SECURITIES AND EXCHANGE COMMISSION
In the Matter of
OPINION OF THE COMMISSION
Ground for Remedial Action
Alleged Fraudulent Markups
Registered broker-dealer and its registered principals allegedly charged fraudulent markups in retail transactions. Held, allegations have not been established and, accordingly, proceeding is dismissed.
Roger A. Tolins, of Tolins & Lowenfels, for D.E. Wine Investments, Inc., W. Randal Miller, and Duncan E. Wine.
Phillip W. Offill, Jr. and Karen L. Cook, for the Division of Enforcement.
Appeal filed: July 1, 1999
Last brief received: October 5, 1999
D.E. Wine Investments, Inc., a registered broker-dealer, ("DEW" or the "Firm"), and W. Randal Miller and Duncan E. Wine, each of whom was a registered principal of the Firm, (collectively, the "Respondents") appeal from an administrative law judge's decision. 1 The law judge found that the Respondents charged retail customers fraudulent markups in 1992 and 1993. Although the Respondents also were alleged to have charged fraudulent markdowns, the law judge found that the evidence did not establish that charge.
The law judge found that the Respondents willfully violated Section 17(a) of the Securities Act of 1933, 2 and Section 10(b) of the Securities Exchange Act of 1934 3 and Rule 10b-5 thereunder. 4 The law judge also found that the Firm willfully violated Section 15(c)(1) of the Exchange Act 5 and Rule 15c1-2 thereunder, 6 and that Miller and Wine willfully aided and abetted these violations. 7
The Respondents seek reversal of the law judge's decision. To the extent that we make findings in this opinion, we base them on anindependent review of the record, except with respect to those findings made by the law judge that are not challenged on appeal. 8
This case concerns the actions of the Respondents with respect to the pricing of the following securities (hereinafter the "Securities") purchased from and sold to DEW's retail customers between December 1992 and July 1993: the common stock of Dynacq International, Inc. and of Market Data Corporation, and the warrants of First National Film, Inc. Based largely on facts that are not in dispute, a law judge found that, in setting prices for the Securities, the Respondents were responsible for charging their customers undisclosed, excessive markups and markdowns, and that, in doing so, they violated the antifraud provisions of the securities laws. 9 On appeal of that decision, we remanded for further factual findings and a revised analysis. 10 This appeal is from the opinion on remand.
The parties agreed, and the law judge found, that during
the period at issue the Firm was a market maker in the Securities and the market for each of the Securities was active and competitive. 11 Based on these premises, the law judge on remand calculated the prevailing market price for most of the trades at issue (on the basis of which the markup or markdown is in turn calculated) by looking to the most contemporaneous appropriate transaction in the relevant security that occurred between a market maker and a non-market maker,without considering other interdealer transactions that occurred closer in time to the retail trades in question. 12 Where markups were at issue, the law judge compared the retail price to a sale from a market maker to a non-market maker. Where markdowns were at issue, she compared the retail price to a purchase by a market maker from a non-market maker. In eight instances, where more than three business days separated the retail transaction from the closest appropriate trade between a market maker and a non-market maker, 13 the law judge considered whether a more contemporaneous interdealer trade that was not between a market maker and a non-market maker was better evidence of the prevailing market price. In five of those instances, where seven or more business days separated the closest appropriate trade between a market maker and a non-market maker from the retail trade at issue, she used a transaction between two market makers to establish the prevailing market price. Finally, where the parties did not agree whether the interdealer trades on a particular date were principal or agency transactions, the law judge found that the record did not contain enough evidence to determine the prevailing market price.
Having thus determined the prevailing market price applicable to each retail trade, the law judge concluded that markups and markdowns that exceeded 5% were fraudulent. Using this approach, she concluded that DEW charged retail customers markups ranging from 5.55% to 36.96% in thirty-six transactions, with the amount of illegal markups totaling $11,054.94. 14
The Respondents do not dispute that charging undisclosed, excessive markups can, under certain circumstances, violate the antifraud provisions of the securities laws. They deny, however, that they charged such markups here. They claim that the law judge'smethod of determining the prevailing market price, from which their markups were calculated, was invalid. The Respondents also contend that the law judge erred in applying a 5% standard for determining whether a given markup was fraudulent. The Division also questions the validity of portions of the law judge's analysis. While the Division agrees with the law judge's ultimate conclusion that the Respondents charged fraudulent markups, it contends that such markups were charged in many more retail trades than the law judge found. The Division contends that the law judge made findings sufficient to support the conclusion that markups between 5% and 10% were fraudulent in this case, although the Division made no such allegation in its complaint, and it recognizes that it did not argue or urge that conclusion in its prior briefing.
In our opinion remanding this case, we set forth principles generally applicable to the calculation of markups by market makers in active, competitive markets. We did not consider in detail the particular transactions at issue, leaving that for the law judge on remand. In reviewing the opinion now before us, we note that the law judge attempted to adhere carefully to the principles we had laid out. But the application of those principles to the facts of this case raises issues not fully addressed in our prior opinion. Further refinement of those principles is therefore necessary.
It is well recognized that undisclosed markups on sales to retail customers can violate the antifraud provisions of the securities laws if they are not reasonably related to the prevailing market price and if such markups are charged with scienter. 15 It also has been recognized that, at the least, markups on equity securities of more than 10% generally are fraudulent. 16
We now turn to the appropriate method for calculating markups, considering the facts of this case. As we have repeatedly held, a market maker in an active, competitive market, like DEW, is entitled to base its retail prices on the interdealer prices it and other market makers charge or pay non-market maker dealers in contemporaneous trades. 17 Retail markups must be reasonablyrelated to the price market makers are contemporaneously charging non-market makers to buy the relevant security. 18 Other interdealer transactions may be used to establish the prevailing market price if there are no contemporaneous transactions between market makers and non-market makers. 19
A market maker usually purchases stock from non-market makers at or around its bid, and sells to non-market makers at or around itsasked or offering price. 20 It is the transaction, however, not the quotation, that establishes the prevailing market price.
Thus, our prior cases reflect two general principles applicable to determining the prevailing market price in cases involving market makers in active, competitive markets. First, appropriate trades between market makers and non-market makers are generally better evidence of the prevailing market price than are other interdealer trades. Second, the closer in time an interdealer transaction is to a particular retail trade, the better evidence of the prevailing market price the interdealer transaction is likely to be.
These principles cannot, however, be applied mechanically. In some instances, the evidence, including quotations as well as transactions, may indicate that the market is changing. Under those circumstances, a close-in-time trade between two market makers may be better evidence of the prevailing market price than a more remote trade between a market maker and a non-market maker. In other instances, a transaction between a market maker and a non-market maker may be at a price so aberrant -- so far away from the quotation that it would ordinarily track -- that it cannot truly be said toreflect the market. 21 Thus, all the available evidence must be considered to determine the prevailing market price.
Based on the foregoing discussion, we conclude that the law judge's analysis, while generally faithful to the principles set forth in our prior opinion in this case, is in some respects inconsistent with our prior holdings in other cases. In determining the prevailing market price, the law judge gave too much weight to the fact that certain trades were between market makers and non-market makers, even if they were at prices that seem aberrational, and too little consideration to interdealer trades that were not between market makers and non-market makers that were closer in time to particular retail trades or may have more accurately indicated the prevailing market price for other reasons.
For example, the law judge found that a June 14 sale of 400 shares of Market Data Corporation stock by the Firm to a non-market maker at $1.25 per share was the best indicator of the prevailing market price against which the reasonableness of markups in retail sales on June 14 and 15 should be measured. Using $1.25 per share as the prevailing market price, she determined that four retail customers were charged markups ranging from 21.4% to 27.7%. We find, however, that the June 14 sale on which the law judge relied was not a reliable measure of the market because it was at the bid side of the market rather than the asked, as would be expected for a sale by a market maker to a non-market maker. Instead, we find that the best indicator of the prevailing market price was a June 14 interdealer sale at $1.625 per share, which was at the asked side of the market. Using $1.625 per share as the prevailing market price, the Firm's markups were not excessive. 22
In another instance, the law judge concluded that a January 25, 1993 sale by a market maker to a non-market maker at $0.34375 pershare was the best indicator of the prevailing market price against which markups on retail sales on February 1, 2, and 3 should be measured. We find, instead, that a February 4 sale by a market maker to a non-market maker at $0.375 per share was a better indicator of the prevailing market price. Both the January 25 sale and the February 4 sale were at the asked side of the market. The market appears to have moved higher during the period in question, however, making the higher sale price on February 4 a better indicator of market price. Additionally, the February 4 sale was closer in time to the retail sales in question than was the January 25 sale. Using $0.34375 per share as the prevailing market price, the law judge found markups ranging from 10.4% to 14.04%. Using $0.375 per share as the prevailing market price, however, the markups were not excessive.
We also disagree with the law judge's application of a 5%
standard in determining whether markups were fraudulent. Since 1943, the National Association of Securities Dealers, Inc. (the "NASD") has had a "5% policy" which provides a guideline for determining whether NASD members have complied with NASD rules requiring "fair" pricing and adherence to "just and equitable principles of trade." 23 The 5% policy is not applicable here, where we must determine not whether the Respondents' pricing conformed to NASD rules, but rather whether it violated the antifraud provisions of the securities laws. Moreover, although the Division now asserts that the law judge was justified in finding fraud where the markups were below 10%, the order instituting proceedings herein alleged violations only with respect to markups higher than 10%, and the briefing and argument throughout the proceeding were based on the theory that only such markups were fraudulent. We will not now apply a standard that was neither initially charged nor fairly litigated at the hearing. 24
Applying these principles, we find that the markups alleged were not fraudulent. In many instances, the law judge correctly determined the prevailing market price, but found markups of less than 10% fraudulent. In other instances, the law judge gave too much weight to the fact that a sale was by a market maker to a non-market maker in the face of other evidence suggesting that that sale was not a valid indicator of the market. Having reviewed the entire record, we conclude that the evidence does not establish the alleged violations at issue.
* * * * *
For the reasons discussed, we find that the record does not support the Division's allegations that the Respondents charged fraudulent markups. 25
An appropriate order will issue. 26
By the Commission (Chairman LEVITT and Commissioners HUNT, CAREY and UNGER)
Jonathan G. Katz
UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
SECURITIES EXCHANGE ACT OF 1934
Rel. No. 43929 / February 6, 2001
Admin. Proc. File No. 3-8543
In the Matter of
ORDER DISMISSING PROCEEDING
On the basis of the Commission's opinion issued this day it is
ORDERED that this administrative proceeding against D.E. Wine Investments, Inc., W. Randal Miller, Duncan E. Wine, and Kenneth B. Karpf be, and it hereby is, dismissed.
By the Commission.
Jonathan G. Katz
1 D.E. Wine Invs., Inc., Initial Decision Rel. No. 143 (June 9, 1999), 69 SEC Docket 2881. Kenneth B. Karpf, also a registered principal of the Firm, has not filed a petition for review. Our decision to dismiss this proceeding also applies to Karpf.
2 15 U.S.C. § 77q(a).
3 15 U.S.C. § 78j(b).
4 17 C.F.R. § 240.10b-5.
5 15 U.S.C. § 78o(c)(1).
6 17 C.F.R. § 240.15c1-2.
7 During the relevant period, Miller was the Firm's compliance officer and Wine was chairman of the board and president of the Firm. Miller developed the Firm's markup and markdown policies and procedures and participated in implementing them. Miller was responsible for reviewing each transaction for pricing before execution. Wine approved the Firm's policies regarding markups and markdowns and delegated responsibility for pricing to Miller and to Karpf, who was a director of the Firm and vice president of trading.
8 The Division of Enforcement did not appeal the law judge's decision, including her finding that the record did not support the Division's allegations that the Respondents had charged fraudulent markdowns. That finding, therefore, is not before us. See 17 C.F.R. § 201.17.
9 D.E. Wine Invs., Inc., Initial Decision Rel. No. 79 (Dec. 8, 1995), 60 SEC Docket 2819.
10 D.E. Wine Invs., Inc., Exchange Act Rel. No. 39517 (Jan. 6, 1998), 66 SEC Docket 763. Although we remanded for further factual findings, we also noted that, to the extent the parties had stipulated to facts that were not inconsistent with our opinion, those findings should not be disturbed. Id., 66 SEC Docket at 770-71. On remand, the law judge based her findings on the record, without conducting a hearing.
11 If the question whether the market was active and competitive had been presented to us for review, we might not have found that the market was active and competitive for all of the Securities during all of the periods at issue, and our analysis of some of the markups consequently might have been different.
12 By "appropriate" we mean sales by market makers to non-market makers in the case of markups, and purchases by market makers from non-market makers in the case of markdowns. The parties had stipulated that a collection of trade data, submitted as a joint exhibit, contained sufficient evidence to determine the market price. If more than one appropriate transaction between a market maker and a non-market maker occurred on the same date, the law judge used the transaction that favored the Respondents.
13 In counting the number of business days between transactions, the law judge did not include the day on which the retail transaction at issue occurred or the day on which the trade between the market maker and the non-market maker occurred.
14 The law judge found that markups of more than 10% were charged in 23 of these trades.
15 E.g., Grandon v. Merrill Lynch & Co., 147 F.3d 184, 189-90 (2d Cir. 1998); S.E.C. v. First Jersey Sec., Inc., 101 F.3d 1450, 1467, 1469 (2d Cir. 1996); Alstead, Dempsey & Co., 47 S.E.C. 1034, 1035 (1984) (noting that the Commission has found excessive markups violative of the antifraud provisions since 1939).
16 See, e.g., Peter J. Kisch, 47 S.E.C. 802, 808 (1982); J.A. Winston & Co., 42 S.E.C. 62, 69 (1964).
17 See, e.g., Adams Sec., Inc., 51 S.E.C. 1092, 1095 (1994). As we previously noted, a "contemporaneous" trade is not always asame-day trade. D.E. Wine Invs., 66 SEC Docket at 767-68. Where there is little interdealer trading in a security, we have looked to interdealer trades that occurred more than a month after the corresponding retail trades to determine whether premiums charged were fraudulent. See Orion Sec., Inc., 52 S.E.C. 46, 51-52 (1994); see also LSCO Sec., Inc., 50 S.E.C. 518, 520 (1991) (considering interdealer trade that occurred more than two weeks after the retail trade at issue in determining appropriateness of markup). In a very active market, on the other hand, it may be necessary to undertake an hour-by-hour or minute-by-minute analysis of interdealer trading to gauge accurately the prevailing market price at a particular time. D.E. Wine Invs., 66 SEC Docket at 768. The record in this case shows only trade dates and thus in many cases does not permit a precise calculation as to which trade was closest in time to a particular retail trade.
18 See Adams Sec., 51 S.E.C. at 1094-5; Adams Sec., Inc., 51 S.E.C. 311, 313 n.8 (1993).
19 D.E. Wine Invs., 66 SEC Docket at 767-68 & nn.8, 14.
20 George Salloum, 52 S.E.C. 208, 213 & n.23 (1995) ("By buying at the bid price and selling at the asked, market makers are able to profit from the spread, or difference, between these two quotations, one of the incentives for acting as a market maker."); Alstead, Dempsey, 47 S.E.C. at 1036; Peter J. Kisch, 47 S.E.C. at 808. A dealer that is not a market maker must base its markups on the prices it pays market makers in contemporaneous purchases of the security, and must base its markdowns on the prices it obtains from market makers in contemporaneous sales of the security unless, in either case, there is "countervailing evidence" of the prevailing market price. See David Disner, 52 S.E.C. 1217, 1220 (1997). A market maker, however, is not required to base its retail sales prices on the interdealer bid, i.e., its cost, because if it were "it might frequently be compelled to sell at retail at prices lower than the interdealer offer and might be deterred from taking the risk of maintaining positions." General Investing Corp., 41 S.E.C. 952, 954-55 (1964); accord, Peter J. Kisch, 47 S.E.C. at 808.
21 See George Salloum, 52 S.E.C. at 213 (choosing not to base determination as to prevailing market price on trades in which market maker bought at asked and sold at bid, a reversal of the usual trading practice for a market maker, because the trades "deviate[d] so substantially from normal trading practices" that they did not accurately reflect the market).
22 Although, using the correct calculation, one of these retail sales of Market Data Corp. shares involved a 12.7% markup, that trade was for only 250 shares, sold at $1.375 per share. We previously have declined to find excessive pricing where, as here, "the size of the total transaction is small and the total compensation charged is equal to or less than a reasonable minimum ticket charge." Century Capital Corp., 50 S.E.C. 1280, 1283 n.10 (1992), aff'd, 22 F.3d 1184 (D.C. Cir. 1984)(Table). Under the circumstances, we do not find that the Firm charged a fraudulent markup on this transaction.
23 See NASD Conduct Rules 2110 and 2440 and IM-2440.
24 Although we reject some aspects of the law judge's analysis, we decline to accept the Respondents' argument that they were entitled to base their retail prices on quotations. We have acknowledged that validated quotations may be considered, but only when there is insufficient other evidence of the prevailing market price. See D.E. Wine Invs., 66 SEC Docket at 769-70, and cases cited therein. Here, however, there is sufficient information concerning interdealer trades in the Securities. The prevailing market price must therefore be determined with reference to those trades, although, as noted above, quotations may be considered, along with other evidence, in assessing the state of the market and determining how it is moving.
We also reject the Division's argument that appropriatetransactions involving DEW are better evidence of the prevailing market price than other interdealer transactions. Interdealer transactions involving other firms may be equally valid indicators of market price. Id., 66 SEC Docket at 768.
25 The Respondents have requested oral argument. Under both our former Rule of Practice 21(a), which applies to this proceeding, and its current counterpart Rule 451(a), on which the Respondents relied in their request, oral argument with respect to the review of initial decisions of hearing officers is granted except in "exceptional circumstances." Former Rule 21(a), 17 C.F.R. § 201.21(a) (1995); Rule 451(a), 17 C.F.R. § 201.451. However, because the issues here have been thoroughly briefed, and given the resolution of this matter, we believe there is no prejudice to the Respondents in denying their request for oral argument and the request is hereby denied.
26 We have considered all of the parties' contentions. We have rejected or sustained them to the extent that they are inconsistent or in accord with the views expressed herein.
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