behalf of Mitchell, Mr. Stefan's position is unequivocal. The developer's contribution of $95,450 was of no economic consequences either to Mitchell or to Mr. Stefan. Tr. 418-23. I find the evidence persuasive that Mitchell did not earn the $95,450, and did not donate its funds to pay issuance costs over 2 percent. As an accommodation to Mr. Thorn and Attorney Peden who arranged the transaction, Mr. Stefan agreed to have it appear that Mitchell was making a contribution. As long as Mitchell and Mr. Stefan received all the economic benefits they had agreed to, Mr. Stefan was willing to do or sign whatever Attorney Peden and Mr. Thorn proposed at the closing.

I reject the position of respondents' municipal bond expert, Attorney Theberge, n22 that:

in the hands of the contractor, once earned it is no longer proceeds from the bonds. . . . if it is a reasonable contract and the proceeds are disbursed to the contractor and they are earned, they lose their character as bond proceeds. What the contractor does with them is irrelevant for our purposes. Tr. 981.

Attorney Theberge's belief is that:

Effectively what happened here was The Mitchell Company's contract was cost plus 10% plus $95,450. That was the contract billing, and that was a reasonable contract. They then took $95,450 and gave it, in one form or another, to their employees and shareholders, who then made a contribution to pay the excess cost of issuance. That's what the transaction was. And that's really what Stefan and -- and that's what Derryl Peden gave his opinion on I think pretty clearly. That's what Stefan I think negotiated; that is, a cost plus 10% and no one paying out-of-pocket. And when they were out-of-pocket he said, "Well, I want to adjust -- adjust it to reflect that net-net, no one's out-of-pocket." So I think the adjustment of the $95,450 was clearly what Stefan -- it was consistent with what they had negotiated. Tr. 2/9/95 at 75.

Attorney Theberge's position is unpersuasive for several reasons. He incorrectly assumed that Mitchell was donating $95,450 which it had earned and which was part of the fee it negotiated. He determined that Mitchell's compensation was reasonable believing that Mitchell's full compensation was cost plus 10 percent and $95,450. Tr. 2/9/95 at 54, 57-58, 77. He was unaware that Mitchell also received $211,571.25 to reimburse it for the contractor's guaranty it was required to post, and that these funds went to Mitchell if the project succeeded and the funds were not used. Tr. 2/9/95 at 59. He also failed to consider that Mitchell received the right to manage the project for an annual fee of 5 percent of gross rental income. n23 Div. Ex. 1 at 9. Finally, he claimed that cost plus 30 or 25 percent would have been a reasonable fee for Mitchell's services based on the testimony of others. He had no independent judgment on this issue. Tr. 2/9/95 at 58.

Attorney Theberge also adopted certain false theories put forward by Attorney Peden:

Mitchell lowered its fee from the reasonable level of cost plus 25 or 30 percent to cost plus 10 percent with no out-of-pocket expenses because its employees and shareholders were members of the limited partnership, Warren-Sherwood, Ltd., which owned the Sherwood Garden Project;

Mitchell earned the $95,450 for reasonable services rendered and contributed it to the project to benefit some of its employees and shareholders; and

Mitchell's contract was adjusted upward by $95,450, within fair value, to cover an out-of-pocket expense (closing costs in excess of 2 percent of the proceeds) in keeping with the agreement that Mitchell would receive cost plus 10 percent without any out-of-pocket expenses, meaning 100 percent financing.

Tr. 235, 315, 322, 896-900; Tr. 2/9/95 at 50-53, 55-56, 58, 64-67, 70-71.

It is well settled that the terms agreed to by independent parties in arms length negotiations are the best evidence of what is reasonable compensation for services rendered. Tr. 2/9/95 at 148, 187. Mitchell and TAW were independent parties, and Mitchell negotiated the best deal it could get for itself and related parties in all the agreements having to do with these projects. Mitchell bargained for and got a compensation package which did not include $95,450. Div. Ex. 113; Tr. 412-19; Tr. 2/9/95 at 159.

The fact that Attorney Peden had to explain to Mr. Stefan why the Official Statement showed a developer's contribution of $95,450 undercuts his position that Mitchell earned this money. According to Attorney Peden:

I was explaining to [Mr. Stefan] and was pointing out the fact that as project coordinator in this and for the functions that they were performing [Mitchell] were certainly entitled to reasonable compensation for this because they had done a great many very valuable things for this project. The project in no way could have gone forward without the Mitchell Company's activities.

I told him that what we are doing here is you are going to be getting funds like this, in effect a developer's type fee, and it is going to be limited, though, to an amount sufficient to offset what you are going to be contributing to pay the developer's contribution. Tr. 898.

There is no evidence that Mitchell left $95,450 on the table. I find it implausible that Mitchell had a claim for an additional $95,450 over the consideration to which it had agreed. Mr. Stefan was unaware that Mitchell was going to be asked to pay these costs prior to his conversation with Attorney Peden. He expected Mitchell would receive at the closing only $211,571.25 for the contractor's guaranty. Tr. 412. It was illogical and contrived for Mr. Thorn and Attorney Peden to inform the construction company that it had earned $95,450 more than it had bargained for, and that it would use the $95,450 to pay issuance costs, including part of their fee, which exceeded the 2 percent of bond proceeds allowed in a tax-exempt offering. Tr. 898-99.

The Peden and Theberge position that Mitchell and TAW were still negotiating a few days before the closing and agreed on terms, including a developer's contribution, on a phone call Attorney Peden held with Mr. Stefan and Mr. Thorn shortly before the closing is false. Mitchell and TAW had agreed on terms, and contracts were in preparation or signed, when the phone conversation occurred. Tr. 375-83, 390-92, 416, 436-46. Both the partnership agreement, which directed a cost plus construction contract, and the construction contract itself were signed on August 24, 1992, a few days before the August 27 closing.

The record is persuasive that Mr. Thorn had, from the beginning of negotiations with Mitchell, consistently represented that the project would be 100 percent financed. Therefore, he and Attorney Peden structured the offering so as not to appear to violate the Internal Revenue Code restrictions for tax-exempt offerings, and yet pay issuance costs in excess of 2 percent from bond proceeds. Tr. 357. To do this, Attorney Peden and Mr. Thorn carried out a scheme to artificially inflate Mitchell's construction contract by $95,450 for services it allegedly rendered, and directed Mitchell to contribute this amount to pay Attorney Peden and TAW for issuance costs over 2 percent of the offering. Tr. 268.

Respondents emphasize all the work Mitchell did, including that of a project coordinator, to show that Mitchell earned the $95,450. Their evidence is unpersuasive. Mr. Stefan testified the term "project coordinator" was meaningless and was used because it was on the documents from a prior transaction. Tr. 495. Someone in Mitchell's role normally incurred the cost of a property appraisal. Mitchell did not order one for Sherwood Garden, however, and it did not do a formal written feasibility study. Tr. 2/9/95 at 10-11; Tr. 495. According to Mr. Stefan, all Mitchell needed was financing because they had the property under contract, had done a walk-through inspection and had budgeted needed repairs, and had spoken with building and county officials. Tr. 355-56. The evidence is that TAW's underwriting of this project as a tax-exempt offering allowed Mitchell to recoup funds that it could not recover by other means, and provided Mr. Thorn, TAW, Mitchell, and some of their officers and employees, substantial financial benefits.

Mitchell had been looking for financing for Sherwood Garden for about two years. The Mitchell employee who located all seven projects, Mr. Griffen, testified that the Department of Housing and Urban Development had rejected Mitchell's financing proposal for Sherwood Garden. According to this Mitchell real estate broker, "Nobody was willing to do [conventional financing] because of the market at that time. And we had accumulated a good amount of cost involved in our efforts to try to do something with this complex." Tr. 2/9/95 at 12-13. According to Mr. Griffen, Mitchell recovered these costs in the reduced price it paid for the property. n24 Mr. Stefan and Mr. Saint appear to have purchased the project from the bank which was controlled by the RTC, paid a $50,000 commission, resold it to Warren-Sherwood, Ltd. for $525,000, and each pocketed $25,000. Tr. 428-30. n25

Respondents note that these projects are all successful in that interest is being paid on the bonds and the projects provide quality housing to low-income tenants. These facts are interesting but irrelevant to resolving the allegations in this proceeding.

As support for his position, Attorney Peden relied on the use of a developer's contribution in a 1990 tax-exempt offering by Clarksdale, Mississippi, in which another law firm served as bond counsel. The Clarksdale situation does not support the legality of the developer's contribution in these seven offerings because here the source of the contribution was bond proceeds while in Clarksdale the project owners obtained a bank loan and used it to make the developer's contribution. Tr. 925.

Because the only money available to pay the expenses of the offering was from the bond issue, n26 and because $95,450 was 6.81 percent of the offering proceeds, well above the 2 percent limit for tax-exempt offerings prescribed by Section 147(g), it follows that 95 percent of the offering was not used as required by Section 142(a) of the Internal Revenue Code. n27 Tr. 668-69.

The expert opinions of Attorney N. Jerold Cohen, former chief counsel of the Internal Revenue Service, n28 and Attorney Earle R. Taylorn29 are persuasive that these bonds were not tax-exempt offerings under either a direct application of the Internal Revenue Code or application of three generally accepted and closely related tax doctrines: (a) substance-over-form; n30 (b) sham transaction; n31 and (c) step transaction. n32 Tr. 650-51, 653-59, 778-90, 807.

For tax analysis purposes, the $95,450 developer's contribution, which Mitchell purportedly earned and contributed to pay issuance costs, was meaningless and should be ignored under the substance-over-form doctrine, was a sham transaction, and was meaningless because the transaction does not survive scrutiny under any of the three versions of the step transaction doctrine.

The substance-over-form doctrine is applicable where the substance of the transaction is different than the form would suggest. In such a situation, the substance of the transaction governs for tax purposes. Tr. 639-40, 780-81, 784. Accordingly, the $95,450, which Attorney Peden characterized as a developer's contribution, is meaningless and should be ignored under the substance-over-form doctrine because it was, in substance, a portion of the bond proceeds used to pay issuance costs. Tr. 653-55, 786-87.

If a transaction has no business purpose or economic substance it is a sham and will be ignored for tax purposes. Mitchell was willing and ready to execute the contract without receiving $95,450. By receiving this amount and disbursing it as Attorney Peden directed, Mitchell was simply a conduit to get funds from the bond proceeds to pay issuance costs. Tr. 645-46, 648, 710. The developer's contribution was therefore a sham transaction and bond proceeds directly financed issuance costs over 2 percent. Tr. 783-86.

Respondents' argument, that Mitchell's costs were reasonable and therefore it deserved the $95,450, is irrelevant. The fact is that Mitchell agreed to do all the work on this project for an amount that did not include the $95,450 that it received, or purportedly received, at the closing which the Official Statement designated as the developer's contribution. Tr. 648-49, 655, 788.

I agree with Attorneys Cohen and Taylor that a finding that the transaction was a sham is supported by the fact that it is unreasonable to believe that (1) the RTC, which controlled the bank that owned Mitchell, would give away funds to pay issuance costs which were the responsibility of a third party, Warren-Sherwood, Ltd.; and (2) Mitchell would donate its funds when the beneficiaries included some Mitchell owners and others who had no connection to Mitchell. n33 Tr. 649, 663, 785.

This transaction does not survive scrutiny under any of the three versions of the step transaction doctrine and is, therefore, meaningless. Under the step transaction doctrine, if the taxpayer designs the transaction to have several steps to avoid taxes, the steps are collapsed and taxability is determined from what actually occurred. Tr. 641-43, 655-59, 784, 787-88. In applying the step transaction doctrine, the closer in time the steps took place, the greater the likelihood the steps will be collapsed. Here, the steps the transfer of bond proceeds to First American, then the transfer from First American to TAW and to Attorney Peden's law firm happened on the day the offering closed. From a tax perspective, this would set off red flags that there is a potential step transaction problem. Tr. 656-57. Even if Mitchell received the $95,450, and I have found that it did not, Mitchell never had the ability to keep the money, because it was always obligated to use these funds to pay the issuance costs in excess of 2 percent of the offering. Tr. 254-55, 656.

Under the interdependence test, a generally accepted version of the step transaction doctrine, if the individual steps would not have been taken but for other steps, you would collapse the steps and examine what actually happened. The tax consequences of the transaction are determined by ignoring the intermediate step or steps. Here the developer's contribution would not have been paid to Mitchell but for Mitchell's agreement to use the funds to pay the issuance costs in excess of 2 percent. The intermediate step the payment to Mitchell would be ignored and the $95,450 would be viewed as coming directly from bond proceeds. Tr. 642, 658-59.

Two other versions of the step transaction doctrine yield the same result. Under the most limited version, the binding commitment test, because Mitchell was committed to pay issuance costs of $95,450 at the time it received that amount, one would, for tax purposes, collapse the steps and look at the end result. The $95,450 would, therefore, be considered as coming directly from the bond proceeds to pay issuance costs in excess of 2 percent. Tr. 642-43, 657. Under the end result test, the broadest application of the doctrine, the alleged payment to Mitchell and the developer's contribution in the same amount are ignored as steps taken to make it appear, for tax purposes, that bond proceeds were not used to pay issuance costs over 2 percent. Tr. 641-42. Since the only money coming in was from the bond offering, bond proceeds are considered to have been used to pay issuance costs. Tr. 657-58.

For purposes of the above analysis, I assumed respondents were correct that Mitchell received $95,450 from the bond proceeds and disbursed it to TAW and Attorney Peden's law firm. However, this claim does not appear to be true. There is nothing to indicate that First American's function was to do more than the normal function of a title company, which is to accept that portion of the bond proceeds going to purchase the property. n34 Tr. 645. I find that Mitchell had no claim to the $95,450, and neither Mitchell nor anyone acting for it ever had custody of the $95,450. This finding is supported by the testimony of the examiners from the Commission's Division of Market Regulation. In their examination of TAW's books and records, the examiners could not reconcile the statement of receipts and disbursements at closing and the Official Statement's sources and uses of funds because the funds from the developer's contribution "were not there at the closing." Tr. 743; see also Tr. 177-78.

2. Bond proceeds totalled $1.5 million

Attorney Peden and at least two experts agreed that reasonable investors would believe that funds at the closing would total $1,501,450 based on information in the Official Statement. Div. Ex 1; Tr. 336, 798; Tr. 2/9/95 at 104. This material representation was false because the developer did not contribute $95,450 so that the offering raised $1,402,500. Counsel Ex. 1 at 7; Tr. 798-99.

3. Application of funds: construction $713,950

The expert testimony is that an investor would interpret this representation to mean that $713,950 was spent on hard costs to improve the property. This was false material information. Tr. 796-97. The $713,000 included only about $425,000 for construction costs including the 10 percent. n35 The rest of the funds were spent on the $211,000 to reimburse Mitchell for the cost of the contractor's guaranty, and on the $95,450 for the developer's contribution. Tr. 376-77, 392, 796.

4. The project was a turnkey project

There is no dispute that Mr. Thorn lied and caused Attorney Peden to believe that the construction contract for Sherwood Garden would be a turnkey contract. Mr. Thorn received a draft of the Official Statement, which stated that the project was a turnkey project, and discussed its contents with Attorney Peden and Mr. Stefan in a phone conversation a few days before August 27. TAW and Mr. Thorn issued an Official Statement which Mr. Thorn knew was materially erroneous because he knew his agreement with Mr. Stefan, the limited partnership agreement, and the construction contract which Mitchell had signed on August 24, all provided for a cost plus construction contract which absolved Mitchell from responsibility for cost overruns.

I reject Mr. Thorn's excuse that he was confused and that the misrepresentation was immaterial because Mitchell had agreed to do the construction for a sum certain. Tr. 114. The expert evidence is that the terms of the construction contract, including liability for cost overruns, are materially significant especially on an offering such as this where the funds to pay interest on the bonds will be generated solely by the cash flows from the project. n36 Tr. 800-01, 822-23.

5. Site value was $525,000

The Official Statement's Application of Funds showed $525,000 as the amount to be paid for the site purchase. Div. Ex. 63C at 11; Div. Ex. 1 at 7. Based on this representation, an investor would reasonably expect that the property was worth about one half million dollars. This was not true. It appears from the record that Mr. Stefan and Mr. Saint exercised an option and acquired the property for approximately $425,000 and resold it to Warren-Sherwood, Ltd. for $525,000. Mr. Stefan admits to negotiating a reduced price. He claimed to have paid a $25,000 commission to a real estate agent and acknowledged splitting $50,000 with Mr. Saint. Tr. 428-29; Tr. 2/9/95 at 12-14.

Mr. Stefan claimed to have told Mr. Thorn before the closing that he and Mr. Saint had purchased the site for less than $525,000. Tr. 428-29, 481-89, 525-26. Mr. Thorn's credibility is highly suspect based on the evidence in this record. Even if you accept Mr. Thorn's position that he did not know that Mr. Stefan paid less than $525,000, he did not fulfill an underwriter's obligation to assure the accuracy of this material information in the Official Statement.

Mr. Thorn devoted little time to the responsibilities of an underwriter on these offerings. Tr. 87-88. In the five months from the initial contact in April, until the August 27 closing, Mr. Stefan and Mr. Thorn only spoke five or six times for about 15 minutes each time. Tr. 358. He met with Mr. Stefan and Mr. Saint once briefly. Mr. Thorn did not verify the price Mr. Stefan actually paid for the property he resold to Warren-Sherwood, Ltd., and he failed to get an appraisal supporting the $525,000 purchase price. In 1988, the property was appraised at $1,750,000 in "as-is" condition. Tr. 2/9/95 at 11. The record does not show whether this appraisal occurred before or after 52 units had been flooded three times, and whether it considered the asbestos and other possible problems with hazardous waste caused by the required removal of the flooded units. Tr. 2/9/95 at 12.

The unrefuted expert testimony is that while the amounts are small, the fact that the property was purchased from related parties made this misrepresentation and omission material. Tr. 801-02.

6. Contractor's guaranty

The Official Statement provided that the contractor would guaranty payment of principal and interest on the bonds pursuant to a limited guaranty agreement issued by Mitchell, and that Mitchell intended to buy government zero based bonds or strips to meet this obligation. Div. Ex. 1 at iii. n37 The Official Statement did not reveal that Mitchell received the cost of the contractor's guaranty, $211,571.25, from bond proceeds. Tr. 2/9/95 at 187-93. According to Mr. Thorn, this money was part of the $713,950 described as "Construction" in the Application of Funds section of the Official Statement. Tr. 83-84; Div. Ex. 1 at 7.

Attorney Cohen's opinion that the Official Statement permitted Mitchell to get out of its obligation to provide a guaranty by buying the strips and depositing them with the trustee is unrefuted on this record. This is not clear from the document. Tr. 2/9/95 at 187-93.

Q. But isn't part of what the contractor's being paid, the $713,000, for providing this guarantee?

A. No, there's no guarantee. The minute this transaction closed there's no guarantee, Mr. Russ. The minute the transaction closed, the strips are purchased, they're deposited, there's no further guarantee. Contractor never had a guarantee.

Tr. 2/9/95 at 192.

The expert's position is affirmed by evidence that Mr. Yelverton at TAW told Attorney Peden that Mitchell would find it difficult to furnish the guaranty because it was under RTC control, and Attorney Peden indicated he was willing for Mitchell to do the work without a bond. Tr. 953.

Municipal Securities Rulemaking Board Rule G-17 and Exchange Act Section 15B(c) (1)

On these facts, TAW violated Municipal Securities Rulemaking Board (MSRB) Rule G-17, which specifies that a broker-dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest or unfair practice, and Section 15B(c) (1) of the Exchange Act, which prohibits a broker-dealer from using the mails or any means of interstate commerce to effect any transaction which violates an MSRB rule. The MSRB has interpreted Rule G-17 as prohibiting conduct which violates the antifraud provisions of the securities statutes. MSRB Manual (CCH) at 4864, 4867.

Mr. Thorn willfully aided and abetted TAW's violations because there were independent or primary securities law violations, he knew that his activities were part of an overall activity that was illegal, and he knowingly gave substantial assistance in effecting the primary violations. Woods v. Barnett Bank of Fort Lauderdale, 765 F.2d 1004, 1009 (11th Cir. 1985); IIT, an International Investment Trust v. Cornfeld, 619 F.2d 909, 922 (2d Cir. 1980).

Respondents' Arguments

Respondents argue: (1) reliance on advice of counsel is an absolute defense to securities fraud charges; (2) the Internal Revenue Service has exclusive jurisdiction on the tax-exempt status of the offerings; and (3) Attorney Peden's tax analysis was correct.

Reliance on counsel's advice is not an absolute defense, and a person asserting reliance on counsel as a defense must show that he/she: (1) made a complete disclosure to counsel; (2) sought and received advice that the proposed conduct was legal; and (3) relied on that advice in good faith. Markowski v. SEC, 34 F.3d 99, 105 (2d Cir. 1994); SEC v. Goldfield Deep Mines Co. of Nevada, 758 F.2d 459, 467 (9th Cir. 1985); SEC v. Mechoir, [1992-1993 Transfer Binder] Fed Sec. L. Rep. (CCH) P 97,356 at 95,838 (D. Utah, Jan. 14, 1993). This defense is inapplicable to Mr. Thorn because he lied and withheld several pieces of material information from underwriter's counsel.

Mr. Thorn did not tell Attorney Peden that Mitchell had agreed to do all the work for compensation which did not include the $95,450; that Mitchell and Warren-Sherwood, Ltd. had entered a cost plus 10 percent construction contract before the Sherwood Garden offering closed on August 27; and that Mitchell would receive a 25 percent incentive fee for managing the property. Because he lied to counsel and withheld material information from him, and because he knew that information he distributed to investors was false and misleading, Mr. Thorn did not act in good faith in reliance on counsel's advice.

Mr. Thorn claimed he directed Attorney Peden to structure a tax-exempt offering and then merely followed his instructions. According to Mr. Thorn,

I said Derryl, are we going to do a taxable tail for this excess of two percent, or are we just going to put in the cash like we did in Clarksdale, which we went to the bank and borrowed the money and put it in. It was paid from the contractor's profits. He said well, let me get back to you. I don't remember exactly.

He got back to me. He said John, you're working with [the] Mitchell Company, which are honorable people. He said they're going to be entitled to certain fees at the closing. They can take these fees, and what we're going to do is we're going to make these fees where they are going to exceed what we need in order to help make the project better because they were really entitled to more money. There's no doubt about that. Tr. 85.

Contrary to his testimony given under oath, Mr. Thorn was not a naive client depending on legal counsel for advice in a difficult legal area in which he was unfamiliar. He is a college graduate with many years of specialized experience in this subject matter. In addition, there is testimony from Attorney Peden that perhaps Mr. Thorn was the one who came up with the structure for the seven offerings. Tr. 268. The evidence is persuasive that Mr. Thorn willingly and willfully participated as underwriter in these seven bond offerings and his participation was part of a scheme to defraud public investors. Mr. Thorn's college and theological education and his thirty years experience specializing in tax-exempt securities caused him to know that the material information he provided to the public was false, and that he omitted to disclose material information which was necessary to make statements he made not misleading.

There are many points in the record where Mr. Thorn lied or where he could not remember information. n38 For example, Mr. Thorn lied in the investigative phase of this proceeding when he stated he was unaware that the bond's tax-exempt status depended on compliance with the 2 percent rule. Tr. 77-79. Contrary to his assertions, the evidence is persuasive that Mr. Thorn knew that: (1) issuance costs paid from the bond proceeds could not exceed 2 percent for the bonds to be tax-exempt; (2) Mitchell agreed to compensation that did not include $95,450; (3) the owner/developer would not be contributing funds; and (4) the Official Statement falsely represented that the developer was contributing funds to pay issuance costs over 2 percent. Tr. 76. Mr. Thorn assured Mitchell that the deal would be 100 percent financed and thus acquired for himself and others an equity interest in the projects.

Mr. Thorn did not recall that the Official Statements represented that all but the last project were turnkey projects. Tr. 164. After the Commission began its investigation, Mr. Thorn tried to understand how the developer's contribution was handled at the closings. Tr. 165.

I reject respondents' defense that the Internal Revenue Service has exclusive jurisdiction in this area. n39 I denied the same argument on October 12, 1994, when respondents advanced it as an affirmative defense. Ruling On Motion to Strike Affirmative Defenses, 57 SEC Docket 2421 (1994).

I find that TAW and Mr. Thorn willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and that TAW willfully violated, and Mr. Thorn willfully aided and abetted violations of, Section 15B(c) (1) of the Exchange Act and MSRB Rule G-17, by offering and selling the seven private activity bond offerings described herein to the public using Offering Statements that were false and misleading in material respects.

Sanctions

Bar and Revocation

I find that revoking TAW's broker-dealer registration and barring Mr. Thorn from association with any broker or dealer and from dealing in municipal securities are necessary to protect public investors.

As a substantial equity owner, firm president, and registered municipal securities principal, Mr. Thorn controlled TAW's involvement in these seven offerings. I therefore impute his knowledge and actions to TAW. SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1097 n.18 (2d Cir. 1972).n40

Mr. Thorn is a tax professional, with 30 years of specialization in tax-exempt offerings, who knew all the material facts. Acting with a high level of scienter, he committed egregious violations of the securities statutes and regulations. The illegalities were not isolated events but occurred in seven bond offerings during a 15 month period that totaled almost $19.5 million. The likelihood of future violations is high since the respondents do not acknowledge any wrongdoing or give any assurance that the violations will not reoccur. Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd, 450 U.S. 91 (1981).

In addition to the Steadman criteria, other factors that persuade me that this sanction is necessary are Mr. Thorn's lack of candor, TAW's abysmal failure to carry out its underwriter's due diligence responsibilities, and the fact that TAW's primary concern was the personal financial benefit of persons in the firm with no concern for their responsibilities as securities professionals.

Mr. Thorn's due diligence activities on the Sherwood Garden offering consisted of coordinating and talking with the construction company, n41 visiting the project, checking on the need for rental units by talking to people, and checking on rents in the area. Tr. 58-59, 71. Personally, Mr. Thorn only made sure the figures on the closing sheet added up. He let others check that disbursements occurred as represented. n42 Tr. 161-62.

Mr. Yelverton, a TAW owner and director, acted in Mr. Thorn's absence. In doing due diligence on Sherwood Gardens, Mr. Yelverton relied on Mitchell for rental information and vacancy rates because "that is their business, and you have to rely on them for that." Tr. 949. Mr. Yelverton only read that part of the partnership agreement for Warren-Sherwood, Ltd. to make sure TAW got its agreed percentage. Tr. 954. TAW did not have a copy of the construction contract in its file. Tr. 956-57. Mr. Yelverton described the underwriter's responsibilities at the closing, "All I was assured of is that out of the closing we received the compensation that was coming to us. At that point I was satisfied." Tr. 969.

Disgorgement

Sections 8A of the Securities Act and 21C of the Exchange Act authorize the Commission to order an accounting and disgorgement, including reasonable interest, in cease and desist proceedings when, as here, respondents have violated the securities statutes and regulations. Disgorgement is an equitable remedy "uniquely suited to redress or cancel unfairness and promote investor confidence in securities transactions." SEC v. World Gambling Corp., 555 F.Supp. 930, 934 (S.D.N.Y. 1983). The deterrent effect of the Commission's enforcement efforts will be diminished if securities violators were not required to disgorge their illicit profits. Manor Nursing Centers, 458 F.2d at 1104.

The rationale cited in the above cases is applicable to this situation. I find, therefore, that TAW and Mr. Thorn should disgorge the net underwriting fee they received on these seven offerings, plus pre-judgment interest; TAW received $117,376 and $116,827, and Mr. Thorn received $116,432. Counsel Ex. 1 at 15. I find further that Mr. Thorn should disgorge his equity interest in the seven partnerships that own the housing projects that were the subject of the offerings. n43 Counsel Ex. 1. Disgorgement wrests ill-gotten gains from the hands of the wrongdoer, and is meant to prevent the wrongdoer from enriching himself by his wrongs. SEC v. Huffman, 996 F.2d 800, 802 (5th Cir. 1993).

Civil Penalty

Section 21B of the Exchange Act provides for three tiers of monetary penalties in an administrative action where the respondents have willfully violated the securities statutes, regulations thereunder, or MSRB rules, and the penalty is in the public interest. The statute does not specify characteristics for the first tier. Tier two is applicable where the violations "involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement." Tier three is applicable where, in addition to the characteristics present at tier two, the violations caused substantial losses or the risk of such, or substantial pecuniary gain to the person who committed the violations. n44

I find it in the public interest to assess civil penalties at the highest level, $100,000 against Mr. Thorn and $500,000 against TAW. Mr. Thorn's unblemished record in the securities industry is outweighed by the following considerations:

(1) his actions involved fraud, deceit, and deliberate or reckless disregard of the applicable laws and regulations;

(2) his actions caused him to be unjustly enriched by partial ownership of seven housing projects which are valuable as real estate investments and as operating businesses:

Property Mr. Thorn's
Ownership
Interest
Property Acquisition
Cost Before Rehab
Record Citation
Sherwood Gardens 19.8% $525,000 Counsel Ex. 1
Northwest Plaza 13.2% $315,000 Div. Ex.46 at 11
Eden Point 19.8% $1,400,000 Div. Ex 70
The Pines 13.2% $1,100,000 Div. Ex. 88 at 11-12
Northpark 19.8% $670,000 Div. Ex. 82 at 12
Glen Oaks 14.9% $2,030,000 Div. Ex. 39 at 11
The Lodge 19.8% $1,100,000 Div. Ex. 66 at 11

(3) his actions could cause financial harm to persons who purchased these bonds relying on the false representation that the interest was tax-exempt; and

(4) the securities industry presents many opportunities for fraud so that these strong penalties are necessary to deter others.

Cease and desist

A cease and desist order is applicable when, as here, the respondents violated the statutes and regulations. n45

Order

Pursuant to Section 8A of the Securities Act, and Sections 15(b), 19(h), and 21C of the Exchange Act,

I ORDER that the broker-dealer registration of Thorn, Welch & Co., Inc., n46 be, and it hereby is, revoked, and that John E. Thorn, Jr., be, and he hereby is, barred from association with any broker or dealer and from dealing in municipal securities; n47

I FURTHER ORDER that Thorn, Welch & Co., Inc., disgorge $234,203, and that Mr. Thorn disgorge $116,432 and his equity interest in the seven limited partnerships that own the seven projects which were the subject of these bond offerings, plus prejudgment interest from November 1, 1993 through the last day of the month preceding which payment is made at the rate of interest established under Section 6621(a) (2) of the Internal Revenue Code, compounded quarterly. n48 A copy of the letter transmitting the payment should be sent to the Atlanta District Office, Division of Enforcement, Securities and Exchange Commission.

If and when the respondents pay any or all of the disgorgement amount and interest, the parties shall submit to the Office of Administrative Law Judges, within 60 days, a plan for the administration and distribution of those funds.

I FURTHER ORDER that Mr. Thorn and Thorn, Welch & Co., Inc. pay penalties of $100,000 and $500,000, respectively. n49

I FURTHER ORDER that John E. Thorn, Jr. and Thorn, Welch & Co., Inc., cease and desist from committing or causing any present or future violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, and that Thorn, Welch & Co., Inc. cease and desist from committing or causing, and Mr. Thorn cease and desist from aiding and abetting, any present or future violations of Section 15B(c) (1) of the Exchange Act and MSRB Rule G-17.

This order shall become effective in accordance with and subject to the provisions of Rule 17(f) of the Commission's Rules of Practice, 17 C.F.R. 201.17 (1995). Pursuant to that rule, this initial decision shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 17(b) within 15 days after service of the initial decision upon that party, unless the Commission, pursuant to Rule 17(c), determines on its own initiative to review this initial decision as to a party. If a party timely files a petition for review, or the Commission acts to review as to a party, the initial decision shall not become final as to that party.

Washington, D.C.

May 2, 1996

Footnotes

-[n1]- Three people testified twice. The transcript for January 2 through 5 is numbered 1 to 1002 and I will refer to it as Tr. . The transcript of February 9 is numbered 1 to 210. I will refer to it as Tr. 2/9/95 at .

-[n2]- The Division's exhibits are referred to by number as Div. Ex. ; the respondents' exhibits are referred to by number as Resp. Ex. . Exhibits that were stipulated to by all parties are referred to by number as Counsel Ex. .

-[n3]- n3 My findings are based on the record and my observation of the witnesses' demeanor. I applied preponderance of the evidence as the applicable standard of proof. I have considered all proposed findings and conclusions and all contentions, and I accept those that are consistent with this decision.

-[n4]- Lewis Carroll, Alice's Adventures in Wonderland, Chap. II.

-[n5]- The term private activity bond indicates that a municipality or state government served in effect as a conduit for the private party to achieve tax-exempt financing. Tr. 635. A bond is a private activity bond if 10 percent or more of the bond issue proceeds are used for private business uses. Internal Revenue Code, 26 U.S.C. 141.

-[n6]- The record is confusing because witnesses used the term Mitchell when they meant individual officers or employees or one of several companies.

-[n7]- Paul C. Wesch, Mitchell secretary, senior vice president, and legal counsel, prepared the documents. According to Attorney Wesch, the certificate of limited partnership executed July 22, 1992, is a perfunctory but statutorily required document. Tr. 728. The partnership agreement is a non-filed instrument prepared on or after July 22, 1992, but prior to its first execution on August 21, 1992.

-[n8]- The underwriter allowed a person with conflicting interests to sign documents for more than one party. For example, Mr. Stefan signed the construction contract between Mitchell and Warren-Sherwood, Ltd., on behalf of Warren-Sherwood, Ltd., of which he was a partial owner. Mr. Stefan was an executive vice president of Mitchell.

-[n9]- I reject Mr. Thorn's denial that he prepared the Official Statement with underwriter's counsel. He admits to furnishing counsel with information, reviewing and providing comments on counsel's draft, and approving the final version which was furnished to investors.

-[n10]- A turnkey contract is where the contractor agrees, for a set fee, to turn over to the developer a completed project that is ready to rent. Tr. 113.

-[n11]- One hundred percent financing refers to a situation where the parties developer, owner and/or construction company do not have to contribute additional funds over what is raised from the offering. Tr. 517-19.

-[n12]- The testimony was that the payment was to Mitchell; however, the limited partnership agreement provided for payment of the management fee and the incentive fee to "the General Partnership and its Affiliates." Div. Ex. 63C at 13. The partnership's general partner was Disposition & Management, owned by Mr. Saint and Mr. Stefan.

-[n13]- Attorney Peden believed the Official Statement accurately described Sherwood Garden as a turnkey project even though the construction contract provided that Mitchell would do the work for actual costs plus 10 percent. Tr. 247-49, 929-33.

-[n14]- Mitchell paid small cost overruns on Sherwood Garden and some of the other projects of between five and ten thousand dollars. One project, Glen Oaks, had more serious problems and Mitchell put in approximately $86,000. Tr. 438-48.

-[n15]- The testimony is that Mr. Stefan was able to understand Attorney Peden's explanation when it was analogized to a Builders and Sponsors Profit and Risk Allowance (BSPRA), a device reportedly used in Federal Housing Act deals by the Department of Housing and Urban Development when the contractor leaves something of value in the project. Respondents' Counterstatement of Proposed Findings of Fact and Conclusions of Law at 25. There was no BSPRA in this situation. Tr. 399, 650, 788.

-[n16]- Attorney Peden prepared this because Mr. Thorn wanted to document the agreement with Mitchell. Attorney Peden believed that TAW and Mitchell "were staffed with honorable men who would adhere to their word." Tr. 254-57.

-[n17]- Respondents and the Division stipulated that the offering proceeds totaled $1,402,500, but the disbursement sheet at closing puts the total at $1,410,693. Compare Counsel Ex. 1 at 7 with Div. Ex. 47.

-[n18]- In the other six offerings, issuance costs as a percentage of bond offerings were as follows: Northwest Plaza, 9.44%; Eden Point, 7.63%; The Pines, 7.57%; Northpark, 9.41%; Glen Oaks, 7.99%; and The Lodge, 6.96%. Tr. 560-74.

-[n19]- This provision was added to the Internal Revenue Code in 1986 when Congress made a policy decision that bond professionals were making too much money from their participation in tax-exempt offerings. Tr. 778.

-[n20]- These two provisions are applied independently. If either provision is not met, interest on the bonds is not tax-exempt. Tr. 636-38.

-[n21]- The evidence is unanimous that issuance costs almost always exceed 2 percent of the offering proceeds in tax-exempt offerings. The two basic ways of raising funds to pay issuance costs over 2 percent of the offering are either a contribution from the developer or owner, or a taxable bond issue (taxable tail) for the amount of the additional costs. Tr. 2/9/95 at 81-82.

-[n22]- Attorney Theberge is a partner in the law firm of Kutak, Rock in Washington, D.C.

-[n23]- No expert has opined that these offerings were tax-exempt on the facts as I have found them.

-[n24]- The witness's references were to Mitchell, but the evidence is that Mr. Stefan and Mr. Saint each made a profit of $25,000 by buying the property for less than the $525,000 they charged the limited partnership.

-[n25]- Attorney Cohen calculated Mitchell's profits on the seven offerings applying respondents' position. The summary of 10 percent of construction costs, the developer's contribution, and the cost of the contractor's guaranty, would give Mitchell a profit of $371,926, or 26.52 percent of the bond offering, on the Sherwood Garden Project. Div., Ex. 117. Similar results occurred on each of the seven offerings. Attorney Cohen characterized these results as staggering in terms of total construction costs and outlandish in terms of hard construction costs. Tr. 2/9/95 at 156.

-[n26]- According to one expert, when, as here, no other money is brought to the table but the bond proceeds, it immediately raises questions as to whether issuance costs above the 2 percent limit are being financed from bond proceeds. Tr. 713.

-[n27]- This is also true for the other six offerings. Counsel Ex. 1 at 7.

-[n28]- Attorney Cohen is a partner in the firm of Sutherland, Asbill & Brennan in Atlanta. Attorney Cohen was qualified as a tax expert. Attorney Cohen believed, with close to 100 percent certainty, that these bonds were not tax-exempt. Tr. 659. In his opinion, it is doubtful that any reasonable, competent tax counsel could find these offerings to be tax-exempt. Tr. 2/9/95 at 208.

-[n29]- Attorney Taylor, a partner in the firm of Kilpatrick & Cody in Atlanta, is a member of the firm's public finance group. He was qualified as an expert on tax law, especially disclosure and materiality. Tr. 771-74.

-[n30]- Attorney Taylor believed this doctrine is the one that most clearly and easily destroys the tax-exempt status of these bonds. Tr. 786.

-[n31]- This is the most difficult of the three theories to satisfy. Tr. 651, 784.

-[n32]- Attorneys Cohen and Taylor believe that the Memorandum of Agreement, which the parties signed at the closing, described a situation which violated Internal Revenue Code Sections 142(a) and 147(g). Tr. 649-50, 779. Attorney Taylor was adamant that it showed a non-exempt transaction because Mitchell got a contract financed with bond proceeds by agreeing to pay costs that could not be paid with bond proceeds. Tr. 784-88.

-[n33]- Attorney Taylor believed the entire scenario contained all types of red flags. Tr. 784-85.

-[n34]- Mr. Stefan selected First American and testified that it was "our agent." Tr. 474-75. However, considering the variety of roles Mr. Stefan played in the transaction, I am not sure if he was referring to Mitchell, he and Mr. Saint who held an option on the property, or Warren-Sherwood, Ltd. of which he was an owner. Since Warren-Sherwood, Ltd. was the owner/developer, it is logical that First American was its agent, not the agent of the construction company.

-[n35]- Mitchell agreed to do the work on a best efforts basis for $429,855 which included the 10 percent return. Tr. 417-19. Mr. Yelverton, who worked with Mr. Thorn at TAW, got a construction cost figure from Mitchell of about $400,000 plus. Tr. 950. Mr. Yelverton accepted the hard costs that Mitchell gave him as true, and made no attempt to verify beyond talking to persons at Mitchell. Tr. 950-53.

-[n36]- Expert Attorney Taylor testified:

So economically there is a big difference between the contractor eating the cost overruns and the partnership eating the cost overruns. . . . To the extent the partnership has to pay cost overruns, there is less cash available to pay my bonds if I were an investor. So on that basis I say there is a material misstatement. Tr. 800-01.

-[n37]- Both Division experts opined that payment of $211,571.25 to Mitchell from bond proceeds for the zero interest bonds or strips violated the Internal Revenue Code provisions for a non-taxable bond offering and made the interest on these bonds taxable. Tr. 651, 779-80; Tr. 2/9/95 at 154-55. I sustained objections to this testimony because the Order Instituting Proceedings did not challenge the legitimacy of this use of bond proceeds.

-[n38]- According to Mr. Stefan and Mr. Griffen, Mr. Thorn consistently stated that the deal would be 100 percent financed. Tr. 357. Mr. Thorn denied ever telling Mr. Stefan that the transaction would be financed 100 percent. Tr. 133-35, 144-45, 162. Mr. Thorn's position is that the offering was not 100 percent financed. Tr. 141-43.

-[n39]- It is obvious that I deny respondents' defense that Attorney Peden's tax analysis was correct.

-[n40]- See also Gotham Securities Corp., 46 S.E.C. 723, 727 n.19 (1976).

-[n41]- Mr. Thorn thought Mitchell was responsible for construction cost overruns even though the construction contract provided otherwise. Tr. 115.

-[n42]- In his investigative testimony, Mr. Thorn said he made sure that disbursements were done according to the Sources and Applications of Funds in the Official Statement. Tr. 148-50.

-[n43]- The Division's position would allow Mr. Thorn to retain what he acquired by fraud. Division's Post-Hearing Brief at 31-32, n.32.

-[n44]- The Division has recommended the application of penalties at the second tier of $50,000 against Mr. Thorn and $250,000 against TAW. Post Hearing Brief at 32; Reply Brief at 22.

-[n45]- The Order Instituting Proceedings raises the possibility of an order requiring future compliance or steps to effect future compliance. In view of the other sanctions that I have ordered, it does not seem necessary.

-[n46]- The firm has changed its name to Thorn, Welch & Co., Inc.

-[n47]- The Division recommended that I bar Mr. Thorn from association with any investment adviser, investment company, and municipal securities dealer. I deny this request because the sections of the statutes which are the basis for this proceeding do not, in my opinion, provide for such broad sanctions. This issue is before the Commission.

-[n48]- I have used November 1, 1993, the first day of the month following the closing of the last bond offering at issue as the date to begin assessing interest. Payment should be made by certified check payable to the Securities and Exchange Commission, bearing on its face the caption John E. Thorn and Thorn, Alvis, Welch, Inc., Administrative Proceeding No. 3-8400. The check should be sent to the Office of the Comptroller, Room 2067, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, on the first day after this decision becomes final.

-[n49]- Payment should be made in accordance with procedures outlined in n.48.

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Modified:09/21/1999