INITIAL DECISION RELEASE NO. 108 ADMINISTRATIVE PROCEEDING FILE NO. 3-8955 UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Washington, D.C. ______________________________________ In the Matter of : : DAVID L. ARNOLD, : INITIAL DECISION W. DAVID EAST, and : March 19, 1997 JERRY PAYNE : : ______________________________________ APPEARANCES: Mark R. Borrelli, Rebecca Carlins, and David J. Medow for the Division of Enforcement, Securities and Exchange Commission James P. O Neal for Respondent W. David East BEFORE: Lillian A. McEwen, Administrative Law Judge PROCEDURAL HISTORY The United States Securities and Exchange Commission (Commission ) instituted these proceedings pursuant to Section 8A of the Securities Act of 1933 ( Securities Act ) and Sections 15(b), 19(h), and 21C of the Securities Exchange Act of 1934 (Exchange Act ). The Order Instituting Proceedings ( OIP ) was filed on February 22, 1996. THE HEARING On January 22, 1997, I granted Jerry Payne s Unopposed Renewed Motion to Dismiss and I deferred ruling on W. David East s Motion to Dismiss, which the Division of Enforcement ( Division ) opposes. On January 30, 1997, the Commission accepted David Arnold s Offer of Settlement. David L. Arnold, Order Making Findings and Imposing Remedial Sanctions, 63 SEC Docket 2057 (January 30, 1997). This initial decision applies only to Respondent East. On May 7, 8, 9, and 10, 1996, a public hearing was held before me in Birmingham, Alabama. The hearing record consists of the testimony of thirteen witnesses and many exhibits. I admitted into evidence eight joint exhibits; thirty-nine exhibits from the Division; fifteen exhibits from Respondent Payne; and nine from Respondent East. ISSUES ==========================================START OF PAGE 2====== The general issue before me is whether East violated the federal securities laws. It is alleged that: From approximately November 1987 through March 1988, East willfully aided and abetted Day's-[1]- violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, in that East was aware that Day intended to allocate profitable trades to his own account and losing trades to the two trust accounts,-[2]- that his role was part of an overall activity involving violative conduct, and East provided knowing and substantial assistance with respect to Day s violations by allowing Day to place profitable trades in East s account and providing Day with fifty percent of the profits from these transactions. (OIP at 3.) If I conclude that the allegations in the OIP are true, I must then determine: What, if any, remedial action is appropriate in the public interest pursuant to Sections 15(b) and 19(h) of the Exchange Act, including, but not limited to, disgorgement pursuant to Section 21B of the Exchange Act; and Whether pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act . . . East should be ordered to cease and desist from committing or causing any violations and any future violations of any and all of the Sections or Rules specified . . . and to pay disgorgement. (OIP at 4.) After the hearing, the Division filed its Proposed Findings of Fact and Conclusions of Law and a Response to Respondents Post-Hearing Briefs. Respondent East filed Proposed Findings of Fact and a Post-Hearing Reply Brief as well as several motions to dismiss the charges in the OIP. -[1]- John Day was a registered representative associated with PaineWebber s Birmingham branch office. -[2]- These were customer accounts for the Robbins heirs. ==========================================START OF PAGE 3====== FINDINGS OF FACT I based the findings and conclusions herein on the entire record and on the demeanor of the witnesses who testified at the hearing. I applied preponderance of the evidence as the applicable standard of proof for the Division s case. Respondent East is 44 years old and lives in Birmingham, Alabama. He is a college graduate with a degree in business and some additional training at the Wharton School of Business at the University of Pennsylvania. He was a vice president at a real estate company where he had worked for three to four years, and then he was vice president at his father s real estate company until 1980. (Tr. 983-85.)-[3]- In November 1980, he began his employment with a Birmingham security firm, Sterne, Agee, and Leach. He became a registered representative in 1981 and remained with that firm until 1985, when he joined First Birmingham Securities. (Tr. 986-87.) In August 1987, East joined PaineWebber, having been recruited by Jerry Payne. (Tr. 991-92.) He left PaineWebber in June 1994. (Tr. 993.) He was unemployed for fifteen months until his employment with Collateral Mortgage Limited, a mortgage banking firm in Birmingham. (Tr. 995.) Before March 1988, East had never been the subject of a complaint in his securities or real estate work. (Tr. 996.) At PaineWebber, East sold municipal bonds, corporate bonds, government bonds, stocks, mutual funds, options, limited partnerships, [and] shares of initial public offerings . . . . (Tr. 998.) He had no experience with the block trading desk in New York City. (Tr. 999.) John Day In November 1987, when Day joined PaineWebber, Jerry Payne, the manager of the Birmingham PaineWebber branch office, introduced John Day to East. Payne told East that Day was the son of the branch manager of the firm Thomson McKinnon, where Day had formerly been employed as a broker. (Tr. 1000.) In October 1987 there was the big two-day fall of the market, with a big fall on Friday and then the big one on Monday. (Tr. 1002.) In October and November 1987 the stock market moved up and down, down and up like a roller coaster. (Tr. 1003.) Day s predictions as to the movement of the market were uncanny to East, and after many early-morning conversations with Day, East -[3]- Citations to the joint exhibits are designated Joint Ex. ; to the Division s Exhibits are Div. Ex. ; and to the Respondents exhibits as Payne Ex. or East Ex. Citations to the transcript pages of the hearing in the instant case are designated Tr. ==========================================START OF PAGE 4====== concluded that the younger Day was right a lot of the time. (Tr. 1004.) East and the other brokers regarded Day as a guru. (Tr. 1005). East discussed index options with Day frequently. (Tr. 1007.) He regarded Day as an extremely bright, smart guy who had been brought over as a top producer of the previous firm that he worked for . . . . (Tr. 1008.) East had done some index options in his personal account and for some of his customers before he met Day; he had first learned about them when he attended Wharton classes in 1986. (Tr. 1009, 1011.) At First Birmingham, he could not get a timely execution on an option. (Tr. 1010.) However, he thought that because Day had the ability to call directly to a trader, a block trader, it would allow a[n] execution to be done at a price more in line with the market at that time. (Tr. 1011.) By December, East had become impressed with the accuracy of Day s predictions, which he thought were unbelievably terrific. (Tr. 1012.) He asked Day if he would consider trading options for his account. (Tr. 1013.) Day told him that he did typically one hundred option trades per block. (Tr. 1014.) East told Day that he did not want to take more than a half to three-quarters of a point loss if he could do it. (Tr. 1014.) Thus if that option is up a half to three-quarters of a point, somewhere in that vicinity, to get out of it. I didn t want to be greedy and I didn t want to lose a lot of money. (Tr. 1014- 15.) He had an agreement that Day would sell or close the position if the market were -- or if that option were up a half to three-quarters of a point or down a half to three-quarters or otherwise have discussion with me. East also knew that one hundred contracts up a half a point is $5,000. (Tr. 1015.) He also told John Day that all [he] had interest in him doing was what I knew of as day trading . . . the purchase or opening position and the sale or closing position of an option in the same day. (Tr. 1017.) These price instructions and conditions that can be placed on option order forms are consistent with PaineWebber Operator Procedures. (Div. Ex. 4.) On January 13, 1988, Day executed his first two transactions for East. (Tr. 1017.) He followed East s guidelines and East made a profit that day. East knew that Day would make a commission from the trades in East s account. (Tr. 1018.) East settled the trade the next day with two cashier s checks. First Alabama Bank loaned East some of the money for the deposit. (Tr. 1019-20.) East computed his maximum loss to be between $5,000 and $10,000 on future trades. However, in an effort to reduce even further his risk of loss, he asked Day to split future trades with him evenly for every trade in the future, win, lose, or draw. (Tr. 1021.) Day agreed. (Tr. 1022.) From that day forward John Day split down the middle, 50- ==========================================START OF PAGE 5====== 50, all profits and losses that occurred on the fifteen option trades that we re here today for. (Tr. 1022-23.) East borrowed money from Philip Waters, a childhood friend, to fund transactions in his account. (Tr. 1024.) For the loans from Waters, East paid interest in advance at a rate that East did not calculate. (Tr. 1026.) There came a point in time when East could not pay for a closed trade and could not find his friend Philip Waters. Upon Day s suggestion he asked David Arnold, another registered representative at the branch office, for a loan, and Arnold twice obtained funds for East. (Tr. 1030-31.) But one of the checks had Alabama Grease on it and the other check had Gotlieb on it. But . . . to [East] they were all coming from Dave Arnold through his same source which was connected to Vickers and Gotlieb. (Tr. 1031-32.) Until February 1988, every transaction that John had done had been according to [East s] agreement with John . . . . (Tr. 1033.) However, Day s failure to sell an option until the next day resulted in a loss of 2 5/8 points or $25,000 to $30,000. (Tr. 1036-37.) Day traded for East again after the loss, however. The total profit in the account was $44,810.77 net. (Tr. 1040; Div. Ex. 18 at 3-5.) The trades by Day for East ended on February 26, 1988. The options were bought and sold on the same day for gains, except for February 3, 1988, with a loss of $6,258.28 and February 19 to February 22 with a loss of $25,518.24. (East Ex. 10.) Although the trading net figure is $44,820.77 for the account as of February 26, 1988, that figure does not have subtracted from it the interest that was paid by East on the borrowed money or the commissions that were paid to Day on the transactions. (Div. Ex. 1 at 3-9 & Div. Ex. 28.) East wrote Day checks for his share of the profits. (Tr. 1041.) For each transaction, East authorized Day to trade for him (Tr. 1041), and East was never aware of a prohibition against cashiers checks in accounts. (Tr. 1041.) East did not know that the loans from Owen Vickers or Alabama Grease were against PaineWebber policy or that splitting profits and losses with Day was a violation of PaineWebber policy. Although East had a Quotron screen at his desk, he could not access client information of other brokers from it. (Tr. 1050-51.) East had no knowledge of the Robbins trust accounts trades or of any plan to delay postings in the Robbins accounts or to allocate profitable trades to his account from theirs. (Tr. 1054.) Pursuant to a settlement, the National Association of Securities Dealers ( NASD ) censured East and fined him $15,000 for failing to disclose to PaineWebber (1) that he had obtained personal loans from two clients of Arnold to finance some block transactions, and (2) that he was sharing profits in his account with Day. (East Ex. 6 at 3-4 and 8.) The Trust Accounts Bert R. Shepherd earned a high school degree and then worked as a junior accountant for two years and an auditor in the ==========================================START OF PAGE 6====== federal government for about twelve years. (Joint Ex. 7, Vol. I at 12-13.) He was the head of the accounting department of several corporations after that, including two companies owned by Davis Robbins, of which Shepherd was treasurer. (Joint Ex. 7, Vol. I at 20-22.) After Robbins sold some of his businesses to Joy Manufacturing Company, Shepherd became treasurer at Vulcan Machinery Company. He remained at Vulcan until 1974, when he returned to work at Robbins Coal Company. Two years later, in 1976, Robbins died. (Joint Ex. 7, Vol. I at 25.) Shepherd died in 1994. (Tr. 81-82.) However, I admitted into evidence excerpts from his sworn testimony at two earlier proceedings as Joint Exhibit Seven. Shepherd opened a brokerage account for the Robbins heirs with Thomson McKinnon in 1983, where his brokers were John Day and John Strauss. (Joint Ex. 7, Vol. I at 30.) The family and marital trusts for the Robbins family were established pursuant to Davis Robbins will, which named Shepherd as executor and co- trustee with Mrs. Robbins. (Joint Ex. 7, Vol. I at 36-38.) The Joy Manufacturing stock (which was acquired upon the sale of the Robbins companies to Joy) had been sold in the early 1980 s by Merrill Lynch before the trust accounts were moved to Thomson McKinnon. (Joint Ex. 7, Vol. I at 52-56.) Thus, the two trust accounts contained a total of four to five million dollars in stock proceeds by 1984. Day and John Strauss began to handle the trust accounts shortly after their arrival at Thomson McKinnon. He and Strauss made all the trades without consulting with Shepherd. (Joint Ex. 7, Vol. I at 62.) As long as [the accounts] had profits, Shepherd did not stop the brokers from trading, and he was content with reviewing the confirmations he received. (Joint Ex. 7, Vol. I at 63.) Consolidated Realty and Management Corporation handled the Robbins family s financial matters. The employees consisted solely of the Robbins family members and Shepherd; however Shepherd earned $30,000 annually for his services. (Joint Ex. 7, Vol. II at 65-67, 109.) In addition to several brokerage accounts the family had quite a bit of activities, coal royalties, timber sales, rental buildings, [and] rental land consisting of thousands of acres that Shepherd also assisted them with managing. (Joint Ex. 7, Vol. II at 276.) During fiscal year 1986, one hundred trades were executed in the two trust accounts for a net gain of $287,000. Shepherd had no problem with Day s failure to clear trades with him as long as every time, [he] got one of these things [confirmations] it made money. (Joint Ex. 7, Vol. II at 187-88.) Shepherd tallied profits and losses on spread sheets as the confirmation tickets came in. (Joint Ex. 7, Vol. II at 195-96.) Mrs. Robbins and the adult children used the two trusts for their living expenses. (Tr. 90-91.) The trust accounts earned $350,000 at Thomson McKinnon, but ==========================================START OF PAGE 7====== Shepherd concluded that Thomson McKinnon had churned the accounts because the firm had made three hundred thousand in commissions during a six-month period. John Day offered 40 to 50 percent off on commissions at PaineWebber, and Strauss did not have much contact with the Robbins family; therefore Shepherd decided to transfer the six to eight Robbins family accounts away from Thomson McKinnon (Joint Ex. 7, Vol. I at 83-84) when Day left the firm, on November 4, 1987. (Joint Ex. 4 at 26.) For the year ending December 1987, the marital trust account and the family trust account had profits of $24,000 on options that had been closed out during the year. (Joint Ex. 7, Vol. II at 219-20.) During December 1987, Day bought $400,000 in options in the marital trust account alone. (Joint Ex. 7, Vol. II at 227.) He earned $15,831 in commission revenue for December 1987 from the family trust account alone. (Div. Ex. 30.) By January 28, 1988, Day had set up a margin account with PaineWebber, and the two Robbins trusts owed PaineWebber over $800,000 for trades because the trust accounts had only $50,000 in cash in them at the time. (Joint Ex. 7, Vol. II at 105-06.) Shortly thereafter, on February 2 and 3, 1988, Shepherd informed PaineWebber in writing that no further trading could take place in the trust accounts except disposing of the options that were still outstanding. (Div. Ex. 8; Joint Ex. 7, Vol. II at 409, 418.) Then Day went to Brazil. (Joint Ex. 7, Vol. II at 430-33.) Shepherd could not tell from the February statement whether the accounts had a profit or a loss for the month: Up to then we thought we were doing like we did in December by breaking even or maybe lost a little. (Joint Ex. 7, Vol. II at 453.) Shepherd testified that before January 1988, the only thing on the stock instructions we gave them, of course, we didn t want to sell and lose all of this money on these stocks we bought. And of course we didn t want to sell them until they came close to what we paid for them and try to convert into some cash. (Joint Ex. 7, Vol. II at 494.) Day ultimately pled guilty on February 4, 1994, to one count of purchasing index options on March 2, 1988, for the Family Trust, without prior knowledge or consent from the trustees. (Div. Ex. 2.) ==========================================START OF PAGE 8====== The Trades James E. Brucki, Jr. was qualified as an expert in the areas of trading strategies, analysis of losses and gains, and execution and entry of orders. (Tr. 1135-36.) I credit the testimony of Mr. Brucki; his testimony was uncontradicted by credible evidence and it was consistent with the data admitted into evidence in the form of tables, computer-generated figures, and order tickets. (Div. Exs. 9-19, 28, and 29; East Ex. 1.) Brucki testified that many of the options in the trust accounts expired worthless. He was examined by Kenneth O. Simon, who called him on behalf of his client, Respondent Payne: Q. Based upon your review of Exhibit 15, sir, Commission Exhibit 15, or Commission Exhibit 16, did you determine or can you determine if any positions expired worthless? A. Yes, I can. Q. And can you tell us what positions those were? A. Tell you which or the total amount? Q. Total amount? A. Well, approximately $680,000 worth of options that were purchased in the two trust accounts expired worthless. Q. What was the total dollar amount of the losses in the marital trust and the family trust account, sir? A. $1,096,000 or something to that effect. Q. Can you express as a percentage, the amount of losses -- the amount of the $1.1 million loss that occurred by virtue of the positions expiring worthless, to the total amount of the losses? A. Sure, the total amount of the losses were 1,096,000; the expiring options were worth 680, so you've got about 63-64 percent of the losses are attributed to options that expired worthless. Q. Can you assume -- strike that. Did the remaining losses occur as a result of movements in the market? ==========================================START OF PAGE 9====== A. The remaining losses were positions that were initiated and then closed out at a loss. (Tr. 1156-57.) Brucki also testified as to the figures for the three brokers, After the time of allocation [of the trade to a specific PaineWebber account by wire] : (Tr. 1171.) Q. Can you tell us again what -- strike that. What was the total amount of the gains in the brokers' accounts? That is, Mr. Day, Mr. East and Mr. Arnold? A. About 103,000 I believe, something like that. Let's just call it 100[,000]. Brucki compared the gains in the brokers accounts to the losses in the trust accounts: Q. And can you express as a percentage, the amount of gains in the brokers' accounts to the losses in the trust accounts? A. Yes. Q. And what percentage is that? A. Well, the total loss in the trust accounts was 1,096,000; the brokers made 103[,000], so the trust accounts lost 990 some odd thousand dollars, regardless of what the brokers' accounts did and that amounts to about a 9-1/2 percent. If all the trades went into the trust accounts, they [the trust accounts] would have saved 9-1/2 percent. Q. Now, based upon your review, sir, of Commission Exhibits 15 through 19, were you able to determine the amount of losses in the trust accounts at the time of allocation [of the trades to their PaineWebber accounts]? A. Yes. Q. Is there a particular exhibit which allows you do this? A. Yes. Q. Which exhibit is that? A. Exhibit 19. ==========================================START OF PAGE 10====== Q. All right, and what were the total amount of losses in the trust accounts at the time of allocation? A. $469,375. Q. How does that compare to the total losses of $1.1 million, as a percentage? A. As a percentage, it's about 46 percent. Q. Is there any significance, in your opinion, as to this particular figure? A. Yes. Q. What significance is that? A. Well, the major part of the losses that accrued in the trust accounts occurred after allocation. Q. All right. JUDGE McEWEN: And how did that occur, in your opinion? THE WITNESS: Well, $600,000 worth of options expired worthless. JUDGE McEWEN: What does that mean? THE WITNESS: Well, an option contract has a finite life, it exists for -- in most of these cases thirty days or less. And if something is not done with it within that time period, it can become worthless. JUDGE McEWEN: In your opinion, what should a broker have done so that it would not have become worthless? THE WITNESS: Well, the broker probably could do two things. One is to sell it and take a smaller loss than letting it become worthless. If you bought it for 6, as opposed to going to zero, at some point set yourself a limit and sell it. (Tr. 1157-59.) Mr. Brucki testified as to why the options might have expired: JUDGE McEWEN: And in your opinion, why would a broker not sell it? ==========================================START OF PAGE 11====== THE WITNESS: Hope springs eternal that the market will recover, and that that position will come back. Or that he can average down -- he bought some at 6 and buy some more at 3, and if it goes to 4-1/2 he's even and he can get out that way. JUDGE McEWEN: Is there anything unusual about options expiring worthless in the market? THE WITNESS: Not -- unusual -- I don't know if unusual is the word I'd use, but clearly I would think a broker would have a plan to, if it drops X, exit. (Tr. 1168.) Mr. Brucki saw a pattern in the losses: JUDGE McEWEN: In your opinion, is there a pattern that you see that emerges in tables -- in Exhibits 15 and 16 as far as the large losses? THE WITNESS: Well, it seems, in looking at it, the positions that are put on that go down in value almost instantly are held and then there are trades that get put on -- there are day trades against them to try and reduce that loss. But it appears the positions that experience immediate losses were held until they expired. (Tr. 1160.) Mr. Brucki also calculated winning and losing trades: Q. Based upon the schedules once again, Exhibits -- Commission Exhibits 15 through 19, Mr. Brucki, can you determine how many total winners, so to speak, that the brokers had? A. Yes, you can. And that's on 19. Q. All right, and how many total winners did they have? A. They had -- well, it doesn't tell you the winners, it tells you what they were at the time of allocation. Q. All right. A. At the time of allocation, they had 23 out of 27. Q. Okay. In your experience, sir, is that unusual? ==========================================START OF PAGE 12====== A. To have 23 out of 27 winners? Q. Correct. A. Not particularly. Q. Why is it not unusual? A. Normally, if you're trading with a market trend, I would expect to have a lot more winners than I would losers. Q. All right. Do the schedules -- this same particular schedule reflect how many winners versus losses that the two trust accounts had? A. Yes, they do. Q. And can you tell the Court what that number is? A. The number is 12 versus 49 at the time of allocation, which is about 25 percent. (Tr. 1163.) Mr. Brucki opined that the seller of an option cannot pick the buyer on the floor: A. Well, if he orders it to be sold, that order is transmitted to the floor of the options exchange on which it trades, in this case the [Chicago Board of Options Exchange] CBOE, and then it's sold. Where does it go when it's sold? It goes to whoever the buyer is of that contract, although options are fungible; that means that I don't buy it directly from the seller, I may sell it to the guy trading on the floor, it might be another broker for another firm, essentially that identity is not discernible. Q. But it's not sold to a person designated by seller of the option. A. I don't quite follow that question. Q. What I'm saying is the person that orders it sold can't say where it's to be gone to, it's just sold on the floor of the exchange, is that correct? A. If you're saying does the person -- does the customer say sell it to Mr. Smith? ==========================================START OF PAGE 13====== Q. Correct. A. It has to go through the mechanics of the exchange and it might be picked up by a market maker on the floor, which is a specialist, or a floor broker acting for someone else, or an order that's already in the book at that particular price. Q. But with respect to the transactions here in question, no sale out of Mr. East's account could have been directly sold to the trust account, is that correct? . . . A. There's no way to establish essentially where they went. It's conceivable one of those accounts had an order in to buy, the other had an order in to sell at the same price, they could have crossed. That's conceivable. Q. But that would be out of the control of the seller, is that right? A. But that's out of the control -- the seller cannot determine who's going to buy it. (Tr. 1178-79.) PaineWebber Procedures Division Exhibit 25 consists of excerpts from the PaineWebber Business Policies Manual. The following definitions are taken from this Exhibit: Exercise Price - The price per share or other unit at which the holder of an option may purchase or sell the underlying security upon exercise. The exercise price is sometimes called the striking price. Expiration Date - The latest date an option contract may be exercised at the [Options Clearing Corporation] OCC. Currently, the expiration date for listed contracts is the Saturday following the third Friday of the expiration month. Expiration Time - The latest time by which an exercise notice must be received in proper form at the OCC. This time is currently 11:59 a.m. Eastern time on the expiration date, unless extended due to unusual or unforeseen circumstances. Limited [sic] Order - A price limit specified in an order beyond which the client does not wish to buy or ==========================================START OF PAGE 14====== sell. (Div. Ex. 25 at 192-93.) The manual explains the fundamentals of stock option trading: The basic function of stock options is to permit the transfer of investment risks and opportunities between buyers and sellers. Listed options are complex securities. To those who understand how they work, they may offer an alternative to short term stock trading at lower commission costs and a smaller commitment of capital. They also provide a means for shifting the risk of unfavorable short term stock price movements from owners of stock who have, but do not wish to bear those risks, to others who are willing to assume such risks in anticipation of possible rewards from favorable price movements. A call is an options contract giving the holder the right to buy a stock at a predetermined price before a specified date. Calls are highly versatile instruments that are traded in different series and used with other securities to achieve various investment objectives. Trading techniques can range anywhere from simply purchasing one call to engaging in highly sophisticated and complex spreading and hedging strategies. Investors dealing in put contracts are subject basically to the same risks and potential rewards as in trading calls, except that the risks differ in relation to the direction of any price movements in the underlying stock. There are a number of possible uses of options by buyers and writers. Each use involves risk in varying degrees, and not every use is suitable for every investor. Buyers of options generally hope for a favorable change in the market price of the underlying security, whereas option writers may profit if the underlying security does not change in price. This means that the risk of the option writer generally increases with the volatility of the underlying security. Further, because the maximum possible gain on any given writing transaction is the premium whereas losses may be considerably in excess of the premium, the profits on a number of successful transactions may be more than offset by a single loss transaction. Factors affecting the risk characteristics of particular options include the remaining term of the option and the difference between the option s exercise price and the market price of the underlying security. ==========================================START OF PAGE 15====== Options that are substantially out of the money and have only a short term remaining before expiration are likely to expire worthless and are therefore extremely risky and unsuitable for buyers who do no have the financial capacity to bear the loss of their entire investments. It is the investment executive s responsibility to inform clients of the risks inherent in options trading and to obtain all appropriate documentation. In connection with the purchase of options the investment executive must emphasize their limited life span. This should be done not only at the time an options account is opened, but each time a purchase is made. The remaining life span is a major consideration in discussing a contemplated purchase. (Div. Ex. 25 at 202.) Day did not delay allocations of trades to customer accounts to facilitate a fraudulent scheme. In the Birmingham branch office, in late 1987 and early 1988, wire operators routinely set aside customer allocation tickets for processing at a later time. After the block trading desk in New York communicated the price to the branch, the registered representative turned in the allocation ticket to the wire operator for transmission to the New York clearing office, which allocated the debit or credit to the account designated by the ticket. The wire operator in Birmingham time-stamped the allocation tickets when they were processed, not when they were dropped off to her by the broker. (Tr. 936-48.) I credit the description of the Birmingham branch s allocation process by PaineWebber wire operator Jama Moore Mayo. It is consistent with the testimony of PaineWebber wire operators Patricia Ann Thomas (Tr. 385-87) and of Mary Wynne Brown. Brown was asked at a prior proceeding about priorities as to customer allocations at the branch: Q. What else would go before an allocation ticket besides an unexecuted order? A. Oh, a trip to the restroom, a telephone call, working on an operational problem that needed to be solved right then. Procedure in the office and what this book [PaineWebber Manual] said were real [sic] two far different things. Q. We are talking about what you did yourself. A. When those orders were dropped, in general, if I was sitting there with absolutely nothing to do, I would put them in. If I have got a stack of market orders, those go first. If I am sitting there starting to put one in and somebody drops a ticket, I put that one aside and put the market order in. If the phone ==========================================START OF PAGE 16====== rings, I am going to answer the phone and not sit there and put those in until I solve whatever problem is on the phone. I mean, that is going to be on my lowest priority list [sic], because these orders have been executed, they are done and I am more worried about current problems. All I have to do really -- basically all I was doing was getting an account number assigned to them. (Joint Ex. 1, Vol. I, at 1393-94.) ==========================================START OF PAGE 17====== CONCLUSIONS OF LAW Contentions of the Parties The Division The Division contends that Day exercised discretionary authority over the Robbins trusts to enter trades through the options desk so that he could delay identifying the customer for whom he placed the trades. Then he dumped losing trades into the trust accounts and used broker accounts for siphoning profits. Day s practice of transferring profitable trades to certain accounts and losing trades to other designated accounts was a fraudulent scheme that violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The Division contends that East s testimony is not credible because East obtained short-term loans at exorbitant interest rates to finance the large trades and because he paid commissions to Day on the trades. Thus, the transaction costs of his trades were large, his ultimate profits were slender, and the volatility of the market made his risk of loss tremendous. It points to East s re-entry into the market after the $25,000 loss on one trade as an example of his belief that he was investing in a sure thing. (Div. Post Hrg. Brief at 18 and Div. Prop. Findings and Conclusions at 46.) Finally, the Division contends that East aided and abetted Day s illegal conduct, while knowing of his option trades for the trust accounts by Day, by violating rules of PaineWebber, including purchasing index options without having money in his account. He assisted Day by allowing him to allocate trades between the trusts and the accounts of the brokers, and East was aware or was reckless in not knowing, that his arrangement violated his employer s rules. He allowed Day to deflect attention from the fraudulent manner in which he [Day] was trading the trust accounts and he rewarded Day by splitting profits with him (Div. Prop. Findings and Conclusions at 43), in violation of his employer s rules. The Division seeks a cease and desist order and disgorgement order against East. (Div. Response to East s Renewed Motion to Dismiss at 2.) The Respondent The Respondent contends that borrowing money for trades and splitting profits and losses with another broker do not provide the level of awareness of illegal conduct required by the law of aiding and abetting. He contends that the state of the evidence precludes a finding that a loss dumping scheme even existed. Finally, the evidence demonstrates that East could not have been aware of such a scheme and did not assist in it. The Respondent argues that a delay in customer allocations ==========================================START OF PAGE 18====== was not unusual; that trading in the broker accounts demonstrated a different strategy from the trading in the trust accounts; and that only nine percent of the losses in the trust accounts would be offset by the total gains in the brokers accounts. (Post Hrg. Reply Brief of Respondent at 3-9.) East contends that his lack of knowledge of any loss dumping scheme is demonstrated by his lack of subterfuge and his net worth. (Id. at 10.) Evaluation of the Evidence East did not violate Section 17(a) of the Securities Act, or Section 10(b) of the Exchange Act, or Rule 10b-5 thereunder. These provisions prohibit the employment of a fraudulent scheme or the making of material misrepresentations and omissions in, and in connection with the offer, purchase, or sale of any security. To prove a violation of these provisions, the Division must show: (1) that a misrepresented or omitted fact was made in an offer, attempt to induce a purchase or sale, or an actual purchase or sale of security; (2) that the misrepresented or omitted fact was "material"; and (3) that the respondent acted with the requisite "scienter." Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); Aaron v. SEC, 446 U.S. 680, 701-02 (1980). "[M]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information." Basic Inc., 485 U.S. at 240. Information is deemed material upon a showing that there is a substantial likelihood that the omitted facts would have assumed actual significance in the investment deliberations of a reasonable investor. A statement is misleading if the information disclosed does not accurately describe the facts, or if insufficient data is revealed. Basic Inc., 485 U.S. at 232; see also United States v. Koening, 388 F. Supp. 670, 700 (S.D.N.Y. 1974). A showing of scienter is required to prove violations of Section 17(a)(i) of the Securities Act and Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder. Aaron, 446 U.S. at 701- 02. Scienter has been described as "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). Scienter is established by a showing that the defendant acted intentionally or with severe recklessness. Raymond L. Dirks, 47 S.E.C. 434, 447 n.47 (1981), aff d, Dirks v. SEC, 681 F.2d 824 (D.C. Cir. 1982), rev'd on other grounds, 463 U.S. 646 (1983); see Broad v. Rockwell Int'l Corp., 642 F.2d 929, 961-62 (5th Cir.), cert. denied, 454 U.S. 965 (1981); see also Warren v. Reserve Fund, Inc., 728 F.2d 741, 745 (5th Cir. 1984); Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); Sunstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1039-40 (7th Cir.), cert. denied, 434 U.S. 875 (1977). Recklessness has been defined as highly unreasonable conduct involving not merely simple or excusable ==========================================START OF PAGE 19====== negligence, but an extreme departure from the standards of ordinary care. SEC v. Carriba Air, Inc., 681 F.2d 1318, 1324 (11th Cir. 1982). Proof of recklessness may be inferred from circumstantial evidence. Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir.), cert. denied, 439 U.S. 1039 (1978). In SEC v. American Commodity Exchange, Inc., 546 F.2d 1361, 1365 (10th Cir. 1976), the court indicated that actual sales by the defendant were not necessary to establish a violation of the antifraud provision of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. To the same effect, see United States v. Dukow, 330 F. Supp. 360 (W.D. Pa. 1971) and Fund of Funds Ltd. v. Arthur Anderson, 545 F. Supp. 1314, 1351-53 (S.D.N.Y. 1982). The Dukow court held that even though the defendant was not a party to sales made by brokerage personnel, he was part of the scheme and was not exonerated from charges of securities fraud. Dukow, 330 F. Supp. at 364. "[T]he securities laws include as a seller entities which proximately cause the sale . . . or whose conduct is a 'substantial factor in causing a purchaser to buy a security.'" Fund of Funds Ltd., 545 F. Supp. at 1353, citing Lawler v. Gilliam, 569 F.2d 1283, 1287 (4th Cir. 1978). Thus, fraud or intentional misconduct designed to deceive or defraud must be proven by the Division. See Ernst & Ernst, 425 U.S. at 194. Of course the Division relies on the theory of aiding and abetting in its case against East. In the context of the federal securities laws, three elements must be present for aiding and abetting: (1) a primary or independent securities law violation that has been committed by some other party; (2) awareness or knowledge by the aider and abettor that his or her role was part of an overall activity that was illegal; and (3) that the aider and abettor knowingly and substantially assisted the conduct that constitutes the violation. Woods v. Barnett Bank of Fort Lauderdale, 765 F.2d 1004, 1009 (11th Cir. 1985); Investors Research v. SEC, 628 F.2d 168, 178 (D.C. Cir.) cert. denied, 449 U.S. 919 (1980); IIT v. Cornfield, 619 F.2d 909, 922 (2d Cir. 1980); Woodward v. Metro Bank of Dallas, 522 F.2d 84, 94-97 (5th Cir. 1975); SEC v. Coffey, 493 F.2d 1304, 1316 (6th Cir. 1974), cert. denied, 420 U.S. 908 (1975); William R. Carter, 47 S.E.C. 471, 502-03 (1981). I conclude that the Division has proved that Day violated the federal securities laws described in the OIP, during the period of his arrangement with East. However, his violations did not consist of a scheme to skim profits from or dump losses into the customer accounts. Rather, his violations consisted of failing to disclose to Shepherd the risks inherent in the trades, and placing trades without authorization. These violations probably began at Thomson McKinnon. They certainly occurred as of Day s first trades at PaineWebber in November 1987. ==========================================START OF PAGE 20====== The extended excerpt from the PaineWebber manual that I rely on is contained in my findings. (Div. Ex. 25 at 202.) These warnings to the registered representatives who choose to trade in options are clear. Day had a duty to inform Shepherd, each time he placed a trade, of the risks to which the trust accounts were exposed. Although Shepherd had an impressive background as an accountant, his training and experience were not a substitute for a thorough exposition by Day on the trading strategy. The facts that Shepherd did know were sketchy and could not possibly enable him to carry out his fiduciary responsibilities to the beneficiaries of the trusts. For example, Shepherd demonstrated no knowledge of index options, expiration dates, expiration times, or the benefits of a limited [sic] order as delineated in the PaineWebber Business Policies Manual, (Div. Ex. 25 at 192- 93), although Respondent East did. (Tr. 1014-37.) Obviously, Day had de facto discretionary trading authority in the trust accounts at Thomson McKinney and then at PaineWebber up to February 2, 1988, when Shepherd withdrew it in writing. However, I conclude that Shepherd would never have given Day that authority at all if Day had revealed to him the risks inherent in the trades in the trust accounts. Day also acted with the requisite scienter. He made hundreds of thousands of dollars from the commissions that the trading generated. (Joint Ex. 7, Vol. II at 219-20.) His trading on margin in January 1988 without authority demonstrates his indifference to the financial well-being of his customer. The debt to PaineWebber would have been paid by the sale of the same securities that Shepherd wished to retain in the other Robbins accounts. (Joint Ex. 7, Vol. II at 105-06, 494.) Beginning on February 2, 1988, Day committed fraud by trading without authority in both trust accounts. From February 2 through March 10, 1988, Day purchased index options for the trust accounts on at least eleven occasions. He also sold index options for the accounts. (Div. Ex. 15.) The purchases were transactions without authority, in contravention of the federal securities laws. Of course, this period of time also coincided with the greatest losses in the marital and trust accounts; these losses are attributable to Day s failure to exercise the options prior to their expiration date, as described in my findings. Day s recklessness in allowing the trust accounts to sustain heavy losses by his inaction provides evidence of his scienter as to the earlier omissions and as to the unauthorized trading from February through March. The motive for these unauthorized trades is clear. Day continued to amass thousands of dollars in commissions from his course of illegal activity. (Div. Ex. 28.) There was no proof of a loss-dumping scheme. I find that the late allocations resulted from the press of business. (Tr. 936-48, 385-87; Joint Ex. 1, Vol. I at 1393-94.) The evidence establishes no correlation between the losses in the trust ==========================================START OF PAGE 21====== accounts and activity in the accounts of the three brokers. The majority of the trust losses occurred after allocation, when $680,000 worth of options expired worthless. (Tr. 1156-57, 1159.) The brokers netted $103,000 on their trades. If all the trades of the brokers has gone into the trust accounts instead, the trust accounts would have saved only nine and a half percent. (Tr. 1158.) The trust accounts lost a total of $1,096,000 from January to March. (Tr. 1156-57.) None of the brokers could have profited from the losses because the seller of an option cannot determine prior to the sale the identity of the purchaser at the time of execution. (Tr. 1179.) The fact that the brokers Arnold, East, and Day also sustained some losses also indicates that the scheme postulated by the Division did not exist. The most dramatic loss for the brokers occurred in East s account, when he lost $25,000 on one trade. Obviously, East sustained the loss because he was at risk, not as a result of his assurance that the trades would result in certain profit. The Division points to the continued trading in East s account after the loss as proof that future profits were guaranteed. However, the trades for East ended four days later whereas Day continued the trust account trading for five more weeks. (Div. Ex. 1 at 3-9 and 28.) The pattern of trading in East s account was also different from the pattern in the trust accounts. Pursuant to East s instructions, Day bought and sold the options on the same day. In fact, the only trade in which East sustained a substantial loss was the one in which the position was held longer than one day. (East Ex. 10.) East also limited his exposure to losses by placing conditions on the trades. (Div. Exs. 4, 25 at 193; Tr. 1012-1017.) Nothing in the record indicates that Shepherd attempted to do the same for the trust accounts or that he was aware of the possibility. The Division makes much of the fact that East financed his trading by obtaining short-term loans at exorbitant interest rates. However, the source of the funds for the trades could not affect the success or failure of a scheme to siphon profits from trades in a customer account. I credit East s uncontroverted testimony that he admired Day and regarded him as a guru and that he did not follow the trades that Day executed for the trust accounts. In fact, it was so time-consuming for him to follow the options trades in his own account that he did not do it consistently. (Tr. 1113-18.) East had no reason to question Day s reputation or his skill as a trader. Day came to PaineWebber with no disciplinary history, millions of dollars in customer accounts, and a reputation as a high producer. East took many risks as a result of the favorable impression that Day made on him, and he has been punished greatly for taking those risks. ==========================================START OF PAGE 22====== However, East did not know that Day acted without informing Shepherd of material facts; he did not know that Day executed trades in the trust accounts without authority; and he did not know that Day recklessly caused the loss of over a million dollars in the trust accounts. Furthermore, the Division has not shown that East assisted Day in the execution of any scheme to violate the federal securities laws. Day acted with impunity because Shepherd trusted him and because Day was not effectively supervised. Thus, the proceeding against East must be dismissed. I deferred ruling on East s Motion to Dismiss based on the application of the five-year statute of limitations under 28 U.S.C.  2462 as interpreted in Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996). I am persuaded by the Respondent s arguments, set forth in his Brief in Support of the Motion, that the customers are satisfied and that a cease and desist order or disgorgement order would constitute penalties against East. Thus, in the alternative, the proceeding against East must be dismissed pursuant to 28 U.S.C.  2462. CERTIFICATION OF THE RECORD Pursuant to Rule 351(b) of the Commission s Rules of Practice, 17 C.F.R.  201.351(b), I hereby certify that the record includes the items set forth in the Record Index issued by the Office of the Secretary on September 27, 1996, and the Revised Record Index as of January 23, 1997, issued by the Office of the Secretary. ORDER IT IS ORDERED that the proceeding against Respondent W. David East, Jr., be, and it hereby is, DISMISSED. This Order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission s Rules of Practice, 17 C.F.R.  201.360 (1996). Pursuant to that rule, a petition for review of this initial decision may be filed within twenty-one days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision upon the party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to any 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. _____________________________________ Lillian A. McEwen ==========================================START OF PAGE 23====== Administrative Law Judge