SECURITIES AND EXCHANGE COMMISSION
In the Matter of
FUNDAMENTAL PORTFOLIO ADVISORS, INC.,
LANCE M. BROFMAN,
FUNDAMENTAL SERVICE CORPORATION
OPINION OF THE COMMISSION
INVESTMENT ADVISER PROCEEDING
INVESTMENT COMPANY PROCEEDING
Grounds for Remedial Action
Violating, Aiding and Abetting, and Causing Violations of the Antifraud Provisions
Violating, Aiding and Abetting, and Causing Violations of Disclosure Requirements
Registered investment adviser made fraudulent statements and omitted material facts in connection with the offer and sale of securities, filed a registration statement with the Commission from which material information was omitted, and failed to disclose soft dollar arrangements; associated person aided and abetted and was a cause of the investment adviser's violations. Registered broker-dealer disseminated materially misleading materials in connection with the sale of securities traded otherwise than on a national securities exchange. Held, it is in the public interest to order the investment adviser to pay a civil money penalty of $500,000; to revoke the broker-dealer's registration and to order the broker-dealer to pay a civil money penalty of $500,000; to bar the associated person from association with any broker, dealer, investment adviser, or investment company and to order the associated person to pay a civil money penalty of $250,000; and to order all three Respondents to cease and desist from committing or causing violations or future violations of the provisions that they were found to have violated.
Lance M. Brofman, pro se and for Fundamental Portfolio Advisors, Inc. and Fundamental Service Corporation.
Leslie Kazon, Janet Ulman, and Teresa M. Ward, for the Division of Enforcement.
Appeal filed: February 21, 2001
Last brief received: May 23, 2001
Oral argument: June 25, 2003
Fundamental Portfolio Advisors, Inc ("FPA"), formerly a registered investment adviser, Fundamental Service Corporation ("FSC"), a registered broker-dealer, and Lance M. Brofman, a person associated with FPA and FSC, appeal from the decision of an administrative law judge. The law judge found that FPA violated Section 17(a) of the Securities Act of 1933,1 Section 10(b) of the Securities Exchange Act of 19342 and Exchange Act Rule 10b-5 thereunder.3 The law judge also found that FPA violated Section 34(b) of the Investment Company Act of1940,4 and Sections 206(1) and (2) of the Investment Advisers Act of 1940.5 Additionally, the law judge found that Brofman "aided and abetted and caused" FPA's violations. Finally, the law judge found that FSC violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rules 10b-3,6 and 10b-5 thereunder, and Section 15(c)(1) of the Exchange Act and Rule 15c1-2 thereunder.7
The law judge revoked FPA's investment adviser registration and ordered that FPA pay a civil money penalty of $500,000; revoked FSC's broker-dealer registration and ordered that FSC pay a civil monetary penalty of $500,000; and barred Brofman from association with any broker, dealer, investment adviser, or investment company and ordered him to pay a civil monetary penalty of $250,000. The law judge also ordered that Respondents cease and desist from committing or causing any violation or future violation of the provisions they were found to have violated. We base our findings on an independent review of the record, except with respect to those findings not challenged on appeal.
FPA registered with the Commission as an investment adviser in 1986. FPA was the investment adviser to The Fundamental U.S. Government Strategic Income Fund ("the Fund") and four other funds constituting the Fundamental Family of Funds ("the Fundamental Funds"). FPA's contract with the Fundamental Funds was renewed for 1997 with the condition that Brofman not be involved with the investments or trading of the Fundamental Funds. FPA was replaced as adviser to the Fundamental Funds in 1998. The company ceased operations in 1998. 8 FPA's fees for managing the Fund were approximately $366,000 in 1993 and $270,000 in 1994.
FSC is a broker-dealer affiliated with FPA and the Fundamental Funds that registered with the Commission in 1987. FSC distributed shares of the Fund and the other Fundamental Funds, directly or through other broker-dealers, and performed marketing activities for the Fundamental Funds, including preparation of the Fund's advertising materials and sales literature, and dissemination of the Fund's marketing materials and prospectuses. From its inception, FSC'sonly activity has been the distribution and marketing of funds managed by FPA. FSC became inactive in 1998 when FPA was replaced as manager of the Fundamental Funds.
Brofman was FPA's chief portfolio strategist and principal portfolio manager for the Fund and the other Fundamental Funds during the period under review. During the period of the alleged violations, Brofman owned 48.5% of FPA and 9.9% of FSC. Brofman was an affiliated person of the Fund; at the time of the hearing he controlled the affairs of FPA and FSC. Brofman has been employed in the securities industry since 1974. He has a Ph.D. in economics and finance, and a bachelors degree in engineering and nuclear engineering. FPA's fees, a source of Brofman's income, were based on the assets under its management. His compensation from FPA was approximately $295,000 in 1993 and $427,000 in 1994; during those years, he was the highest paid person at FPA.
Other Relevant Persons
The Fund is a no-load, open-end management investment company established by Brofman and registered with the Commission since 1992 pursuant to the Investment Company Act of 1940. During the period at issue, the Fund invested primarily in securities that were issued or guaranteed by the U. S. Government and its agencies or instrumentalities ("government bonds"). As of June 14, 1993, the Fund had total net assets of $60,896,861; as of December 31, 1995, it had total net assets of $15,194,229. During the six-month period ending December 31, 1993, the Fund raised approximately $24 million in the form of initial or additional investments or dividend re-investments. For the six-month period ending June 30, 1994, the Fund raised approximately $12 million in such investments.
Vincent J. Malanga was chairman of the board and president of the Fundamental Funds, and president and 48.5% owner of FPA, as well as a registered principal and 43.7% owner of FSC. A former Federal Reserve Board economist, Malanga was associated with FPA and FSC, and was an affiliated person of the Fund during the period at issue. Malanga was the architect of the Fund's investment strategy.9
The Boards of Directors for all of the Fundamental Funds, including the Fund, had the same membership (collectively, the "Board"). During the period under review, Board meetings generally were held jointly for all the funds.
FUND MARKETING AND INVESTMENTS
From its creation in 1992, the Fund was offered and sold as a relatively safe and conservative investment. The Fund's stated goal was to invest in high-yielding U.S. Government securities, in order to avoid any credit or currency risk. Sales materials and prospectuses touted the Fund's safety and relative stability of net asset value ("NAV" or price),10 as well as its high yields. The offering documents stated that the Fund's investment objective of generating high current income would be "realized with minimum risk of principal."
The Fund's marketing materials amplified the safety claims in the Fund's prospectuses with statements such as "playing it safe was never so rewarding," "maximum safety of U.S. Government Securities," and "earn high yields with the maximum safety." The sales literature declared that: "[i]n uncertain times, the [Fund] makes tough choices easy for conservative investors;" and "the Fund offers conservative investors the advantage of both high yields and maximum safety."
The Fund's April 30, 1993 and May 2, 1994 prospectuses were filed with the Commission as part of its registration statements. To put its safety claims in concrete terms, the prospectuses and sales literature highlighted the Fund's limited duration.11 Those documents touted theability of the Fund's managers to control interest rate risk by limiting the Fund's duration to three years or less. Presenting duration as "a yardstick to bond price volatility with respect to changes in [interest] rates," the Fund's prospectuses expressly linked limited duration to the stated objectives of minimizing risk and providing "greater share price stability than longer-term investments." The Fund's sales literature similarly touted the Fund's limited duration: "[b]y limiting duration, the [Fund] seeks to avoid violent swings in prices stemming from sharp changes in interest rates;" and "[t]he Fund . . . seeks to protect investors' principal and maximize stability by limiting the average weighted duration of the Fund's portfolio to three years."12 Brofman participated in the preparation of the Fund's prospectuses and marketing materials.
By representing that the Fund would maintain a duration of three years or less, the Fund, in effect, represented that its price volatility would be in line with that of a short or intermediate-term bond fund, rather than that of a long-term bond fund. The prospectuses stated that:
By investing in a portfolio of Government Securities with high current yield and limiting the weighted average duration of the portfolio to three years or less, the Fund seeks to offer a higher yield than a money market fund and less fluctuation in net asset value than a longer-term bond fund.
In June 1994 FSC sent a letter to prospective investors describing the Fund's performance and risks. This letter specifically compared the Fund to short-term government bond funds and highlighted the Fund's ranking among such funds. For instance:
Each month for the past twenty months, this Fund has been ranked as one of the top 3 U.S. Government bond funds in its class based on yield as ranked by Lipper Analytical Services (in the most recent survey, 4/30/94, this Fund ranked #1 out of 110 funds in its class of short term U.S. Government bond funds). As of 5/31/94, the current yield of the U.S. Government Strategic Income Fund was 11.90%.
The Fund's marketing materials also distinguished the Fund from long-term funds:
The Fund seeks to minimize the risks investors face when fluctuating interest rates cause long-term bond funds to lose value. To maintain high stability, the Fund limits the average weighted duration of its portfolio to 3 years or less.
The statement above appeared in marketing brochures below a graph contrasting a virtually flat line, representing the anticipated price stability due to the Fund's intended low duration, with mountain peaks and valleys, representing the fluctuating market values of other funds (or, in some versions of the brochures, the behavior of a standard thirty-year portfolio). The graph appeared under the heading "How the Fund Seeks To Protect Value With Limited Portfolio Duration."
To limit the Fund's exposure to interest rate risk, and thereby achieve the promised duration of three, the Fund promised to implement hedging techniques with futures and options. The prospectuses stated:
The Fund may . . . engage in certain options and futures transactions only as a defensive measure (i.e. as a hedge and not for speculation) to improve the Fund's liquidity and stabilize the value of its portfolio . . . . It is the policy of the Fund to limit the duration by the use of hedging techniques, so that the average weighted duration of the Fund's portfolio is three years or less.13
Thus, rather than investing in short term securities, the Fund's strategy for maintaining relative price stability was to invest in securities of varying maturities and to hedge away unwanted interest rate sensitivity. The key to this strategy was the ability to measure properly the Fund's exposure to interest rate changes.
Changes In The Fund's Investments
Before May 1993, the Fund held primarily securities such as U.S. Treasury bills and obligations of U.S. government agencies and instrumentalities. Division expert FrankFabozzi 14 called these securities "simple" or "option-free" because the amount and timing of the cash flows (coupon interest plus principal payments) from the securities were known. The certainty of the cash flow of these securities made it relatively easy to assess their exposure to interest changes, and hence to hedge against this risk.
For the year ended March 31, 1993, the Fund's performance compared unfavorably with funds investing in similar instruments. Lipper Analytical Services, Inc.("Lipper"), which tracks mutual fund performance, ranked the Fund 33rd out of 50 mutual funds, based on total return, in its category of short-term government bond funds. For the month ended March 31, 1993, Lipper ranked the Fund last in the same category.
In May 1993, in response to the Fund's poor performance, Brofman decided to follow the example of a top-rated Piper Jaffray Fund and begin investing in inverse floating-rate mortgage obligations ("inverse floaters"), a type of mortgage-backed security that was then among the highest-yielding government bonds. Inverse floaters are securities that are "'structured' to provide a rate of return that [is] equal to a fixed rate less a multiple of a floating rate index," such as the London Interbank Offered Rate ("LIBOR").15 Such securities are backed by collateralized mortgage obligations ("CMOs"), which in turn are derived from pools of mortgages. The holders of CMO-backed securities receive payments generated by the mortgages in the underlying collateral pool.16
Payments with respect to CMO-backed securities are subject to "prepayment risk" because of the mortgagors' ability to prepay the balance owed on the underlying loan. The tendency of mortgagors to prepay their mortgages is highly sensitive to changes in interest rates. Thus, as interest rates decline, mortgagors are more likely to prepay their mortgages by refinancing their debt with lower-rate mortgages.17
Because inverse floater coupons move in the opposite direction of the reference rate, investors generally require higher yields to compensate them for the risk of price decline. In order to increase the yield, inverse floaters are often structured with "multipliers" imbedded in their coupon formulas, which magnify movements in the underlying reference rate. 18 The multiple in the coupon formula, referred to as "coupon leverage," will increase any price decline experienced by inverse floaters. Inverse floater prices can be highly volatile because they are simultaneously exposed to prepayment risk and coupon leverage ("inverse floater risks"). Inverse floater support tranches are exposed to the highest level of prepayment risk of all mortgage-backed securities. This characteristic of support tranche inverse floaters makes it much more difficult to assess their interest rate sensitivity. Accordingly, it is more difficult to hedge against the risk created by that sensitivity.
By the end of October 1993, inverse floaters represented approximately 28.7% of the Fund's net assets and 18.1% of its total assets.19 Throughout 1994, inverse floaters represented approximately 30% of the Fund's net assets and approximately 20% of its total assets. Most of the Fund's inverse floaters were support tranches. They had multipliers ranging from 1.8 to 7.
As stated by Fabozzi:
[W]ith the purchase of inverse floaters, the Fund's portfolio changed from a portfolio of predominantly simple securities to an extremely complex portfolio due to significant prepayment risk. An implication of this is that the portfolio changed from one in which it was not difficult to hedge to obtain the desired interest rate exposure to one which became extremely complicated to hedge.
Initially, the Fund's investment in inverse floaters succeeded in boosting the Fund's performance. The first quarter after the Fund began to invest in inverse floaters, Lipper Analytical Services ranked the Fund first in its category of short-term government funds. On June 30, 1993, the Fund had net assets totaling $58,711,022. The 5-year Treasury bond issued on June 30, 1993 (the "5-year Treasury") had an average duration of approximately 3.58, comparable to the Fund's target duration of three. The Fund's NAV increased by 3.5% (from 2.00 to $2.07) from June to September 1993, while the price of the 5-year Treasury security was up only 0.4% (from $100.31 to $101.69).
However, when interest rates rose in 1994, the Fund's value plummeted; its NAV declined more than almost all other government bond funds at the time. By June 30, 1994, the Fund's net assets had declined to $30,260,350. From December 31, 1993 to December 30, 1994, the Fund's NAV dropped from $2.01 to $1.37, approximately 32%. In that same period, themaximum change in interest rates for Treasury securities was 342 basis points ("bp").20 The decline in NAV expected for a fund with a duration of three when interest rates increase by 342 bp would be approximately 10.26% (3 x .0342). Lipper ranked the Fund second to last out of 108 funds in its short-term government bond funds category for 1994, based on the Fund's annual percentage change of -25.56%; the average annual percentage change for the entire category was -1.65%. Morningstar, Inc., another service that ranks bond funds, placed the Fund last in terms of total return among the 270 government bond funds that it tracked in 1994.
Brofman's Duration Calculations
Brofman claims that, in calculating the Fund's duration, he used a function available through Bloomberg Information Systems ("Bloomberg")21 that measures the "Modified Duration" of fixed income securities. Brofman claims that the Fund's duration was three or less at all relevant times and that the Fund's volatility was consistent with his calculation.22 Modified Duration assumes the bond is "option-free," which means that there is no uncertainty in the cash flows over the life of the bond. For inverse floaters, this is an unrealistic assumption since the possibility of prepayments makes their cash flows uncertain. Moreover, Modified Duration does not consider the impact of multipliers on inverse floater values.23 Divisionexperts Fabozzi and Mark Abbott,24 testified that, as early as the 1980's, the limitations of Modified Duration were known in the industry.25
The Fund's Effective Duration
Fabozzi and Abbott agreed that, in order to determine properly how the price of a mortgage-backed security will change as interest rates and prepayments fluctuate, it is necessary to use a model that takes into account the expected changes in cash flows. In the securities industry, this model is referred to as Effective Duration.
Abbott testified that, from at least June 1993, the time the Fund became substantially invested in inverse floaters, through at least June 1994, the Fund's Effective Duration ranged from approximately 6.71 to approximately 12.92, indicating that the Fund's price was very volatile. Between June 30, 1993 and December 31, 1993, the Fund's Effective Duration approximated that of the Lehman Brothers ("Lehman") Long-Term Government ("Gov't") Index Fund, which is comprised of government bonds having a maturity greater than ten years:
As calculated by Abbott, the Fund's Effective Duration exceeded four at all times under review. Fabozzi testified that, while the use of other reasonable assumptions and systems for measuring duration might have produced slightly different duration numbers, no method of calculating duration to measure price volatility would have resulted in a duration of three as represented by the Fund. 26
An additional fact affected the Fund's duration. From June 1993 through June 1994, borrowed monies accounted for approximately 25% to 33.33% of the Fund's total assets. As noted above, the duration of a portfolio is calculated as the weighted average of the duration of the securities comprising the portfolio. The duration of a fund's portfolio in which some of the securities have been purchased with borrowed funds, however, is different. The impact of interest rate increases on a portfolio's NAV is greatly amplified when assets in the portfolio are purchased with borrowed money.27
Brofman Ignored Warnings
Brofman received specific warnings from several sources that the Fund's inverse floaters were extremely sensitive to interest-rate changes and had a duration higher than three. The offering circulars for almost all of the inverse floaters contained warnings about, among other things, inverse floater interest-rate sensitivity. Brofman admitted that he received or had access to those supplements but that, generally, he did not read them.
Srikanth Sankaran28 testified that in the summer of 1993, shortly after the Fund began investing in inverse floaters, he told Brofman that Modified Duration could not be used to calculate the duration of inverse floaters because it did not measure their interest-rate sensitivity. Although Brofman knew that Sankaran had experience dealing with mortgage-backed securities, Brofman continued to use the Bloomberg function that calculated Modified Duration. Brofman admitted that he did nothing to educate himself about Modified Duration, and gave no consideration to the way he calculated the duration of the Fund's inverse floaters until 1995.
Sankaran also testified that he warned Brofman that the objectives of high yield with low risk and stable NAV were inconsistent. According to Sankaran, Brofman responded that theretail investors being targeted for the Fund did not understand these concepts and would not question the Fund's objectives and strategy.
Brofman admitted that Sankaran sent him excerpts from The Handbook of Mortgage-Backed Securities29 that discussed the volatility of inverse floaters. Sankaran testified that in January 1994 he urged Brofman to sell all of the Fund's inverse floaters because they had become so difficult to hedge. According to Sankaran, Brofman rejected his recommendation. Sankaran further testified that, when the Fund's NAV dropped below $2 per share, he sent Brofman a written proposal in which he reiterated his position that the Fund's inverse floaters should be sold in order to stop the erosion of NAV. According to Sankaran, Brofman again rejected this suggestion, on the grounds that the Fund had to maintain high yields in order to attract investors. Brofman does not dispute Sankaran's testimony.
The antifraud provisions of the Securities Act and Exchange Act prohibit making material misstatements or omissions in connection with the offer, purchase, or sale of a security.30 It is undisputed that all of the statements or omissions at issue here were made in connection with the offer, purchase, or sale of securities, i.e. shares of the Fund. Section 34(b) of the Investment Company Act, among other things, makes it unlawful for any person filing a registration statement with the Commission to omit to state therein any fact necessary to prevent statements from being materially misleading.31 A fact is material if there is a "substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."32
Scienter is a necessary element of a violation of Section 17(a)(1) of the Securities Act, 33 and Section 10(b) of the Exchange Act and Rule 10b-5.34 The same scienter standardsapply to violations of Section 15(c)(1) of the Exchange Act and Rules 10b-3 and 15c1-2 thereunder. 35 Scienter has been defined by the Supreme Court as a "mental state embracing intent to deceive, manipulate, or defraud." 36 Proof of scienter need not be direct, but may be "a matter of inference from circumstantial evidence." 37 Reckless behavior satisfies the scienter requirement.38 Scienter need not be found to establish a violation of Section 17(a)(2) or 17(a)(3) of the Securities Act or Section 34(b) of the Company Act.
The Division alleges that the Fund made material misrepresentations in its prospectuses and sales materials by stating that the Fund was a relatively safe and conservative investment and that the Fund's price volatility would be in line with that of a short or intermediate-term bond fund, rather than a longer-term bond fund. The Division also alleges that the Fund's assertions concerning the duration of the portfolio and the use of hedging techniques to limit duration were misleading.
The statements in the Fund's prospectuses and marketing materials that the Fund was a safe investment and provided relative stability of net asset value were false and misleading in light of the investment strategy that the Fund commenced in 1993. Inverse floaters constituted nearly 30% of the Fund's portfolio in 1994. As discussed above, the price of inverse floaters isvolatile because of their extreme sensitivity to interest rate changes and it is exceptionally difficult to hedge against this risk. These attributes meant that concentration of a large portion of the Fund's assets in inverse floaters created a risk of significant change in the Fund's NAV in response to even moderate changes in interest rates. In fact, this is what happened when interest rates began to increase around the end of 1993. The Fund experienced negative returns, depletion of assets, and significant declines in NAV. The substantial amount of assets purchased with borrowed funds exacerbated the effect on NAV created by the concentration of assets in inverse floaters.
Brofman argues that the Fund's NAV did not decline by 32%, as the Division's experts testified, but by 19.8%, if measured from "the top of the market on October 15, 1993 to the bottom on December 13, 1994." According to Brofman, two-thirds of this purported 19.8% decline in NAV was "due to the futures and options that comprised the hedge positions not providing as much of an offset to the movements in [the prices of] the Fund's securities." He asserts that this was caused by the "tremendous increase in interest rates" and "turmoil in the CMO market" during 1994, and was unrelated to the Fund's purchase of inverse floaters as the Division claims. Even if we accept Brofman's 19.8% calculation, that is a significant decline in NAV for a fund that promised price stability. In any event, Brofman fails to document how he arrived at the 19.8% figure. Moreover, the failure of the Fund's hedge positions to offset adequately movements in the prices of the Fund's securities is part of the problem, not a defense. The difficulty in adequately hedging support tranche inverse floaters to protect against interest rate movements is, in part, why the Fund's investments in inverse floaters increased the risk of price instability.
No disclosure of the shift in the Fund's investment strategy was made until May 1994. The May 1994 prospectus disclosure was woefully inadequate. It stated merely that:
The Fund may also invest in [inverse floaters, which] are typically more volatile than fixed or floating rate tranches of CMOs, [and] would be purchased by the Fund to attempt to protect against a reduction in the income earned on the Fund's investments due to a decline in interest rates. The Fund would be adversely affected by the purchase of such CMOs in the event of an increase in interest rates since the coupon rate thereon will decrease as interest rates increase, and, like other mortgage-related securities, the value will decrease as interest rates increase.
This disclosure failed to apprise investors that, in fact, a sizable portion of the Fund's portfolio was already invested in inverse floaters, failed to disclose the risk of significant volatility in NAV due to the change, and failed to disclose the implications of this change for the Fund's hedging strategy.
The assertions in the prospectuses concerning the Fund's duration were false and misleading. The Fund's prospectuses and sales literature promised duration would be "ayardstick to bond price volatility," that limiting the Fund's duration to three would enable the Fund to achieve safety and relative stability of NAV (price), that the Fund would employ hedging techniques to limit duration, and that the Fund's managers had the necessary expertise to deliver on these promises. These assertions specifically linked the ability of the Fund's managers to maintain a duration of three with the representations that the Fund was a relatively safe and conservative investment that would experience minimal price volatility.
Once the Fund became substantially invested in inverse floaters, however, Brofman's ability to balance the portfolio, or to hedge against the risks of interest rate sensitivity was seriously compromised. The predictable price volatility resulting from such a substantial investment in inverse floaters and the difficulty in hedging against the risk of interest rate changes was plainly inconsistent with the Fund's stated goal of maintaining a duration of three. The Fund's substantial borrowing exacerbated the impact of interest rate changes on the Fund's duration. In fact, the record evidence amply demonstrates that, contrary to the Fund's representations, the Fund's duration exceeded three at all times during the period under review. The Fund's 32% price decline and its negative total return in 1994 are inconsistent with the performance of a portfolio with a duration of three. The Fund's marketing materials specifically compared the Fund's duration to those of short-term government funds and the Fund's prospectuses stated that the Fund would have greater price stability than a long-term bond fund. In fact, the Fund's duration was higher than most long-term government bond funds over the same period and its decline in value exceeded that of such funds.
Brofman admitted that he understood that the Fund's inverse floaters were support tranches that are sensitive to interest rate changes. Yet, he asserts that Modified Duration, which does not measure an instrument's sensitivity to interest rate changes, was an appropriate model to measure the Fund's duration. He claims that, in selecting investments for the Fund, he screened out those inverse floaters that were subject to prepayment risk. As explained above, the record does not support this contention: the support tranche inverse floaters Brofman purchased for the Fund were more interest rate sensitive than any other CMO. Prepayment and interest rate risks are intrinsic characteristics of these instruments that could not be screened out as Brofman claims.
In his Post-Hearing Memorandum, Brofman for the first time asserted that the law judge failed to consider as evidence his recalculation of the Fund's March 31, 1994 duration, which, in his view, established that the Fund's duration was three or less at all times. Brofman points to an updated model for calculating Effective Duration that was published in the Spring 1996 issue of the "BARRA Newsletter" by members of a company that acquired Abbott's firm. According to Brofman, the updated model, when applied to various "FNMA 30-year TBA mortgages" and "GNMA I 30-year TBA mortgages" as of December 1995, reduced the "old" Effective Duration calculations of those securities by 46.2%. Brofman argues that applying this newer model to the inverse floaters held by the Fund in December 1994 would therefore result in a duration of three or less. Brofman does not explain how he reached this conclusion. Brofman also fails to explain why an analysis of the 1995 securities discussed in the BARRA Newsletter should be used todemonstrate the duration of the Fund in 1994. There is no evidence that the securities Brofman selected for recalculation of the Fund's duration were substantially the same as those held in the Fund's portfolio as of December 1994.39
Brofman argues that the prospectuses adequately informed investors of the risks associated with investing in the Fund, pointing to disclosures in the prospectuses that, as a result of borrowing, "the net asset value of the Fund's shares will decrease faster than otherwise would be the case," and that borrowing "increases the amount of fluctuation in the Fund's price, given any particular change in the value of its securities holdings." Brofman further asserts that disclosure in the prospectuses that a "sudden and extreme increase in prevailing rates would likely cause a decline in the Fund's net asset value" gave investors adequate warning of the Fund's precipitous drop in NAV. These prospectus disclosures, while accurate, do not go far enough. Overall the prospectuses emphasized safety and stability and de-emphasized risk. As the U.S. Court of Appeals for the Second Circuit has noted:
The "prospectus must be read as a whole . . . . The central issue . . . is not whether the particular statements, taken separately were literally true, but whether defendant's representations, taken together and in context, wouldhave mis[led] a reasonable investor about the nature of the [securities]." 40
We conclude that the Fund's prospectuses and sales literature misrepresented the Fund's safety, stability, and duration.41
A fundamental purpose of the federal securities laws is to "substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry."42 In order to achieve this high standard, investors must be provided with all material facts relating to their investment decisions.
A reasonable investor would have considered it important that the Fund was changing its portfolio from one predominately invested in the low risk securities described in the 1993 prospectus and sales literature to a portfolio with a substantial portion of the Fund's assets in CMOs that were highly exposed to interest rate risks and, thus, were highly volatile. Reasonable investors would likely question whether the Fund would be able to achieve its stated investment objectives of safety, relative stability, and duration in view of the changed investment strategy, and would think carefully about investing in a fund where there was such a high potential for loss. The fact that the Fund's duration was actually more comparable to that of long-term government bond funds than the short-term bond fund comparison promised in the literature would have been material in evaluating the total mix of information about investing in the Fund. Indeed, public investor Donald Ray Nichols testified that, had he known the Fund was not being managed in a manner reasonably designed to achieve its stated objective of relative stability of NAV or that the Fund's duration was significantly greater than three, he would not have investedin the Fund. We conclude that the misrepresentations and omissions made by Respondents in the Fund's prospectuses and sales literature were material.
There is no merit to Brofman's argument that he did not act with scienter. Brofman helped to write and, therefore, was aware of the Fund's representations concerning safety and the relative stability of NAV and duration. Brofman has a doctorate in economics and finance and extensive experience managing portfolios. He received specific warnings, and admittedly understood, that the cash flows of inverse floaters were extremely sensitive to interest-rate changes, and that by buying inverse floaters the Fund was taking on a high degree of interest-rate risk. Brofman does not challenge the substantial evidence in the record that there were numerous "red flags" warning him that inverse floaters were extremely sensitive to interest-rate changes, and that the Fund performed in a manner that was inconsistent with representations in the Fund's offering documents.43
Given Brofman's expertise and the substantial information he had concerning the impact of the inverse floaters on the stability of the Fund's NAV, we find that he was at least reckless in failing to make adequate disclosure concerning the shift in the Fund's investment strategy and its implications for stability of NAV. Moreover, Brofman rejected Sankaran's suggestion that the Fund's inverse floaters should be sold to stop the erosion of NAV, on the grounds that the high yield generated by the inverse floaters was necessary to attract investors. He also cynically told Sankaran that the retail investors targeted by the Fund would not question the Fund's strategy. These statements demonstrate that Brofman was more than reckless; he knew the effect of theinverse floaters on NAV and considered that effect an appropriate trade-off for generating high yields.
Brofman was at least reckless in letting the Fund continue to state that its duration was three. His basis for concluding that the Fund's duration was three was his calculations made using the Modified Duration model. He knew, however, that that model did not reflect the effect of interest-rate changes on the Fund's duration. Sankaran told him that the Modified Duration model was not an accurate way of calculating duration for inverse floaters. It is inconceivable that he did not understand that the Modified Duration calculations he made grossly understated the Fund's actual duration. The performance of the Fund was wildly inconsistent with that of a fund with the relatively stable price that Brofman's duration calculations suggested the Fund should have. In the face of the Fund's performance, it is inexcusable that Brofman did not question the accuracy of his calculations.
Brofman extensively argues that his use of Modified Duration was not reckless because it was consistent with industry practice. Specifically, Brofman argues that "[i]t cannot be reckless to use a methodology that is recognized in the industry;" and "[i]t can not be a misrepresentation to have a prospectus that states that a fund is seeking to have a duration of three or less when, by that methodology, that is recognized in the industry, the duration was indeed three or less." Even if Modified Duration was then an industry standard, it was not the standard for the type of instrument Brofman purchased for the Fund.44 In any event, a practice may be universal withinthe industry and still be fraudulent.45 As discussed above, Brofman was specifically on notice that Modified Duration did not reflect the interest-rate sensitivity of the inverse floaters purchased by the Fund.
Brofman argues that the law judge erred by excluding as an exhibit his purported calculation of the yields of the inverse floaters held by the Fund on June 30, 1993. Brofman claims that the proposed exhibit shows that relatively high yields and low durations are not unusual for inverse floaters, and establishes that he was not reckless in failing to question the Fund's duration as the Division's experts testified. The record establishes that none of the inverse floaters included in Brofman's proposed exhibit was held by the Fund on December 31, 1993, having been sold prior to that date. The proposed exhibit was irrelevant and was properly excluded by the law judge.
* * * * * * * * * *
Accordingly, we find that FPA willfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 by at least recklessly making material misrepresentations in the Fund's prospectuses and marketing materials. Moreover, the Fund's 1994 registration statement incorporated the Fund's 1994 prospectus, and thereby incorporated the misrepresentations contained in the prospectus. We find that, by filing a registration statement that incorporated material misrepresentations, FPA wilfully violated Section 34(b) of the Investment Company Act.46
The elements required to analyze Brofman's aiding and abetting liability are: (1) primary violations by FPA; (2) Brofman's substantial assistance in the conduct constituting those violations; and (3) Brofman's general awareness or knowledge that his actions were part of an overall course of conduct that was improper.47 We have already found that FPA violated the above-referenced securities laws provisions. Brofman participated in preparation of the Fund's misleading prospectus that was included in the registration statement filed with the Commission. Brofman was responsible for calculating portfolio duration and rebalancing the Fund's portfolio holdings to reach the target duration of three. Our findings with respect to Brofman's scienter establish that he had the requisite knowledge that his conduct was improper. We find thatBrofman wilfully aided and abetted FPA's violations. We further find that Brofman was a cause of those violations.48
Additionally, we find that FSC wilfully violated Sections 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rules10b-3, and 10b-5 thereunder, Section 15(c) of the Exchange Act and Rule 15c1-2 thereunder by disseminating the Fund's prospectuses and sales literature which falsely portrayed the Fund as safe and stable and failed to disclose the risks of the Fund.
FPA SOFT DOLLAR DISCLOSURE
From 1990 through December 1995, FPA had a soft dollar49 arrangement with Capital Institutional Services ("CIS"), a broker-dealer that made soft dollar payments generated by transactions executed on behalf of the Fundamental Funds. During this period, CIS made soft dollar payments on FPA's behalf totaling $670,921, including payments of $115,000 to Capital Market Services, Inc. ("CMS"), a consulting firm operated by Donald M. Newell, a business associate of both Malanga and Srikanth Sankaran, and ostensibly owned by Newell's wife.50 From August 1993 through July 1995, pursuant to the FPA-CIS soft dollar arrangement, CIS paidCMS $5,000 per month, purportedly for oral research. Brofman testified that he believed the payments to CMS were for services provided by Sankaran.
Brofman admitted that he was aware of FPA's soft dollar arrangement with CIS from the time it was established and of the payments to CMS, as well as the amount of soft dollar credits and how they were used. He also admits that he did not inform the Board of FPA's soft dollar arrangements or the soft dollar payments to Malanga's associate, Newell, prior to May 1996. Jules Buchwald, the Fundamental Funds' lawyer and an independent Board member, testified that, at meetings on October 19, 1994, January 25, 1995 and October 18, 1995 during which the Board reviewed FPA's management contract, he asked Brofman and Malanga whether FPA had any soft dollar arrangements. Each time, according to Buchwald, Brofman and Malanga responded that FPA had no such arrangements.
Buchwald further testified that, in the Spring of 1996, he learned that FPA had a soft dollar arrangement with CIS, as a result of Commission subpoenas to FPA seeking information concerning soft dollars. Buchwald testified that he informed the other Board members of his discovery of FPA's soft dollar arrangements at the Board's May 2, 1996 meeting. According to Buchwald, after his disclosure, Malanga acknowledged FPA's soft dollar arrangements with CIS and CMS, but claimed that he had only recently learned that CMS was owned by Newell's wife. Malanga challenged the accuracy of prior Board meeting minutes, claiming that they erroneously represented that FPA had no soft dollar arrangements. Buchwald testified that Malanga requested that the Board minutes discussing soft dollars be revised to reflect that the Board had been advised of FPA's soft dollar arrangements. Buchwald, who was responsible for preparing the Board minutes, testified that he refused to do so.51 Former independent Board members Clark Bullock and James Bowers testified that, immediately upon learning of FPA's soft dollar arrangement with CIS, the independent Board members directed FPA to discontinue all soft dollar arrangements, to reimburse the Fundamental Funds the $115,000 paid to CMS, and to provide "complete and periodic disclosure" to them regarding FPA's soft dollar practices.
As fiduciaries, investment advisers and their associated persons "must be governed by the highest standards of conduct." 52 They have an "affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts.'"53 Sections 206(1) and (2) of the Investment Company Act specifically prohibit "investment advisers" from employing any device, scheme, or artifice to defraud clients or from engaging in any transaction, practice or course of business that defrauds clients. Failure by an investment adviser to disclose potential conflicts of interest to its clients constitutes fraud within the meaning of Sections 206(1) and (2).54 It is important for independent board members to consider any soft dollar arrangements in order that they negotiate advisory fees at arms' length, and to be aware of any actual or potential conflicts of interest that might result from an adviser's allocating brokerage in return for some benefit.55 Scienter is an element of a Section 206(1) violation. Scienter need not be found to establish a violation of Section 206(2) of the Advisers Act.56
This record demonstrates that, not only did Brofman fail to disclose the existence of the soft dollar arrangements to the Board, he affirmatively misrepresented the existence of any such arrangements, thereby acting with the requisite scienter to establish a Section 206(1) violation. Brofman does not dispute that he did not inform the Board about FPA's ongoing soft dollar arrangement with CMS. Nor does he dispute that at Board meetings in 1994 and 1995 he and Malanga did not advise the Board of the soft dollar arrangement between CMS and CIS. Rather, Brofman argues that the Board was aware of FPA's soft dollar arrangements because such arrangements were common in the industry, and Board members had attended seminars paid for with soft dollars. Independent Board Members Bullock and Bowers testified that, although they were aware that FPA had soft dollar arrangements in the past, they had no knowledge of any ongoing arrangements. The law judge credited the testimony of Bullock and Bowers regarding the Board's lack of knowledge of FPA's soft dollar arrangements. We see no reason to reject thelaw judge's credibility determinations which are amply supported by other evidence in the record, including contemporaneous Board minutes.57
Brofman further argues that the law judge erred by finding not credible FPA's and Malanga's claims that they were unaware of CMS' ownership. Brofman is not charged with failure to disclose the ownership of CMS, but rather with failure to disclose the existence of soft dollar arrangements. Therefore, Malanga's knowledge of CMS' ownership is not relevant. Brofman's motion pursuant to Rule of Practice 452 to submit an "affidavit from Malanga reiterating his previous statements and testimony" about CMS' ownership and additional evidence regarding the "veracity and motives of those who testified about the Board's lack of knowledge of FPA's soft dollar arrangements"58 is denied because CMS's ownership is not relevant and also because Brofman's motion has not "shown with particularity that such additional evidence is material and there were reasonable grounds for failure to adduce such evidence previously" as required by Rule 452.
Additionally, Brofman asserts that the Fund's prospectuses provided sufficient disclosure to Board members about FPA's soft dollar arrangements and that FPA's disclosure practices concerning soft dollars were consistent with industry practice. However, the Fund's prospectuses simply stated that the Fund "may" have soft dollar arrangements. Particularly, in light of Brofman's and Malanga's repeated denials of the existence of any current soft dollar arrangements, the statements in the prospectuses were inadequate.
Accordingly, we find that FPA defrauded the Fund when Brofman and Malanga falsely told the Fund's directors that it had no soft dollar arrangements. This was a willful violation of Sections 206(1) and (2) of the Advisers Act. With respect to Brofman's aiding and abettingliability, FPA's primary violation satisfies the first prong of the test.59 Brofman's deliberate lies to the Board established his substantial assistance and also his general awareness that his actions were part of an overall course of conduct that was improper. We therefore find that Brofman wilfully aided and abetted, and was a cause of FPA's misconduct.
Respondents request that, if the initial decision is not reversed in its entirety or remanded for a rehearing, the sanctions imposed, including the civil monetary penalties, be reduced or eliminated. In determining whether a sanction is in the public interest, we consider a number of factors including:
the seriousness of the violation, the isolated or recurrent nature of the violation, the respondent's state of mind, the sincerity of the respondent's assurances against future violations, the respondent's recognition of the wrongful nature of his or her conduct, and the respondent's opportunity to commit future violations.60
Consideration of these factors strongly militates in favor of imposing stringent sanctions upon Respondents.
The record evidence amply supports our finding that Respondents' violations were egregious. Their violations were neither isolated nor insignificant. The fraud upon Fund investors continued for almost two years and resulted in substantial losses to them. In addition, Brofman and FPA engaged in fraudulent conduct related to soft dollar disclosures that continued for at least one year. With respect to the misrepresentations in the Fund's prospectuses and sales literature and failure to disclose FPA's soft dollar arrangements, Brofman acted with a high degree of scienter. Brofman continued to attract unsuspecting investors into the Fund with false representations of safety, high yields and low duration, even after he had changed the Fund's investment strategy. Brofman's assertion that investors would not understand or question the Fund's objectives or strategy illustrates Brofman's callous disregard for the investing public. Although aware of FPA's soft dollar arrangements, Brofman deliberately withheld this information from the Board. By failing to advise the Board of FPA's soft dollar arrangements, Brofman's deception aided and abetted and was a cause of FPA's disclosure violations.
Brofman's past misconduct holds out scant assurance against future violations. This is the third proceeding against Brofman, and the third time he has defrauded mutual fund investors by failing to disclose material facts concerning risks associated with a fund's strategy to achieve high yields.61 Less stringent sanctions, previously imposed on Brofman for violations substantially similar to those at issue here, proved to be insufficient to preclude future misconduct. Brofman has neither acknowledged the wrongfulness of his conduct nor offered any assurances against future violations. To the contrary, Brofman, who claims to be "one of theforemost experts on duration living," remains unwilling or unable to comprehend that the Fund's performance was inconsistent with the promises of low risk, relative stability and high rewards. Brofman failed to acknowledge that he did not properly monitor the Fund's duration and rebalance the portfolio to achieve the Fund's stated objectives, insisting that he could ignore inverse floater risks, the market's assessment of those risks, and the impact of borrowing on the Fund's volatility. Brofman's conduct with regard to the soft dollar arrangement exposes his unfitness to act as fiduciary and to handle the money of public investors. There is a likelihood that Brofman's occupation will present opportunities for future violations. Unless barred, Brofman would be free to fulfill his expressed goal of resuming his career as a mutual fund portfolio manager. Accordingly, we find it is in the public interest to bar Brofman from association with any broker, dealer, investment adviser, or investment company.
The public interest warrants severe sanctions against FPA and FSC. FPA and FSC engaged in serious and recurrent misconduct. Neither FPA nor FSC questioned the Fund's performance, even though they were on notice by late 1993 that the Fund's duration exceeded three, were aware by September 1994 of the existence of the Commission's investigation into the Fund's duration practices, and had entered into settlements requiring them to provide prospective investors with information concerning another fund's effective portfolio duration. Despite their disciplinary histories, FPA and FSC continued to manage and market the Fund without regard to the truthfulness of their claims concerning the Fund's safety, duration, and relative stability of NAV.62 FPA and FSC have failed to acknowledge their violative conduct and offered little by way of assurances against future wrongdoing. As noted above, FPA's registration was cancelled in 2001 for failure to convert to electronic filing. As for FSC, only a significant sanction will convey the seriousness with which we view its violative conduct and will serve as appropriate deterrents. We have determined to revoke FSC's registration as a broker-dealer.
The Division seeks penalties against Respondents pursuant to Sections 21B of the Exchange Act, Section 9(d) of the Investment Company Act, and Section 203(i) of the Advisers Act. Second-tier penalties may be imposed if the conduct involves fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement. A third-tier penalty may be imposed if the conduct involves any of the acts described and the conduct resulted in substantiallosses or created significant risk of such losses to others or resulted in substantial pecuniary gain to the respondent. Determination of whether civil penalties are in the public interest requires examination of the above factors and also whether the act or omission involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement; the harm caused to another person either directly or indirectly from such act or omission; the extent to which any person was unjustly enriched; the respondent's prior disciplinary history; the need to deter others; and other matters as justice may require.63 Second-tier penalties may be in amounts up to $50,000 against individuals, and up to $250,000 against entities for each violation related to the soft dollar fraud; and third-tier penalties of up to $100,000 against individuals, and up to $500,000 against entities for each violation resulting from their participation in the fraud upon Fund investors.
We have found that Respondents engaged in fraudulent acts and omissions, both with respect to the fraud upon Fund investors and the soft dollar fraud. Because of Respondents' fraudulent conduct, Fund shareholders suffered substantial harm. As discussed above, Respondents have a disciplinary history. Imposing substantial penalties upon each of the Respondents will serve the important purpose of deterring Respondents and others from knowingly or recklessly defrauding mutual fund investors and defrauding fund boards concerning soft dollar arrangements.
At the hearing below, the Division requested that, rather than viewing each sale of Fund shares and each undisclosed use of soft dollars as a violation and imposing the maximum penalty per violation, Brofman, FPA and FSC each pay third-tier civil penalties for two violations: the sales of Fund shares in connection with the 1993 prospectus, and the filing and distribution of the 1994 prospectus. In addition, the Division requested that Brofman and FPA each pay second-tier penalties for the soft dollar violations. Accordingly, the Division requested that Brofman pay aggregate civil penalties in the amount of $250,000, that FPA pay civil penalties of $1.5 million, and that FSC pay civil penalties of $1 million. The law judge, however, determined to impose civil money penalties on FPA and FSC in the amount of $500,000 each, based on FPA's and FSC's demonstrated inability to pay.64 The Division has not appealed the amounts of the civil penalties imposed by the law judge. We find it in the public interest to impose a civil money penalty of $250,000 on Brofman, and $500,000 on each FPA and FSC.
The Division seeks a cease-and-desist order under Sections 8A of the Securities Act, 21C(a) of the Exchange Act, 9(f) of the Investment Company Act, and 203(k) of the AdvisersAct.65 Because a cease-and-desist order is a forward-looking sanction, in assessing whether a cease-and-desist order is an appropriate sanction, we focus on the risk of future violations.66 "This inquiry is a flexible one and no one factor is dispositive. This inquiry is undertaken not to determine whether there is a 'reasonable likelihood' of future violations but to guide our discretion."67 In the ordinary case, and absent evidence to the contrary, a finding of past violation raises a risk of future violation sufficient to support our ordering a respondent to cease and desist. "To put it another way, evidence showing that a respondent violated the law once probably also shows a risk of repetition that merits our ordering him to cease and desist."68 We further may consider the function a cease-and-desist order will serve in alerting the public that a respondent has violated the securities laws.69
The record demonstrates that cease-and-desist orders are warranted against Respondents. Respondents' fraudulent violations were recurrent, egregious, and caused investors to suffer substantial harm. Although Brofman, FPA and FSC have been sanctioned previously for misconduct substantially the same as that found here, Respondents continue to insist that there were no violations. In view of Respondents' failure to appreciate their obligation to deal honestly with public investors and to understand important regulatory requirements, there is risk that they will transgress in the future. Accordingly, we conclude that cease-and-desist orders against Respondents are in the public interest.70
An appropriate order will issue.71
By the Commission (Chairman DONALDSON and Commissioners GLASSMAN, GOLDSCHMID, ATKINS and CAMPOS).
Jonathan G. Katz
SECURITIES EXCHANGE ACT OF 1934
Rel. No. 48177 / July 15, 2003
INVESTMENT ADVISERS ACT OF 1940
Rel. No. 2146 / July 15, 2003
INVESTMENT COMPANY ACT OF 1940
Rel. No. 26099 / July 15, 2003
Admin. Proc. File No. 3-9461
In the Matter of the Applications of
FUNDAMENTAL PORTFOLIO ADVISORS, INC.
FUNDAMENTAL SERVICE CORPORATION
ORDER IMPOSING REMEDIAL SANCTIONS
On the basis of the Commission's opinion issued this day, it is
ORDERED that the investment adviser registration of Fundamental Portfolio Advisors, Inc. be, and it hereby is, revoked; and it is further
ORDERED that Lance M. Brofman be, and hereby is barred from association with any broker, dealer, investment adviser, or investment company; and it is further
ORDERED that the broker-dealer registration of Fundamental Service Corporation be, and it hereby is revoked; and it is further
ORDERED that Fundamental Portfolio Advisors, Inc. and Fundamental Service Corporation each pay a civil money penalty of $500,000, and that Lance M. Brofman pay a civil money penalty of $250,000; and that and it is further
ORDERED that Lance M. Brofman and Fundamental Portfolio Advisors, Inc. cease and desist from committing or causing any future violation of Sections 17(a) of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, Section 34(b) of the Investment Company Act of 1940, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940; and it is further
ORDERED that Fundamental Service Corporation cease and desist from committing or causing any future violation of Sections 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rules 10b-3 and 10b-5 thereunder, and Section 15(c) of the Exchange Act and Rule 15c1-2 thereunder.
Payment of the civil money penalty shall be made within 21 days of the issuance of this order. The civil money penalty shall be: (i) made by United States postal money order, certified check, bank cashiers's check, or bank money order; (ii) made payable to the Securities and Exchange Commission; and (iii) mailed or delivered by hand or courier to the Comptroller, 6432 General Green Way, Alexandria, VA 22312; and (iv) submitted under cover letter that identifies the particular respondent in these proceedings, as well as the Commission's administrative file number. A copy of this cover letter and money order or check shall be sent to Leslie Kazon, Northeast Regional Office, Securities and Exchange Commission, The Woolworth Building, 233 Broadway, New York, NY 10279.
By the Commission.
Jonathan G. Katz
|1||15 U.S.C. § 77q.|
|2||15 U.S.C. § 78j.|
|3||17 C.F.R. § 240.10b-5.|
|4||15 U.S.C. § 80a-33.|
|5||15 U.S.C. §§ 80b-6 (1) and (2).|
|6||17 C.F.R. § 240.10b-3.|
|7||15 U.S.C. § 78o and 17 C.F.R. § 240.15c1-2.|
|8||FPA's registration was cancelled in 2001 for failure to convert to electronic filing.|
|9||The Order Instituting Proceedings also named Malanga. On July 7, 1998, the Commission accepted Malanga's offer of settlement. Without admitting or denying the allegations in the Order, Malanga consented to findings that, among other things, he knowingly or recklessly: marketed the Fund as a safe and stable investment when he knew the Fund was investing in securities that heightened the Fund's sensitivity to interest rate risk and that were contrary to representations in the Fund's prospectus and sales literature; failed properly to supervise Brofman; and failed to inform the Board about FPA's commission arrangements.|
|10|| Investment Company Act Rule 22c-1provides that the price of a mutual fund share must be based upon the current "net asset value" ("NAV") of the share.
17 C. F. R. § 270.22c-1.
|11|| The most significant risk associated with a government bond is interest rate risk. Generally, the price of a government bond has an inverse relationship to the movement of interest rates. That is, when interest rates rise, a bond's price will fall; when interest rates fall, a bond's price will rise. It is common in bond portfolio management to quantify the exposure of a bond or portfolio to interest-rate risk. The name given to this measure of interest-rate risk is duration. Duration is an estimate of the sensitivity of a portfolio to changes in interest rates. Duration is expressed in years, although a security's duration is not necessarily the same as its years to maturity. The link between the duration of a portfolio and the portfolio's responsiveness to changes in interest rates is expressed in the following equation:
A duration of three years, for example, denotes that for a 100 basis-point change in interest rates, the price (or value) of a security (or portfolio) will change by 3% (3 x .01); for a 300 basis-point change in interest rates, the price (or value) of a security will change by 9% (3x.03). Thus, a higher duration indicates a higher degree of price sensitivity to interest rate changes, and hence greater risk to investors.
|12||The duration of a portfolio is the weighted average of the duration of the individual securities in the portfolio. See Barrons Finance and Investment Handbook 285 (4th ed. 1995). As used herein, the term "duration" refers to the "weighted average duration" or "average weighted duration" of the Fund's portfolio.|
|13||The duration of a portfolio may change over time due to changes in the durations of securities in a portfolio. Fund managers generally measure a portfolio's exposure to interest rate changes and use hedging techniques involving futures and options to "rebalance" the portfolio's duration in order to assure that the interest rate risk will not exceed the upper limit specified for the Fund's duration.|
|14||Fabozzi was accepted by the law judge as an expert in fixed-income securities, including mortgage-backed securities such as collateralized mortgage obligations, and with respect to the management of bond funds and other fixed-income portfolios.|
|15||Derivative Financial Instruments Relating to Banks and Financial Institutions, Hearings Before the Senate Committee on Banking, Housing and Urban Affairs, 104th Cong. 1st Sess. 57 (Jan. 5, 1995) (statement of Arthur Levitt, Chairman of the SEC) (hereafter "Levitt Statement"), text accompanying n.21, available at http://www.sec.gov/news/testimony/testarchive/1995/spch022.txt. See also Lyle Roberts, Suitability Claims Under Rule 10b-5: Are Public Entities Sophisticated Enough to Use Derivatives, 63 U. Chi. L. Rev. 801, n.3 (1996).|
|16|| See generally Kenneth G. Lore & Cameron L. Cowan, Mortgage- Backed Securities §3.03 (1999).
The structuring of floating rate securities based on fixed rate payment streams works as follows. As a stream of payments from a pool of mortgages (with fixed interest rates) is paid to a particular bond class, payments are divided into two payment streams based on a specified floating interest rate. One payment stream varies directly with the specified interest rate (floaters) and the other payment stream varies inversely with the specified interest rate (inverse floaters). The extent to which floaters/inverse floaters vary with thespecified interest rate is calculated so that the total return of both payment streams equals the total payment stream from the (fixed interest rate) mortgage pool at any point in time.
|17||Securities may be structured so that the underlying CMO payments are distributed on a prioritized basis to mitigate the prepayment risk. This structuring makes CMOs more marketable to customers with different income stream needs. See generally Frank J. Fabozzi, The Handbook of Fixed Income Securities, (5th ed. 1997). To accomplish this, securities derived from the underlying mortgage pool are sold in classes, or tranches, where each class has a different payment priority. For example, three classes of CMO bonds may be offered, Class A, Class B, and Class C. Holders of Class A bonds receive all interest and principal from the underlying mortgage pool until the payments equal the Class A bonds' full par value. After holders of Class A bonds have received payments equal to par, holders of Class B bonds receive all interest and principal for those bonds until par value for those bonds is reached. After Class B bonds have received full payment of interest and principal, all remaining payments from the mortgage pool go to the Class C bonds. The tranches that assume the greatest prepayment risk are called support tranches.|
|18||Generally, the coupon rate of a floater is reset monthly. Consequently, there is little, if any, change in the market value of a floater as the reference rate changes. Most of the change is absorbed by the inverse floater and explains why an inverse floaters can have a very high duration. The degree of change in the value of an inverse floater when interest rates change is influenced by its multiple. The duration of an inverse floater is computed as: (1 + the multiple) x the duration of the fixed rate tranche.|
|19||Net assets represent the Fund's total assets minus its debt obligation. The prospectuses and sales literature advised prospective investors that, in order to boost income, the Fund might use bank loans or other forms of borrowing to fund securities purchases, and that borrowed funds could comprise up to one third "of the value of [the Fund's] total assets."|
|20|| The record indicates the following interest rate changes from December 31, 1993 to December 30, 1994:
|21||Bloomberg is a 24-hour on-line system that provides financial news, market information, and analytics.|
|22||Although Brofman could not produce documentation of his duration calculations prior to December 1994, neither the Division nor the law judge challenged his assertions that he made calculations prior to that time, or that he used the Bloomberg Modified Duration function in making his calculations.|
|23||Bloomberg actually used "Spread Duration" which is a form of Modified Duration. Spread Duration fails to factor interest rate changes into the duration calculation. For simplicity, we will refer to the Bloomberg model as Modified Duration.|
|24||Abbott was accepted by the law judge as an expert in calculating the Fund's duration.|
|25||Kenneth Gaertner ("Gaertner"), who has been in charge of the development of mortgage-backed securities analytics for Bloomberg for over ten years, testified that the Modified Duration screens used by Brofman did not measure the sensitivity of inverse floaters to changes in interest rates, and because of this substantially understated their price volatility.|
|26||The Division does not contend that the particular system used by Abbott to calculate the Fund's duration was the only appropriate method for doing so. Rather, the Division maintains that no appropriate method for calculating duration consistent with the Fund'srepresentations would have resulted in a duration anywhere near three.|
|27||This is because the number representing the percentage change in the portfolio value (the first half of the duration equation) reflects the change in the net value of the portfolio. A portfolio with securities worth $100 million and a duration of 3 can be expected to decline in value by 3 percent, or $3 million, in response to a 1 percent increase in interest rates. However, if the same securities were purchased with $80 million of borrowed money, the net value of the fund is only $20 million. The $3 million decline in value of the total assets would mean that the net value would decline to $17 million, which is a 15 percent decline in the net value. Thus, the duration of the portfolio purchased with borrowed money would be 15.|
|28||Sankaran was the owner of a registered broker-dealer that executed futures and options transactions for the Fund. He made recommendations to Brofman about inverse floaters, hedging, and other matters.|
|29||See The Handbook of Mortgage-backed Securities (1988), edited by Fabozzi.|
|30||Section 17(a) of the Securities Act, 15 U.S.C. § 77q, Section 10(b) of the Exchange Act, 15 U.S.C. § 78j, and Section15(c) of the Exchange Act, 15 U.S.C § 78o.|
|31||15 U.S.C. § 80a-33(b).|
|32||See, e.g., Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).|
|33||SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 195 (1963).|
|34||See Aaron v. SEC, 446 U.S. 680, 695, 697 (1980); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976); Steadman v. SEC, 603 F.2d 1126, 1134 (5th Cir. 1979), aff'd, 450 U.S.91 (1981). See, e.g., Aaron v. SEC, 446 U.S. at 696; SEC v. Capital Gains, 375 U.S. at 196.|
|35||Darvin v. Bache Halsey Stuart Shields, Inc., 479 F. Supp 460, 464 (S.D.N.Y. 1979) ("the same scienter standard applies to [S]ections 10(b) and 15(c), and Rules 10b-5 and 15c1-2"); and L. C. Wegard & Co., 53 S.E.C. 607, 615 (1998), aff'd, 189 F.3d 461 (2d Cir. 1999) (Table) (respondent lacked requisite scienter to have violated Sections 17(a)(1), 10(b), and 15(c)).|
|36||Ernst & Ernst v. Hochfelder, 425 U.S. at 193.|
|37||Herman & MacLean v. Huddleston, 459 U.S. 375, 390 n.30 (1983); Pagel, Inc. v. SEC, 803 F.2d 942, 946 (8th Cir. 1986); In re Meyer Blinder, 50 S.E.C. 1215, 1230 (1992).|
|38|| See, e.g., Howard v. Everex Systems, Inc., 228 F.3d 1057 (9th Cir. 2000). The Ninth Circuit defined recklessness as:
See also Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 272-73 (3d Cir. 1998) ("recovery on a federal securities fraud claim requires a showing of scienter: a deliberate or reckless misrepresentation of a material fact").
|39|| In further support of the correctness of his duration calculations, Brofman argues that the
Brofman goes on to argue that "there is absolutely no doubt that the Black-Scholes Methodology for the options-on-futures was the prevailing industry standard at the time." The import of this argument is unclear. The Black-Scholes methodology to which Brofman refers is an options pricing model propounded by economists Myron Scholes and Fischer Black in 1973. Brofman is not charged, however, with incorrectly pricing the options that were used to hedge the inverse floaters.
|40||See Hunt v. Alliance North American Gov't Income Trust, Inc., 159 F.3d 723, 728-29 (2d Cir. 1998) (quoting Olkey v. Hyperion 1999 Term Trust, Inc., 98 F.3d 2, 5 (2d Cir. 1996)).|
|41||Brofman asserts that the law judge erred by failing to admit as an exhibit Brofman's standard deviation analysis of the Fund's "historically observed volatility," which purported to demonstrate that the Fund's volatility was lower than longer-term fixed income investments. None of the Fund's offering documents disclosed that relative stability of NAV would be measured by standard deviation. Instead, the Fund represented that low volatility was linked to the Fund's limited duration. Standard deviation is not a duration calculation model. Thus, Brofman's proposed analysis is irrelevant to any disclosures concerning the Fund's performance and was properly excluded by the law judge.|
|42||SEC v. Capital Research Bureau, Inc., 375 U.S. at 186.|
|43||In April 1994, FPA and FSC entered into settlements with the New York State Attorney General ("NYAG") concerning the marketing of the New York Muni Fund, one of the Fundamental Funds. The NYAG found that the New York Muni Fund pursued "aggressive portfolio strategies to obtain income and capital appreciation from investments in municipal bonds." These strategies included (a) substantial investments in several types of inverse floating-rate municipal bonds; and (b) leverage. FPA and FSC, without admitting or denying the NYAG's findings, entered into an Assurance of Discontinuance and Undertaking. FPA and FSC undertook, among other things, to: (a) provide prospective investors with a narrative and, if feasible, visual description of the New York Muni Fund's "effective portfolio duration or sensitivity to interest rate risk" and use of leverage; and (b) retain or designate a Compliance Officer to review the Muni Fund's compliance with applicable federal and state rules and regulations and the rules and regulations for the National Association of Securities Dealers, Inc. ("NASD"), particularly those relating to sales materials. Brofman, as the Fund's manager, was necessarily aware of the NYAG's concern with respect to duration calculations for the inverse floaters at issue there, and should have realized the implications of these concerns for the Fund's duration calculations.|
|44||In support of his claims, Brofman cites language in a 1996 Commission order issued pursuant to a settlement agreement, County of Orange, California, et al., Exchange Act Rel. No. 36761 (Jan. 24, 1996), 61 SEC Docket 487, noting that the Modified Duration of the Orange County investment pool was a measure of the pool's interest-rate sensitivity resulting from its investment in "inverse floaters." The order in County of Orange does not indicate that the inverse floaters at issue in County of Orange were mortgage-backed securities with pre-payment risk and other imbedded options creating the extreme sensitivity to interest rate fluctuations associated with the Fund's inverse floaters. Therefore, the discussion of duration in County of Orange is not relevant. Moreover, to the extent that Brofman is arguing that the County of Orange order validates his use of Modified Duration to calculate the Fund's duration, that argument ignores Brofman's admission that he used Modified Duration on the Bloomberg screen, Spread Duration, a form of Modified Duration that did not measure interest rate sensitivity. See n.25 supra. Brofman also cites the initial decision in Piper Capital Management, Inc. et al. Initial Decision No. 175, 73 SEC Docket 3175 (Nov. 30, 2000), appeals filed Dec. 22, 2000. However, because we granted the Division's petition for review, the initial decision ceased to have any force or effect. See 17 C.F.R. §§ 201.360 (d) and (e). Moreover, the law judge in Piper Capital, while recognizing that Modified Duration was one of at least three duration calculation models recognized in the industry from 1991 through early 1994, did not determine any of those models to be the industry standard.|
|45||Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d at 274.|
|46||See Mitchell Hutchins, Securities Act Rel. No. 7444 (Sept. 2, 1997), 65 SEC Docket 780; USAA Inv. Mgmt. Co., Investment Advisers Act Rel. No. 1359 (Jan. 22, 1993), 53 SEC Docket 1085 .|
|47||Graham v. SEC, 222 F. 3d 994, 1000 (D.C. Cir. 2000) (setting forth elements for aiding and abetting liability); Levine v. Diamanthuset, Inc., 950 F.2d 1478, 1483 (9th Cir. 1990).|
|48||Sharon M. Graham, 53 S.E.C. 1072, 1085 n.35 (1998); (noting that a respondent is a "cause" of another's violation if the respondent "knew or should have known" that his or her act or omission would contribute to such violation), aff'd, 222 F.3d 994 (D.C. Cir. 2000); Richard D. Chema, 53 S.E.C. 1049, 1059 n.20 (1998) (finding that respondent willfully aided and abetted primary violations "necessarily makes him a 'cause' of those violations").|
|49||As used here, the term "soft dollars" describes an arrangement whereby an investment adviser directs its client transactions to a broker-dealer and in exchange for the commissions generated by these transactions receives research, brokerage, or other products or services. See Oakwood Counselors, Inc., Advisers Act Rel. No. 1614, 63 SEC Docket 2485, 2486 (Feb. 10, 1997). The term also includes soft dollar credits generated by syndicate designations.|
|50||CMS is identified in the record as an "affiliate" of Malanga. Brofman admitted knowing at the time of the soft dollar payments to CMS that Newell and Sankaran were business associates involved with the company, and that Newell and Malanga were partners in several businesses. Brofman also acknowledged "the possible appearance of an affiliation between  Malanga and  Newell, (through Newell's wife)." There is no record evidence of CMS's ownership.|
|51||Buchwald testified that it was his responsibility to prepare a draft of the Board minutes soon after the meeting, while the event was fresh in his memory, and to send copies of the draft to Board members for their review and comment in advance of its final approval at the Board's next meeting.|
|52||See Victor Teicher, Exchange Act Rel. No. 40010 (May 20, 1998), 67 SEC Docket 542, 547, aff'd, 177 F.3d 1016 (D.C. Cir. 1999).|
|53||See Capital Gains, 375 U.S. at 194.|
|54||See Capital Gains, 375 U.S. at 191-193, 200-01 (suppression of information material to an evaluation of the disinterestedness of investment adviser "operates as a fraud or deceit" on purchaser).|
|55||Kingsley, Jennison, McNulty & Morse, Inc. et. al., 51 S.E.C. 904, 906, 909 (1993).|
|56||Steadman v. SEC, 603 F.2d at 1134. See also, S Squared Technology Corp., Advisers Act Rel. No. 1575 (Aug. 7, 1996), 62 SEC Docket 1560 (Section 206 (2)); SEC v. Tandem Mgmt., Inc., Litigation Rel. No. 14670 (Oct. 2, 1995), 60 SEC Docket 1331 (Sections 206 (1) and (2)).|
|57||Credibility determinations are the prerogative of the trier of fact, and are ordinarily entitled to great weight in our review of the record. See Universal Camera Corp. v. NLRB, 340 U.S. 474, 496 (1951); Jacob Wonsover, Exchange Act Rel. No. 41123 (Mar. 1, 1999), 69 SEC Docket 694, 701 n.14, petition denied, 205 F.3d 408 (D.C. Cir. 2000) (law judge credited testimony when it was supported by documentary evidence or the evidence of other witnesses and the Commission found no basis to reject that determination); Litwin Sec., Inc., 52 S.E.C. 1339, 1342 n.13 (1997) (the Commission will reject initial fact-finders determination as to credibility only when the record contains "substantial evidence" to the contrary); C. James Padgett, 52 S.E.C. 1257, 1277 n.65 (1997) (credibility determination of the initial decision maker is entitled to considerable weight as it is based on hearing witnesses' testimony and observing their demeanor), petition denied, Sullivan v. SEC, 159 F.3d 637 (D.C. Cir. 1998) (Table).|
|58||Only Bullock is specifically identified in Brofman's Brief on Appeal as one of the referenced witnesses.|
|59||See discussion supra at p.26.|
|60||KPMG Peat Marwick LLP, Exchange Act Rel. No. 43862 (Jan. 19, 2001), 74 SEC Docket 384, 436 (quoting SEC v. Steadman, 967 F.2d 636, 647-648 (D.C. Cir. 1992)), motion for reconsideration denied, Exchange Act Rel. No.44050 (Mar. 8, 2001), 74 SEC Docket 1351, petition denied, 289 F.3d 109 (D.C. Cir. 2002). See also Donald T. Sheldon, 51 S.E.C. 59, 87 n.124 (1992), aff'd, 45 F.3d 1515 (11th Cir. 1995).|
|61|| On two prior occasions the Commission has found that Brofman engaged in fraud in connection with his management of mutual funds:
|62||In 1998, in proceedings involving the conduct at issue in this matter, FSC, Malanga and FSC's head of marketing, David Wieder, settled NASD charges that they had overstated the Fund's safety and stability, omitted to state its risks and potential volatility, and misrepresented the nature of the portfolio. FSC and Malanga were censured and, jointly and severally, ordered to pay a $100,000 fine. FSC was required to pre-file with the NASD all advertising and sales literature for a period of three years, and to engage, at the firm's expense, a consultant to review FSC's compliance procedures and to make recommendations to improve the same. Malanga was suspended for 30 days from association, in any capacity, with any member firm, required to requalify as an investment company products/variable contracts principal and limited representative, and undertook not to apply for registration as a general securities principal for a period of three years.|
|63||15 U.S.C. § 78u-2 (b), 15 U.S.C. § 80a-9 (d), and 15 U.S.C. § 80b-3 (i).|
|64||The law judge's determination was based on financial statements and tax returns for FPA and FSC. The financial records indicated that, in 1997, FPA had a net income of approximately $76,000 and FSC experienced a net loss of approximately ($89,000).|
|65||15 U.S.C. § 77h-1, 15 U.S.C. § 78u-3 (a), 15 U.S.C. § 80a-9 (f) and 80b-3 (k).|
|66||KPMG, at 429-436.|
|67||KPMG, at 436.|
|68||Id. at 430.|
|69||Id. at 436, n.148.|
|70||While FPA's registration was cancelled, the record contains no information concerning whether FPA has ceased to exist entirely, and for that reason we find that the cease-and-desist order is appropriate for FPA.|
|71||We have considered all of the contentions advanced by the parties. We reject or sustain them to the extent that they are inconsistent or in accord with the views expressed in this opinion.|
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