UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION
Securities Exchange Act Release No. 43478 / October 24, 2000
The Securities and Exchange Commission (the Commission) deems it appropriate and in the public interest that public administrative proceedings be instituted pursuant to Sections 15(b)(4) and 21C of the Securities Exchange Act of 1934 (Exchange Act) against First Union Securities, Inc. (First Union Securities).
In anticipation of the institution of these proceedings, First Union Securities has submitted an Offer of Settlement which the Commission has determined to accept. Solely for the purposes of these proceedings and any other proceedings or actions brought by or on behalf of the Commission or to which the Commission is a party, First Union Securities, without admitting or denying the findings contained herein, except that it admits to the jurisdiction of the Commission over it and over the subject matter of these proceedings, consents to the issuance of this Order Instituting Proceedings Pursuant to Sections 15(b) and 21C of the Exchange Act of 1934, Making Findings, Issuing a Cease-and-Desist Order and Imposing Remedial Sanctions (Order).
The Commission makes the following findings:
First Union Securities is a broker-dealer registered with the Commission pursuant to Section 15 of the Exchange Act. The firm is an indirect subsidiary of First Union Corporation. In 1995, when the conduct in this matter began, the firm was known as First Union Capital Markets Corp. (First Union Capital). First Union Corporation acquired Wheat First Butcher Singer, Inc. on January 31, 1998, at which time First Union Capital was merged with and into Wheat First Securities, Inc. On October 1, 1999, First Union Capital (formerly known as Wheat First Securities, Inc.) was merged with and into EVEREN Securities, Inc. Immediately thereafter, EVEREN Securities, Inc. changed its name to First Union Securities, Inc.1
First Union Securities, a registered broker-dealer, violated the recordkeeping provisions of the federal securities laws in connection with the purchase and sale of United States Treasury notes and bonds issued through the noncompetitive auction process ("noncompetitive securities") from 1995 through 1998. First Union Securities' books and records failed to reflect certain terms of customer orders, which were pre-auction agreements between First Union Securities and its noncompetitive bidding customers, to sell the securities those customers would be awarded through the auction. Those pre-auction agreements violated a Treasury Department prohibition of such agreements. First Union Securities received approximately $225,000 in markdowns from its customers on the noncompetitive securities transactions.
1. Treasury Securities Auctions
Auctions of government securities are conducted on a periodic basis by the Treasury Department, in conjunction with the Federal Reserve Banks. Treasury securities can be purchased in an auction through either the competitive or noncompetitive bidding process. Competitive bidders submit sealed bids at a specified price for the amount of securities they want to purchase. Securities are awarded to the highest bidders until all the competitive securities are sold. In contrast, noncompetitive bidders specify only the amount of securities they want to purchase, up to a limit of $5 million of securities per auction. Noncompetitive bidders then pay the average price of the successful competitive bids for the amount of securities that the noncompetitive bidders requested.2 Uniform Offering Circular, 31 C.F.R. § 356.
In October 1983, the Treasury Department published a notice prohibiting agreements to sell securities purchased through the noncompetitive auction process prior to 1:00 p.m. on the day of the auction. This deadline was extended in January 1991. The revised Treasury notice provided:
A noncompetitive bidder may not have entered into an agreement, nor made an agreement to purchase or sell or otherwise dispose of any noncompetitive awards of this issue being auctioned prior to the designated closing time for receipt of competitive tenders.
31 C.F.R. § 356.12(2). The deadline for receipt of competitive bids was usually just after 1:00 p.m.3
The Treasury Department provides noncompetitive bidding to encourage the widespread, long-term distribution of Treasury securities, principally into the hands of smaller investors. The prohibition on prearranged sales is designed to minimize the use of noncompetitive bidding by bidders that more appropriately should bid competitively. See Department of the Treasury, Securities and Exchange Commission, and Board of Governors of the Federal Reserve System, Joint Report on the Government Securities Market, p. A-2 (Jan. 1992). As described below, First Union Securities violated Treasury's noncompetitive bidding rules by entering into pre-auction agreements with its customers to sell their noncompetitive awards as soon as possible after the auction deadlines.4
2. First Union Securities' Noncompetitive Trading Strategy
A former trader in First Union Capital's Taxable Fixed Income Sales Department devised a Treasury securities trading strategy in the early 1990's. Pursuant to this trading strategy, First Union Securities customers purchased Treasury securities through the noncompetitive auction process and then sold those securities at or immediately after the applicable deadline. The former trader, who was familiar with the Treasury market, developed the strategy after observing that prices of noncompetitive Treasury securities increased following the close of the auction process. First Union Securities salesmen using the strategy believed that, because the noncompetitive securities were sold at the average price of the competitive bids, and because the competitive bids were filled from highest bid to lowest bid, the noncompetitive bids would be priced slightly lower than the secondary trading market price of the securities, creating a potential for profit. The key component of the strategy was the sale of the noncompetitive bidders' securities as close to the deadline as possible, in order to capture the spread between the average price in the auction and the price offered in the secondary market thereafter. After the auction close, the opportunity for profit could be lost through changes in the market price of the auctioned securities.
In order to ensure that the noncompetitive securities would be sold as close to the deadline as possible, First Union Securities entered into pre-auction agreements with certain customers to liquidate the customers' securities at or immediately after the deadline. First Union Securities did not record the agreements on the order tickets for the transactions; nor did First Union Securities record the agreements in any of its other books or records.
3. The First Union Securities Noncompetitive Transactions
Six First Union Securities salesmen used the trading strategy in 35 Treasury auctions during the period May 1995 through February 1998. The salesmen solicited a number of individuals and small institutional customers to engage in the strategy. The salesmen explained the trading strategy to the customers generally, and told them that it presented little risk of loss, and an opportunity for a small but quick profit.
The salesmen usually contacted the customers on the morning of each auction to determine whether the customers would purchase securities in the auction that day. The customers relied on First Union Securities' expertise in engaging in the noncompetitive transactions; they had little knowledge of the details of the transactions. In order to maximize the profit opportunity that was available immediately after auction as described above, First Union Securities entered into pre-auction agreements with the customers to liquidate the customers' securities at or immediately after the deadline. In most instances, customers bid for the maximum $5 million allowable noncompetitive award. Once the customers were awarded the Treasury securities through the noncompetitive process, First Union Securities immediately purchased the securities from the customers pursuant to the pre-auction agreements it had entered into with them.
First Union Securities did not record on its books and records the fact that the pre-auction agreements with its customers were in place. First Union Securities' books and records therefore failed to reflect that the customers' order to purchase the Treasury securities was accompanied with an order to immediately sell the securities, and that the order to sell occurred at or before the time of the order to purchase. The customers' purchase orders that were conditioned on the pre-auction agreements would not have occurred without the pre-auction agreements to sell the securities immediately.
In purchasing the securities from its customers, First Union Securities paid prevailing market prices, and charged customers a markdown of 1/8 to 1/3 of a basis point (00.125 basis point - 00.333 basis point) of the security's yield. The customers participating in the strategy generally made a profit on the transactions. First Union Securities made over $225,000 in markdowns charged to its customers upon First Union Securities' purchase of their Treasury securities.
III. LEGAL ANALYSIS
Section 17(a) (1) of the Exchange Act requires registered brokers and dealers to "make and keep ... such records ... as the Commission, by rule, prescribes as necessary or appropriate in the public interest, for the protection of investors...." Pursuant to this section, the Commission has promulgated Rule 17a-3. Rule 17a-3 specifies the types of records that broker-dealers are required to make and keep current, including a record of the terms and conditions attached to each order placed for the purchase or sale of securities. The Commission has emphasized the importance of records maintained by broker-dealers as the "keystone of the surveillance of brokers and dealers by our staff and by the industry's self-regulatory bodies." Edward J. Mawod & Co., 46 SEC 865, 873 n.39 (1977), aff'd, Mawod v. SEC, 591 F.2d 588, 594 (10th Cir. 1979).
When First Union Securities offered the noncompetitive trading strategy to its customers, it entered into agreements with its customers for the sale of their noncompetitive securities immediately following each auction. These agreements between First Union Securities and its customers violated the Treasury Department's prohibition of pre-auction agreements to sell noncompetitive securities.
First Union Securities' failure to record on its books and records these pre-auction agreements with its customers constituted a violation of Section 17(a) of the Exchange Act and Rule 17a-3 promulgated thereunder. The order tickets relating to the customers' purchase of the Treasury securities should have recorded the pre-auction agreements between First Union Securities and its customers to sell the customers' noncompetitive Treasury securities as soon as possible after the auctions. Rule 17a-3 requires brokers and dealers to record the terms and conditions attached to each order placed for the purchase or sale of securities. The pre-auction agreements constituted a term or condition of the customers' orders to purchase the Treasury securities at auction, since those orders would not have been placed without the accompanying agreements to sell being in place. Accordingly, they should have been recorded on the order tickets pursuant to Exchange Act Rule 17a-3(a)(6). See, e.g., In the Matter of Cantor Fitzgerald & Co., 56 S.E.C. 812 (1994).
First Union Securities benefited from the transactions by obtaining markdowns from its customers. Since First Union Securities violated the federal securities laws in connection with these transactions, it should disgorge any markdowns it made in these transactions. See Cantor Fitzgerald, supra, at 817.
First Union Securities willfully violated Section 17(a) of the Exchange Act and Rule 17a-3 thereunder.5
On the basis of the foregoing, the Commission deems it appropriate and in the public interest to accept First Union Securities' Offer of Settlement.
IT IS HEREBY ORDERED:
A. That First Union Securities cease and desist from committing or causing any violation, and from committing or causing any future violation, of Section 17(a) of the Exchange Act and Rule 17a-3 thereunder; and
B. That First Union Securities, within 30 days of the date of this Order, shall pay the amount of $308,931.00 representing disgorgement and interest thereon to the United States Treasury; and
C. That First Union Securities, within 30 days of the date of this Order, shall pay the amount of $100,000, representing a civil money penalty, to the United States Treasury.
D. That the amounts to be paid in sections B. and C. above shall be: (1) made by United States postal money order, certified check, bank cashier's check or bank money order; (2) made payable to the Securities and Exchange Commission; (3) hand-delivered or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312; and (4) submitted under cover letter which identifies First Union Securities as a Respondent in this proceeding, the file number of this proceeding, and the Commission's case number (HO-7056), a copy of which cover letter and money order(s) or check(s) shall be sent to Ivonia K. Slade, Senior Counsel, Division of Enforcement, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, DC 20549-0709.By the Commission.
Jonathan G. Katz
1 The term "First Union Securities" as used throughout this Order refers to First Union Securities, Inc. and its predecessors. At all relevant times, First Union Securities was registered as a broker-dealer with the Commission pursuant to Section 15 of the Exchange Act.
2 Competitive bidders are typically large institutions and broker-dealers, while non-competitive bidders are typically individuals and smaller institutions or entities.
3 Effective January 28, 1998, this deadline was extended so that such agreements could not be entered into prior to the announcement by Treasury of the results of the auction, which was usually at about 1:30 p.m. First Union Securities customers participated in a total of 35 non-competitive auctions; 32 of those auctions took place prior to January 28, 1998.
4 In a letter dated November 24, 1998 to the United States Department of the Treasury, First Union Securities acknowledged that it violated the Treasury Department auction rule prohibiting a broker from accepting customer market orders to liquidate Treasury securities positions prior to the specified deadline. First Union Securities' violations were disclosed publicly by the Department of the Treasury in a press release dated November 24, 1998.
5 In applying the term "willful" in Commission administrative proceedings instituted pursuant to Section 15(b) of the Securities Exchange 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 its 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 and entities - specifically, securities industry firms and 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.