Initial Decision of an SEC Administrative Law Judge
In the Matter of
In the Matter of
January 31, 2000
William S. Dixon and William A. Rees for the Division of Enforcement, Securities and Exchange Commission.
David J. Gellen and Michael K. Wolensky for Respondents.
James T. Kelly, Administrative Law Judge
The United States Securities and Exchange Commission (Commission) instituted these proceedings on December 9, 1998, pursuant to Section 8A of the Securities Act of 1933 (Securities Act), Sections 15(b), 19(h), and 21C of the Securities Exchange Act of 1934 (Exchange Act), and Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 (Advisers Act). The Order Instituting Proceedings (OIP) alleges that, between June 1, 1993, and December 31, 1995, Respondents engaged in a course of business which operated as a fraud and deceit on their customers and clients and, as part of that course of business, omitted to disclose and misrepresented material facts in connection with the purchase of mutual funds.
The OIP alleges that Respondents Flanagan and Kindschi willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder. It further alleges that Respondent Spectrum Administration, Inc. willfully violated Sections 206(1) and 206(2) of the Advisers Act, and that Respondent Kindschi willfully aided and abetted those violations. As relief, the OIP seeks the imposition of remedial sanctions in the public interest, including cease and desist orders, disgorgement of ill-gotten gains, civil monetary penalties, a registration revocation, and bars from the securities industry.
This matter was initially assigned to Administrative Law Judge Lillian A. McEwen; it was reassigned to my docket on April 12, 1999. I held a public hearing on April 27-30, 1999, in Atlanta, Georgia. The hearing record consists of 810 pages of transcript, including the testimony of nine fact witnesses and two expert witnesses, as well as thirty-two exhibits from the Division of Enforcement (Division) and fifty-three exhibits from Respondents. The Division filed its Post Hearing Brief, and Proposed Findings of Fact and Conclusions of Law on July 20, 1999. Respondents filed their Post Hearing Brief, and Proposed Findings of Fact and Conclusions of Law on August 30, 1999. The Division filed its Reply Brief on September 15, 1999.1
I base 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. Steadman v. SEC, 450 U.S. 91, 97-104 (1981). I have considered and rejected all arguments and proposed findings and conclusions that are inconsistent with this decision.
Ronald O. Kindschi is fifty-three years of age. He earned a B.S. degree in finance from California State University, Long Beach, and an M.S. degree in financial services from The American College, Bryn Mawr, Pennsylvania. By 1993, Mr. Kindschi also held designations as a certified financial planner, chartered life underwriter, and chartered financial consultant (Tr. 52-54). He began working in the securities industry in 1970 with Connecticut General Equity Sales Corporation (Connecticut General). Concurrently, he worked as a licensed life insurance agent of Connecticut General. Fifteen years later, he started his own broker-dealer firm.
From 1991 to the present, Mr. Kindschi has been a registered representative of Financial Services Corporation (FSC), a broker-dealer with headquarters in Atlanta and small branch offices throughout the country. At all relevant times, Mr. Kindschi has been a principal at FSC's branch office in Seal Beach, California. He supervised about fifty registered representatives from 1993 through 1995, and he had been trained to detect sales practice abuses (Tr. 56-57). In 1991, Mr. Kindschi also became a principal of FFR Consulting, a registered investment adviser (Tr. 50, 674-75).2
In 1993, Mr. Kindschi had about forty to fifty clients, and their average net worth exceeded $10 million. His gross sales production that year was approximately $1.6 million (Tr. 660-61). He has assisted his customers with hundreds of purchases of mutual fund shares, and considers himself to be very knowledgeable about mutual funds (Tr. 53, 57-58, 69). Mr. Kindschi has never had a customer complaint or an arbitration claim filed against him, and he has never been the subject of any enforcement action, apart from the present proceeding (Tr. 661-62).3
Michael A. Flanagan, Sr., is also fifty-three years of age. He studied business administration at the University of North Carolina, Chapel Hill, from 1964 to 1968, but did not earn a degree (Tr. 162, 570). Thereafter, Mr. Flanagan played professional baseball for seven to eight years in the Houston Astros organization, pitching mostly at the AAA level (Tr. 569). From the mid-1970s to 1993, he was employed by Connecticut General as a registered representative and assisted customers with mutual fund transactions (Tr. 163, 569). He also earned designations as a chartered financial consultant, certified financial planner, and chartered life underwriter (Tr. 162). Mr. Flanagan left Connecticut General in late 1993, moving from New Jersey to California to work with Mr. Kindschi (Tr. 561, 570, 626).
From the Fall of 1993 to the present, Mr. Flanagan has been a registered representative of FSC: first, in Seal Beach, and then in Odessa, Delaware (Tr. 161, 561, 571).4 About half of his customers invest in mutual funds (Tr. 163-64). During the time at issue in this proceeding, Mr. Flanagan's customer base and production grew steadily. He had seventy-five customers in 1993, eighty-five in 1994, and 100 in 1995. His gross sales production was $300,000 in 1993, $400,000 to $500,000 in 1994, and $600,000 to $700,000 in 1995 (Tr. 571). Until this case, Mr. Flanagan had not been the subject of any customer complaints, arbitration claims, or regulatory proceedings (Tr. 559-60).
Commission records show that FFR Consulting was incorporated in California on April 24, 1991; the Commission granted it registration as an investment adviser on July 18, 1991. The corporation notified the Commission on July 12, 1994, that it had amended its name from FFR Consulting to Spectrum Administration, Inc. (SAI) (Tr. 559-60). At all relevant times, the corporation's principal place of business has been in the same Seal Beach building as FSC's branch office (id.). The firm used DataLynx, Inc., a subsidiary of First Trust Corporation of Denver, to provide back office services and to serve as an intermediary with mutual fund families (see Tr. 37, 93, 637; Div. Ex. 1-17).
As relevant here, FFR Consulting (and later SAI) provided asset allocation advice to clients who wished to diversify investments of substantial assets among mutual funds. The firm helped clients to determine how their assets would be allocated. It then helped clients to select money managers and specific investment vehicles. When FFR Consulting (and later SAI) was selected as the money manager, it provided a timing service, and delivered instructions to mutual funds to purchase, sell, or exchange shares based upon its evaluation of certain economic or market forces expected to have an impact on the price of those shares.
Many mutual funds, including those in the Putnam, Kemper, and MFS families at issue here, offer more than one class of shares. Each class participates in the same portfolio of investments and is identical to the other classes, except for differing sales loads, expenses, and the commission credits paid to the broker-dealer. For example, a fund may offer classes with different sales charges, such as one class with a front-end load and lower fees, and another class with a back-end load and higher fees. In this proceeding, the Division focuses on two commonly-encountered classes of shares, Classes A and B. Respondents briefly address two transactions in Class C shares. Those will be considered below, at page 26.
For Class A shares, an initial sales charge or front-end load is commonly levied. The load is taken out of the customer's purchase price before the investment goes into the fund. Most mutual funds reduce the basic sales load in a series of steps as the size of an investment increases. The point at which the load is reduced is referred to as a "breakpoint" (Tr. 82-83, 760-61; Div. Ex. 25-83). Comparable discounts can be obtained through the aggregation of multiple purchases over a specified period through the exercise of a purchaser's "rights of accumulation." A "letter of intent" is a statement given to the fund that indicates the intent to purchase a certain amount of shares within a certain period.
For Class B shares, no initial sales charge or front-end load is involved. However, purchasers of Class B shares are subject to higher annual expenses than Class A shares (Tr. 342). Many also incur a contingent deferred sales charge (CDSC) upon the sale of their shares. These charges are sometimes called back-end loads. They usually occur on a declining basis, based on the length of time the shares are owned, and typically are eliminated after six to eight years. Breakpoints are not available on Class B shares (Tr. 107-08, 434). Some fund families prohibit purchases of Class B shares in large dollar amounts (Div. Ex. 25-83), while others do not (Tr. 422). One investment adviser testified that he normally recommends clients use Class A shares, rather than Class B shares, if they are investing over $100,000 (Tr. 464-65, 468-69).
The owners of Class A and Class B shares periodically pay expenses, including "12b-1" fees.5 The expense ratios charged to Class B shareholders are generally higher than the expense ratios charged to Class A shareholders. At the end of an investor's CDSC period in Class B shares, some funds convert shares automatically to Class A shares, while others may give shareholders the right to convert to Class A shares. Still others have no conversion privileges. Conversion to Class A shares has the effect of lowering the annual expenses charged (Div. Ex. 25-83). After their shares are converted to Class A shares, investors who originally purchased Class B shares are subject to the same expense ratios and experience the same returns as investors who originally purchased Class A shares.
The primary advantage of Class B shares is that sales charges may be reduced or avoided altogether, depending on the investor's holding period of the shares. Moreover, the absence of a front-end load means that 100 percent of the customer's funds are invested (Tr. 343). Small purchases of Class B shares may be more advantageous for investors than small purchases of Class A shares, since small investments would not meet any breakpoints and would incur the highest front-end load rate on Class A shares (Div. Ex. 25-83).
The primary disadvantage of Class B shares is that their annual expense ratios are usually higher than those for Class A shares by one-half to one percent, a significant amount (Tr. 342, 344). Class B shares that do not automatically convert to Class A shares at the end of the CDSC period are also disadvantageous in that the investor continues to pay the higher annual expense ratios of the Class B shares (Div. Ex. 25-83).
Multiple classes of shares developed in the mutual fund industry as a marketing device. There always has been significant public resistance to the payment of front-end loads (Tr. 757). In addition, the late 1970s and early 1980s were a time of industry-wide net redemptions (Tr. 759). With the Commission's promulgation of Rule 12b-1 in November 1980, fund companies realized they could collect money over time through the 12b-1 plans, and finance deferred sales loads until the shares were ultimately redeemed (Tr. 757-58, 761). This combination of factors made the notion of a CDSC an attractive idea (Tr. 758).
From the early 1980s through 1995, mutual funds seeking to sell the public different classes of shares had to approach the Commission's Division of Investment Management on a case-by-case basis, seeking exemptive relief. In 1995, the Commission promulgated Rules 6c-10 and 18f-3 under the Investment Company Act of 1940.6 These Rules allow mutual funds to sell multiple classes of shares to the public without exemptive orders from the Commission.
The term "commission credit" is used to denote the dollar amount of commission, or production, actually credited to a registered representative. It is the dollar amount upon which the representative's actual compensation for a transaction is based. A registered representative receives a commission credit at the time mutual fund shares are purchased, regardless of whether Class A or Class B shares are purchased. In other words, there is no incentive for the representative to recommend Class A or Class B shares based solely on the timing of his receipt of the commission credit. However, there may be a substantial difference in the amount of commission credit a registered representative receives for selling Class B versus Class A shares of the same fund. This occurs because a representative receives a declining rate of commission credits at breakpoints for the sale of Class A shares, but the same percentage commission credit for the sale of all Class B shares, regardless of dollar amount (Tr. 81). For large-dollar purchases, the representative's commission credit is usually higher for Class B shares than for Class A shares (Div. Ex. 25-83).
In this proceeding, the Division alleges that Respondents committed fraud by steering their customers and clients to purchase Class B shares in various mutual funds, thus maximizing their own compensation and depriving their customers and clients of the discounts on sales charges that would have been applicable to their investments had Class A shares been purchased. Respondents contend that their customers and clients received full disclosure of all material facts before making any mutual fund purchases, that the customers' and clients' decisions to use market timing strategies sometimes dictated the classes of mutual fund shares that could be used with those timing strategies, and that their customers and clients wanted the benefits they believed could be derived from those timing strategies and not just the lowest-cost long-term investment they could find.
Market timing of mutual fund purchases and sales does not violate federal securities laws, but it is far from popular with many fund portfolio managers (Tr. 522, 775-76). Mutual funds are designed as long-term investments and traditionally have been viewed as unsuitable short-term trading vehicles. Cf. Winston H. Kinderdick, 46 S.E.C. 636, 639 (1976). Through a mutual fund, individual investors pool their cash, diversify their portfolios, and collectively delegate their financial decision-making and stock-and-bond-picking to a professional, the fund's portfolio manager. When a second professional is added to the mix a market timer willing to move millions of dollars on short notice to protect his clients from volatile markets or inconsistent fund managers friction often results. Two conflicting approaches are in play: one, stressing time in the market; the other, stressing timing the market.
Market timers represent only a small proportion of a fund's shareholders, but account for a disproportionate percentage of the volume and frequency of transfers and redemptions. Heavy short-term trading by market timers disrupts the fund manager's activities, forcing him to buy or sell on somebody else's schedule, perhaps at a disadvantageous price (Tr. 158, 514). A fund manager may find he is unable to remain as fully invested in the market as he would prefer, because he needs to maintain larger than normal cash positions to protect against the risk of sudden redemptions (Tr. 158-59). This may limit the fund's performance during a rising market. See Windsor Sec., Inc. v. Hartford Life Ins. Co., 986 F.2d 655, 666 (3d Cir. 1993) (accepting a mutual fund's argument that market timing caused increased trading and transaction costs, disrupted planned investment strategies, forced unplanned portfolio turnovers, lost opportunity costs, and subjected the fund's asset base to large swings, and holding that the mutual fund acted legitimately in imposing restrictions on a market timer).
Faced with these perceived threats, many mutual fund families have tried to track the timers who use their funds and/or to impose "anti-timer" restrictions (Tr. 298, 777; Resp. Exs. 5-57, 6, 14, 15). Tracking is not always successful, as the funds are aware of only the biggest timers (Tr. 151-52, 156-57, 301). Anti-timer restrictions are intended to slow down the frequent traders or to discourage them from using a particular fund at all.7 Typical restrictions include adding language to the fund's prospectus: (1) prohibiting frequent movement between money market funds, on the one hand, and equity or bond funds, on the other; (2) limiting switches between funds in a family to two or four per year; (3) placing a fifteen or thirty day prohibition on the movement of funds after the first purchase; (4) limiting the privilege of redeeming or exchanging by telephone, and requiring transactions to be made by mail; (5) charging a one or two percent redemption fee to those who sell their shares in a fund within one year of purchase, with the fee proceeds redeposited in the fund for the benefit of the long-term shareholders (Tr. 776); (8) honoring redemption requests by short-term shareholders only with "payment in kind" a proportional amount of every stock in the fund's portfolio, rather than cash; or (9) simply telling market timers to take their business elsewhere (Tr. 158-59, 498-99, 507-08, 583-84).
From the viewpoint of the market timer, "finding space" is "a major problem," given the changing restrictions that mutual funds impose (Tr. 511). Market timers try to stay away from fund families that impose too many restrictions (Tr. 479-80).
Ralph J. Doudera, age fifty-three, earned a B.S. degree in mechanical engineering and an M.S. degree in finance and management from the New Jersey Institute of Technology (Tr. 460; Resp. Ex. 11). While working in the estate and financial planning fields at Connecticut General, he was a colleague of Respondents Kindschi and Flanagan (Tr. 520-21, 569). He left Connecticut General in 1983 to form Spectrum Financial, Inc. (SFI) in Virginia Beach, Va. (Tr. 65, 461, 521). SFI offered insurance and estate planning services for five years; in 1988, it registered as an investment adviser (Tr. 520-21). SFI is not affiliated with Respondent SAI. Mr. Doudera is the president and sole shareholder of SFI. He is also a registered representative of Royal Alliance Associates, Inc., a broker-dealer (Tr. 462).
SFI provides asset management services to clients who invest in bond and stock mutual funds. The firm has developed several different investment systems which involve asset allocation and the timing of mutual fund purchases and sales. It maintains that these systems can outperform buy-and-hold strategies by "going to cash" on appropriate days of the month (Tr. 461, 504). Mr. Doudera describes his systems to prospective clients as a way to avoid declining markets and participate in rising markets (Tr. 495-96). SFI assists clients in making conversions between defensive (money market) funds and aggressive (bond or stock) funds within the same mutual fund family. Conversions are initiated in response to signals from Mr. Doudera's mathematical models. The systems chosen are based on the client's objectives and risk tolerance, and each system trades independently of the others. In 1993, SFI had about $250 million under management (Tr. 474). SFI does not charge its clients commissions on trades (Tr. 481-82), but collects annual fees based on the value of the assets it manages (Tr. 461, 463).
Most relevant to the present case are Mr. Doudera's "multi-bond" and "seasonal stock" systems. Based on buy/sell signals, the multi-bond system makes exchanges between a money market fund and some type of bond fund (usually, high-yield bonds, but occasionally, government or municipal bonds) (Tr. 479; Resp. Ex. 49-26). It moves to the money markets when interest rates are rising and to bond funds when rates are falling (Resp. Ex. 13). The seasonal system is based on Mr. Doudera's belief that there are certain days during the year which have a substantial upward bias in stock prices, generally at the beginning and end of each month and on the days prior to holidays. The seasonal system recommends investing in stocks for just those days which have been historically good days to be in stocks. Under this system, the client will be invested in mutual funds holding stocks for only about 25 percent of the time. When the client's funds are not in stocks, they follow the multi-bond system (Tr. 476-78; Resp. Ex. 11). The seasonal strategy involves making approximate twenty-five to thirty exchanges per year per investor, or twelve to fifteen round trips (Tr. 477; Resp. Ex. 11). Prospective clients are advised that short-term capital gains and losses may be realized, and that dividends may be received only on an irregular basis.
SFI publishes a quarterly four-page newsletter called The Full Spectrum. It is distributed to SFI's clients and the registered representatives who referred them to Mr. Doudera (Tr. 508-09). It discusses Mr. Doudera's investment philosophy, and offers his views on the stock market, interest rates, the national economy, and international developments. The publication also summarizes the preceding quarter's and prior year's events, and measures the performance of SFI's systems on timed managed accounts (Tr. 486-88; Resp. Exs. 1, 13). Mr. Doudera uses the newsletter as a marketing tool: "to explain to clients why they needed me" (Tr. 488).8
From 1993 through 1995, several mutual fund families, including Putnam Investments, continued to restrict the ability of market timers to use certain of their funds (Tr. 298-301, 467, 514-17; Resp. Exs. 5-57, 6, 15). Putnam's June 1994 restrictions on daily exchanges, in particular, "caused havoc" in Mr. Doudera's office (Tr. 516).9
In response, Mr. Doudera determined that he did not want SFI to grow any larger. SFI decided not to accept new client referrals from FFR Consulting. To accommodate such clients, FFR Consulting purchased SFI's timing signals and research and administered the clients' accounts previously managed by SFI. A year or two earlier, SFI had caused another firm like FFR Consulting to undertake a similar transition (Tr. 523-24). The transition from SFI management to FFR Consulting management continued through 1993 and 1994 (Tr. 467). The goal of both Mr. Doudera and Mr. Kindschi was to establish multiple small investment advisers that would not be "perceived" by the mutual funds as being one large investment adviser, and generally to stay "off the radar screens" of the mutual funds that tracked timers (Tr. 66-67, 471-73, 523, 678-79). FFR Consulting later refined its system even further; it registered timed funds by the individual representative, rather than by the investment advisory company. By that device, Mr. Kindschi was able to "get client money in[to a mutual fund when] Mr. Doudera was still blocked out" (Tr. 679).
Both Mr. Doudera and Mr. Kindschi believe that the ability to time a mutual fund is a much more significant issue than the question of whether Class A shares or Class B shares are chosen to do it (Tr. 522-27, 681, 676-77).
In Mr. Doudera's and Mr. Kindschi's experience, when mutual fund families have frozen their clients' ability to exchange, eliminated the prospect of timing, and caused them to move the clients' assets elsewhere, the clients have been unable to get a refund of the front-end loads they paid for the purchase of Class A shares (Tr. 498-99, 679-81). Mr. Kindschi estimated the amount of money lost because of such restrictions over the past several years has involved tens of thousands of dollars. In contrast, when fund families have asked him to move his clients' timed Class B shares elsewhere, Mr. Kindschi testified that he has been successful in persuading the funds to waive their CDSCs (Tr. 681).10
Philip A. Wiedrick, Jr., is fifty-nine years of age, with a junior college education (Tr. 148). For forty years, he has worked for his family's business, the Long Beach Plywood Company, Inc., selling lumber, plywood, and building materials (Tr. 61-62, 117-18). His annual income during 1993 was $100,000 (Tr. 118). Mr. Wiedrick is one of the trustees for the firm's retirement plan, the Long Beach Plywood Company Profit Sharing Plan (Plan) (Tr. 61, 118). The Plan has been in existence since 1959, and Mr. Wiedrick has been a trustee since the early 1970s (Tr. 149).
Mr. Wiedrick has been a customer and client of Mr. Kindschi's since the early 1970s, not only as trustee of the Plan, but also for his personal investments (Tr. 121, 140). Mr. Wiedrick actively monitored the status of the Plan's accounts, and was not bashful about questioning Mr. Kindschi when he noted discrepancies in account statements (Tr. 129-31, 142-43, 675; Div. Exs. 8-15, 9-16). Notwithstanding the fraud allegations in the OIP, Mr. Wiedrick continued to do business with Mr. Kindschi through the date of the hearing.
FFR Consulting, through Mr. Kindschi, provided its clients with asset allocation advice, using a five-step investment management process (Tr. 58-60, 666; Resp. Ex. 48-3). The process involved: (1) analyzing the client's current portfolio; (2) designing an optimal portfolio; (3) preparing a written investment strategy; (4) determining whether a buy-and-hold strategy or active style of management would be appropriate and proposing and selecting one or more money managers; and (5) periodically reviewing the client's portfolio. Mr. Kindschi had employed this process several times over the years with Mr. Wiedrick (Tr. 667). The Plan had used SFI's multi-bond timing system on a $47,800 investment as early as December 1990 (Tr. 484-86; Resp. Ex. 12-25). Mr. Wiedrick also received copies of The Full Spectrum and, by June 1993, was familiar with Mr. Doudera's timing strategies (Tr. 136-37).
Over several months in early 1993, Mr. Kindschi again took the Plan through the five-step process (Tr. 63-64; Div. Ex. 3-12, Resp. Ex. 12-25). The Plan's assets at the time were $1,344,000. When the process was completed in May 1993, the Plan's investment policy statement articulated five objectives: (1) to maintain a fully funded status with regard to the Accumulated Benefit Obligation; (2) to have the ability to pay all benefit and expense obligations when due; (3) to maintain a "funding cushion" for unexpected developments and for possible future increases in benefit structure and expense levels; (4) to maintain flexibility in determining the future level of contributions; and (5) to maximize return within reasonable and prudent levels of risk in order to minimize contributions (Div. Ex. 3-12 at 6; Tr. 64, 120). The investment policy statement described the Plan's risk tolerance as "able to tolerate some interim fluctuations in market value and rates of return in order to achieve long-term objectives" (Div. Ex. 3-12 at 7). The Plan's performance expectations were described as "a long-term rate of return on assets that is at least 5.0% greater than the rate of inflation as measured by the Consumer Price Index" (id.). To meet these goals, the Plan chose SFI as one of its investment advisers and Computime Institutional Services, Inc., (Computime) of Pensacola, Florida, as a second investment adviser (Tr. 64-65, 140).
Once the Plan had selected these particular money managers, Mr. Wiedrick met with Mr. Kindschi to decide which mutual funds to use and what type of shares to select (Tr. 670). In preparation for such meetings, Mr. Kindschi would typically gather information on which mutual funds the money managers were comfortable with and could manage well. He would then decide which funds made the most sense in light of the strategies the client wanted to employ (id.).
The Plan decided to invest $572,500 in SFI's multi-bond timing strategy and $285,000 in SFI's seasonal timing strategy (Tr. 137-38; Resp. Exs. 49-26, 50-27). The sum the Plan committed to Computime management and the $572,500 invested through SFI's multi-bond strategy are not at issue here. This case involves only the $285,000 committed to SFI's seasonal timing strategy. For that purpose, Mr. Kindschi discussed different fund families with Mr. Wiedrick, and recommended Putnam (Tr. 122-23).
Class B shares first became available for purchase in the Putnam family of funds in late 1992 or early 1993 (Tr. 302, 671). The Putnam High Yield Trust Prospectus dated January 1, 1993, which governs the transactions at issue here, explained the differences between Class A and Class B shares under the heading of "Which arrangement is better for you?" In pertinent part, the prospectus stated: "Orders for Class B shares for $250,000 or more will be treated as orders for Class A shares or declined . . . . Class A shares and Class B shares may only be exchanged for the shares of the same class of other Putnam funds" (Resp. Ex. 7 at 13).11
Mr. Wiedrick received and read the applicable Putnam prospectus, and believes he understood its description of the differences in Class A and Class B shares (Tr. 139-40). At the time, Mr. Wiedrick already owned both classes of shares of various mutual funds, and was aware of the differences in the two classes on that basis, as well (Tr. 673-74). Before making his choice, Mr. Wiedrick discussed the relative costs and benefits of Class A and Class B shares with Mr. Kindschi (Tr. 123-26, 132-35). Mr. Kindschi told Mr. Wiedrick about the breakpoints available on the purchase of Class A shares (Tr. 125). However, Mr. Kindschi did not tell Mr. Wiedrick about Putnam's dollar limit on the purchase of Class B shares (Tr. 93, 96, 125). Ultimately, Mr. Wiedrick selected Class B shares, and not Class A shares, to avoid the front-end load and have the extra money in the account working to build up equity (Tr. 91, 123, 126).12
On June 6, 1993, FFR Consulting sent the Plan two form contracts it had prepared. Mr. Wiedrick executed the documents on June 10, 1993 (Resp. Exs. 49-26, 50-27). FFR Consulting promised to use SFI's market timing programs to manage certain of the Plan's investments. The Plan authorized FFR Consulting to effect conversions between funds in a family of mutual funds in accordance with buy or sell signals received from SFI. For these services, the Plan agreed to pay FFR Consulting a yearly fee of 1.9 percent of the assets managed. The fee was to be collected in advance, on a quarterly basis.
In 1993, the Seal Beach office had about ten to fifteen employees. The office administrator, David Konell, would record information about a client's account on an inter-office computerized system called SmartPad. Through SmartPad, Mr. Konell kept others in the office, including Mr. Kindschi, informed about events affecting an account (Tr. 36, 41-43, 47-48). SmartPad was not an electronic mail system. Its use was encouraged, but not required (Tr. 632-33). The relevant SmartPad notes for the Plan's account are the entries for June 7 and 8, 1993, and the second entry for June 18, 1993 (Div. Ex. 2-20). In the June 8 entry, Mr. Konell wrote that DataLynx, the intermediary with the mutual fund families that provided FFR with back office services, had recommended that the Plan use Class A shares, which have no monetary limits and get breakpoints on the $285,000 transaction. His entry for June 18 stated that the final papers were ready for Mr. Wiedrick's signature and that the Plan's $285,000 purchase would be split due to Putnam's Class B rules: one segment for $249,999.99 and another for $35,000.01 (id.).
Putnam's two-page account opening application was signed by Mr. Wiedrick (Div. Ex. 6-19; Tr. 94). Entries showing the trade date, confirmation number, purchase amount ($249,999.99), and the date of execution next to Mr. Wiedrick's signature appear in a different handwriting from other entries. I infer that these items were filled in by FFR Consulting personnel, and not by Mr. Wiedrick. Item 6 on page 2, captioned "You May Qualify For Reduced Sales Charges" was left blank.
On June 22, 1993, the Plan purchased $249,999.99 of Class B shares in the Putnam High Yield Trust (Tr. 71-72; Div. Exs. 1-17, 4-1, 5-8 at 3). Immediately, the funds were being timed, using SFI's seasonal strategy (Resp. Ex. 50-27). On June 30, 1993, the Plan made a telephone exchange of these shares (which had appreciated in value over eight days to $251,826.03) from Putnam's High Yield Trust to Class B shares of Putnam Investors Trust (Div. Ex. 5-8 at 3, 6).
For the June 22 transaction, FSC, the broker-dealer, received a gross commission credit of 4 percent of the amount the Plan invested, or $10,000 (Div. Ex. 26-13; Tr. 71-72). If Class A shares in the amount of $250,000 had been purchased instead, with a commission credit of 2.25 percent as specified in Putnam's prospectus, FSC's gross commission credit would have been $5625 (Resp. Ex. 7 at 13), a savings to the Plan of $4375 (Tr. 358-60).
FFR Consulting then turned to the remaining $35,000.01 the Plan had committed to the seasonal timing strategy.13 On July 1, 1993, the Plan wired $30,876 (that is, $35,000.01 less FFR Consulting's quarterly fees) to Putnam Investors Trust (Div. Ex. 5-8 at 6).14 The next day, July 2, 1993, based on another timing signal, FFR Consulting made a telephone transfer of the Plan's combined balance of $280,353.34 from Putnam Investors Trust back to Class B shares of the Putnam High Yield Trust (Tr. 88, 640-50; Div. Ex. 5-8 at 3; Resp. Exs. 45-60, 46-59).15
For the July 1 transaction, FSC received a gross commission credit of 4 percent of the amount the Plan invested, or $1235.08 (Div. Ex. 26-13).16
Mr. Kindschi developed several points in opposition to the allegations in the OIP. While they are not strictly affirmative defenses, they place the Division's presentation in a broader context. The evidence on each such point is summarized here.
By informal agreement between FFR Consulting and Putnam, Putnam's Class A shares were temporarily closed to clients using FFR Consulting's timing services, and only Putnam's Class B shares could be timed. In June 1993, FFR Consulting's clients had $20 to $50 million allocated in the seasonal and multi-bond trading strategies (Tr. 670-71). Several million dollars were invested at Putnam in the seasonal strategy (Tr. 671). Most of that money was invested in Class A shares, but some was in Class B shares. As part of an informal peace treaty between the timers and the fund managers, Mr. Kindschi knew that Mr. Doudera had agreed to time no more than one-half of one percent of the assets in various Putnam funds (Tr. 671-72). He understood that "we were going to have to operate within those same confines" (Tr. 672; see Tr. 652-53). Mr. Kindschi testified that, in June 1993, "we were actually over" that percentage in Class A shares of the Putnam High Yield Trust Fund (Tr. 672). In the summer of 1993, therefore, no FFR Consulting clients using the Putnam funds for the seasonal timing strategy were put into Class A shares because "we had been by then stopped" (Tr. 672). Mr. Kindschi explained that Putnam still allowed FFR Consulting's clients to purchase additional Class A shares, but could have refused to honor requests to time exchanges of such shares (Tr. 673). In those circumstances, Mr. Kindschi believed that FFR Consulting would be risking all its clients' opportunities to exchange and to time Class A shares of the Putnam High Yield Trust if it purchased and then timed additional Class A shares for the Plan. He further believed that by using Class B shares, he reduced the risk that the Plan's investment would not be able to be managed in accordance with the Plan's objectives.17
Mr. Kindschi never shared this information with Mr. Wiedrick (Tr. 148). In addition, his explanation is at odds with other evidence in the record. Mr. Doudera was unaware of any restrictions that would have limited SFI's clients to Class B shares, as opposed to Class A shares, during the relevant time (Tr. 467, 470). Mitchell Fishman, a senior vice president of Putnam Mutual Funds, was also unaware of such restrictions (Tr. 280-81, 298). Finally, contemporaneous records prepared to keep FFR Consulting's staff abreast of market developments did not support Mr. Kindschi's testimony that only Class B Putnam shares were able to be timed when the Plan made its purchase. I consider Mr. Kindschi's testimony on this issue incredible.
Paul D. Kanter functioned as the Seal Beach office manager. He coordinated back office operations with DataLynx, and dealt directly with SFI and various mutual funds, on behalf of Mr. Kindschi and the registered representatives who worked under him (Tr. 630-31, 637). As one of his duties, Mr. Kanter would speak with representatives of SFI, to determine the mutual funds it was recommending with its timing programs (Tr. 652-59). Mr. Kanter compiled this information in two weekly reports, the Weekly Asset Manager Report and the Weekly Update. He distributed the reports to the staff in the Seal Beach office, including Mr. Kindschi (Resp. Ex. 47-67). For May and June 1993, the Weekly Updates generally show Putnam funds as available for SFI's seasonal strategy.18
SmartPad. When asked if he used the SmartPad system, Mr. Kindschi stated "not directly" (Tr. 663-66). He explained that he did not make entries into the SmartPad system from his own computer, but instead dictated notes to his secretary, who would then type them into the system on his behalf. Mr. Kindschi described himself as "a paper guy [who] wanted it in writing," and opined that everyone in the office understood that (Tr. 664). This is at odds with the testimony of David Konell (Tr. 42-43), whom Respondents elected not to cross-examine.19
Mr. Kindschi also testified that he had never seen the SmartPad notes for June 7, 8, and 18, 1993, until the hearing (Tr. 665-66). This testimony is rejected. Before the hearing, the Division not only gave Respondents a copy of the notes, but also explained how it would use them.20
No prior knowledge that the $285,000 transaction would be split into two segments. Mr. Kindschi was asked if he had spoken to Mr. Wiedrick in advance about splitting the Plan's $285,000 transaction into two segments. He replied that the matter was "definitely [discussed] by somebody working with me, not by me" (Tr. 93; see Div. Ex. 1-17). Mr. Kindschi testified that he first learned of the matter when he received "a surprise phone call" from Mr. Wiedrick after June 1993, inquiring why a transaction for $249,999.99 had been made in the Plan's account (Tr. 93, 675-76). He told Mr. Wiedrick that he did not know, but would find out and call him back. As Mr. Wiedrick recalls the eventual answer, Mr. Kindschi told him "their computer would only do that amount, so they had to do it in two stages" (Tr. 125). As Mr. Kindschi recalls his response, "the computers either at DataLynx or Putnam, I never understood whose, wouldn't take an amount greater than that amount. So they had to do what the client wanted in two trades" (Tr. 93).
I find that Mr. Kindschi's professed lack of prior knowledge, as well as his professed inability to understand (even in retrospect) the events of June 22 through July 2, 1993, are both incredible in light of his earlier testimony that he was highly knowledgeable about mutual funds and had read the relevant Putnam prospectus (Tr. 69, 83).
Mr. Kindschi's efforts to obtain a commission reduction for the Wiedricks in 1994 demonstrate how unlikely it was that he cheated the Plan out of a smaller dollar amount of commission credits in 1993. On May 20, 1994, FFR Consulting, through Mr. Kindschi, asked Putnam Investor Services to convert an earlier purchase of Class B shares by Mr. and Mrs. Wiedrick to Class A shares, and to recalculate the commissions the Wiedricks had previously paid (Div. Ex. 7-14). The transaction in question involved a $200,000 purchase in the Wiedricks' joint account on June 28, 1993. It was not made in any of the Plan's accounts. The specific Putnam fund the Wiedricks bought on June 28, 1993, was not identified. Mr. Kindschi's letter was limited to conversions (Tr. 100, 416-17). He tried to persuade Putnam that, if transactions in the Wiedricks' personal account were to be aggregated with transactions in certain of the Plan's accounts, the combined balance would exceed Putnam's $1 million breakpoint (Tr. 106-07, 677-78, 725).
Putnam agreed that partial relief was due to the Wiedricks, but it would not aggregate transactions in the Wiedricks' personal accounts with transactions in the Plan's accounts, because different ownership interests were involved (Tr. 677-78). Mr. Kindschi ultimately reimbursed Putnam $6852.99 in June 1994 (Tr. 102-07, 677-78, 724-26; Div. Ex. 7-14).21 Once Putnam received Mr. Kindschi's portion of the adjustment amount, its practice was to adjust the sales charge and invest that amount in the customer's account (see Div. Ex. 6-19 at 2).
Mr. Wiedrick is happy; the Plan's investment has been successful; the alleged fraud lacks an identifiable victim. When the Plan stated its investment policy in May 1993, its time horizon was greater than five years (Tr. 731-32; Div. Ex. 3-12 at 6). By June 1997, when Mr. Kindschi and Mr. Wiedrick conducted their annual portfolio review, the Plan's $285,000 investment in the seasonal timing strategy had grown to about $490,000 (Tr. 736; Div. Ex. 24-6). At that juncture, however, Mr. Wiedrick changed the Plan's goals. He decided to move the Plan's funds out of SFI's seasonal strategy and into its sector strategy, a more aggressive equity trading program (Tr. 141, 732-34). Accordingly, the Plan sold all its Class B shares in Putnam's High Yield Trust, and paid a CDSC of about $4841 (Tr. 724, 736; Div. Ex. 24-6).
By December 31, 1998, using SFI's more aggressive sector strategy, the Plan's initial investment of $285,000 had grown to over $700,000 (Tr. 142, 685, 736; Resp. Ex. 52-62C). The Plan's total assets at the time of the hearing, including contributions of fresh capital, were about $3 million (Tr. 141). Mr. Wiedrick does not believe Mr. Kindschi misled him, and is satisfied with those results (Tr. 110, 140, 142).
John L. Holloway, III, is sixty-one years of age and lives in Tucson, Arizona. Mr. Holloway earned a B.A. degree in business administration from the University of Delaware, and has a background in mechanical engineering. He previously managed a closely-held family business in Wilmington, Delaware (Tr. 165, 221, 262, 566). The business, an industrial tool supply company, had approximately thirty to fifty employees and a going concern value of about $3 million (Tr. 565-67). In 1993, Mr. Holloway earned about $100,000 per year (Tr. 222). His wife, Esther, worked as an administrator in the family business (Tr. 567). In July 1994, the Holloways sold the business to their son and retired to Tucson (Tr. 165, 221, 565-66).
Mr. Holloway and his family have been clients of Mr. Flanagan's for over fifteen years (Tr. 222, 562). When the Holloways lived in Delaware and Mr. Flanagan was in New Jersey, the three of them would meet frequently to discuss financial matters (Tr. 560, 627). After the Holloways relocated to Arizona, and Mr. Flanagan to California, in-person meetings were limited to once or twice a year, but were supplemented by telephone calls or facsimile communications at least once every two weeks (Tr. 260, 561, 565).
In October 1996, well after the events at issue here, Mr. Holloway was seriously injured in a bicycling accident. He is now a paraplegic, has undergone several surgical procedures, suffers complications such as pneumonia, and must take various medications (Tr. 257-58, 564, 627-28). By agreement of the parties, Mr. Holloway did not appear at the hearing, but testified by telephone from his home in Arizona.22
Mr. Holloway and other members of his family maintain twenty to thirty different accounts with Mr. Flanagan (Tr. 225), and five of those accounts are relevant here.23 Notwithstanding the fraud charges in the OIP, Mr. Holloway considers Mr. Flanagan to be an honest and knowledgeable financial consultant and continues to do business with him (Tr. 222, 239). After Mr. Holloway won a net settlement of $1.2 million for his bicycling injury, he forwarded the proceeds to Mr. Flanagan to invest in securities (Tr. 258-60). When Mr. Flanagan conducts his annual portfolio reviews for the Holloways, he and his wife stay as guests in the Holloways' house in Tucson (Tr. 562).
When Mr. Flanagan joined Mr. Kindschi in California in the autumn of 1993, he brought the Holloway accounts with him. Mr. Flanagan introduced the Holloways to the timing services of SFI (Tr. 168, 238). In November 1993, the Holloways went through FFR Consulting's five-step investment management process (Tr. 166, 245; Resp. Ex. 21-32). Their joint assets at the time were $1.3 million, their risk tolerance was "moderate," and their objective was a rate of return of 10 percent per year (Tr. 233, 245-46; Resp. Ex. 21-32). The Holloways signed several different asset management agreements with FFR Consulting, opting to participate in a variety of market timing strategies (Tr. 238, 584, 596-97, 601-07; Resp. Exs. 21-32 through 26-37).
Before the Holloways made the investments at issue here, Mr. Flanagan had read the relevant mutual fund prospectuses, knew the distinctions between Class A and Class B shares, understood the different fees assessed for each, and was familiar with rights of accumulation and letters of intent (Tr. 200, 205-06). Mr. Flanagan testified that he did not know that Putnam limited purchases of Class B shares to $250,000 (Tr. 206). He attributed to Mr. Holloway a strong desire to avoid paying front-end loads (Tr. 197, 206-07, 235, 577), and testified that Mr. Holloway was aware of the different expense ratios charged to Class A and Class B shareholders (Tr. 197).
John Holloway regularly received prospectuses from Mr. Flanagan and signed acknowledgments that he had read them (Resp. Exs. 2-18 at 4, 3-21, 33-48, 34-49). In contrast, Mr. Holloway testified that he would skim or glance at such documents, but not read them in detail (Tr. 242-43, 255, 260-61). Based on the time he had available, the detailed presentations Mr. Flanagan usually made, and his trust in Mr. Flanagan, he relied on Mr. Flanagan to tell him what he needed to know about a prospective investment in layman's terms. Mr. Flanagan had no idea Mr. Holloway was not fully reading these materials (Tr. 577-78). Esther Holloway also received prospectuses from Mr. Flanagan and signed acknowledgments that she had read them (Tr. 611-13; Resp. Exs. 29-42, 30-43). Mrs. Holloway did not testify.
Mr. Holloway understood that, if he sold Class B shares within six to eight years of purchase, he would have to pay a CDSC (Tr. 197, 237, 242). Mr. Holloway attributed his decision to purchase Class B shares to Mr. Flanagan's recommendation (Tr. 234). According to Mr. Holloway, Mr. Flanagan offered no explanation of the breakpoints available on large purchases of Class A shares, rights of accumulation, increased commission costs and expense ratios attributable to purchases of Class B shares, or Putnam's limit on large purchases of Class B shares (Tr. 233-35, 237, 239, 241).
John and Esther Holloway Joint Account at Putnam. On November 17, 1993, the Holloways signed an asset management agreement with FFR Consulting. They allocated $250,000 of their joint funds to SFI's bond timing strategy (Tr. 206-07; Resp. Ex. 26-37). That strategy envisioned telephone transfers between a money market fund and a bond fund in the same mutual fund family, based on SFI's timing signals. With Mr. Flanagan's guidance, the Holloways requested Putnam's Municipal Income Fund as their bond fund.
The prospectus then in effect for the Putnam Municipal Income Fund was dated August 1, 1993 (Div. Ex. 12-43). That document explained the distinctions between Class A and Class B shares, as well as breakpoints and conversions, on pages 18 through 24. On page 18, the prospectus stated: "Orders for Class B shares for $250,000 or more will be treated as orders for Class A shares or declined."
On November 19, 1993, the Holloways placed $250,000 in the Putnam Daily Dividend Trust, a money market fund (Div. Ex. 11-26). On November 29, 1993, in response to a timing signal from SFI, FFR Consulting moved $240,000 of the Holloways' assets out of the money market fund, and purchased an equal dollar amount of Class B shares in the Putnam Municipal Income Fund. On November 30, 1999, FFR Consulting moved the remaining $10,187.47 from the money market fund, and purchased an equal dollar amount of Class B shares in the Putnam Municipal Income Fund.24 At that point, there was a zero balance in the Holloway's joint money market fund, and a $250,187.47 balance in Class B shares of Putnam's Municipal Income Fund.
The transaction of November 29 produced a gross commission credit for FSC of 4 percent, or $9600 (Div. Ex. 26-13 at 2). The transaction of November 30 produced an additional 4 percent gross commission credit for FSC of $407 (id.). If the two transactions had been accumulated (or not split in two in the first place) and a purchase of Class A shares had been made instead, the Holloways would have qualified for Putnam's $250,000 breakpoint. Gross commission credits accruing to FSC on such a transaction would have been 2.75 percent, or $6880 (Div. Ex. 12-43 at 19). This would have resulted in a savings to the Holloways of $3127.
Mr. Flanagan testified that, at the time, he was unaware of Putnam's $250,000 limit on purchases of Class B shares (Tr. 206).25 He further testified that Mr. Holloway strongly desired to avoid payment of front-end loads (Tr. 206-07).26
John Holloway IRA and Esther Holloway IRA Accounts at MFS and Kemper. In July 1994, as the Holloways were selling their business to their son and moving to Arizona, they went through the five-step process for their Individual Retirement Accounts (IRAs) and variable annuities. FFR Advisory Services, through Mr. Flanagan, prepared an investment policy statement (Resp. Ex. 27-38; Tr. 606-07, 609). First Trust Corporation of Denver was chosen as the trustee of both IRAs (Div. Exs. 13-32, 15-34; Tr. 610-11).
The John Holloway IRA executed an asset management agreement with SAI on July 8, 1994 (Div. Ex. 23-39). Mr. Holloway selected four different timing strategies and divided the assets in his IRA portfolio among them. He allocated $308,000 to the multi-bond timing strategy, using the Kemper family of funds; $150,000 to the seasonal timing strategy, using the MFS family of funds; $60,000 to an international timing strategy, using the Fidelity family of funds; and $60,000 to a short-term timing strategy at American Funds (id.).
At the same time, Esther Holloway moved her retirement savings from a 401(k) plan to an IRA (Resp. Exs. 28-39, 29-42). Mrs. Holloway executed two asset management agreements with SAI. She selected the Putnam family of funds for a $232,000 investment in the seasonal timing strategy (Resp. Ex. 31-44). The Esther Holloway IRA selected the MFS family of funds for a $60,000 investment in the seasonal timing strategy and the Kemper family of funds for a $105,000 investment in the multi-bond timing strategy (Resp. Ex. 32-45).
On August 25, 1994, the John Holloway IRA purchased $150,000 in Class B shares of the MFS Cash Reserves Fund, a money market account (Div. Ex. 13-32). Gross commission credits accruing to FSC for this transaction were 4 percent, or $6000 (Div. Ex. 26 at 5). On September 28, 1994, the John Holloway IRA exchanged $150,056.34 from the MFS Cash Reserves Fund to purchase an equal dollar amount of Class B shares of the MFS OTC Fund, a long-term capital growth fund (Div. Exs. 13-32, 30; Tr. 179, 226-27).27
On August 25, 1994, the Esther Holloway IRA also purchased $60,000 in Class B shares of the MFS Cash Reserve Fund (Div. Ex. 15-34). Gross commission credits accruing to FSC for this transaction were 4 percent, or $2400 (Div. Ex. 26 at 5). On September 28, 1994, the Esther Holloway IRA exchanged $60,022.53 from the MFS Cash Reserves Fund to purchase an equal dollar amount of Class B shares of the MFS OTC Fund (Div. Ex. 15-34).28
On August 31, 1994, the John Holloway IRA purchased $229,708.70 in Class B shares of the Kemper Cash Reserves Fund, a money market fund (Div. Ex. 16-27). Gross commission credits accruing to FSC for this transaction were 4 percent, or $9188.35 (Div. Ex. 26 at 5). On September 15, 1994, the John Holloway IRA exchanged $229,708.70 from the Kemper Cash Reserves Fund to purchase an equal dollar amount of Class B shares of the Kemper High Yield Trust, a junk bond fund (Div. Ex. 16-27).
On August 31, 1994, the Esther Holloway IRA purchased $78,538.68 in Class B shares of the Kemper Cash Reserves Fund (Div. Ex. 20-28). Gross commission credits accruing to FSC for this transaction were 4 percent, or $3141.55 (Div. Ex. 26 at 5). On September 15, 1994, the Esther Holloway IRA exchanged $78,538.68 from the Kemper Cash Reserves Fund to purchase an equal dollar amount of Class B shares in the Kemper High Yield Trust (Div. Ex. 20-28; Tr. 202-04, 227).
Before the hearing, the Division alleged that: (1) the transactions at MFS in the John Holloway IRA and the Esther Holloway IRA could have been made in Class A shares, and could have been aggregated with each other; (2) the transactions at Kemper in the John Holloway IRA and the Esther Holloway IRA could have been made in Class A shares, and could have been aggregated with each other.
The Division's expert witness, Mary Calhoun, opined that the two Kemper purchases by the John Holloway IRA and the Esther Holloway IRA could have been accumulated with each other if Class A shares had been selected (Tr. 377). However, she acknowledged that rights of accumulation vary among fund families (Div. Ex. 25-83 at 15). Ms. Calhoun also conceded that the relevant Kemper prospectus and applications did not discuss this subject. Nonetheless, she stated that "if you call Kemper, they will tell you that you can do it" (Tr. 403-04, 406-07). In her experience, "the general rule with mutual funds is that you ask, and often the right of accumulation is broader than it may seem at first glance. You call them up and you ask if you can accumulate" (Tr. 416). Ms. Calhoun testified that her office assistant contacted Kemper by telephone in preparation for the hearing to question Kemper about its policy on aggregation. However, Ms. Calhoun could not identify the Kemper official by name and did not produce written confirmation of Kemper's policy (Tr. 404, 406, 414). Ms. Calhoun did not address accumulation rights between the IRAs at MFS if Class A shares had been purchased. Both her written report and her testimony were silent on this issue.29
Mr. Flanagan was conversant with rights of accumulation and letters of intent (Tr. 200). However, when asked if the Holloways' 1994 MFS and Kemper IRA transactions could have been aggregated with each other, he was unsure (Tr. 201, 204-05). When asked if he had checked on such matters before executing the IRA transactions and discussed his findings with the Holloways, Mr. Flanagan replied in the affirmative (Tr. 205).
Mr. Holloway never had any authority over his wife's IRA (Tr. 244). As previously noted, Mrs. Holloway did not testify. The witness from Kemper was not asked about rights of accumulation between a husband's IRA and a wife's IRA. No witness appeared from MFS Funds.
As a separate matter, even without aggregation, the Division argues that the John Holloway IRA's purchase of $150,000 at MFS would have qualified for a breakpoint if made in Class A shares. Had Class A shares been purchased instead of Class B shares, the gross commission credit accruing to FSC would have been 3.2 percent, or $4800 (Div. Ex. 30 at 12). The savings would have been $1200.30 Likewise, the Division argues that the John Holloway IRA's purchase of $229,708.70 at Kemper would have qualified for a breakpoint if made in Class A shares. Had Class A shares been purchased instead of Class B shares, the gross commission credit accruing to FSC would have been 3 percent, or $6891.26 (Div. Ex. 28 at 36). The savings would have been $2297.
Nell E. Holloway Account, John Holloway as Attorney-in-Fact. Beginning in 1990, John Holloway held a power of attorney to act for his mother, Nell E. Holloway. On November 10, 1993, Mr. Holloway signed an asset management agreement with FFR Consulting to manage $450,000 of his mother's money, using SFI's multi-bond timing strategy (Resp. Ex. 20-22). In connection with that investment, Mr. Holloway signed a statement on November 10, 1993, in which he acknowledged that he and Mr. Flanagan had discussed the movement of Nell Holloway's funds from a savings account to a Kemper money market account. He also acknowledged that he had received and read the applicable money market prospectus, and understood that an additional CDSC period might be assessed upon purchase of the investment (id.).31
On November 15, 1993, Mr. Holloway, acting as attorney-in-fact for his mother, invested $450,000 in the Kemper Investment Portfolio (KIP) money market portfolio (Div. Ex. 17-52). This transaction generated a gross commission credit for FSC of 4 percent, or $18,000 (Div. Ex. 26-13 at 2). On December 1, 1993, the Nell Holloway account transferred $450,072.82 from the KIP money market portfolio to the KIP High Yield Portfolio (Div. Ex. 17-52; Tr. 190-92, 225, 227).32 Both transactions involved the equivalent of Class B shares. Kemper did not restrict investors using market timers to KIP shares, and the equivalent of Class A shares could have been purchased (Tr. 153).
If these purchases had been made instead in the Kemper High Yield Fund, the Class A share fund, the gross commission credit would have been 2.25 percent, or $10,125 (Div. Ex. 33 at 27). The savings to the Nell Holloway account would have been $7875.
Nell E. Holloway Estate Account, John Holloway as Executor. Nell Holloway died on March 19, 1995 (Tr. 208, 228, 572, 593; Div. Ex. 21-55). She left an estate worth about half a million dollars, consisting of Kemper mutual funds and a Dean Witter account (Tr. 262, 572, 578). Nell Holloway's will appointed her son, John, as executor (Tr. 572). The will established a testamentary trust, with the income going to John Holloway during his lifetime, and the principal to be distributed on John's death to his children (Nell's grandchildren) (Tr. 231, 247, 573).
The estate assets in issue here originated with Nell Holloway's holdings of Class B shares in the Kemper High Yield Trust. At her death, these shares were worth $491,000 (Resp. Ex. 2-18 at 6).33 In the space of seven weeks, the estate moved from a Kemper junk bond fund, to cash, to an MFS single-state tax-free municipal bond fund, to an MFS multi-state tax-free municipal bond fund, to an MFS junk bond fund. The OIP alleges that Mr. Flanagan's material misrepresentation fraudulently induced this switch.
On April 18, 1995, John Holloway informed Kemper of his mother's death. He requested that Kemper liquidate all her mutual fund accounts and send the proceeds to him, as executor (Div. Ex. 21-55; Tr. 211-14). Because the account holder was deceased, Kemper waived its CDSC on the liquidation (Div. Ex. 28 at 42-43; Tr. 246, 382, 576).
On April 19, 1995, John Holloway, as executor of his mother's estate, signed an asset management agreement with SAI (Resp. Ex. 2-18). He committed $491,000 to a municipal bond timing strategy, using the MFS Cash Reserve Fund and the MFS Municipal Bond Fund (id.). Mr. Holloway acknowledged receipt of the relevant MFS prospectuses. He further stated that he had been informed about alternative fund share pricing arrangements. He signed a letter authorizing the switch from Kemper to MFS, and stated that he understood a new CDSC might be involved (Resp. Ex. 3-21). He applied to open an account in Class B shares at the MFS Cash Reserve Fund that same day (Resp. Ex. 17-13).
On April 27, 1995, the Nell Holloway estate purchased $494,354.18 in Class B shares of the MFS Cash Reserve Fund (Div. Ex. 22-58; Resp. Ex. 19-15). On May 3, 1995, the Nell Holloway estate transferred this same dollar amount to purchase Class B shares of the MFS's Maryland Municipal Bond Fund, a single-state tax-free bond fund (id.; Div. Ex. 25-83 at 17). On May 5, 1995, the estate transferred $496,183.42 from the Maryland Municipal Bond Fund to MFS's Municipal Bond Fund (id.; on the statement, the two funds are described as "MUMDB" and "MUBDB," respectively). On June 2, 1995, the Nell Holloway estate transferred $512,398.56 from the MFS's Municipal Bond Fund to purchase Class B shares of the MFS High Income Fund, a junk bond fund (id.).34 There is no documentary evidence that FSC received any commission credit on any of these transactions.35
On June 2, 1995, Mr. Holloway also advised SAI that he was terminating the estate's asset management agreement, which had been executed only six weeks earlier (Resp. Ex. 4-16). He explained that the estate would thereafter rely on the mutual fund's portfolio manager and would not use a timing service (Tr. 252-54, 257, 575-76).
On June 17, 1995, the Nell Holloway estate applied to purchase $69,631 in Class C shares of the MFS High Income Fund (Tr. 578-81, 591-92; Resp. Ex. 18-14). Mr. Holloway selected Class C shares because he expected to settle his mother's estate within the next year, and wanted liquid funds. After discussing the options with his attorney and with Mr. Flanagan, Mr. Holloway understood that MFS's Class C shares carried the same expense ratio as Class B shares. Unlike MFS's Class B shares, they would not eventually convert to Class A shares. In contrast to Class A shares, which would have required payment of a full front-end load, and to Class B shares, which would have required payment of a full CDSC upon early termination, MFS's Class C shares required payment of a CDSC of 1 percent if sold within one year of purchase (id.). On November 21, 1995, the Nell Holloway estate liquidated all its Class C shares in the MFS High Income Fund (Tr. 585-86; Resp. Ex. 16-11).
Mr. Holloway did not remember many of the decisions he made from March 1995 to June 1995. He did understand that better performance (higher income) was the rationale for switching fund families (see, e.g., Tr. 248, 252, 255-57). In contrast, Mr. Flanagan provided considerable detail. He explained that the estate's initial move to a non-taxable municipal bond timing strategy was based on Mr. Holloway's expectations that he would be the sole beneficiary of his mother's estate, and that the chosen strategy would permit income, capital accumulation, and income-tax avoidance (Tr. 572-74; Resp. Ex. 2-18 at 6-7). To accomplish these goals, SAI recommended the MFS family of funds for the estate (Tr. 574).36 One month later, following an additional meeting with his attorney and his accountant, Mr. Holloway learned that he would only be an income beneficiary, but would not receive the principal from his mother's estate. By that time, he had also come to appreciate that he could maximize his after-tax income by participating in a taxable bond fund (and paying the taxes), in contrast to the lesser sum he was then receiving from the non-taxable bond fund. According to Mr. Flanagan, Mr. Holloway then changed the estate's investment strategy. He moved the estate's holdings to Class B shares of the MFS High Income Fund, and terminated SAI's timing contract (Tr. 574-76).37
The OIP alleges that Messrs. Flanagan and Kindschi violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 through a series of misrepresentations and omissions.
These provisions prohibit essentially the same type of conduct. See United States v. Naftalin, 441 U.S. 768, 773 n.4 (1979). To prevail under Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5, the Division must show: (1) mis-statements or omissions of material facts; (2) made in connection with the offer, sale, or purchase of securities; and (3) that Respondents acted with scienter. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). No scienter requirement exists for violations of Section 17(a)(2) or Section 17(a)(3) of the Securities Act; negligence alone is sufficient. Aaron v. SEC, 446 U.S. 680, 701-02 (1980); Pagel, Inc. v. SEC, 803 F.2d 942, 946 (8th Cir. 1986).
A fact is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision and if disclosure of the omitted fact would have significantly altered the total mix of information made available. Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
With respect to material misrepresentations, the Division need not prove detrimental reliance by customers. SEC v. Blavin, 760 F.2d 706, 711 (6th Cir. 1985); SEC v. Rana Research, Inc., 8 F.3d 1358, 1364 (9th Cir. 1993). With respect to material omissions, reliance is presumed. Affiliated Ute Citizens v. United States, 406 U.S. 128, 153 (1972); Wright v. Heizer Corp., 560 F.2d 236, 249 (7th Cir. 1977); Schwarz v. Folloder, 767 F.2d 125, 132 (5th Cir. 1985). A respondent may prevail by rebutting the presumption i.e., proving that customers did not rely on the omitted information, or were aware of the risk, or would have been indifferent to the omitted information, if it had been disclosed. Keirnan v. Homeland, Inc., 611 F.2d 785, 789 (9th Cir. 1980) (collecting cases).
Courts have interpreted broadly the requirement of Section 10(b) and Rule 10b-5 that violations must occur "in connection with" the purchase or sale of a security. Superintendent of Ins. of N.Y. v. Bankers Life and Cas. Co., 404 U.S. 6, 12 (1971); In re Ames Dep't Store, Inc. Stock Litig., 991 F.2d 953, 964-66 (2d Cir. 1993). The jurisdictional requirements of the antifraud provisions are also interpreted broadly, and are satisfied by intrastate telephone calls and even the most ancillary mailings. SEC v. Softpoint, Inc., 958 F. Supp. 846, 865 (S.D.N.Y. 1997), aff'd, 159 F.3d 1348 (2d Cir. 1998).
Scienter is defined as "a mental state embracing intent to deceive, manipulate, or defraud." Hochfelder, 425 U.S. at 193 n.12. It may be established by a showing of recklessness. David Disner, 52 S.E.C. 1217, 1222 & n.20 (1997) (citing Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990) (en banc). The en banc Ninth Circuit adopted the standard of recklessness articulated by the Seventh Circuit in Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044-45 (7th Cir.), cert. denied, 434 U.S. 875 (1977): "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."38 Negligence is a failure to exercise reasonable care or competence. SEC v. Hughes Capital Corp., 124 F.3d 449, 453-54 (3d Cir. 1997).
The OIP further alleges that SAI willfully violated Sections 206(1) and 206(2) of the Advisers Act, and that Mr. Kindschi willfully aided and abetted those violations.
Section 206(1) of the Advisers Act makes it unlawful for an investment adviser to employ any device, scheme, or artifice to defraud any client or prospective client. Section 206(2) makes it unlawful for an investment adviser to engage in any transaction, practice, or course of business that operates as a fraud or deceit upon any client. Section 206 establishes "federal fiduciary standards" to govern the conduct of investment advisers. Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 16-17 (1979) (collecting cases). As a fiduciary, SAI owes its clients "an affirmative duty of good faith, and full and fair disclosure of all material facts." SEC v. Capital Gains Research Bureau, 375 U.S. 180, 194 (1963). Its duty to disclose includes facts that might incline it, consciously or unconsciously, to render advice that was not disinterested. Id., at 191-92. The failure to disclose such facts is deemed a fraud or deceit within the meaning of Sections 206(1) and 206(2) of the Advisers Act. Id., at 200.
Two circuits have held that proof of scienter is required to establish a violation of Section 206(1). Steadman v. SEC, 603 F.2d 1126, 1134 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981); SEC v. Steadman, 967 F.2d 636, 641-43 & nn. 3, 5 (D.C. Cir. 1992). The Supreme Court has ruled that scienter is not required under Section 206(2). Capital Gains Research, 375 U.S. at 195.
Because Section 206 of the Advisers Act is aimed at fraudulent conduct by an investment adviser (here, Respondent SAI), the OIP has charged Mr. Kindschi as an aider and abetter. In order to be found liable as an aider and abetter of a securities law violation in an administrative enforcement proceeding, the Commission has held that three elements must be present: (1) another party has committed a securities law violation; (2) the accused aider and abetter has a general awareness that his role was part of an overall activity that was improper or illegal; and (3) the accused aider and abetter knowingly and substantially assisted the principal violation. Donald T. Sheldon, 51 S.E.C. 59, 66 (1992), aff'd, 45 F.3d 1515 (11th Cir. 1995).
Irrespective of the level of proof required to establish the primary violation, the Commission has made clear that the accused aider and abetter must still be shown to have acted with scienter. Sheldon, 51 S.E.C. at 66 (underlying violations by broker-dealer firm involved "back office misconduct," such as violations of the net capital and advertising rules; president of the firm held liable as aider and abetter because he was found to have "acted with the requisite knowledge"); Kingsley, Jennison, McNulty & Morse, Inc., 51 S.E.C. 904, 911 n.28 (1993) (finding a registered investment adviser liable for willful violations of Section 206(2) of the Advisers Act, but holding that "good faith" by the firm's officer "precludes a finding of scienter necessary to hold that . . . [the officer] aided and abetted [the firm's] various violations").39
In subsequent decisions, the Commission has stated that the "substantial assistance" prong of the test may be satisfied by a showing of recklessness. Russo Sec., Inc., 65 SEC Docket 1990, 1998 (Oct. 1, 1997); Sharon M. Graham, 68 SEC Docket 2056, 2066 (Nov. 30, 1998). In footnote 16 of Russo, the Commission also stated:
Courts use various formulations of the second two elements of the standard for aiding and abetting . . . . As a result, courts are not uniform as to the precise degree of intent required for each of these two elements. The formulation we have used here is intended as a synthesis of current case law, and reflects the spectrum of analyses.
1. Respondents did not have fair notice that "suitability" would be an issue to be adjudicated in this case.
The OIP does not mention "suitability." In contrast, the OIP in a companion administrative enforcement action, issued by the Commission on the same day, also alleging misconduct in connection with mutual fund transactions, and also prosecuted by the Atlanta District Office, does identify "suitability" as an issue. See OIP in Richard Hoffman and Kirk Montgomery, Administrative Proceeding No. 3-9786. When the Commission wants to allege that "suitability" is an issue in an administrative enforcement proceeding, it knows how to do so.
Two months after the OIP was issued, the Division sought to bring "suitability" into the case. See Division's Reply of February 8, 1999 to Respondents' Motion For A More Definite Statement, item A.6. Assuming that a charge not identified in the OIP may be brought into a case by means of a responsive pleading under Rule 220(d) (as distinguished from a Motion To Amend The OIP under Rule 200(d)), the question of "suitability" was dormant after February 8, 1999. When the Division filed the eighteen-page report of its expert witness on March 15, 1999, and again, when the Division filed its twenty-nine-page pre-hearing brief on April 6, 1999, "suitability" was not mentioned in either document.
These developments took place before the proceeding was assigned to my docket on April 12, 1999. When the Division tried to raise the issue of "suitability" at the hearing, Respondents immediately objected, claiming lack of fair notice. I agreed with them and the Division acquiesced in my bench ruling (Tr. 312-13, 318-25).
The Division's post-hearing pleadings request that Respondents be sanctioned because they sold unsuitable securities. See Div. Prop. Find. at 1, 2; Div. Br. at 1, 20-21; Div. Reply Br. at 17. The request is denied. No conclusions of law are possible on this untried issue.
2. Failure to disclose breakpoint discounts on Class A shares and unavailability of breakpoint discounts on Class B shares.
Paragraph III.B.1 of the OIP alleges that Mr. Flanagan and Mr. Kindschi failed to disclose that large investments in Class A shares entitled the investor to breakpoint discounts and that comparable discounts on sales charges were not available for large investments in Class B shares. This aspect of the OIP has been sustained.
If a registered representative sells mutual fund shares, in amounts close to but less than a breakpoint at which a lower sales load becomes applicable, to a customer known to have available for investment total amounts which exceed the breakpoint, the representative must disclose to the customer prior to the transaction the savings in sales charges obtainable through increasing the amount of the purchase. A representative who fails to do so violates the antifraud provisions of the securities laws. Russell L. Irish, 42 S.E.C. 735, 741-42 (1965), aff'd, 367 F.2d 637 (9th Cir. 1966); Shearson, Hammill & Co., 42 S.E.C. 811, 849-51 (1965); Robert J. Check, 49 S.E.C. 1004, 1005-06 (1988).
Such sales occurred here repeatedly: the Plan invested $249,999.99; the Holloways' joint account invested $250,000; John Holloway's IRA invested $150,000 at MFS and $229,708 at Kemper; and Nell Holloway invested $450,000.
Mr. Kindschi initially discussed breakpoint discounts with Mr. Wiedrick, as well as the relative costs and benefits of purchasing Class A and Class B shares. In the context of the Plan's proposed $285,000 investment, however, a basic discussion of general concepts was not sufficient disclosure. Mr. Kindschi omitted material facts when he did not discuss with Mr. Wiedrick the impact of Putnam's $250,000 limit on Class B share purchases on the Plan's proposed $285,000 transaction.
Mr. Holloway credibly testified that he relied on Mr. Flanagan to tell him what he needed to know about prospective investments in layman's terms. Based on my findings, supra at page 20, I conclude that Mr. Flanagan's verbal presentation to Mr. Holloway also omitted material facts.
Respondents contend that the breakpoint discounts available on Class A shares are irrelevant, because the customers in question had a strong preference for Class B shares, and breakpoint discounts are not available on Class B shares. This begs the question. Many mutual fund investors have a natural dislike for front-end loads (Tr. 757). The question here is whether the customers' selections of Class B shares were fully-informed ones, following disclosure of all material facts.
Respondents also argue that, under the circumstances here, the delivery of a prospectus was legally sufficient disclosure of material facts addressed in the prospectus. As to mutual fund transactions just below a breakpoint, the Commission has repeatedly held otherwise. Financial Estate Planning, 15 SEC Docket 352, 355 & n.17 (1978); Mason, Moran & Co., 35 S.E.C. 84, 90 (1953); Irish, 42 S.E.C. at 740-42 & n.15.
Respondents criticize such Commission opinions as "archaic." Most such opinions pre-date the Supreme Court's decisions in Hochfelder and Aaron, and come from an era when proof of scienter was not required in administrative enforcement proceedings. The Division makes frequent references to "fiduciary duties" and passing reference to the "shingle theory," which posits that a broker-dealer makes an implied representation of fair dealing when it hangs out a shingle and solocits customers. I conclude that the Division must still prove scienter to prevail under Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act, Rule 10b-5, and Section 206(1) of the Advisers Act. All three Respondents acted as fiduciaries, not only when advising on asset allocations, but also when exercising discretionary authority to make exchanges in response to timing signals. However, after Hochfelder and Aaron, it is not enough for the Division to show that a fiduciary breached an implied representation. It must also show a specific intent to deceive the customer to prevail under those antifraud provisions requiring proof of scienter. See heading 9, infra.
In any event, the material misrepresentations and omissions established on this record go far beyond the generic breakpoint disclosures made by fund management in the various prospectuses. The core fraud here was in the way that Mr. Kindschi and Mr. Flanagan marketed their asset allocation strategies and mutual fund timing programs. They did not fully explain to prospective investors how breakpoints on Class A shares and CDSCs on Class B shares could impact the recommended asset allocations and timing programs. These matters were material facts not covered by the prospectuses, and should have been disclosed by Respondents. National Association of Securities Dealers (NASD) Notice to Members 98-98 (December 1998), clarifying the application of mutual fund breakpoint sales rules to modern portfolio investment strategies, provides no safe harbor to Respondents. That Notice explains that customers must be informed that, as a result of their chosen asset allocation strategy, they may not qualify for otherwise available breakpoint reductions (Resp. Ex. 53).
Mr. Kindschi gave Mr. Wiedrick a presentation about timeable funds that was incomplete on this score. He also failed to share with Mr. Wiedrick his conviction that the load issue had only minor significance and that it was more important for Mr. Wiedrick to get into the game even at a higher transaction cost than it was to quibble over the level of loads and fees. Mr. Kindschi did not personally inform Mr. Wiedrick that the Plan could only accomplish its goal of placing $285,000 into Class B shares of Putnam's high yield bond fund by disguising the transaction: splitting it into two segments to evade Putnam's rules, and leaving blank item 6, Statement of Intention, on the back of Putnam's account application form (Div. Ex. 6).40 These were material omissions, made in connection with the purchase of a security.
Putnam's representative explained the rationale for the $250,000 limitation: in management's view, the breakpoint available on purchases of Class A shares at that level made Class A shares more beneficial to shareholders than purchases of Class B shares at the same dollar amount (Tr. 278-80, 303). One need not accept the entirety of Ms. Calhoun's opinion to appreciate the concerns of Putnam management. At the very least, extra caution and careful disclosure were required when Messrs. Kindschi and Flanagan attempted to execute purchases of Class B shares of Putnam funds at or above the $250,000 level.
To be sure, the $250,000 limit on purchases of Class B shares arose from Putnam's policy, not from an Act of Congress or a Commission Rule (Tr. 294). The record shows that Putnam's limit applied to purchases at one time, and not to total ownership. See supra note 11. There is also evidence that a lower-level Putnam employee worked with FFR Consulting personnel to implement the Plan's $285,000 purchase of Class B shares. If in the future Putnam wishes to adopt a blanket prohibition on Class B share ownership above a particular dollar level, it may do so. In the absence of such a blanket prohibition, however, Respondents' circumvention of Putnam's limit was not shown to be per se fraud.
In the world of money laundering, "structuring" or "smurfing" is the criminal offense of breaking down large currency transactions into a series of smaller transactions, for the purpose of evading federal reporting requirements. See 31 U.S.C. § 5324. What happened to the Plan and the Holloways here involved neither currency nor federally-imposed ceilings. Nonetheless, large proposed transactions by both the Plan and the Holloways were essentially "structured" or "smurfed" by the Respondents without their clients' advance knowledge or consent.
Both Respondents were incredible in testifying that they were unaware of Putnam's limit and the steps taken by their own employees to avoid it. See supra notes 19 and 25. There is a substantial likelihood that a reasonable investor would consider these facts important in making an investment decision. Disclosure of the omitted facts would have significantly altered the total mix of information made available. I conclude that Respondents engaged in such "structuring" or "smurfing" to circumvent the Putnam prospectus limit of $250,000 on purchases of Class B shares, and that this course of business should have been disclosed in advance.
Mr. Kindschi has litigated this case on the apparent assumption that his duty to disclose material facts to customers and clients may be delegated to subordinates, and that the failure of those subordinates to follow through somehow absolves him of culpability. This notion appears in his testimony (Tr. 92-93) and his post-hearing pleadings (Resp. Prop. Find. 51-53). He also maintains that he had no role in processing the Plan's transaction (Resp. Br. at 16), although he pocketed a substantial commission for doing precisely that. The self-serving and artificial distinction that Mr. Kindschi draws between his own actions and those of "his staff" is explicitly rejected. The duty of full disclosure to customers and clients is Mr. Kindschi's alone; the failure to disclose may not be blamed on "the staff."
In one of the more surprising moments at the hearing, Mr. Kindschi volunteered that FFR Consulting clients using the Putnam funds in June 1993 for the seasonal timing strategy were put into Class B shares because Class A shares were temporarily closed to them (Tr. 670-73). Mr. Kindschi acknowledged that he had an obligation to discuss such a development with Mr. Wiedrick (Tr. 673). However, Mr. Wiedrick was quite clear that Mr. Kindschi never told him any such thing (Tr. 148). I have previously expressed skepticism that Mr. Kindschi testified truthfully on this point. See supra note 17 and accompanying text. However, assuming the accuracy of his testimony, such information would be material to a reasonable investor. Mr. Kindschi thus implicated himself in fraudulently omitting disclosure of the very information that Mr. Flanagan was alleged, but not proven, to have misrepresented in Paragraph III.C.3 of the OIP, infra.
3. The Division has shown that a reasonable "buy and hold" mutual fund investor would consider it material to know that, above breakpoints, Class A shares generally outperform Class B shares in the long run. It has also shown that the two investors in this case were not provided with such information. Respondents have failed to rebut the presumption that this information was not material to Mr. Wiedrick or Mr. Holloway or to show that a reasonable investor who is using a timing service has different standards of materiality than a reasonable "buy and hold" investor.
Paragraph III.B.2 of the OIP alleges that Respondents defrauded their customers and clients by failing to disclose that Class A shares "generally produce materially higher returns" than Class B shares of the same mutual funds for long-term investors making purchases large enough to take advantage of the breakpoint discounts available for purchases of Class A shares. The Division does not suggest that Class B shares are inherently inferior to Class A shares, or that the sale of Class B shares constitutes a per se violation of the antifraud provisions. It concedes that, where breakpoint discounts are not available, the performance of Class A and Class B shares and the gross commission credits paid to broker-dealers will be about the same (Div. Reply Br. 17 n.9; Tr. 343).
In support of this charge, the Division offered the report and opinion testimony of Ms. Calhoun (Div. Ex. 25-83 at 10 & Appendices; Tr. 345-46, 349, 351-52, 362). She examined hypothetical investments of $500,000, $250,000, and $210,000 in the Kemper, Putnam, and MFS families of funds in both gain and loss situations, and concluded that there was no scenario under which a long-term investor would have been better off with Class B shares.41
At the hearing, Respondents argued that Ms. Calhoun's comparisons were unrealistic because her charts assumed straight-line growth as if a mutual fund's portfolio of securities were a T-bill and straight-line loss. They contended that she had ignored real-world variables, such as volatile markets, flat markets, and differing fund growth rates (Tr. 464-65, 711-12, 717-18). They accused her of overstating the impact of Class B fees, because funds typically take out such fees continuously, not just at the end of the year (Tr. 718-19, 737, 785). Although Respondents claimed to have conducted their own tests in which Class B shares outperformed Class A shares (Tr. 711-12) and to have seen "innumerable" studies in which front-end loads and back-end loads had a roughly equal impact on investors over the long term (Tr. 763-64, 793), they elected not to present such tests and studies for the record. For these reasons, Respondents' carping over Ms. Calhoun's methodology is given little weight.
Respondents' expert, Kathryn B. McGrath, opined that if the Commission ever really believed that it was mathematically impossible for Class B shares to outperform Class A shares, the cure would not be more disclosure. Rather, she opined that the Commission would never have allowed Class B shares to be sold to the public in the first place (Tr. 782, 785). This is an interesting point of view, but it is tempered by Ms. McGrath's observation that recently-enacted disclosure requirements call for prospectuses to state that Class B shares may cost more over the long term (Tr. 782-83). As noted, the Division's concern is limited to large purchases of Class B shares.
Respondents also claim that there is no recognized legal duty to project the future performance of a security, because NASD Rule 2210(d)(2)(N) prohibits predictions and projections (Resp. Ex. 9; Tr. 397-99). Ms. Calhoun correctly observed that hypothetical illustrations of mathematical principles are not considered projections of performance, and are not forbidden by the NASD Rule.
Respondents' final argument is that their "hot money" customers and clients are different from the "buy and hold" mutual fund investors the Division seeks to protect from fraud. They maintain that the "hypothetical slight" additional cost difference was immaterial to their sophisticated customers and clients: (1) who understood that securities markets can be volatile and that straight line growth or loss assumptions are unrealistic; (2) who considered the "buy and hold" strategy to be something out of the Stone Age; and (3) who entered asset management agreements and timed the markets so they could participate in upswings, avoid downturns, and thereby enhance their total return. Respondents point to Mr. Doudera's belief that the ability to have unrestricted exchanges was paramount to considerations of the difference in expenses between Class A and Class B shares. They find support for their own actions in his view that, if SFI could exchange B shares with fewer restrictions than A shares, it would select the B shares and not even consider the load issue (Resp. Br. at 14 & n.17).
Respondents assume that there are two types of reasonable investors: those with a "buy and hold" philosophy and those who believe that timing strategies work better. They contend that the Division's entire presentation was aimed at the wrong group. But see SEC v. Texas Gulf Sulphur, 401 F.2d 833, 849 (2d Cir. 1968) (en banc) (speculators and chartists are also reasonable investors and are entitled to the same legal protections afforded conservative investors); Woolfe v. S.P. Cohn & Co., 515 F.2d 591, 602 n.5 (5th Cir. 1975) (same).
The burden of persuasion on this issue lies with Respondents. Once the Division established a prima facie case, as I conclude that it has, it became Respondents' obligation to show that reasonable investors would have been indifferent to such disclosure, if it had been provided. Mr. Doudera and Mr. Kindschi may well have considered the load issue to be immaterial to investors using their timing services. What is missing is testimony from Mr. Wiedrick and Mr. Holloway that, had such information been provided to them in advance of a sale, they would have agreed with Mr. Doudera's and Mr. Kindschi's thinking on this subject. Respondents elected not to recall the customer witnesses to establish this point. Nor did Respondents question their own expert on whether, in her view, the reasonable investor involved in a timing program would have considered such disclosure unimportant.
Contrary to Respondents' assumptions, it is not an established fact that the timing strategies of Mr. Doudera historically increased the total return on timed investments over the dividend return available from fund management alone. Nothing in this record "proves" that timing mutual funds works; we have only the optimistic opinions of two timers who say it works. Thus, I decline to infer that the reasonable investor involved in timing programs would consider such disclosure immaterial. This aspect of the OIP also has been sustained.
4. Alleged duty to disclose broker-dealer's and registered representatives' com-missions, investment adviser's compensation, and Mr. Kindschi's "conflict of interest."
Paragraph III.B.3 of the OIP alleges that the Respondents failed to disclose to customers and clients that investments in Class B shares as opposed to Class A shares of the same mutual funds significantly increased the commissions paid to the registered broker-dealer, Mr. Flanagan, and Mr. Kindschi; increased the compensation paid to the investment adviser and Mr. Kindschi; and created a conflict of interest for Mr. Kindschi.
The Division has abandoned any claim that Mr. Kindschi and Mr. Flanagan should have disclosed the specific dollar amount of net commission credits they personally received for any of the transactions at issue (Div. Reply Br. 17 n.11; see Tr. 765-66, 775, 790).
The Division did not introduce evidence to demonstrate that the advisory compensation paid to FFR Consulting and Mr. Kindschi increased because the Plan invested in Class B shares of Putnam mutual funds, as opposed to Class A shares of the same funds. The investment adviser in this case earned a flat fee, a percentage of the assets it managed. The level of the advisory fee was fully and fairly disclosed to the client in advance. The Division's charts purport to show that, in the long run, Class A shares would generally produce a materially higher return than Class B shares of the same fund. Assuming the validity of these charts, the investment adviser would be worse off in the long run, because it would be earning flat percentage fees from a smaller level of assets under management. To be sure, the fees earned by the investment adviser on a Class B portfolio would be larger in the first year, because no front-end load had been deducted and more money would be under management. However, the Division has not quantified the differences, or established that the client is worse off in the long run. In these circumstances, neither the investment adviser nor Mr. Kindschi has been shown to have a "conflict of interest" based on their flat fee advisory compensation.
The Division's real concern is narrower: it argues that a fiduciary duty rooted in the Advisers Act created an obligation for Mr. Kindschi to disclose comparative gross commission credits accruing to the broker-dealer from the sale of different class shares. It contends that such disclosure should have been made in advance, and on a transaction-by-transaction basis, in addition to prospectus disclosure by the mutual fund of gross commission credit percentages and confirmation disclosure by the broker-dealer of actual commission charges and estimated CDSCs. The breach of that duty is said to be fraud. The Division does not argue that an investment adviser must inform clients that a broker-dealer and its registered representatives will benefit from the sale of Class B shares, as opposed to Class A shares, if there is no affiliation between the investment adviser and the broker-dealer. Rather, the duty to disclose comparative gross commission credit information is limited to those who, like Mr. Kindschi, wear two hats at once.
FFR Consulting's asset management agreements clearly informed clients that its affiliates, including Mr. Kindschi, were licensed with FSC, a registered broker-dealer, and that, if the clients executed investment transactions through FSC, Mr. Kindschi would share in the commissions received by FSC. The written agreements made plain that this arrangement was for the convenience of the clients, and that the clients were under no obligation to execute any investment transaction through FSC (Resp. Exs. 49-26, 50-27). According to the Division, this was not enough.
The Division finds support for the asserted duty to disclose comparative gross commission credits in the language of two Supreme Court decisions to the effect that investment advisers have a fiduciary obligation to eliminate, or at least expose, conflicts of interest. See Div. Prehearing Br. at 26-27; Div. Br. at 25-26. See also NASD Notice to Members 94-16 (March 1994) (reminding members of their obligation to ensure that communications with customers about mutual fund transactions are accurate and complete, and to discuss with customers the impact of CDSCs on the anticipated return on investments). In contrast, Respondents point to several more specific pronouncements, none of which the Division has even attempted to rebut.
There is no case law directly on point. However, related judicial decisions do not recognize a legal obligation for brokers or advisers to disclose comparative non-excessive compensation or "conflicts" to clients and customers in the absence of special circumstances. Cf. Shivangi v. Dean Witter Reynolds, Inc., 825 F.2d 885, 889 (5th Cir. 1987); Platsis v. E.F. Hutton & Co., 946 F.2d 38, 40-41 (6th Cir. 1991); Castillo v. Dean Witter Discover & Co., Fed. Sec. L. Rep. (CCH) &PARA; 90,249 (S.D.N.Y. 1998).
In June 1992, the Commission "strongly object[ed]" to proposed legislation requiring that a recommendation by an investment adviser for a particular securities product be accompanied by a written statement of the compensation to be received by the adviser making the recommendation. Investment Adviser Industry Reform: Hearings Before the Subcom-mittee on Telecommunication and Finance of the Committee on Energy and Commerce, House of Representatives, 102nd Cong., 2d Sess. 87, 109 (June 10, 1992) (Markey Subcommittee) (testimony and statement of Richard C. Breeden, Chairman, SEC) ("This provision would be a considerable burden on advisers and clients, who would have to delay any transaction until the required disclosure is provided. A client could miss a market opportunity because of this delay. Given the expense reporting provisions contained in the discussion draft, and existing transaction confirmation requirements of the Commission [in Rule 10b-10, 17 C.F.R. 240.10b-10], this provision is unnecessary"). In contrast to the agency's views, Ms. Calhoun told the Markey Subcommittee that the proposed disclosure of commissions and conflicts was "essential" to "level the playing field." Id. at 68, 75-76 (June 4, 1992); see Tr. 783-84. The legislation was never enacted.
In May 1994, an industry committee chaired by Merrill Lynch Chairman Daniel P. Tully was formed at the request of Commission Chairman Arthur Levitt to address concerns regarding conflicts of interest in the brokerage industry. The committee's mandates were to review industry compensation practices for registered representatives, identify actual and perceived conflicts of interest, and identify the best practices used in the industry to eliminate, reduce, or mitigate such conflicts. The committee issued its report on April 10, 1995 (Tully Report). At that time, none of the brokerage firms responding to the committee's survey followed a practice of providing disclosure to customers of the differing compensation received depending upon the product sold (Tr. 429-33).
In August 1997, when NASD Regulation requested comments from its members on regulation of the payment and receipt of cash compensation incentives, as discussed in the Tully Report, disclosure of such conflicts was still not mandatory. See Resp. Ex. 10, NASD Notice to Members 97-50 at 8 (soliciting comments on whether it would be appropriate for NASD Regulation to prohibit differential compensation in connection with the offer and sale of multiple-class shares of mutual funds, to ensure that the form of compensation would not unduly influence a registered representative's recommendation of a class).
Finally, the notice-and-comment rulemaking proceeding leading to the Commission's adoption of Rule 18f-3 is instructive. The proposed rule would have created extensive prospectus disclosure requirements for multiple class funds to promote an understanding of investors' options among funds' sales and service arrangements, particularly as to 12b-1 fees and CDSCs. The notice sought public comment on whether prospectus disclosure alone would be effective to ensure that investors would understand their options, and whether the Commission should work with NASD to set standards for basic information that representatives must communicate with their customers, either orally or in writing. 58 Fed. Reg. 68,074 (Dec. 23, 1993), 55 SEC Docket 2027, 2034-38 (Dec. 21, 1993).
Most commenters strongly opposed the proposed prospectus disclosure requirements. In publishing the final Rule in March 1995, the Commission adopted much less extensive requirements. It stated:
The Commission recognizes that the complexity of distribution charge options can be confusing to some investors. Instead of relying on prospectus disclosure, however, the Commission is addressing these concerns through consumer education and the promotion of good sales practices. . . . The Commission's staff has been working, and will continue to work, with the NASD on providing guidance about the duties of sales representatives when recommending the purchase of multiple class . . . funds. Finally, the Commission expects to promote consumer education in this area through the development and publication of a brochure explaining the structure and expenses of multiple class . . . funds.
(Resp. Ex. 8 at 86,358)(footnotes omitted). At the time of the hearing, the proposed brochure had not yet been published.
The Division has neither defined the purported duty to disclose gross commission credits nor explained its boundaries. It has not pointed to statutory language, agency regulations, agency policy, or industry practice to support its position. Based on the size of the differences between gross commission credits accruing to the broker-dealer from the sale of Class A shares and Class B shares in this case, I agree with the Division that the differences were material. However, I conclude that there was no clear duty to disclose such comparative gross commission credits and/or "conflict of interest" information to customers and clients on a transaction-by-transaction basis between June 1993 and December 1995. Even assuming a duty to disclose existed at that time, I conclude that the Division has failed to prove that Respondents were reckless, or even negligent, in failing to disclose. This aspect of the OIP will be dismissed.
5. Letters of intent and rights of accumulation
Paragraph III.B.4 of the OIP alleges that Mr. Kindschi and Mr. Flanagan failed to inform their customers and clients that there were ways to structure their investments in mutual funds using Class A shares in the same fund family, letters of intent, and rights of accumulation which would have: (a) provided the diversification the customers and clients desired; (b) qualified such investments for breakpoints; and (c) produced materially higher returns for long term investors than Class B shares of the same, or similar, mutual funds.
The Division presented no evidence on this issue with respect to Mr. Kindschi and the Plan. It argues that Mr. Flanagan's recommendation that the Holloways invest $768,746 in Class B shares of three fund families in an eleven-month period was fraudulent because Mr. Flanagan should have recommended an investment in Class A shares of the same fund or a single family of funds. The Division contends that doing so would have reduced the annual 12b-1 fees paid by the Holloways, as well as the commissions paid to FSC and Mr. Flanagan (Div. Prehearing Br. at 22; Div. Br. at 11).
The Division did not meet its burden of showing that the accounts in question could have been aggregated. As to the MFS funds, no evidence was presented. As to the Kemper funds, Ms. Calhoun admitted that the prospectuses and applications did not state that the accounts could be aggregated. She contended that unnamed persons now at the fund company said in a telephone conversation that it could be done. While she claimed to have documentary support, it was never produced.
The Holloways embraced several different asset allocation and estate planning strategies (Resp. Exs. 21-32 through 27-38). The Division's suggestion that all of the Holloways' funds should have been aggregated in one fund or one fund family to minimize mutual fund fees is not well taken. Ms. Calhoun agreed that it probably would not have been appropriate for Mr. Flanagan to advise Mr. Holloway that he should invest all his money, his wife's money, their IRA money, his mother's estate money, and his father-in-law's trust money in one fund (Tr. 410-11). This aspect of the OIP will be dismissed for failure of proof.
6. Mr. Flanagan's sales at or near breakpoints; related misrepresentations and omissions.
Paragraph III.C.1 of the OIP alleges that Mr. Flanagan sold shares of mutual funds in amounts close to or in excess of breakpoints to customers known to have available for investment total amounts sufficient to benefit from breakpoints without informing his customers of the availability of breakpoint discounts and making sure that his customers had adequate opportunity to study and understand the alternatives.
Paragraph III.C.2 of the OIP alleges that Mr. Flanagan recommended large purchases of Class B shares and misrepresented the advantages of Class B shares when compared with Class A shares.
These issues have been discussed above in connection with the allegations in Paragraph III.B.1 of the OIP. The allegations have been sustained.
7. Mr. Flanagan's alleged misrepresentation that purchase of Class B shares was required to use a timing service.
Paragraph III.C.3 of the OIP alleges that Mr. Flanagan misrepresented that customers had to purchase Class B shares of particular funds in order to take advantage of a market timing service. The Division has presented no evidence that Mr. Flanagan ever made such a misrepresentation. This aspect of the OIP will be dismissed.
8. Mr. Flanagan's alleged switch violation
Paragraph III.C.4 of the OIP alleges that Mr. Flanagan fraudulently induced a customer to switch from one mutual fund to another fund with similar objectives by misrepresenting that a particular market timing service would not provide its services in the absence of such a switch. It is well-settled that a pattern of mutual fund switching violates the antifraud provisions of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5, as well as other provisions not relevant to this case. Irish, 42 S.E.C. at 740.
A review of the Commission's opinions shows that the indicia of fraudulent switching include the following: (1) the accused followed a policy of recommending to customers that they redeem shares of one fund and use the proceeds to buy shares of another fund with similar objectives; (2) no evidence of a change of objective by the customer; (3) the switch required the payment of successive sales commissions; (4) the switch occurred after the first fund had been in the customer's account for a relatively brief period of time; (5) the switch accounted for a large part of the accused's commission income from the account in question; and (6) the switch resulted in a reduction of the profits that the customer otherwise would have made. See Irish, 42 S.E.C. at 737-40; Charles E. Marland & Co. Inc., 45 S.E.C. 632, 635-36 (1974); Kinderdick, 46 S.E.C. at 637-39; Terry Wayne White, 50 S.E.C. 211, 212-13 (1990); Kenneth C. Krull, 68 SEC Docket 2324, 2325-31 (Dec. 10, 1998), appeal pending, 9th Cir., No. 99-70290. The Commission has never stated whether each of these indicia must be present, or if fraud may be found if only some of them are present. The question is significant, because the Division has established no more than half of them here.
If a "pattern" of switching transactions in fund shares has been established in a proceeding brought by a self-regulatory organization, the self-regulatory organization has shifted the burden to the accused to demonstrate the unusual circumstances which justified it. See Marland, 45 S.E.C. at 636 (holding that a "pattern" justifies a presumption of improper recommendations, which the accused must rebut); see also Kinderdick, 46 S.E.C. at 639; Krull, 68 SEC Docket at 2326. In the absence of a "pattern," limited guidance is provided by Irish, which stated that "an occasional switch from a fund of one type to that of another might [be] justified in a particular situation." 42 S.E.C. at 740.
A review of the Commission's opinions shows that efforts by an accused to rebut the presumption have been consistently unsuccessful. As illustrations, the following explanations for switching have been found wanting: (1) respondent lost confidence in fund management; (2) respondent sought better performance; (3) respondent believed the asset value of a fund specializing in stocks of a particular industry would decline; (4) customer insisted on a switch because of rumors that the impending departure of the fund's portfolio manager would have a drastic adverse consequences for the fund's performance; (5) during a declining market and in view of an especially poor performance for the fund in question, the customer became dissatisfied with the shares, insisted on redeeming them, and on investing in other funds. See Irish, 42 S.E.C. at 739; Marland, 45 S.E.C. at 634; Kinderdick, 46 S.E.C. at 638; see also White, 50 S.E.C. at 213 (where respondent discussed a switch with his supervisor and had the customer sign a letter authorizing the switch, self-regulatory organization found this to be "a transparent and cynical approach"); Marland, 45 S.E.C. at 635 n.11 (having an inventory of blank switch letters in stock was evidence that the firm anticipated frequent switching); id. at 636 (if the customer is retired or of retirement age, and is a long-term personal friend of the accused, it is unlikely that the customer would have insisted on making an investment decision contrary to the recommendation of the accused).
In the present proceeding, Mr. Flanagan is accused of fraudulently inducing one unlawful switch, not of engineering a "pattern" of unlawful switches. I decline to engage in a presumption of an improper recommendation, which Mr. Flanagan must rebut on pain of losing. Such a presumption is not warranted by the holding of any prior Commission administrative proceedings. Nor would it be warranted under the rationale of Commission decisions reviewing determinations by self-regulatory organizations.42
The Division has established that Nell Holloway's estate held a Kemper high yield bond fund and, seven weeks later, held an MFS high yield bond fund. Based on a review of the two prospectuses, on the testimony of Ms. Calhoun (Tr. 424), and on Respondents' determination not to contest the point, I conclude that both funds had identical objectives. I am particularly troubled by the estate's two-day holding of MFS's Maryland Municipal Bond Fund. See supra note 37. There was financial harm to the estate in that the CDSC clock started running anew, once the switch to Class B shares in the MFS family of funds had been effectuated. However, Mr. Holloway understood this could happen (Resp. Ex. 3-21).
The predicate of Paragraph III.C.4 of the OIP has not been established: the Division has not shown that Mr. Flanagan misrepresented that a market timing service would not provide its services if the Nell Holloway estate refused to switch from the Kemper family of funds to the MFS family of funds. Before the switch, in November and December 1993, Nell Holloway's KIP account was subject to an asset management agreement with FFR Consulting and was, in fact, being timed (Resp. Ex. 20-22). The Division did not show that this asset management agreement had expired, or had been terminated, before Nell Holloway's death. See supra note 33. Thus, the switch may well have been from one timed fund to another timed fund. The Division has failed to prove the only misrepresentation alleged to have fraudulently induced the switch.
Likewise, there has been no proof that the estate paid successive commissions on the switch: Kemper waived its CDSC upon liquidation because of Nell Holloway's death, there was no front-end load on the purchase of MFS funds because they were Class B shares, and any commission credit accruing to FSC and Mr. Flanagan as a result of the purchase of MFS shares is no more than conjecture and estimates. See supra note 35. Even if a fraudulently-induced switch were to be found, disgorgement could not be ordered on the basis of such speculation. Mr. Holloway initiated the switch because he wanted better performance (higher income) (Tr. 257). Mr. Doudera confirmed that MFS's junk bond fund was outperforming Kemper's junk bond fund at the time (Tr. 505-06; Resp. Ex. 13 (July 1995 Full Spectrum)). The Division has not even attempted to show that there is reason to discount Mr. Holloway's explanation or expectations. Cf. Irish, 42 S.E.C. at 738; Krull, 68 SEC Docket at 2333. Although I do not consider the explanations for the switch offered by Mr. Flanagan and Mr. Kindschi to be credible (see supra notes 36 and 37), the burden on this issue remains with the Division. Finally, assuming that the case law requires a registered representative to do everything in his power to dissuade a customer from initiating a switch, the Division posed no questions to Mr. Flanagan on this subject.
Even if an impermissible switch occurred, Mr. Flanagan was not shown to have acted recklessly or even negligently. This aspect of the OIP will be dismissed for failure of proof.
I conclude that the violations alleged in Paragraphs III.B.1, III.B.2, III.C.1, and III.C.2 of the OIP, which are discussed above under headings 2 and 3, were willful and reckless under the standard of Sundstrand, Disner, and Hollinger.
I have not assumed that the material misrepresentations and omissions, by themselves, provide grounds for an inference of willfulness and recklessness. Rather, I base such an inference on Mr. Kindschi's and Mr. Flanagan's expertise as securities industry professionals specializing in mutual fund transactions; on the caution demonstrated by their colleague, Mr. Doudera, who generally recommends Class A shares for clients investing over $100,000 (Tr. 468-69); and on the wording of the Putnam prospectuses about Class B transactions at and above $250,000, which provided the Respondents, if not with a red light, at least with a yellow caution light. In addition, I base it on the representation that clients who had undergone FFR Consulting's five-step investment analysis process had received something of value, including a thorough explanation of all material facts (Tr. 59-60, 666-67). In Mr. Kindschi's case, I also base the inference on the training he had received to detect sales practice abuses, on his willingness to delegate his own disclosure obligations to his staff, and on his failure personally to recontact Mr. Wiedrick about the Plan's proposed purchase of $285,000 in Class B shares after FFR Consulting had received DataLynx's recommendation on June 8, 1993. Mr. Konell's SmartPad entry gave Mr. Kindschi a second yellow caution light. If Mr. Kindschi failed to see it, his failure was reckless.
10. Adviser Act issues
When Mr. Kindschi prepared the Plan's investment policy statement, offered asset allocation advice, provided information about what mutual funds were available for particular timing strategies, recommended the Putnam family of funds, and assisted Mr. Wiedrick in the selection of a specific investment vehicle (Class A vs. Class B shares), he was acting in an advisory capacity (Div. Ex. 3-12; Resp. Exs. 49-26, 50-27).
A corporation acts through its employees. Thus, the acts and omissions of Mr. Kindschi, a principal of FFR Consulting, are attributable to FFR Consulting because they were within the scope of his employment. Mr. Kindschi's scienter is also attributed to the corporation. The acts and omissions described in the prior paragraph constitute violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 by Mr. Kindschi. They also constitute violations of Sections 206(1) and 206(2) of the Advisers Act by FFR Consulting. The Division contends that Respondent SAI is merely a continuation of FFR Consulting under a different name, as discussed at page 4, supra. Respondents have not contested this claim. On that basis, FFR Consulting's violations are SAI's violations. Cf. Oppenheimer v. Prudential Sec., Inc., 94 F.3d 189, 193 (5th Cir. 1996).
Having used Mr. Kindschi's misconduct to move upstream to hold the corporate investment adviser liable, the OIP then moves downstream on the theory that Mr. Kindschi aided and abetted the corporation's violations. The parties have given almost no attention to this aspect of the charges, which appear to be driven by sanctioning considerations. Mr. Kindschi's liability under Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 could lead to sanctions in his role as registered representative of a broker-dealer, but would not by itself warrant a bar against his continuing to act as an associated person of an investment adviser. I conclude that the requirements of Sheldon have been satisfied, and that aiding and abetting liability also has been established.
At the close of its case, the Division sought the following sanctions in the public interest: (1) cease and desist orders against all three Respondents; (2) civil penalties of $20,000 each against Mr. Flanagan and Mr. Kindschi; (3) censure against SAI; (4) bars against Mr. Flanagan and Mr. Kindschi, with a right to reapply after two years; and (5) disgorgement of ill-gotten gains by Mr. Flanagan and Mr. Kindschi.43 Respondents contend that no sanctions are appropriate.
The public interest analysis requires that several factors be considered, including: (1) the egregiousness of the respondents' actions; (2) the isolated or recurrent nature of the infraction; (3) the degree of scienter involved; (4) the sincerity of the respondents' assurances against future violations; (5) the respondents' recognition of the wrongful nature of their conduct; and (6) the likelihood that their occupation will present opportunities for future violations. Steadman, 603 F.2d at 1140. The severity of sanctions depends on the facts of each case and the value of the sanctions in preventing a recurrence of the violative conduct. Berko v. SEC, 316 F.2d 137, 141 (2d Cir. 1963). Sanctions should demonstrate to the particular respondent, the industry, and the public generally that egregious conduct will elecit a harsh response. Arthur Lipper, 547 F.2d at 184. Sanctions are not intended to punish a respondent, but to protect the public from future harm. Leo Glassman, 46 S.E.C. 209, 211-12 (1975).
The level of sanctions sought by the Division is not warranted. Many of the allegations in the OIP remain unproven. Mr. Wiedrick and Mr. Holloway are intelligent and sophisticated customers, not neophytes. They still have faith in the Respondents, despite the pendency of this proceeding. In short, they do not act or sound like victims of fraud. I consider Mr. Holloway's written acknowledgements that he had read various prospectuses, and Mr. Wiedrick's June 21, 1993, letter to DataLynx (authorizing a wire transfer of $249,999.99) to be mitigating factors. I agree with Respondents that industry professionals are entitled to rely on the accuracy of what their customers tell them. Neither Mr. Flanagan nor Mr. Kindschi has previously been the subject of a customer complaint, arbitration claim, or enforcement action. The level of scienter here was moderate, not high.
On the other hand, the proven violations were serious. They were repeated. Customers did suffer financial harm, and the absence of customer outrage may be due in part to prosperity from a long-term bull market. Respondents remain active in the industry, and insist that they have done nothing wrong. Mr. Kindschi's proven violations are fewer in number than Mr. Flanagan's. The differing levels of civil penalties and suspensions assessed below reflect my balancing of the Respondents' respective culpability.
Cease and desist orders. Under Sections 8A(a) of the Securities Act, Section 21C(a) of the Exchange Act, and Section 203(k) of the Advisers Act, the Commission may impose a cease and desist order upon any person who "is violating, has violated, or is about to violate" any provisions of the federal securities laws. There is a dispute as to whether the Commission may only impose a cease and desist order where the respondent is reasonably likely to commit similar securities violations in the future, or whether no additional showing beyond the underlying violation itself is necessary. Neither the Commission nor the appellate courts have yet resolved the dispute. See Warren G. Trepp, 70 SEC Docket 2037 (Sept. 24, 1999).
The evidence establishes that Respondents willfully engaged in a series of material misrepresentations and omissions. The violations were closely associated in time and constituted an ongoing course of business which operated as a fraud or deceit on their customers and clients. Respondents show no remorse, insist they have done nothing wrong, make no promises of altering their behavior in the future, and remain in a position to repeat their violations. Assuming, without deciding, that the Division must show a reasonable likelihood of future violations, that showing has been made here as to all three Respondents. In these circumstances, cease and desist orders are appropriate.
Civil monetary penalties. Under Section 21B(a) of the Exchange Act and Section 203(i) of the Advisers Act, the Commission may assess civil monetary penalties in an administrative enforcement proceeding. As here relevant, the Commission must find that the respondent has willfully violated the federal securities laws. It must also find that such a penalty is in the public interest. In its discretion, the Commission may consider evidence of the respondent's ability to pay.
Section 21B(b) of the Exchange Act and Section 203(i)(2) of the Advisers Act specify a three-tier system identifying the maximum amount of a penalty. For each "act or omission" by a natural person, the maximum amount of a penalty in the first tier is $5000; in the second tier, it is $50,000; and in the third tier, it is $100,000. A second-tier penalty is permissible if the act or omission involved fraud or deceit.
The violations proven as to both Mr. Kindschi and Mr. Flanagan involved fraud; thus, tier-two penalties are permissible. There is no issue as to Respondents' ability to pay (Tr. 707-10). Based on the public interest discussion above, I conclude that Mr. Kindschi should pay a civil penalty of $7500 and that Mr. Flanagan should pay a civil penalty of $10,000.
Censure, bars. Sections 15(b) and 19(h) of the Exchange Act empower the Commission to impose administrative sanctions against a person associated with, respectively, a broker-dealer and a member of a self regulatory organization if such a person or member willfully violated the federal securities laws. Sections 203(e) and 203(f) of the Advisers Act permit such sanctions against an adviser and a person associated with an adviser if such adviser willfully violated the federal securities laws or such person willfully aided and abetted the violations. Specifically, the Commission may censure, place limitations on the activities or functions of such persons, suspend them for a period not exceeding twelve months, or bar them from being associated with a broker, dealer, or investment adviser if the Commission finds, on the record after notice and opportunity for hearing, that such censure, placing of limitations, suspension, or bar is in the public interest.
The OIP seeks broker, dealer, and investment adviser bars as to Mr. Kindschi. It seeks only a broker-dealer bar as to Mr. Flanagan, and only an investment adviser bar as to SAI. At the hearing, the Division scaled back the relief it sought, as described above.
Based on the public interest discussion above, I conclude that SAI should be censured, that Mr. Kindschi should be suspended for three months from association with brokers, dealers, and investment advisers, and that Mr. Flanagan should be suspended for four months from association with a brokers and dealers. Collateral bars are foreclosed by Teicher v. SEC, 177 F.3d 1016 (D.C. Cir. 1999).
Disgorgement. Section 8A(e) of the Securities Act, Sections 21B(e) and 21C(e) of the Exchange Act, and Section 203(k)(5) of the Advisers Act provide that the Commission may enter an order requiring disgorgement, including reasonable interest. Disgorgement seeks to deprive the wrongdoer of his ill-gotten gains, not to compensate investors. SEC v. First City Fin. Corp., 890 F.2d 1215, 1230 (D.C. Cir. 1989).
Disgorgement need only be a reasonable approximation of profits causally connected to the violation. Id. at 1231. Once the Division shows that its disgorgement figure reasonably approximates the amount of unjust enrichment, the burden of going forward shifts to the respondent clearly to demonstrate that the Division's disgorgement figure is not a reasonable approximation. SEC v. Lorin, 76 F.3d 458, 462 (2d Cir. 1996); SEC v. Patel, 61 F.3d 137, 140 (2d Cir. 1995). Any risk of uncertainty as to the disgorgement amount falls on the wrongdoer whose illegal conduct created that uncertainty. First City, 890 F.2d at 1232.
The evidence on gross commission credits accruing to FSC, the broker-dealer, is soft. Respondents argued that there were conflicts between the FSC commission credit log (Div. Ex. 26-13), which showed gross commission credits of 4 percent per transaction, and some of the fund prospectuses, which showed a lesser credit, such as 3.75 percent (Tr. 332-37, 400-02, 450-52). The hearing was held in Atlanta, site of FSC's headquarters, and I signed a subpoena for an FSC witness to testify. No such witness was called, making the parties' dispute over the accuracy of the log all the more frustrating.
Neither side asked Mr. Kindschi or Mr. Flanagan what their net payout rates were, and Ms. Calhoun's efforts to recall the investigative testimony on this subject were unsuccessful (Tr. 347, 366). The Division's post-hearing argument that a payout rate of 86 percent should be imputed to Mr. Kindschi is reasonable. However, it is a stretch to think that Mr. Flanagan, new to the job in November 1993, received a net payout equal to that of the Seal Beach office's big producer (Div. Prop. Find. at 18). On the other hand, Respondents' argument that any disgorgement figure should be limited to in-pocket net after expenses is foreclosed by Laurie Jones Canady, 69 SEC Docket 1468, 1487 n.35 (April 5, 1999).
I accept the log and the Division's imputation of 86 percent payout rates to both Respondents as reasonable approximations. The burden of going forward then shifts to the Respondents, who had clear advance notice of the showing that was expected. See Prehearing Conference of April 22, 1999, at PHC Tr. 31. Having elected to brief the case on an all-or-nothing basis, and not to address the Division's request for sanctions with specificity, Respondents have waived the opportunity to do so, and are bound by the Division's reasonable approximations. There is no issue as to the Respondents' ability to pay disgorgement (Tr. 707-10).
Mr. Kindschi will be ordered to disgorge $3762. That figure equals 86 percent of $4375, the gross commission credit differential on the Plan's transaction. His violation occurred on June 22, 1993. Prejudgment interest is must also be paid, and shall be computed at the rate specified in Rule 600, from July 1, 1993 to the date of payment.
Mr. Flanagan will be ordered to disgorge $12,469. That figure equals 86 percent of $14,469. The latter figure represents the sum of gross commission credit differentials of $3127 on the John and Esther Holloway joint account on November 29, 1993; $1200 on the John Holloway IRA at MFS on August 25, 1994; $2297 on the John Holloway IRA at Kemper on August 31, 1994; and $7875 on the Nell Holloway KIP account on November 15, 1993. Prejudgment interest must also be paid and shall be computed at the rate specified in Rule 600. Giving Mr. Flanagan the benefit of the doubt, his violations will be deemed to have occured on August 31, 1994. Prejudgment interest shall run from September 1, 1994 to the date of payment.
Pursuant to Rule 351(b) of the Commission's Rules of Practice, I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on October 18, 1999.
Based on the findings and conclusions set forth above, I order Respondents Michael A. Flanagan, Sr., and Ronald O. Kindschi to cease and desist from willfully violating Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5. I further order Respondents SAI and Kindschi to cease and desist from willful violations of, and willfully aiding and abetting violations of, Sections 206(1) and 206(2) of the Advisers Act, in the manner described in this initial decision.
Respondent Kindschi shall pay a civil penalty of $7500 and Respondent Flanagan shall pay a civil penalty of $10,000.
Respondent Spectrum Administration, Inc., is censured. Respondent Kindschi is suspended from association with a broker, dealer, or investment adviser for three months. Respondent Flanagan is suspended from association with a broker or dealer for four months.
Respondent Kindshi shall disgorge $3762, plus prejudgment interest computed at the rate set forth in Rule 600, from July 1, 1993, to the date of payment. Respondent Flanagan shall disgorge $12,469, plus prejudgment interest computed at the rate set forth in Rule 600, from September 1, 1994, to the date of payment.
Payment of civil penalties and disgorgement shall be made on the first day following the day this initial decision becomes final. Payment shall be made by certified check, United States Postal money order, bank cashier's check, or bank money order, payable to the Securities and Exchange Commission. The payments, and cover letters identifying the Respondents and the proceeding designation, should be delivered to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, Virginia 22312. A copy of the cover letters should be sent to the Commission's Division of Enforcement.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice. Pursuant to that Rule, a petition for review of this initial decision may be filed within twenty-one days after service of the initial 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 on that party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to that party. If a party timely files a petition for review, or the Commission acts to review on its own motion, the initial decision shall not become final as to that party.
James T. Kelly
Administrative Law Judge
1 Citations to the prehearing transcript, transcript, and to exhibits offered by the Division and by Respondents will be noted as "PH Tr.___," "Tr. ___," "Div. Ex. ___," and "Resp. Ex. ___," respectively. Citations to the posthearing pleadings will be noted as "Div. Br. ___," "Div. Prop. Find. ___," "Resp. Br. ___," "Resp. Prop. Find. ___," and "Div. Reply Br. ___," respectively.
2 Commission records, which may be officially noticed under Rule 323, show that Mr. Kindschi became a principal of FFR Advisory Services, Inc., a non-party investment adviser, on October 1, 1993. FFR Advisory Services, Inc., was incorporated in California on March 24, 1993; the Commission granted it registration as an investment adviser on October 1, 1993. The corporation withdrew its registration on July 8, 1997. FFR Advisory, LLC, was established on January 20, 1997. Its application for registration as an investment adviser, stating that it would take over the business of FFR Advisory Services, Inc., was granted by the Commission on November 14, 1997. These businesses operated out of the same Seal Beach office identified above.
3 Respondents ask me to infer from this limited testimony that Mr. Kindschi has an unblemished record in the securities industry (Resp. Prop. Find. at 3). I decline to do so. See First American Bank of Virginia v. Kindschi, 813 F.2d 400 (4th Cir. 1986) (Table Case), 1986 WL 18584; and In re Kindschi, Futuresoft Synergies, Inc. v. Kindschi, 113 F.3d 1241 (9th Cir. 1997) (Table Case), 1997 U.S. App. LEXIS 9691.
4 Mr. Flanagan was not affiliated with FFR Consulting and, unlike Mr. Kindschi, is not charged with aiding and abetting that firm's violations. See OIP, Para. III.E. Commission records show that he was an associate, and later a principal, of FFR Advisory Services, Inc., and is currently a member of FFR Advisory Services, LLC.
5 See Rule 12b-1 under the Investment Company Act of 1940, 17 C.F.R. § 270.12b-1. As adopted in 1980, the Rule permits mutual funds to pay distribution expenses and sales commissions out of fund assets. In essence, it permits existing shareholders to pay for bringing new shareholders into the fund (Tr. 759).
6 See 17 C.F.R. §§ 270.6c-10 and 270.18f-3; 60 Fed. Reg. 11885-91 (Mar. 2, 1995); Tr. 755-56; Resp. Ex. 8.
7 Tr. 776; see Rule 11a-3 under the Investment Company Act of 1940, 17 C.F.R. § 270.11a-3.
8 Representative passages from the newsletter are as follows: April 1991 ("The chart below illustrates Spectrum's buy and sell dates using Kemper's High Yield Bond Fund since 1987. `Buy and Hope' showed a total return of 13.5% versus a total return of 71.7% using timing"); April 1994 ("There are still people out there like Peter Lynch, who ran the Magellan fund . . . who say that market timing `doesn't work.' What he means is it didn't work for his style of money management. But by combining his stock picking talent with technical market analysis, it may be possible to enhance returns and reduce risk"); October 1994 ("Remember that we are traders, not long term investors, so it really is not that important to know where the markets go on a long-term basis, as long as prices fluctuate").
9 The Division notes that the Putnam letter in question, Resp. Ex. 6, was addressed to Mr. Doudera, and that there is no evidence that Mr. Kindschi knew of it. The Division also observes that the customer at issue in this case left its assets in the Putnam family of funds, where they were timed for three years, notwithstanding these purported restrictions.
10 The Division argues that, during the relevant time period, registered investment companies were required to disclose in registration statements filed with the Commission the circumstances under which a CDSC would be waived. See, e.g., Div. Ex. 28 at 42-43 (Kemper prospectus, waiving a CDSC on the death of a shareholder). It emphasizes that Respondents did not produce any documents filed with the Commission by the mutual funds in this case, or any testimony from executives of such mutual funds, disclosing the waiver described by Mr. Kindschi.
11 Putnam's $250,000 limitation on its Class B shares applied only to purchases, not to ownership. The limitation did not prohibit investors from owning $250,000 or more in Class B shares; it only limited them to purchasing $250,000 or more at one time (Tr. 278-80, 305-06, 637-40).
12 Putnam did not restrict the clients of market timers to using only its Class B shares (Tr. 467). SFI played no role in the selection of Class B shares by the Plan and did not recommend a particular class of shares to the Plan (Tr. 468). Mr. Wiedrick relied on Mr. Kindschi's recommendation, and no one else's (Tr. 126-27).
13 Putnam informed FFR Consulting that additional placement of funds could not be made until a Putnam account number was available, and that an account number would not be available until the first trade settled (Resp. Ex. 45-60). The first trade settled on June 29, 1993 (Div. Ex. 4-1).
14 $35,000.01 minus $4123.13 equals $30,876.88. The figure of $4123.13 represents FFR Consulting's quarterly fee of 1.9 percent of the funds invested in both the multi-bond and seasonal timing systems. That is, $572,500 + $285,000 = $857,500 x 1.9 percent, with the result divided by four. The additional $50 deduction represents FFR Consulting's quarterly retainers ($25 x 2). It is not clear why fees related to the investment of $572,500 in the multi-bond timing strategy were deducted from a pool of money devoted to the seasonal system. The parties have not addressed this issue.
15 Mr. Kindschi maintains that the movement of the Plan's assets from one Putnam fund to another and then back to the first fund were nothing more than the operation of timing signals, and not an attempt to hide the initial investment of $249,999.99 (Tr. 110-11). This claim finds independent support in the Weekly Asset Manager reports from May 24, 1993 through July 6, 1993 (Resp. Ex. 47 at 44-50). Those reports show SFI's seasonal timing system going to the Putnam High Yield Fund on June 4, 1993, then to equity on June 25, 1993, and back to the High Yield Fund on July 2, 1993.
16 As shown below, the transactions of November 29 and 30, 1993, involving Respondent Flanagan were also split into two segments, and the Division has sought disgorgement with respect to both segments. In contrast, the Division has focused exclusively on the first leg of the transaction involving Respondent Kindschi (June 22, 1993). No disgorgement has been sought with respect to the second leg of the Plan's $285,000 purchase (July 2, 1993).
17 In essence, Mr. Kindschi suggests that FFR Consulting's informal agreement with Putnam permitted the clients of FFR Consulting to time one-half of one percent of the fund's assets in Class A shares, and another one-half of one percent of the fund's assets in Class B shares.
Respondents have presented no documentary evidence as to the asset value of Putnam's mutual funds, or how much FFR Consulting's clients then had in them. Moreover, purchasers of Class A and Class B shares of Putnam's mutual funds were investing in the same mutual fund. Class B shares at Putnam did not, as Mr. Kindschi's testimony presumes, constitute a different mutual fund from Class A shares of that fund. See Div. Reply Br. at 4-5. In this regard, the Putnam funds differed from the Kemper and KIP funds (Tr. 378-79).
18 Resp. Ex. 47-67. One Weekly Update states "Spectrum Seasonal - closed until further notice," but it does not distinguish between Class A shares and Class B shares. Compare Bates stamped pages 23, 30, 34, 37, 40, 56, 61 with Bates stamped page 51.
19 Before the hearing, the Division asked if Mr. Konell might testify by telephone, instead of traveling from California to Georgia. Respondents strenuously objected, and insisted on their right to confront and cross-examine him. See Prehearing Conference of April 22, 1999, PH Tr. 10-12, 33. I denied the Division's request, and ruled that Mr. Konell had to appear in person. Order of April 22, 1999. At the hearing, however, Respondents conducted no cross-examination of Mr. Konell, and only a brief voir dire concerning two exhibits (Tr. 35-48).
It is simply not realistic that professionals in a small office (ten to fifteen employees) would have so much difficulty in communicating with each other about administering the large account of a valued long-term client like the Plan. I find that Mr. Konell was credible in testifying that he put notes into the SmartPad system for the benefit of all, including Mr. Kindschi. I find that Mr. Kindschi was not credible in claiming that he never saw the relevant SmartPad entries before June 22, 1993. It was his duty to keep up with all relevant material information and any failure to do so was reckless.
20 See Division Exhibit List, filed March 26, 1999, item 20; Division Witness List, filed March 26, 1999; Division Prehearing Brief, filed April 6, 1999, at 13 (quoting the SmartPad notes and explaining their significance).
21 The commission returned to the Wiedricks in this episode exceeds the amount the Division seeks as disgorgement for the June 22, 1993, transaction. Mr. Kindschi relies on these events to counter the Division's claim that he was corruptly selling Class B shares on June 22, 1993, simply to collect higher commissions.
The May 20, 1994, letter is equally important for what it omits. Mr. Kindschi's correspondence identified several of the Plan's accounts at Putnam, but it did not list the Plan's account in Putnam's High Yield Trust: Account No. A62-1-95-3549491-BBCN. See Div. Ex. 5. The issue in this proceeding is not the availability of a $1 million breakpoint for transactions in the Wiedrick's personal accounts, but whether the Plan should have received the benefit of a $250,000 breakpoint on a transaction in its account. There is no evidence that Mr. Kindschi told high level Putnam officials in May 1994 or at any other time that FFR Consulting had split the Plan's intended purchase of $285,000 into separate segments of $249,999.99 and $30,000, that he now wished to obtain Class A shareholder status for the Plan and aggregate those two segments, and that he was willing to reduce his commission credit in order to do so.
22 Prehearing Conference of January 22, 1999, at PH Tr. 8, 19, 21-28; Prehearing Conference of April 22, 1999, at PH Tr. 9-10; Order of April 22, 1999. Respondents now argue that Mr. Holloway's injuries have taken an obvious toll on his faculties and that his telephonic testimony was so unreliable as to have little, if any, probative value (Resp. Br. at 22 n.28). This is a bold argument, inasmuch as Respondents vigorously opposed a videotaped deposition of Mr. Holloway, which would have given the fact-finder a better opportunity to assess Mr. Holloway's demeanor. I agree with the Division that Mr. Holloway was able to distinguish between those things he was sure of, those things that sounded correct, those things he needed more information to confirm, those things he did not know, those things he did not recall at the time of his testimony, and those things he did not know at the time of his investment but learned prior to hearing (Div. Reply Br. at 12 n.7).
23 The Division initially contended that Mr. Holloway had authority over a sixth account: a trust established by Mr. Holloway's deceased father-in-law, Alex N. Williams, for the benefit of Mr. Williams's daughters. However, the testimony demonstrated that Esther Holloway was the trustee and made all decisions with respect to that account. John Holloway never controlled that account and was not always present when Esther Holloway discussed it with Mr. Flanagan (Tr. 194-96, 231-32, 244-45, 567-68, 615-17; Div. Ex. 19-71, Resp. Exs. 35-51, 36-52, 37-53, 38-54, 39-55, 40-56). In its post-hearing pleadings, the Division has abandoned all charges relating to Mr. Flanagan's handling of the Alex N. Williams Trust Account.
24 The extra $187.47 represents dividends credited to the money market account on November 30, 1993.
25 The asset management agreement was signed by Paul Kanter on behalf of FFR Consulting on November 30, 1993 (Resp. Ex. 26-37 at 3). As found above, Mr. Kanter testified at some length about his endeavors to work around Putnam's $250,000 purchase limit on the June 1993 transactions for the Plan (Tr. 642-50; Resp. Ex. 46-39). Having gone through this experience only five months before when purchasing shares in Putnam's High Yield Fund, Respondents have offered no explanation for the purported lack of communication between Mr. Kanter and Mr. Flanagan about an identical $250,000 purchase limit in Putnam's Municipal Income Fund. Mr. Flanagan's denial of knowledge is not credible because he had read the prospectus (Tr. 200, 205-06).
26 Respondents assert that the Holloways' joint purchase was "made by them in error" and that it should have been titled separately in each spouse's trust account. They further maintain that this error was corrected eighteen months later. Resp. Prop. Find. 71. The transcript citation offered by Respondents does not support these claims, and the record does not identify any such subsequent transactions. In any event, it is unclear how purported errors of this magnitude could possibly have occurred after the Holloways had gone through FFR Consulting's five-step process, formulated an investment policy, and reduced it to writing (Tr. 166, 245, 596-97, 606-07; Resp. Ex. 21-32).
27 The extra $56.34 represents dividends credited to the money market account on August 31, 1994.
28 The extra $22.53 represents dividends credited to the money market account on August 31, 1994.
29 The Division's post-hearing pleadings do not argue that Mr. Flanagan committed any violation with respect to the Holloways' two IRA accounts at MFS. See Div. Prop. Find. 17(e) and 35, and p. 22.
30 See Div. Prehearing Brief, filed April 5, 1999, at 14-15, 19.
31 Although Mr. Holloway's written acknowledgment was confined to the money market account (Resp. Ex. 22-20 at 5), the KIP High Yield Portfolio and the KIP Money Market Portfolio used the same prospectus (Div. Ex. 32).
32 The difference of $72.82 represents dividends earned in the money market account after November 15, 1993.
33 As discussed above, Nell Holloway had invested $450,000 in the KIP High Yield Portfolio in November and December 1993, and had entered an asset management agreement with FFR Consulting. On May 31, 1994, shares in the KIP High Yield Portfolio became Class B shares in the Kemper High Yield Fund (Tr. 153). Also in 1994, FFR Consulting changed its name to SAI. By March 1995, Nell Holloway's investment of $450,000 had grown to $491,000. The record is silent as to whether this account was still the subject of an asset management agreement and still being timed.
34 Purchasers of Class A shares of the MFS High Income Fund were entitled to a commission discount at the $500,000 breakpoint (Div. Ex. 31 at 17; Tr. 625). However, the Division has not alleged a breakpoint violation with respect to this transaction. Rather, it has confined its allegations to impermissible mutual fund switching.
35 The FSC "commissions earned log" ends in 1994 (Div. Ex. 26-13). The parties did not ask Mr. Flanagan if he or FSC earned commission credits on any of these transactions. The report and testimony of the Division's expert witness was quite limited on this topic. See Div. Ex. 25-83 at 18 ("the switch presumably resulted in a commission credit for Mr. Flanagan") (emphasis added) and Tr. 383 ("the transactions at 4 percent would have generated more than $19,000 in commission credits for the registered representative") (emphasis added); see also Div. Prop. Find. at 18, item D.1 (acknowledging that the commission credit for the switch transaction is estimated).
The lack of documentary evidence is significant, because the switch transaction represents most of the "ill gotten gains" that the Division seeks to have Mr. Flanagan disgorge.
36 In support of Mr. Flanagan's defense, Mr. Kindschi testified that the Kemper Municipal Bond Fund had a fifteen-day exchange restriction that made it an undesirable vehicle for the multi-bond timing strategy in 1995, and that there were other funds that did not have such a restriction (Tr. 682-83). This testimony is at odds with Mr. Doudera's reports in the May 1995 and July 1995 issues of The Full Spectrum, which show that SFI obtained positive results timing the Kemper Municipal Bond Fund from January 1, 1995 through June 30, 1995 (Resp. Ex. 13). Aside from the fifteen-day hold, Kemper did not impose restrictions on market timers (Tr. 157).
37 I find Mr. Flanagan's testimony about the executor's change in investment strategy to be both incredible and incomplete. First, Mr. Flanagan elsewhere described Mr. Holloway as a "very strong willed" individual who was "firm on decisions" (Tr. 564, 610). The level of confusion, faulty assumptions, and false starts that Mr. Flanagan ascribes to Mr. Holloway in April and May 1995 is at odds with that description. I find it unlikely that such an individual would flip-flop twice in a short period when addressing the investment goals of an estate with assets worth half a million dollars.
Second, Mr. Holloway had managed his mother's affairs under a power of attorney since 1990. In April and May 1995, he was consulting with an attorney and an accountant, in addition to Mr. Flanagan. I find it dubious that Mr. Holloway was unaware of the precise terms of his mother's will and testamentary trust, and the significance of those terms, after April 18, 1995 (Tr. 572, 587-90; Resp. Ex. 17-13).
Third, Mr. Flanagan has failed to address the estate's two-day move into the MFS Maryland Municipal Bond Fund. Based on Nell Holloway's power of attorney from 1990 (see Resp. Ex. 20-22) and on Mr. Flanagan's reference to the Delaware courts (see Tr. 575), I infer that Nell Holloway died a resident of Delaware. By March 1995, John Holloway was a resident of Arizona. In these circumstances, it is unclear how dividends paid on Maryland municipal bonds (which are tax-free only to Maryland residents) could have achieved the stated objective of either the estate or John Holloway.
The estate's two-day move through MFS's Maryland Municipal Bond fund is troubling for additional reasons. The use of an intervening stock or bond transaction to mask a switch is a fraudulent technique that is well-known to the industry. Cf. Sandra Simpson, 70 SEC Docket 1921, 1924 n.6 (Sept. 21, 1999), appeal pending. Moreover, FSC's inability to detect mutual fund switching between 1992 and 1995 led to disciplinary action against the broker-dealer firm. Cf. FSC Sec. Corp., 68 SEC Docket 2318, 2319 (Dec. 9, 1998) (settled proceeding).
Fourth, it is unclear why the estate had to enter transactions and wait for the first month's tax-free dividends to arrive before Mr. Holloway could comprehend the relative benefits to the estate of taxable dividends versus tax-free dividends. This is a pen-and-paper exercise, and a competent professional like Mr. Flanagan could surely have assisted Mr. Holloway with the calculations.
38 A recent decision by a panel of the Ninth Circuit stated that recklessness must be "deliberate" or "conscious." The panel did not define the terms, and did not make clear whether its "deliberate recklessness" requirement differs in any respect from Sundstrand. See In re Silicon Graphics, Inc. Sec. Litig., 183 F.3d 970, 974-75 & n.3 (9th Cir.), reh'g denied, 195 F.3d 521 (1999). The panel majority's use of these terms has been criticized by a strong dissent, see 183 F.3d at 991-96, by five judges dissenting from the denial of rehearing en banc, see 195 F. 3d at 522, and by other circuits, see Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1281-84 & n.21 (11th Cir. 1999); Greebel v. FTP Software, Inc., 194 F.3d 185, 199-201 (1st Cir. 1999). In this decision, I have applied the generally-accepted standard of recklessness from Sundstrand, Disner, and Hollinger, and not the deliberate recklessness language of Silicon Graphics.
39 Accord, In re Lincolnwood Commodities, Inc. of California, [1982-1984 Transfer Binder] Comm. Fut. L. Rep. (CCH) &PARA; 21,986 at 28,254 (CFTC 1984) (construing the aiding and abetting provision of the Commodity Exchange Act in the same fashion).
40 There is some evidence that Mr. Wiedrick actually had such advance notice. Div. Ex. 1-17, a June 21, 1993, letter signed by Mr. Wiedrick certainly suggests that he did. The SmartPad entry for June 18, 1993, anticipates communication between Mr. Wiedrick and the back office staff of the Seal Beach office ("Have package ready for Phil to sign"). However, Mr. Wiedrick's later telephone inquiry to Mr. Kindschi persuades me that he did not receive full disclosure. I conclude that there was no real explanation by Mr. Kindschi, that Mr. Kindschi's staff just presented the letter to Mr. Wiedrick as one of many documents to sign, and that Mr. Wiedrick did not appreciate the significance of the June 21 letter.
41 The Division does not suggest that Ms. Calhoun's calculations should have been shown to Respondents' customers. Rather, it argues that Respondents, who understood the calculations, should have disclosed that the broker-dealer's gross commission credits would be increased by investment in Class B shares and that their customers' total return would be lowered (Div. Reply Br. at 17 n.10).
42 Marland and Krull not only shift the burden of producing evidence, but require that the party denying the existence of the presumed fact assume the burden of persuasion on the issue as well. Cf. McCormick on Evidence, &PARA; 342 (2d Ed. 1972). But cf. Fed. Rule of Evidence 301 (in a civil proceeding, a presumption imposes on the party against whom it is directed the burden of going forward with evidence to rebut or meet the presumption, but does not shift to such party the burden of proof, and the risk of nonpersuasion remains upon the party on whom it was originally cast).
43 See Tr. 532-34, 708; Prehearing Conference of April 22, 1999, PH Tr. 26-32. But see Div. Prop. Find. at 25-28 and Div. Br. at 28 (seeking different relief). As with the issue of "suitability" above, I have relied on the representations made by counsel at the hearing, and given lesser weight to subsequent pleadings that neither acknowledge nor explain the conflict.
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