UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
Securities Exchange Act of 1934
Release No. 42080 / November 1, 1999
Accounting and Auditing Enforcement
Release No. 1199 / November 1, 1999
File No. 3-9846
In the Matter of :
: ORDER MAKING
JEFFREY L. HARFST,WILLIAM R. : FINDINGS, IMPOSING
HEBEL and JOSEPH E. MUEHL : REMEDIAL SANCTIONS
: AND CEASE-AND-DESIST
: ORDER AS TO JEFFREY L.
Jeffrey L. Harfst has submitted an Offer of Settlement for the purpose of disposing of the issues raised by these proceedings. Solely for the purposes of these proceedings and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and prior to hearing and without admitting or denying the findings set forth herein, Harfst consents to the entry of this Order Making Findings, Imposing Remedial Sanctions and Cease-and-Desist Order as to Jeffrey L. Harfst ("Order"). The Commission has determined that it is appropriate and in the public interest to accept the Offer of Settlement from Harfst, and accordingly is issuing this Order.1
Based on the foregoing, the Commission finds that:2
Jeffrey L. Harfst, age 59, at all relevant times, was an Executive Vice President and co-Chief Financial Officer at The Nikko Securities Co. International, Inc. ("Nikko"). Nikko is a broker-dealer registered with the Commission pursuant to Section 15 of the Securities Exchange Act of 1934 ("Exchange Act") and is a wholly-owned subsidiary of The Nikko Securities Co. Ltd.
From August 1994 through October 1994, Nikko, with Harfst's knowledge, overstated the fair value of its portfolio of mortgage-backed securities (the "MBS portfolio") in its books and records and in FOCUS reports. In November 1994, Nikko sold the majority of the MBS portfolio in a less-than-arm's-length transaction to its London-based affiliate, Nikko Europe Plc ("Nikko Europe") for $134 million, at least $17 million above fair value. Nikko, again with Harfst's knowledge, then improperly booked the transaction as trading proceeds and failed to report the $17 million loss that would have been recognized had the securities purchased by Nikko Europe been properly valued.
Several months later, in February 1995, Nikko, acting as broker for Nikko Europe, sold a portion of the MBS portfolio. In connection with that sale, a Nikko salesman ("Salesman") and his supervisor ("Salesman's Supervisor") engaged in a fraudulent scheme to misappropriate approximately $842,000 for the benefit of Nikko from Nikko Europe. The Salesman arranged to sell the MBS portfolio in four swap transactions with a third party, in which the prices were deliberately marked down to generate a profit at the expense of Nikko Europe. In order to conceal their scheme, the Salesman, with the Salesman's Supervisor, falsified Nikko's books and records to hide the illicit profits. As part of this scheme, the Salesman and the Salesman's Supervisor told Harfst that the Salesman had certain profits he wanted to recognize over time, instead of on the day made. Harfst agreed to allow the profits to be recorded within two days so long as all the profits were recorded by month-end. Harfst learned in early March that the profits had not been recorded as instructed, yet took no further action. As a result of these activities, Nikko's books and records and FOCUS reports were inaccurate.
Throughout the period of these violations, Nikko was subject to a May 19, 1993 Commission administrative and cease-and-desist order for violating the same provisions and was working with a consultant on a report to be delivered to the Commission with respect to its compliance with the Commission's outstanding order. At the time of the actions described herein, Harfst was working with the consultant to prepare the report, which was delivered to the Commission on May 1, 1995.
C. Nikko Mismarks Its MBS Portfolio
During the summer of 1994, MBS market prices declined following an increase in long-term interest rates and a drop in demand for the MBS derivative securities like those held in the Nikko portfolio. Consequently, the fair value of Nikko's MBS portfolio declined. Under Harfst's supervision, Nikko's risk manager prepared and distributed reports to Nikko's upper management reflecting the decline in the fair value3 of Nikko's MBS portfolio and documented the amount by which Nikko's carrying value exceeded fair value. In fact, the risk manager's reports documented that Nikko's carrying value for the portfolio exceeded fair value by $9.6 million at the end of August and September 1994, by $17.5 million by the end of October 1994, and by $21 million by November 18, 1994. Harfst knew that despite the decline in the fair value of its MBS portfolio, Nikko had not marked its position down.
In October 1994, Nikko discontinued proprietary trading in the MBS market and terminated twenty-six of the MBS trading and sales personnel. Only one employee, the Salesman, was retained to sell off the remainder of the MBS portfolio and to trade MBS pass-through securities.
At an October 13, 1994 meeting, Harfst told Nikko's risk committee that since the retail sales force had been terminated, management should consider increasing the reserve for the MBS portfolio from $5 million to $10-15 million "to reach broker bid levels," if the portfolio was still owned by Nikko at the end of October. Although Nikko held the position at the end of October 1994, Harfst took insufficient steps to ensure that the reserve was increased and, in fact, the reserve was not increased.
From at least August through early November 1994, Nikko, with Harfst's knowledge, carried the portfolio in its books and records at inflated values and reported these inflated values in its monthly FOCUS reports.
D. The Sale of the MBS Portfolio to Nikko Europe
When the Salesman was unable to sell Nikko's MBS portfolio at prices sought by Nikko, which were close to the inflated values at which the portfolio was carried on Nikko's books, Nikko decided to sell the majority of the MBS portfolio to Nikko Europe.
On November 23, 1994, Nikko Europe paid $134 million in cash for the portfolio, a sale price Nikko could not have realized in a sale to the market and a $17 million premium to market value, as calculated by the firm's risk manager.
Harfst knew that the sale to Nikko Europe, which occurred on November 23, 1994, was not an arm's-length transaction, but was an attempt by Nikko Europe to come to the aid of Nikko.
Through the above-market purchase of the majority of the MBS portfolio, Nikko Europe effectively eliminated the $17 million trading loss that Nikko should have recognized and effectively provided Nikko with $17 million paid-in capital. Nikko's internal books and records and its monthly FOCUS reports nonetheless recorded the proceeds from the transaction as if there were only a $3 million loss, thus improperly presenting the income statement for November 1994, and retained earnings and additional paid-in capital for all succeeding months.
Harfst knew about the terms of the sale to Nikko Europe, yet did not ensure that the firm's books and records accurately reflected the transaction.
E. Fraudulent Swap Transactions
After terminating its MBS sales force, the New York Stock Exchange contacted Harfst to warn Nikko against attempting to shift its losses temporarily to an affiliated company. After receiving that warning, Harfst understood that Nikko could not act as a principal in any subsequent sale of the MBS portfolio.
In January 1995, when the MBS market began to improve, Nikko Europe placed an order with Nikko to sell on an agency basis a block of the MBS portfolio securities at Nikko Europe's break-even price "or higher."
The Salesman and the Salesman's Supervisor devised a plan to generate profits for Nikko and for the Fixed Income trading operation, and to hide the profits from the firm's customer, Nikko Europe. The Salesman sold the securities well below the market price to an unaffiliated broker (the "Unaffiliated Broker"). The Unaffiliated Broker simultaneously sold to Nikko's proprietary account certain pass-through securities at prices that had been adjusted down to correspond to the profits hidden by the Salesman from the customer, Nikko Europe. The Salesman then immediately sold the pass-through securities to the market and generated a total of $842,851 in profits for the benefit of Nikko without the knowledge or consent of Nikko Europe.
F. The Salesman and The Salesman's Supervisor Conceal Profits
by Mismarking GNMA Positions in Nikko's Proprietary Accounts
To hide the large daily profits made on the swap transactions and to prevent the appearance of volatility on his daily profit and loss, the Salesman, with the Salesman's Supervisor's knowledge, deliberately mismarked the prices on certain GNMA securities owned by Nikko.
On February 23, 1995, the day after the first swap, an internal accountant at Nikko (the "Accountant") discovered that the Salesman's pricing on the GNMA securities was unreasonably low. That day, the Accountant and his supervisor (the "Accounting Supervisor") learned from the Salesman that he had priced the GNMA position to offset $267,000 in profits that Nikko realized on the resale of the pass-through securities on February 22 in order to "bleed in" the profits over time.
In a meeting later that day, February 23, 1995, between Harfst, the Salesman, the Salesman's Supervisor and the Accounting Supervisor, and over the Accounting Supervisor's objections, Harfst agreed to let the Salesman and the Salesman's Supervisor recognize the profits over time, rather than on the day earned, as long as the profits were all recognized by the end of February.
Neither the Salesman nor the Salesman's Supervisor told Harfst that the securities or profits involved in the mismarking were related to the recent sale of the MBS securities on behalf of Nikko Europe. Nor did the Salesman or the Salesman's Supervisor reveal that they had already realized $369,297 in additional profits that very day, February 23, 1995.
In early March 1995, the Accountant discovered that the Salesman's GNMA position was still mismarked and that the Salesman had hidden additional profits by further mismarking. The Accountant informed the Accounting Supervisor, who immediately told Harfst.
Harfst did not discuss the matter with the Salesman or the Salesman's Supervisor or take any other action at that time.
Nikko's February 1995 FOCUS report included the incorrect valuations and understated the firm's profits for that month by approximately $264,000. Net income reported for February 1995 was $645,169. Thus, the incorrect valuations of the GNMA positions caused Nikko's February net income to be understated by approximately 41% which Harfst failed to take steps to correct.
A. Broker-Dealer Books and Records Violations Section 17(a)
of the Exchange Act and Rule 17a-3 Thereunder
Section 17(a) of the Exchange Act requires brokerage firms to create and maintain books and records. Rule 17a-3 requires broker-dealers to maintain ledgers or other internal records "reflecting all assets and liabilities, income and expense and capital accounts" (Rule 17a-3(a)(2). Information contained in a required record must be accurate. See Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the Distribution of Certain Debt Securities Issued by Government Sponsored Enterprises, Exchange Act Rel. No. 30255 (Jan. 16, 1992). See also Sinclair v. SEC, 444 F.2d 399, 401 (2d Cir. 1971); In the Matter of James F. Novak, Exchange Act Rel. No. 19660, 47 S.E.C. 892 (1983).
Nikko willfully violated Section 17(a) and Rule 17a-3 by maintaining inaccurate books and records in that (i) from August through October 1994, Nikko's books and records did not reflect the fair value of the MBS portfolio; (ii) the funds generated by the November 1994 sale to the Nikko Europe were inaccurately booked by Nikko as trading profits, instead of a capital infusion; and (iii) the alteration in the valuation of the GNMA securities and the "bleeding" in the profits from the swaps resulted in inaccurate accounting ledgers and profit and loss statements for February 1995. Based on the conduct described above, Harfst willfully aided and abetted and caused Nikko's violations of these books and records provisions.
B. False FOCUS Reports Sections 17(a) and 17(e) of the Exchange Act
and Rule 17a-5
Sections 17(a) and 17(e) of the Exchange Act require broker-dealers to file certain financial reports. Section 17(e) and Rule 17a-5 require broker-dealers to file annual reports with the Commission, containing, among other things, a statement of financial condition, a statement of income, and a statement of changes in financial position. Rule 17a-5(a) thereunder requires brokers and dealers to file monthly and quarterly unaudited financial reports, known as FOCUS reports, with the Commission or an SRO. Information contained in those reports must be accurate. See In the Matter of D.S. Meyers & Co., Exchange Act Rel. No. 22417, 1985 SEC LEXIS (Sept. 17, 1985) (filing of inaccurate FOCUS reports constitutes a willful violation of Rule 17a-5); see also In the Matter of Anthony Stoisich, Anthony DeStefano, Exchange Act Rel. No. 27626, 1990 SEC LEXIS 142 (Jan. 16, 1990) (filing false FOCUS reports with the NASD violates Section 17(a) of the Exchange Act and Rule 17a-5). The FOCUS report "constitutes the basic financial and operational report required of those brokers or dealers subject to any minimum net capital requirement . . . ." Form X-17A-5, Part II (General Instructions).
Nikko willfully violated Sections 17(a) and 17(e) of the Exchange Act and Rule 17a-5 thereunder by filing FOCUS reports containing inaccurate financial statements regarding the valuation of the MBS portfolio from August to October 1994. The FOCUS reports also misstated the nature of the proceeds from the initial transfer of the MBS portfolio to the Affiliate from November 1994 forward, and had an incorrect income statement reflecting the alterations by the Salesman to disguise the profits taken on the sale of pass-through securities for February 1995. Nikko's FOCUS reports misstated Nikko's retained earnings and additional paid-in capital from November 1994 forward, and misstated Nikko's February 1995 net income to be understated by approximately $264,000 (41%). Based on Harfst's conduct described above, he willfully aided and abetted and caused Nikko's violations of these reporting provisions.
Based on the above, the Commission finds that Harfst willfully aided, abetted and caused Nikko's violations of Sections 17(a) and 17(e) of the Exchange Act and Rules 17a-3 and 17a-5 thereunder.
Accordingly, it is hereby ordered that Harfst,
1. cease and desist from committing or causing any violations of, and committing or causing any future violations of, Sections 17(a) and 17(e) of the Exchange Act and Rules 17a-3 and 17a-5 thereunder;
2. be, and hereby is suspended from association with any broker or dealer for a period of six (6) months; and
3. pay a civil money penalty of $50,000 within thirty (30) days of the entry of this Order. Payment is to be made by U.S. Postal money order, certified check, bank cashier's check, or bank money order, made payable to the Securities and Exchange Commission and shall be hand-delivered or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312, under cover of a letter that identifies the respondent and the name and file
number of this proceeding. A copy of the cover letter and of the form of payment shall be simultaneously transmitted to Laura B. Josephs, Esq., Securities and Exchange Commission, Division of Enforcement, 450 Fifth Street, N.W., Washington, D.C. 20549-0703.
By the Commission.
Jonathan G. Katz
1 This matter was instituted pursuant to Sections 15(b)(6) and 21C of the Securities Exchange Act of 1934 and Rule 102(e) of the Commission's Rules of Practice on March 8, 1999. In a related administrative proceeding, instituted August 27, 1998 (Release No. 34-40375), The Nikko Securities Co. International, Inc. ("Nikko") consented to the entry of a cease-and-desist order and three Nikko officers each consented to the entry of a cease-and-desist order, six month suspension from association with a broker-dealer and a $50,000 civil penalty. In a related civil action, also filed August 28, 1998 (Lit. Rel. No. 15861), Nikko consented to the entry of an order by the court pursuant to Section 21(e) of the Exchange Act ordering Nikko to comply with the Commission's prior cease-and-desist order and ordering the firm to pay a $2.5 million civil penalty. SEC v. The Nikko Securities Co. International Inc., 98 Civ. 2058 (D.D.C. 1998).
2 The findings herein are made pursuant to Harfst's Offer of Settlement and are not binding on any other person or entity in this or any other proceeding.
3 Broker-dealers must maintain financial statements consistent with Generally Accepted Accounting Principals, which require that inventory securities be valued at "fair value." AICPA Audit and Accounting Guide for Brokers and Dealers in Securities, Ch. 7, ¶ 7.02. "Quoted market prices, if available, are the best evidence of the fair value of a financial instrument." Id., Ch. 7, ¶ 7.04. For securities not having a readily available market price, a firm must determine fair value in "good faith." Id., Ch. 7, ¶ 7.10.