SECURITIES AND EXCHANGE COMMISSION
SECURITIES EXCHANGE ACT OF 1934
Admin. Proc. File No. 3-9034
In the Matter of
J. STEPHEN STOUT
Opinion of the Commission
Grounds for Remedial Action
Fraud in Offer and Sale of Securities
Former salesperson of registered broker-dealer engaged in unsuitable and unauthorized trading and made fraudulent statements and omitted material facts in connection with the offer and sale of securities. Held, it is in the public interest to bar salesperson from association with any broker or dealer; to order salesperson permanently to cease and desist from committing or causing any violation and committing or causing any future violation of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder; and to order him to pay a civil money penalty of $300,000.
J. Stephen Stout, pro se.
Gregory P. von Schaumburg and Adriane W. Burkland, for the Division of Enforcement.
Appeal filed: January 25, 1999
J. Stephen Stout, formerly a salesperson in the Flint, Michigan office of PaineWebber, Inc. ("PaineWebber"), appeals from the decision of an administrative law judge. 1 The law judge found that Stout had provided false valuations to customers, engaged in unauthorized and unsuitable trading, and churned customer accounts. The law judge further found that Stout's sales practices, including short-term holding periods, mutual fund switches, breakpoint violations, and transactions to enhance his commissions, violated the antifraud provisions of the securities laws. The law judge concluded that, by engaging in this conduct, Stout willfully violated Section 17(a) of the Securities Act of 1933, 2 Section 10(b) of the Securities Exchange Act of 1934, 3 and Exchange Act Rule 10b-5. 4
The law judge barred Stout from association with any broker or dealer, ordered him to cease and desist from committing or causing any violation or future violation of the antifraud provisions and ordered him to pay a civil money penalty of $300,000. We base our findings on an independent review of the record, except with respect to those findings not challenged on appeal.
This proceeding concerns Stout's conduct with respect to ten customer accounts while employed as a registered representative at PaineWebber's Flint, Michigan office. 5 Stout joined PaineWebber in February 1989 after six years as a registered representative at Prudential-Bache Securities, Inc. ("Prudential"), where he was the registered representative for nine of the customer accounts discussed below. Stout was a top seller of "direct investments," or limited partnership securities, at Prudential. 6 Stout continued to sell limited partnership securities at PaineWebber.
The Blevins Family Accounts
Eight of the ten accounts at issue in this proceeding involved members of the Blevins family. Stout began his business relationship with the Blevins family in 1978, when he opened an account for Mark Blevins at Merrill Lynch, Pierce, Fenner and Smith, Incorporated ("Merrill Lynch"). 7 Stout directed trading in the account of Lottie Balasko, Mark Blevins' great-aunt. Stout also was the registered representative for the accounts of Mark Blevins' parents, Wayne and Patty Blevins, and the three Blevins family corporations: Blevins Screw Products ("Blevins Products"); Extreme Precision Screw Products ("Extreme Precision"); and Borneman and Peterson ("Borneman"). 8
A. Lottie Balasko
In 1990, Lottie Balasko suffered a debilitating stroke. The stroke limited Balasko's ability to speak and partially paralyzed Balasko on her right side. 9 Balasko could walk with a leg brace and a quad cane, but required assistance for bathing, dressing, and writing. Balasko could write only to sign her name. The stroke did not affect Balasko's mental capacity.
After Balasko's stroke, Bruce Blevins asked Stout whether an investment account could generate sufficient income to cover Balasko's living expenses. Bruce Blevins told Stout that Balasko, who was approximately 71 years old at the time, required 24-hour care in order to live at home.
Bruce Blevins provided Stout with Balasko's income and expense information. Balasko received a monthly income of approximately $1,444 from pension and social security checks. She also had approximately $200,000 in the bank from the sale of a farm. Balasko's major expense, approximately $1,139 per month, was the salary for a 24-hour home health aide. Her other expenses includedcar payments and tax obligations. Balasko's life expectancy was uncertain. 10
In August 1990, Stout and Kyle Andrews, who was a registered representative at PaineWebber and a childhood friend of Mark Blevins, met with Balasko and Bruce and Mark Blevins at Balasko's home. 11 During the meeting, Balasko opened an investment account at PaineWebber.
1. Balasko was the sole signatory on the account opening documents. 12 Stout testified at the hearing that Balasko did not grant him discretionary authority to trade in her account and that, prior to purchasing a security, he needed authorization for any account transaction. Stout purchased securities on margin for Balasko's account without obtaining Balasko's express authorization to conduct the margin transactions.
Stout consulted with Bruce or Mark Blevins, rather than Balasko, about matters in Balasko's account. Stout claimed that Balasko executed a "letter of authorization" that granted the brothers authority over her account. However, both Bruce and Mark Blevins contradicted Stout's testimony. They denied that Balasko had granted them authority over her account and could not recall seeing any document granting them such authority. Stout failed to produce the purported authorization letter at the hearing. Moreover, his testimony about the preparation, contents, and execution of the letter was vague. 13
2. Stout testified that Balasko authorized margin trading in 1990 when she signed the Resource Management Agreement upon opening her account. Balasko executed a Resource Management Agreement. However, her purpose in executing this agreement was to obtain check-writing privileges for her account. Stout did not tell Balasko that the agreement contained a provision authorizing the use of margin or that she could delete the margin provision.
Moreover, Stout never explained the concept or the risks of purchasing securities on margin to Balasko. 14 By June 21, 1991, Balasko's account had accumulated a margin debt of $325,318. Approximately two months later, as of August 30, 1991, Balasko's account carried a debit balance of $196,282.92, a sum equal to approximately half of the account's total value, $396,500. As of December 31, 1991, Balasko had paid $15,119.40 in margin interest.
In the spring of 1992, Charles Shemes, the Blevins family accountant, prepared Balasko's 1991 tax return and alerted Bruce Blevins to the high degree of activity in Balasko's PaineWebber account. 15 At that time, Bruce Blevins noticed large payments of interest for "margin," but he did not understand the term. Stout explained the use of margin in Balasko's account when Bruce Blevins raised the issue with him in the spring of 1992. Stout also told Bruce Blevins that the use of margin was profitable despite thepayment of margin interest because the rate of return on the investments was greater than the margin interest rate.
3. Bruce Blevins had told Stout that, because Balasko would be relying on investment income for her living expenses, preservation of principal was an important goal for Balasko's account. Despite Balasko's advanced age, uncertain health, conservative investment objectives, and need for current income, Stout recommended illiquid limited partnerships for Balasko.
Stout also purchased risky mutual funds for Balasko's account. As of February 1992, Balasko's account had invested in the PaineWebber High Income Fund ("PW High Income") and the PaineWebber Equity Trust Special Situation Series 6 ("PW Special Series 6"). PW High Income's prospectus disclosed that the fund invested primarily in high-risk, high-yield corporate bonds and contained a legend in capital letters declaring, "THESE ARE SPECULATIVE SECURITIES." The Division's expert characterized this fund as a speculative "junk" bond fund. The prospectus for PW Special Series 6 disclosed that the fund contained the stocks of many biotechnology and medical technology companies that were relatively young, in the developmental stage, and had not generated earnings or brought their products to market. The prospectus also warned, "[t]he equity markets of these biotechnology and medical technology industries are considered quite volatile."
Balasko always reviewed the net account value when looking at her account statements because she relied on the account to provide her living expenses. In April 1992, Balasko noted a significant drop in the value of her account and became so worried she asked her home health aide to contact Bruce Blevins. 16 Balasko continued to monitor the fluctuations in the account's value closely and grew increasingly worried when the account's net asset value continued to drop through August 1992. 17
4. Stout's trading strategy for Balasko's account resulted in frequent turnover of assets. The Division's expert testified that the average annualized turnover rate in Balasko's account was 11.20.18 The average annualized cost-to-equity ratio for the account was 70%. 19
5. Stout failed to take advantage of favorable commission rates for significant purchases of securities. Balasko paid a sales charge of 5.5% for $49,978 worth of Zweig Strategy Fund on October 31, 1991. A $50,000 purchase would have incurred a sales charge of 5%. The prospectus for the Zweig Strategy Fund indicated that salespersons were granted a higher commission credit for purchases that paid higher sales charges.
B. Wayne and Patty Blevins
Wayne Blevins started Blevins Products in 1957, sold the company to Bruce Blevins in 1985, and retired from the business in 1989 when he was fifty-eight years old. Wayne's wife, Patty Blevins, worked at Blevins Products until her retirement in August 1992, whenshe was approximately sixty-two years old. Wayne Blevins attended high school, but did not graduate. Patty Blevins graduated from high school. Stout did not consider Wayne or Patty Blevins to be sophisticated investors.
1. Wayne Blevins told Stout that he wanted to preserve the principal of both his individual retirement account ("IRA") and the joint account with Patty Blevins. He expected a 6% to 8% rate of return on the investments. Patty Blevins told Stout that she wanted "safe" investments for her IRA and the joint account. Wayne and Patty Blevins moved their joint account and their IRAs from Prudential to PaineWebber in March 1989 in order to retain Stout as their broker.
Stout told Wayne and Patty Blevins that limited partnerships were safe investments that met their investment objectives. On Stout's recommendation, Wayne and Patty Blevins purchased limited partnerships for their accounts. At the time they made their purchases, they did not understand the term "limited partnership."
2. In early January 1992, Stout met with Wayne and Patty Blevins, and provided them with handwritten valuations for the securities in their accounts as of December 31, 1991. 20 Stout reported that the joint account was worth $586,517. Stout told Wayne and Patty Blevins that this sum, combined with the funds in the IRAs, made them millionaires.
Stout claimed that he obtained the valuation information provided to Wayne and Patty Blevins in January 1992 from the general partners of the limited partnerships or from the Direct Investment Group at Prudential. During 1991 and 1992, Prudential reported to the public two types of valuation information on limited partnerships. The limited partnerships provided Prudential with a "fair-market value" for the partnership interests at year-end in accordance with the Employee Retirement Income Security Act of 1974 ("ERISA"). 21 Prudential also reported resale values; the source of those values was commission runs of Prudential salespersons involved in the sale of limited partnership securities in the secondary market.
The figures that Stout supplied significantly exceeded the values Prudential had disseminated for these investments. Stout reported that the aggregate value of the Pru-Tech Research & Development Fund III limited partnership ("Pru-Tech III") units in the joint account was $88,835 as of December 31, 1991. The aggregate ERISA value for the same number of partnership units, as of December 31, 1991, was $42,500 -- a difference of $46,335. The total resalevalue of the Pru-Tech units was $12,500. 22 Stout's values were more than twice the ERISA value and more than seven times the resale value. Stout could not identify any individuals at the limited partnerships or Prudential's Direct Investment Group who he claimed had provided the figures that he used in his valuations. The record does not contain any evidence, other than Stout's unsupported assertion, that he obtained these values from the limited partnerships or the Direct Investment Group.
At the hearing, Stout testified that, by the end of June 1991, he became aware of a pending lawsuit over investments sponsored by VMS Realty Partners and its affiliates ("VMS") and, as a result, "had concerns" that Prudential had provided inaccurate valuation information for the limited partnerships he had recommended to his customers. 23 In fact, Stout had earlier notice of customer dissatisfaction with Prudential limited partnerships. On February 15, 1990, two of Stout's former customers brought a lawsuit against Stout in Michigan state court concerning various limited partnership investments. 24 Moreover, in a memorandum dated July 2, 1991, to a PaineWebber supervisor, Stout stated his "firm" belief that "there was either a massive failure of due diligence or fraud or both in the direct investment department at [Prudential] Bache." Stout did not inform Wayne and Patty Blevins about the problems with Prudential limited partnerships until October 1992. Wayne and Patty Blevins purchased for their IRAs additional shares of the PaineWebber Retirement Money Fund through Stout after January 1992.
C. The Blevins Family Corporations
1. Blevins Products
After graduating from the West Point Military Academy, Bruce Blevins, the oldest son of Wayne and Patty Blevins, served in the military for several years. He thereafter worked at Blevins Products and bought the company from his father on January 1, 1985. InJanuary 1989, Bruce Blevins became the sole trustee for the Blevins Products pension plan and the Blevins Products profit-sharing plan. At Stout's urging, Bruce Blevins moved the plan accounts from Prudential to PaineWebber in March 1989.
a. Bruce Blevins relied on Stout's knowledge, expertise, and training as a broker when making investment decisions for the plan accounts. Bruce Blevins did not have any training in finance or in buying and selling securities. Stout knew that Bruce Blevins relied on his investment advice.
Stout was told that the investment objectives for the plan accounts were to preserve principal and earn a "decent" rate of return. Bruce Blevins did not want to lose any of the money in the plan accounts because the money belonged to the employees of Blevins Products, not to the Blevins family. Based on Stout's representations that limited partnerships were appropriate for the plan accounts' investment objectives, Bruce Blevins purchased numerous limited partnerships for the Blevins Products pension and profit-sharing plans. Bruce Blevins did not reject any of Stout's recommendations except on one occasion when the plan accounts lacked the cash to make a suggested purchase. 25
Stout's trading strategy for the Blevins Products plan accounts resulted in high turnover of the accounts' liquid assets, despite the accounts' conservative investment objectives. For the period from June 1991 through August 1992, the annual average turnover rate in the Blevins Products pension plan account was 5.40. The annual average turnover rate in the profit-sharing plan account, for the same period, was 4.04. The average annualized cost-to-equity ratio for the Blevins Products pension plan account was 24.82%. The profit-sharing plan account had an average annualized cost-to-equity ratio of 18.29%.
b. Stout provided to Charles Shemes, the Blevins' family accountant, valuations for various investments in the plan accounts so that Shemes could prepare the plan accounts' financial statements (for the company and for the individual plan participants) and the Forms 5500, to satisfy an annual filing obligation for pension and profit-sharing plans. Stout knew that Shemes would use the valuations provided to prepare these financial documents.
On October 8, 1991, Stout sent Shemes valuation information as of December 30, 1990 for various limited partnerships for the plan accounts' financial statements and the Forms 5500. Stout provided materially false values in the October 8, 1991 facsimile transmission. Stout valued the plan accounts' investment in Pru-Tech III at $163,456 as of December 31, 1990. However, the ERISA value of Pru-Tech III as of December 31, 1990 was $92,000 -- a difference of $71,456. Prudential further reported that, as of January 8, 1991, there had been a secondary market transaction in Pru-Tech III unitsat $120 per unit. 26 Based on this resale transaction, the Pru-Tech III units in the plan accounts were worth $5,520. Stout's valuations were more than two-thirds higher than the ERISA value and approximately thirty times the resale value.
At the hearing, Stout initially testified that he obtained most of these values from Prudential statements. However, none of the Prudential monthly statements for 1990, including the year-end summary, contained information about the investments that Stout had valued. Moreover, the December 1990 PaineWebber account statements for the pension and the profit-sharing accounts reported that price and value information was "unavailable" on one of the investments for which Stout provided information. None of the remaining investments appeared on the PaineWebber account statements. Later in the hearing, Stout testified that he obtained the valuation information in the October 8 facsimile transmission from Prudential's Direct Investment Group or from the general partner of the limited partnerships, but again could not identify any individuals contacted by him or his staff.
Stout met with the employees of Blevins Products and Extreme Precision in the fall of 1991, after the financial statements for the pension and profit-sharing plans for both companies had been distributed. Stout did not indicate to anyone at that time that he was aware of problems with the limited partnership investments, or that Blevins Products had received overinflated values for those investments. Blevins Products continued to purchase and sell securities on Stout's recommendations after October 1991.
c. Stout repeatedly failed to take advantage of break-points to minimize the cost of trading in the Blevins Products plan accounts and structured orders to increase the amount of commissions that he received. On November 29, 1991, the profit-sharing plan purchased shares of the Zweig Strategy Fund and paid a sales charge of 5.5% on a $30,011.10 purchase. Those shares were sold in January 1992 and replaced with shares of the Kemper U.S. Government Securities Fund ("Kemper"). The profit-sharing plan paid a sales charge of 4.5% on this $32,006.48 purchase. The profit-sharing plan could have avoided the sales charge if Stout had exchanged shares of Zweig Strategy Fund for those in the Zweig Government Securities Fund. Stout testified at the hearing that he had recommended investing in the Kemper Fund because he was more familiar with that fund than the Zweig Government Securities Fund.
2. Extreme Precision
Mark Blevins graduated from high school and attended approximately three semesters at junior college. In 1976, he became the sole owner of Extreme Precision and the sole trustee for Extreme Precision's pension and profit-sharing plans. When Stout changedfirms in 1989, Mark Blevins moved the Extreme Precision pension and profit-sharing accounts to Stout at PaineWebber.
a. Mark Blevins had opened investment accounts for the plan accounts with Stout when Stout was at Merrill Lynch. At that time, Mark Blevins told Stout that the investment objectives for the Extreme Precision accounts were long-term growth and conservation of principal. Although Mark Blevins expressed willingness to speculate with a small portion of his personal funds, he told Stout that he would not speculate with any of Extreme Precision's pension or profit-sharing funds.
Mark Blevins almost always followed Stout's recommendations because the Blevinses considered Stout highly qualified to give investment advice. Mark Blevins also relied on Stout to explain PaineWebber's monthly statements because he had difficulty understanding them.
Mark Blevins purchased limited partnerships for the pension and profit-sharing plans on Stout's recommendations. He also purchased shares in equity and bond funds recommended by Stout. As a result of following Stout's investment advice, Extreme Precision's pension and profit-sharing accounts became heavily concentrated in illiquid and speculative securities. Most of the plan accounts' securities consisted of shares of illiquid limited partnerships. The remaining assets were invested in risky bond funds. 27
b. The investments in Extreme Precision's pension and profit-sharing accounts also turned over frequently, given their investment goals. The average annual turnover rate in the Extreme Precision pension account from June 1991 through August 1992 was 3.94. During the same time period, the average annual turnover rate for the profit-sharing account was 4.77. From June 28, 1991 to August 31, 1992, the average annualized cost-to-equity ratio was 16.16% for the pension plan account and 19% for the profit-sharing plan account.
c. Stout structured mutual fund orders for the Extreme Precision pension plan and profit-sharing plan accounts in order to avoid various discounts offered by those mutual funds. From October through December 1991, the pension and profit-sharing accounts invested $106,775 in the Zweig Strategy Fund. Stout did not deny that Extreme Precision qualified for a "cumulative quantity discount" and could have paid a sales charge of only 4.5% on all of its purchases if Stout had filed a "Letter of Intention" with the fund. 28 Instead, the profit-sharing plan paid a 5% sales charge on a$60,009 purchase, and the pension plan paid a sales charge of 5.5% on a $36,908 purchase. 29
Roger Blevins purchased Borneman in 1983. His formal education ended after graduation from high school. In 1989, Roger Blevins established investment accounts for the Borneman pension and profit-sharing plans with Stout at PaineWebber. As trustee for both accounts, Roger Blevins had the sole authority to buy and sell securities for the Borneman pension and profit-sharing plans.
a. Roger Blevins told Stout that he wanted low- to medium-risk growth in the pension and profit-sharing accounts. Roger Blevins purchased securities for the Borneman accounts based on Stout's recommendations. He did not initiate any investments and always followed Stout's recommendations. Stout's investment strategy for Borneman resulted in frequent turnover of assets and unsuitably high cost-to-equity ratios in Borneman's plan accounts.
The average annual turnover rate, for the period from June 1991 through August 1992, was 3.65 for the pension plan account and 3.44 for the profit-sharing plan account. For the same time period, the average annualized cost-to-equity ratio was 14.43% for the pension plan account and 13.68% for the profit-sharing plan account.
b. Stout also failed to minimize mutual fund sales charges when switching mutual funds in Borneman's plan accounts. Both plans purchased shares of the Zweig Strategy Fund in October 1991 and paid the accompanying sales charge of 5.0%. These purchases were replaced with shares of the Kemper U.S. Government Securities Fund in January 1992. The plans paid a 4.5% sales charge for these securities even though shares of the Zweig Strategy Fund could have been exchanged into the Zweig Government Securities Fund without charge.
* * * * *
In October 1992, Stout met with Wayne, Patty, Bruce and Mark Blevins. 30 At the meeting, Stout disclosed lower valuations for the limited partnerships than he had previously represented. Soon thereafter, Wayne and Patty Blevins, Blevins Products, Extreme Precision and Borneman ceased doing business with Stout.
David and Kathryn Hergenreder
On March 27, 1989, David and Kathryn Hergenreder opened an account at PaineWebber with a $50,000 Certificate of Deposit. 31 At that time, the Hergenreders earned a combined income of approximately $74,000. Their prior investment experience was limited to purchasing a mutual fund from a friend and investing through David Hergenreder's 401(k) program.
Kathryn Hergenreder told Stout "early on" that she did not understand the monthly account statements she received from PaineWebber. David Hergenreder also could not understand the account statements.
A. The Hergenreders told Stout that they were saving money to buy a new house in three to five years and that they were not looking for any "get rich quick" schemes. They wanted to safeguard their money while keeping pace with inflation. The Hergenreders, moreover, were averse to debt. They characterized their lifestyle as "frugal." 32 They did not borrow money to buy cars. They paid off the mortgage on their home in four years and planned to purchase their new home with cash. The Hergenreders did not give Stout discretionary authority to trade securities in their account.
In April 1990, the Hergenreders authorized the purchase of discounted bonds issued by the Government National Mortgage Association ("GNMA"). Stout, however, did not tell the Hergenreders that this initial purchase had been made on margin or obtain their permission to make subsequent purchases of GNMA securities. Stout did not discuss with the Hergenreders the term "margin" or the concept of borrowing money to purchase securities, along with the attendant risks of such a strategy, until after they received amargin call on July 9, 1992. 33 The Hergenreders could not recall authorizing a margin account and discovered at the end of July 1992, when they obtained and reviewed a copy of their margin account form, that the signatures on the form were not theirs.
In a memorandum dated June 4, 1991, a PaineWebber supervisor instructed Stout to review the propriety of the GNMA positions in the Hergenreders' account in light of the Hergenreders' investment objectives. Stout thereafter purchased additional GNMA securities on margin for the Hergenreders' account. As of June 28, 1991, the Hergenreders had an account equity level of 32.7%, which indicated that margin debt comprised more than two thirds of the account's total value. 34
On June 28, 1991, the only other investments in the Hergenreder's account besides the margined GNMA securities were illiquid limited partnerships. 35 Kathryn Hergenreder, however, did not hear the term "limited partnership" until March 1992, when her tax preparer told her that the Hergenreders had invested in limited partnerships. Kathryn Hergenreder testified that, if the Hergenreders had known what limited partnerships were, they would not have purchased them.
B. Stout's trading strategy for the Hergenreders' account also resulted in frequent turnover of assets. The average annualized turnover rate of the Hergenreder's account was 11.84. The annualized cost-to-equity ratio for the account averaged 79.63%.
C. As with his other clients, Stout failed to minimize the costs of trading in the Hergenreders' account. In March 1992, Stout replaced a closed-end mutual fund that had "high current income" as its objective with another closed-end mutual fund with the same objective at a cost of $977 in commissions. He did not discuss with the Hergenreders the purchase or sale of mutual funds, families of funds, varying sales charges for different levels of purchases, or commissions.
A. Philip Hagerman and his father, Dale Hagerman, operated Diplomat Pharmacy until Dale Hagerman retired in 1990 at the age of sixty-two, at which time Philip Hagerman took control of the business. 36 The Hagermans had limited investment experience. They originally opened a trust account at a bank for Diplomat Pharmacy's pension fund. The Hagermans always deferred to the bank's judgment about appropriate investments for the trust. 37 Philip had no other investment experience prior to dealing with Stout.
In 1985, the Hagermans decided to invest Diplomat's pension funds with Stout, a customer of the drugstore, in part because Stout had received favorable publicity for successfully managing pension accounts. In 1989, the Hagermans moved the Diplomat Pharmacy Defined Benefit Pension Trust account ("Pension Trust Account") from Prudential to PaineWebber when Stout switched firms. 38 The Hagermans' goals for the Pension Trust Account were preservation of principal and a 10% to 12% rate of return on the account's investments.
Stout recommended that the Hagermans purchase limited partnerships for the Pension Trust Account and the Hagermans followed his recommendations. Stout did not explain limited partnerships to Philip Hagerman, and at the hearing Philip Hagerman was still unsure of the status and function of limited partnerships.
B. Stout met with the Hagermans approximately every six months and provided them with written valuations for their investments because the Hagermans had difficulty understanding their account statements. The Hagermans relied on Stout's valuations to monitor the progress of the investments and to determine, based on Stout's advice and the performance of the various investments, what investments to make. They continued investing with Stout because Stout's valuations indicated that their investment goals for the Pension Trust Account were being met.
Stout's valuations for the partnerships did not always coincide with the values the Hagermans received from the bank where the trust for Diplomat's pension fund had been formed. 39 When questioned about the discrepancies, Stout told the Hagermans that a bank, unlike a brokerage firm, did not have the most recent or accurate valuation information for the Pension Trust Account investments. 40
In June 1991, during the pendency of a lawsuit over VMS-sponsored investments, in which Stout and Prudential were named as defendants, 41 the Pension Trust Account held shares in the VMS Mortgage Investment Fund. Stout testified that, because the VMS lawsuit caused him to have "concerns" about the accuracy of Prudential's valuations, he checked the accuracy of the limited partnership valuations he had previously provided to the Hagermans. Stout, however, did not inform the Hagermans of these "concerns" even though the Pension Trust Account had invested in a VMS-sponsored investment. Stout's failure to disclose this information deprived the Hagermans of material information relating to the VMS Mortgage Investment Fund, an investment that Stout had recommended.
Stout provided the Hagermans with a valuation statement for the Pension Trust Account as of June 28, 1991, which indicated a $140,000 drop in the value of Pension Trust Account assets from February 22, 1991. 42 Stout attributed the precipitous drop to "better, more accurate pricing" than what he had previously been able to obtain from Prudential's Direct Investment Group or from the general partner of the limited partnerships.
However, Stout's June 28, 1991 figures differed substantially from the figures disseminated by Prudential. In June 1991, Stout valued Diplomat's holdings in the Prudential Realty Acquisition Fund II ("Pru Realty II") at $100,000. Prudential reported the aggregate year-end ERISA value for Pru Realty II, as of December 31, 1990, at $65,700. The total resale value of Pru Realty II, as determined by a resale transaction that occurred on December 20, 1990, was $20,000. The December 20, 1990 transaction, at $200 per unit, occurred closest in time to June 1991. Stout's valuation exceeded the ERISA value of Pru Realty II by $34,300 and the total resale value by $80,000. The Hagermans immediately sought legal advice after reviewing the June 1991 valuations and ceased doing business with Stout.
The antifraud provisions of the securities laws prohibit employing a scheme to defraud, or any act, practice or course of business that operates as a fraud or deceit in connection with the offer, sale or purchase of a security. 43
A. False Valuations
Stout violated the antifraud provisions of the securities laws by misleading clients about the profitability of their accounts. 44 He knew that his clients relied on his valuations to monitor the progress of their investments and to make investment decisions. The customers continued to invest with Stout because of the purported success of their investments. During the relevant time period, however, Stout's valuations consistently and materially exceeded the values Prudential reported for the same investments. Stout could not identify any individuals that he or members of his staff had contacted at either Prudential or the limited partnerships regarding the value of the partnerships. In light of this failure and the wide and unexplained disparity between Stout's figures and the ERISA and resale values for the same partnerships, we reject Stout's claim thathe obtained his valuation information from Prudential or the limited partnerships.
Stout willfully provided materially false valuations to Diplomat Pharmacy, Blevins Products, and Wayne and Patty Blevins, giving them inflated values for their limited partnership investments. Blevins Products and Wayne and Patty Blevins purchased additional securities for their investment accounts after they received the false valuations from Stout. 45
Stout argues that the law judge erroneously ignored Prudential's presentation of falsely optimistic valuations in the account statements Prudential sent to its customers. Even if values provided by Prudential were inflated, Stout's valuations exceeded the ERISA and resale values reported by Prudential during the relevant time period. Stout cannot claim reliance on Prudential's values because his figures materially exceeded them.
B. Unauthorized Trading
The Order Instituting Proceedings ("OIP") alleged that Stout made unauthorized purchases of securities on margin in his customers' accounts. "Purchasing securities on margin in customer accounts without customer approval violates the anti-fraud provisions of thesecurities laws." 46 The record contains ample evidence that Stoutmade unauthorized trades on margin for Balasko and the Hergenreders.
Stout admits that he did not seek Balasko's approval before he made trades in her account. Although Stout claimed that an authorization letter provided Bruce and Mark Blevins with authority over the account, Stout did not produce the letter at the hearing and could not recall ever seeing such a letter or any details of the letter's contents. Bruce and Mark Blevins testified that they had never been given any authority over Balasko's account. We reject Stout's contention that Bruce and Mark Blevins had authorization to make decisions for Balasko's account.
The Hergenreders did not authorize the use of margin in their account. The Hergenreders did not sign the margin agreement that purportedly authorized margin trading in their account. Although the Hergenreders approved the purchase of GNMA securities in April 1990, Stout made the purchase on margin without obtaining the Hergenreders' permission to engage in margin transactions. Stout thereafter purchased additional GNMA securities on margin without the Hergenreders' authorization. The Hergenreders did not realize that Stout had purchased securities on margin for their account until they received a margin call in July 1992.
C. Unsuitable Recommendations
As part of a broker's basic obligation to deal fairly with customers, a broker's recommendation must be suitable for the client in light of the client's investment objectives, as determined by the client's financial situation and needs. 47 We have previously stated that "stock recommendations made in disregard of an investor's professed investment objectives violate the antifraud provisions, when they are coupled . . . with false representations that the recommended securities meet those objectives." 48
Stout recommended trades in many of these accounts. The customers followed his recommendations because Stout had established long-term relationships with the customers that caused them to trust Stout's judgments. In the case of Balasko and the Hergenreders, Stout simply placed orders for their accounts without authority.
Balasko was seventy-one years old and recovering from a debilitating stroke when Bruce Blevins approached Stout about opening an investment account for his great-aunt. Balasko received a fixed income from social security and pension checks. She also had received approximately $200,000 from the sale of her farm. She relied on investment income to cover her living expenses, including 24-hour home health care. Her prognosis was uncertain. Despite Balasko's clear need for income and liquid investments that could readily be converted into cash, Stout purchased illiquid limited partnership securities for Balasko's account. 49
Stout also risked the principal in Balasko's account by pursuing aggressive and risky trading strategies despite Balasko's necessity for conservative investments. Stout engaged in margin trading without explaining the concept or risks of margin trading to Balasko. He traded the securities in the account so that the assets turned over 11.20 times in one year, an extremely high rate of activity. 50 Balasko's account would have had to increase 70% to break even. Cost-to-equity ratios exceeding 38% have been found toindicate excessive trading. 51 Stout failed to minimize sales charges when purchasing mutual funds and purchased risky mutual funds for Balasko's account.
Wayne Blevins was fifty-eight years old when he retired in 1989, and Patty Blevins was sixty-two years old when she retired in 1991. Despite their clear need for liquid investments that could readily be converted to cash in the event they required additional retirement income, Stout purchased limited partnerships for the Blevinses.
The Blevins brothers, Bruce, Mark, and Roger, all expressed conservative investment objectives for their businesses' pension and profit-sharing plan accounts. The funds in these accounts belonged to the employees of the Blevins family corporations, not to the Blevins family. Even though the pension accounts required liquid investments so that retirees could withdraw their funds, Stout recommended illiquid limited partnerships for all of the plan accounts. Stout also recommended risky mutual funds, aggressively and excessively traded securities in the accounts, and failed to minimize sales charges for mutual fund purchases.
The Hergenreders lived a frugal lifestyle and avoided debt. They were saving money to purchase a new home and wanted to safeguard their funds while keeping pace with inflation. Despite these conservative investment objectives and the Hergenreders' need for cash to purchase a new home, Stout purchased illiquid limited partnerships for the Hergenreders' account. Stout also purchased securities on margin for the Hergenreders' account despite their debt-averse profile. The transaction costs associated with Stout's trading strategy were so high that the Hergenreders' investments required an average annualized return of 79.63% just to break even.
Stout acted with scienter. Stout testified that he was aware that he had an obligation to understand his clients' investment objectives, willingness to accept risk, knowledge of securities and securities markets, and financial status. He further admitted that he understood that he was required to manage clients' accounts in conformity with their investment objectives. His conduct with respect to these accounts demonstrates that he recklessly circumvented these responsibilities.
In light of the foregoing, we conclude that Stout made unsuitable recommendations for the accounts held by Balasko, Blevins Products, Extreme Precision, Borneman, Wayne and Patty Blevins, and the Hergenreders. 52
Stout appears to claim that he is not culpable for the frequency of trading in his clients' accounts because the trades he effected were in accordance with recommendations by PaineWebber. Stout was the registered representative on most of these accounts and the "advisor" on Balasko's account. He could not make a particular recommendation from a PaineWebber trading desk without assessing whether it was suitable for his client. Stout cannot excuse his failure to conduct this inquiry by claiming that he blindly relied on his firm's recommendations. 53
The annualized turnover ratios in Stout's client accounts ranged from 3.44 to 11.84. We have previously stated that in assessing the suitability of trading activity, there is no "magical per annum percentage" measure of trading, however calculated, thatconclusively indicates whether excessive trading occurred. 54 The trading must be examined in light of the investment objectives of the customer. 55 The turnover in these customer accounts, particularly in light of the high cost-to-equity ratios, was unsuitable given the investment goals and needs of Stout's customers. 56
The law judge concluded that Stout churned certain customer accounts. Stout objects that the OIP alleged that he made unsuitable recommendations to his clients, without making any reference to churning. While excessive trading in a customer account can violate suitability standards as discussed above, excessive trading is not synonymous with churning. 57 Churning occurs when trading in an account is excessive in light of the client's investment objectives, the broker exercises control over the account, and the broker acts with the intent to defraud or with reckless disregard for the client's interests. 58 Since the OIP did not charge Stout with churning and was never amended during the proceeding, we set aside the law judge's finding that Stout churned customer accounts.
Stout argues that the statute of limitations in Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996) bars the "inclusion of all references to activities prior to June 1991." Stout further contends that the law judge's references to pre-June 1991 activities were not incidental and were the focus of the entire proceeding.
In Johnson, the United States Court of Appeals for the District of Columbia Circuit held that the five-year statute of limitations in 28 U.S.C. § 2462 prohibited the Commission from imposing a censure or a suspension on a securities industry supervisor where the entirety of the supervisor's allegedly wrongful conduct occurred five years prior to the commencement of administrative proceedings against her. The Johnson case does not preclude any and all references to relevant conduct that occurs outside of the statutory period.
The Commission and the law judge may consider events outside the limitations period, where relevant, to provide context for the violations or to establish the respondent's motive, intent, or knowledge concerning the commission of violations within the limitations period. 59 Stout's relationships with the customers whose accounts are at issue here began well before June 1991. Furthermore, although Stout provided false valuations to his customers after June 1991, Stout's customers had purchased the investments before then, and those investments had been declining in value. The law judge appropriately referred to Stout's pre-June 1991 conduct to provide context and background for the misconduct alleged in the OIP and to determine Stout's intent and knowledge during the commission of the securities law violations within the statutory period.
Based on the foregoing, we conclude that Stout willfully violated Securities Act 17(a) and Exchange Act Section 10(b) and Exchange Act Rule 10b-5. Section 15(b) of the Exchange Act provides the Commission with authority to impose appropriate sanctions against a person associated with a broker-dealer who, among other things, willfully violates any provision of the Securities Act or the Exchange Act. 60 Agencies have substantial discretion in assessing administrative sanctions. 61 In determining whether administrative sanctions serve the public interest, we are guided by the following factors: the egregiousness of a respondent's actions, the isolatedor recurrent nature of the violation, the degree of scienter, the sincerity of a respondent's assurances against future violations, the respondent's recognition that the conduct was wrongful, and the likelihood of recurring violations. 62 Exchange Act Section 21C further authorizes the Commission to impose a cease-and-desist order if it finds that any person has violated or caused violations of the Act. 63
Stout argues that the law judge erred in barring him from association with any broker or dealer. Stout points to the lack of customer complaints in the years since his departure from PaineWebber as support for not imposing a bar. Stout contends that his post-PaineWebber association with World Invest Corporation and Centennial Capital Management have been without incident.
However, Stout's misconduct here was egregious and neither isolated nor insignificant. Over a substantial period of time, he engaged in various types of sales practice misconduct, including unauthorized trading, unsuitable and excessive trading in ten customer accounts, improper mutual fund transactions, and provided false valuations to customers. Many customers did not understand their account statements and relied upon Stout to keep them apprised of the progress of their investments.
We find Stout's conduct in the Balasko account particularly egregious. Balasko, an elderly client who had been partially paralyzed by a stroke, relied on the investment income from her account to cover her living expenses, which included the salary for a 24-hour home health aide. Stout made unauthorized purchases of securities on margin for a client who thought she was merely obtaining check-writing privileges. He did not explain the concept or risks of margin trading to her. He traded her account excessively and purchased risky and illiquid investments for an elderly woman who needed income.
Moreover, Stout acted with a high degree of scienter in committing his violations of the securities laws. By June 1991, Stout knew that he had provided inaccurate valuations to his clients. Stout not only failed promptly to inform his clients of this fact, he presented his clients with valuations substantially more optimistic than those provided by Prudential. Stout also willfully engaged in unauthorized margin trading in customer accounts. Stout's denial that he engaged in unauthorized margin trading lacked credibility and was contradicted by other, more credible evidence in the record. The record indicates that Stout repeatedly disregarded his clients' interests.
Stout has also steadfastly denied the wrongfulness of his conduct and continues to blame Prudential and PaineWebber for his clients' ills. We also note that Stout has continued to participate in the securities industry by associating with World Invest Corporation and Centennial Capital Management after his departure from PaineWebber. 64
In light of these circumstances, we conclude that Stout poses a high risk of future securities law violations. The law judge properly barred Stout from association with any broker or dealer. The sanctions imposed on Stout included a civil money penalty of $300,000. The law judge determined that Stout's misconduct merited third-tier penalties because his violations involved deceit and resulted in Stout's pecuniary gain. The law judge further determined that Stout's dealings with Lottie Balasko, the Blevins family companies, and the Hergenreders
constituted separate courses of action and assessed the maximum $100,000 penalty for each course of conduct. We agree with the
law judge's reasoning and determine to impose a $300,000 civil monetary penalty. We further conclude that, in order to protect the public interest, Stout should be ordered to cease and desist
from future violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Exchange Act Rule 10b-5.
An appropriate order will issue. 65
By the Commission (Chairman LEVITT and Commissioners HUNT, CAREY and UNGER).
Jonathan G. Katz
UNITED STATES OF AMERICA
SECURITIES EXCHANGE ACT OF 1934
Admin. Proc. File No. 3-9034
In the Matter of
J. STEPHEN STOUT
ORDER IMPOSING SANCTIONS
On the basis of the Commission's opinion issued this day, it is
ORDERED that J. Stephen Stout be, and he hereby is, barred from association with any broker or dealer; and it is further
ORDERED that J. Stephen Stout cease and desist from committing or causing any violation of or future violation of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5; and it is further
ORDERED that, within 30 days of the entry of this order, Stout shall pay a civil money penalty in the amount of $300,000. Such payment shall be (i) made by United States postal money order, certified check, bank cashier's check, or bank money order made payable to the Securities and Exchange Commission; (ii) hand-delivered or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, Virginia 22312; and (iii) submitted under cover letter which identifies Stout as the respondent in this proceeding, and gives the file number of this proceeding. A copy of the cover letter and check shall be sent to Gregory P. von Schaumburg, counsel for the Division of Enforcement, Securities and Exchange Commission, Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661-2511.
By the Commission.
Jonathan G. Katz
1 The Order Instituting Proceedings also named Alfred M. Bauer as a respondent. Bauer settled the charges against him. Alfred M. Bauer, Securities Exchange Act Rel. No. 37821 (Oct. 15, 1996), 63 SEC Docket 40.
2 15 U.S.C. § 77q.
3 15 U.S.C. § 78j.
4 17 C.F.R. § 240.10b-5.
5 The allegations in the Order Instituting Proceedings relate to Stout's conduct from June 1991 until at least April 1992.
6 At Prudential, the term "direct investment" was used interchangeably with limited partnership.
7 Stout began his career in the securities industry at Merrill Lynch, where he was employed as a registered representative from June 1977 through April 1982.
8 Between June 1991 and October 1992, the Blevins family corporations were owned and operated by Wayne and Patty Blevins' sons. Bruce Blevins owned and operated Blevins Products, Mark Blevins owned and operated Extreme Precision, and Roger Blevins owned and operated Borneman.
9 Balasko's home health aide, who lived with Balasko from 1990 to 1993, testified that Balasko's everyday vocabulary consisted of three words. Balasko could say other words only after concentrating heavily for an extended period of time.
10 Balasko died in February 1993.
11 Although Andrews was Balasko's designated account executive, Stout acted as the "investment advisor" for Balasko's account. Andrews did not take any action in the account without consulting Stout, and they split the commissions.
12 As discussed below, Balasko executed a Resource Management Agreement so that she could have check-writing privileges on her account. She did not realize that the agreement authorized the use of margin. See Section II.A.2 infra.
13 Stout testified, "[t]he letter of authorization, as I stated, like the trust documents that we looked at yesterday, all of those were things that were back office requirements. If we told somebody that it needed to be done and then the trading went on that way, then the documents would be there in the office that would support that. . . . I knew there was authorization." Stout claimed at the hearing that although he couldn't remember specifically, "[s]omeone in our office, oneof the sales assistants" prepared the letter of authorization and would have sent it to Balasko.
14 Stout claimed that Mark Blevins explained the risks of purchasing securities on margin to Balasko at a February 1991 meeting, at which Stout, Andrews, and Bruce Blevins were also present. The law judge found Stout's claim not credible and we find no basis in the record to disagree. The credibility determinations of the fact-finder are entitled to significant weight and deference, and will be rejected only where there is substantial evidence in the record for doing so. Martin R. Kaiden, Exchange Rel. No. 41629 (Jul. 20, 1999), 70 SEC Docket 439, 450 and n.32.
Stout's claim was contradicted by Bruce and Mark Blevins' testimony. Furthermore, Stout had initially testified at the hearing that he could not recall the details of the February 1991 meeting.
15 Shemes told Bruce Blevins that Balasko's account went from zero sales of securities in 1990 to approximately fifty to sixty sales and purchases of securities in 1991.
16 The account dropped from a value of $200,622.70 as of February 28, 1992, to $181,256.55 as of March 31, 1992.
17 Balasko's net account value as of August 31, 1992, was $160,336.01.
18 The Division's expert testified that turnover rate is a measure of the level of activity in an account. The expert suggested as a "rule of thumb" that "a turnover rate of two may be considered suggestive of excessive trading for a conservative investor. A turnover rate of four may be considered presumptive of excessive trading for a conservative investor, and a turnover rate of six may be considered conclusive of excessive trading for a conservative investor."
The Division's expert also explained that she excluded the limited partnerships from the turnover calculations because of their illiquidity, and that this was a standard practice in the industry. Stout did not present any expert testimony that countered the testimony given by the Division's expert.
Stout now argues that the turnover ratios were incorrectly calculated, but does not identify the investments that he claims were not included in the calculations. He also contends that "funds added" to various accounts could have skewed the ratios. We understand Stout to complain that the turnover ratio did not consider subsequent deposits to the customers' accounts. However, the expert testified that she calculated turnover by dividing total purchases by average account equity and then annualized the result. This calculation would have accounted for any additional deposits.
19 The cost-to-equity ratio measures the total return that an account must earn in order to break even after paying commissions and other expenses. Rafael Pinchas, Exchange Act Rel. No. 41816 (Sep. 1, 1999), 70 SEC Docket 1516, 1524.
20 Stout met with Wayne and Patty Blevins at least once a year to go over their accounts because they had difficulty understanding the account statements.
21 29 U.S.C. § 1001 et seq.
22 The resale transaction for Pru-Tech III closest in time to December 31, 1991 occurred on August 8, 1991 for $250 per unit.
23 See In Re: VMS Securities Litig., 145 F.R.D. 458 (N.D. Ill. Feb. 20, 1992). Stout, along with Prudential, was named as a defendant in this class action lawsuit.
24 The customers' complaint alleged securities fraud under state law, negligence, breach of fiduciary duty, and intentional misrepresentations with respect to the customers' investments in the Prudential-Bache Strategic Income Fund, Prudential-Bache Diversified Futures Funds, VMS Mortgage Investment Fund, and Southwest Financial Series 54 Collateralized Mortgage Obligations. See Sharp v. Stout, 1997 U.S. Dist. LEXIS 18666 at *3 (N.D. Ill. Nov. 6, 1997).
25 Bruce also initiated some purchases for the plan accounts.
26 The January 8, 1991 resale transaction occurred closest in time to December 31, 1990.
27 For example, at the end of September 1991, Extreme Precision's pension account funds were invested in limited partnerships and PW High Income, a high-risk, high-yield corporate bond fund.
28 According to the prospectus for the Zweig Strategy Fund, aLetter of Intention permits investors to aggregate their purchases over a 13-month period to qualify for reduced sales charges. Purchases made within 90 days prior to the filing of a Letter of Intention also qualify for aggregation. A Letter of Intention does not obligate the investor to purchase securities. Investments greater than $100,000 but less than $250,000 qualified for a sales charge of 4.5%.
29 Both plans made other small purchases of the Zweig Strategy Fund at a sales charge of 5.5%.
30 Kyle Andrews and an attorney who had apparently been brought to the meeting by Stout and Andrews also attended.
31 The Hergenreders learned about the investment opportunity from a newspaper advertisement. Since the Hergenreders were "walk-ins," all three salesmen in PaineWebber's Flint office (Stout, Andrews, and Tom Curtis) shared the commissions in the account. The Hergenreders dealt exclusively with Stout.
32 Kathryn Hergenreder described herself as "very cheap" and testified that the Hergenreders bought used furniture and purchased clothes at rummage sales.
33 The law judge found that Stout's claim that he explained the risks of margin trading to David Hergenreder in 1989 was not credible. The record contains ample support for the law judge's conclusion. The Hergenreders consistently testified that Stout did not discuss the concept of margin until after they received the July 1992 margin call. Stout initially testified that he could not recall any specific conversation with the Hergenreders about margin trading. Later, after the Hergenreders had finished giving their testimony, Stout testified to conversations with David Hergenreder in 1989 and 1991 in great detail. The Hergenreders' lifestyle and careful avoidance of debt further supports the conclusion that they would not have knowingly authorized margin trading.
34 The total account value of the Hergenreders' account as of June 28, 1991 was $262,902.43. The debit balance at that time was $176,264.95.
35 The limited partnerships comprised 24.81% of the account's assets; the GNMA securities constituted 75.19% of the account's assets.
36 Philip Hagerman's formal education concluded with a degree in pharmacy.
37 The bank invested the pension's funds in conservative instruments earning a return of slightly less than 10%.
38 The PaineWebber account opening documents named the trust, which had been created at the Genesee Bank, as the client, and Dale and Philip Hagerman as trustees for the account. Genesee Bank apparently received monthly statements from PaineWebber. Statements for the Pension Trust Account were addressed to the trust at Genesee Bank, to the attention of a person in the trust department.
39 The record does not indicate where the bank obtained its valuation information. But see n.38.
40 Stout also told the Hagermans that they could not track the Pension Trust Account investments in newspapers. The Hagermans later discovered that at least one of the investments was listed in the newspaper.
41 See n.23 and accompanying text.
42 The February 22, 1991 valuation statement indicated a total value of $661,874.72 for the Pension Trust Account assets. That figure had dropped to $519,315.34 as of June 28, 1991.
43 See 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 Exchange Act Rule 10b-5, 17 C.F.R. § 240.10b-5.
44 Laurie Jones Canady, Exchange Act Rel. No. 41250 (April 5, 1999), 69 SEC Docket 1468, 1480. See also Albert Vincent O'Neal, 51 SEC 1128, 1131-32 (1994) (salespersons violated the antifraud provisions of the securities laws by providing customers with misleading computer printouts that listed market values as positives when in fact they were liabilities); Robert F. Lynch, 46 S.E.C. 5, 7 (1975) (president and director of mutual fund's management company violated the antifraud provisions of the securities laws by overvaluing the fund's net asset value).
45 Diplomat Pharmacy immediately ceased investing with Stout after receiving the June 28, 1991 valuation statement. Thus, we do not find that Stout's misrepresentations as to the value of the Pension Trust Account assets were made in connection with the purchase or sale of securities. We do, however, believe this evidence to be probative of Stout's practices, as it further supports the testimony of the Blevins family regarding Stout's conduct.
46 SEC v. Hasho, 784 F.Supp. 1059, 1110 (S.D.N.Y. 1992). See also Messer v. E.F. Hutton & Co., 847 F.2d 673, 679 (11th Cir. 1988) (unauthorized trading violates the antifraud provision of the Exchange Act when accompanied by an intent to defraud or a willful and reckless disregard of the client's best interests); Canady, 69 SEC Docket at 1484
(salesperson violated the antifraud provisions of the securities laws by engaging in unauthorized trading).
47 Donald T. Sheldon, 51 S.E.C. 59, 74 n.59 (1992) ("[T]he broker has a duty to satisfy himself that speculative investments are suitable for the customer and that the customer understands and is willing to undertake the risks."), aff'd, 45 F.3d 1515 (11th Cir. 1995); Richard N. Cea, 44 S.E.C. 8, 18 (1969) (holding that salesman's basic obligation to deal fairly with customers includes obligation to make suitable recommendations).
48 Martin Herer Engelman, 52 S.E.C. 271, 283 n.40 (1995), aff'd, 87 F.3d 1319 (9th Cir. 1996) (Table). See also Joseph J. Barbato, Exchange Act Release No. 41034 (Feb. 10, 1999), 69 SECDocket 178, 193 (same).
49 As the expert for the Division explained, limited partnerships lack liquidity. The lack of liquidity can create problems for investors because illiquid securities cannot be sold, or sold at a price fairly related to their market value, in response to developing market conditions, including problems with the issuer, or economic or fiscal events. Moreover, if the investor requires liquidity to deal with an emergency, the limited partnership interest cannot readily be sold to meet that need.
50 The annual turnover rate is the number of times during a year that securities in an account are replaced by new securities. Shearson Lehman Hutton, Inc., 49 S.E.C. 1119, 1122 (1989). See also Michael H. Hume, 52 S.E.C. 243, 245 n.4 (1995); Frederick C. Heller, 51 S.E.C. 275, 279 (1993) (explaining turnover rate as "'the ratio of total cost of purchases made for the account during a given period of time to the amount invested'")(citing Hecht v. Harris Upham & Co., 283 F. Supp. 417, 435 (N.D. Cal. 1968)); Looper & Co., 38 S.E.C. 294, 297 (1958).
51 See e.g. Joseph J. Barbato, 69 SEC Docket at 195.
52 Stout argues that the law judge's reference to limited partnerships as "illiquid and speculative" was "totallyinappropriate, prejudicial and beyond statute [sic] of limitations." It appears that Stout relies on earlier marketing material provided by Prudential and PaineWebber that characterized these investments as safe and "with a secondary market."
We agree with the opinion of the Division's expert that limited partnerships generally lack liquidity. The Division's expert further testified that she considered the total mix of assets when assessing the suitability of Stout's recommendations at issue here. Stout's recommendation of limited partnerships as suitable for his customers reduced the availability of liquid funds for his customers' use. Stout's recommendation of risky bond funds was also unsuitable for investors seeking preservation of capital and relatively low risk. We have reviewed Stout's recommendations and conclude, for the reasons discussed above, that they were unsuitable for these customers. See n.47.
53 Walker v. SEC, 383 F.2d 344, 345 (2d Cir. 1967) (holding that a salesman "cannot avoid his duty to the public by blindly relying on his employer's brochures."); Susan Justine Fischer, 53 S.E.C. 775 (1998) (concluding that fact that representative's firm recommended a particular investment in general did not relieve representative of obligation to determine that investment was suitable for her customers.) See also Berko v. SEC, 316 F.2d 137, 142 (2d Cir. 1963) (holding that salesman improperly relied on firm's fraudulent sales literature where salesman could have determined that literature was deceptive and misleading).
54 Gerald E. Donnelly, 52 S.E.C. 600, 602-03 (1996).
55 Mihara, 619 F.2d at 821. The court also observed that there is "no clear line of demarcation" where trading becomes excessive.
56 We have found turnover ratios similar to or lower than those in evidence here to be indicative of excessive and unsuitable trading. See Donald A. Roche, Exchange Act Rel. No. 38742 (June 17, 1997), 64 SEC Docket 2042, 2047 (finding annualized turnover rate of 3.3 to be excessive); Donnelly, 52 S.E.C. at 602 n.11 (finding annualized turnover ratios between 3.1 and 3.8 to be excessive); Samuel B. Franklin & Company, 42 S.E.C. 325, 330 (1964) (finding turnover rates of 3.5 and 4.4 to be excessive).
57 Roche, 64 SEC Docket at 2048; Albert Vincent O'Neal, 51 S.E.C. 1128, 1130 n.8 (1994).
58 Hotmar v. Lowell H. Listrom & Co., 808 F.2d 1384, 1385 (10th Cir. 1987); Miley v. Oppenheimer & Co., 637 F.2d 318, 324 (5th Cir. 1981); Mihara v. Dean Witter & Co., 619 F.2d 814, 821 (9th Cir. 1980).
59 Terry T. Steen, Exchange Act Rel. No. 8798 (June 2, 1998), 67 SEC Docket 837, 843.
60 15 U.S.C. § 78o(b).
61 Butz v. Glover Livestock Commission Co., Inc., 411 U.S. 182, 187-88 (1973).
62 Sheldon, 51 S.E.C. at 86, quoting from Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd, 450 U.S. 91 (1981).
63 15 U.S.C. § 78u-3.
64 After Stout left PaineWebber in 1992, he formed Partnership Arbitration to assist former Prudential investors, who had purchased limited partnerships, file arbitration claims against the firm. Partnership Arbitration required all claimants, including Stout's former clients, to sign retainer agreements waiving any conflict of interest and to sign letters exonerating Prudential brokers from any wrongdoing. Stout used an alias when soliciting clients for Partnership Arbitration and hired a third party to sign statements of claim in order to hide his involvement with the company.
65 We have considered all of the arguments advanced by the parties. We reject or sustain them to the extent that they are inconsistent or in accord with the views expressed herein.