SECURITIES AND EXCHANGE COMMISSION
SECURITIES ACT OF 1933
Rel. No. 7638 / February 10, 1999
SECURITIES EXCHANGE ACT OF 1934
Rel. No. 41034 / February 10, 1999
Admin. Proc. File No. 3-8575
In the Matter of
JOSEPH J. BARBATO
867 Normandy Trace Road
Tampa, FL 33602
OPINION OF THE COMMISSION
Grounds for Remedial Action
Fraud in Offer and Sale of Securities
Salesman of former registered broker-dealer made fraudulent price predictions, material misrepresentations and omissions, and unsuitable recommendations, in addition to churning the account of a customer. Held, it is in the public interest to: bar salesman from association with any broker or dealer or from participating in any penny stock offering; order salesman to cease and desist from committing or causing any violation or future violation of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder; and order salesman to disgorge $45,142.20, plus prejudgment interest.
Howard A. Tescher, of Kipnis Tescher Lippman Valinsky & Kain, for Joseph J. Barbato.
William H. Kuehnle and Nancy E. McGinley, for the Commission's Division of Enforcement.
Appeal filed: December 3, 1996
Last brief received: April 24, 1997
Oral argument: October 27, 1998
Joseph J. Barbato, formerly a registered representative of the Stuart-James Co., Inc. ("Stuart-James"), a former registered broker-dealer, appeals from the decision of an administrative law judge. The law judge found that Barbato engaged in fraudulent sales practices, made material misrepresentations and omissions, made recommendations that were unsuitable in light of his customers' stated investment objectives, and churned a customer's account in violation of Section 17(a) of the Securities Act of 1933 ("Securities Act") 1 and Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") 2 and Rule 10b-5 thereunder. 3 The law judge barred Barbato from association with any broker or dealer and from participating in any offering of penny stock; ordered Barbato to cease and desist from committing or causing any violation of, or any future violation of, Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder; and ordered him to disgorge $623,020, plus prejudgment interest.
We find that Barbato made fraudulent price predictions, material misrepresentations and omissions, and unsuitable recommendations, in addition to churning the account of a customer. We bar Barbato from association with any broker or dealer and from participating in any penny stock offering and order him to cease and desist from committing or causing any violation or future violation of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. We further assess disgorgement in the amount of $45,142 (plus prejudgment interest), based on the particular facts demonstrated with respect to each customer witness who testified in this proceeding. See Section IV.B. below. We base our findings on an independent review of the record, except with respect to those findings not challenged on appeal.
Barbato joined Stuart-James as a registered representative in its Altamonte Springs, Florida branch office in May 1985. By 1989, Barbato had been promoted to branch manager of Stuart-James's Orlando, Florida branch. Barbato handled more than three hundred Stuart-James customer accounts.
As we explain below, we find that Barbato engaged in violations with respect to the offer and sale of a number of unseasoned speculative securities to at least seven Stuart-James customers, whose transactions are discussed in this section. During the period at issue, the securities of three of these companies -- Meadow Group, Inc., Warrentech Corporation, and Europa Cruises Corporation -- were penny stocks. Barbato made unwarranted price predictions. He also made material misrepresentations and omissions to customers and engaged in high-pressure sales tactics. Barbato further made unsuitable recommendations to certain Stuart-James customers and churned a customer's account.
A. Susan Campbell Gordon
Susan Campbell Gordon, a registered nurse and chemotherapist, opened an account at Stuart-James in 1989. She became Barbato's customer in early 1990 when Barbato replaced her previous Stuart-James salesman. Gordon also maintained an account at Shearson Lehman, in which she had purchased equity securities, municipal bonds, and mutual funds. Gordon invested approximately 90% of a $100,000 inheritance in her Shearson Lehman account and the remainder with Stuart-James. Gordon testified that Barbato was aware of her inheritance and knew that it was the source of her investment funds. Gordon testified that Barbato would repeatedly call her to urge her to invest. He would insist that she had "to do it today" or that she had to "jump on" his recommendation.
In March 1990, Barbato repeatedly called Gordon, urging her to purchase National Media Corporation common stock. National Media was a direct marketer of health, beauty, and self-improvement products and books, principally through television, print media, and catalogs. A prospectus filed with this Commission by National Media in January 1989 identified many risk factors, including National Media's history of losses for the three prior fiscal years, the company's working capital deficit, and questions about whether the company would be able to compete effectively with other direct marketers with greater financial and personnel resources. In addition, the products marketed by National Media had a four- to twelve-month life cycle, and the company was dependent on finding new products that were suitable for marketing. National Media previously had declared bankruptcy in October 1985.
Barbato admitted at the hearing that he had reviewed prospectuses, Commission filings, and due diligence files regarding National Media, and was therefore aware of the risks associated with National Media stock. He nevertheless predicted to Gordon that the price of National Media stock was going to "take off" in two, three, or six months. He assured Gordon that National Media was a "great stock" that would make up for previous losses in her account and then some. Barbato did not provide Gordon with a prospectus or any other written information about the company before she purchased National Media stock.
Gordon initially was hesitant to purchase any stock recommended by Barbato because her previous investments with Stuart-James had performed poorly. Barbato nevertheless convinced her to liquidate certain securities that she held in her Stuart-James account to purchase the National Media stock. Barbato told Gordon that there would be a loss on the sales but that he had minimized the loss. In fact, Gordon lost $2,190, or approximately 40% of her initial investment of $4,920 in these particular securities. Based on Barbato's recommendations, Gordon purchased 500 shares of National Media stock in March 1990 at $5.25 per share. During March 1990, National Media stock traded in the $4.94 to $7.56 range. By the end of 1990, the stock traded for less than $2 per share.
Around April 1990, Barbato again made repeated telephone calls to Gordon, this time urging her to buy Cedar Group, Inc. common stock. Cedar Group was engaged in the business of importing and distributing metal fasteners (i.e., nuts and bolts), and its securities were speculative. In a Cedar Group prospectus dated November 1989, the company registered the issuance of certain debentures and units to be used in part to purchase a fastener distributor for approximately $2.3 million. At that time, the company identified several risk factors, including: (i) Cedar Group's minimal operating history (which was limited to negotiating for the acquisition of the distributor) and Cedar Group's limited reserves, (ii) its inability to assure continued profits, (iii) its inability to assure that it could satisfy its obligations to pay interest and principal on the debentures without additional financing, and (iv) its inability to assure that it would be able to compete effectively with other fastener distributors with "vastly greater resources, personnel, technical expertise, and financial capability."
On February 5, 1990, Forbes magazine had published a story implying that Cedar Group's $13 stock price was attributable to manipulation by its management and by Stuart-James, rather than to the company's outlook. Among other things, this article stated that Stuart-James was "frantically flogging" the stock of Cedar Group. Barbato admitted that he had read this article.
Moreover, Barbato was aware that certain Stuart-James registered representatives were engaged in a "short squeeze" of Cedar Group stock. 5 Barbato knew that, beginning in February 1990, Steve Phillips, his supervisor at Stuart-James, encouraged several Stuart-James brokers in various branch offices around the country to buy Cedar Group stock before the market closed in order to drive the stock price up. To maintain the short squeeze, Phillips had also discouraged these brokers from selling any Cedar Group stock. While Barbato denies participating in the short squeeze, he was aware of these activities at the time he recommended Cedar Group stock to Gordon. Barbato admitted that he saw a poster stating, "THE SQUEEZE GOES ON," which Phillips faxed to the Stuart-James representatives involved in the short squeeze three days after the unfavorable article on Cedar Group appeared in Forbes magazine.
Barbato nonetheless recommended Cedar Group stock to Gordon in April 1990. He failed to inform her about the Forbes article and its potential effect on the price of Cedar Group stock, about the short squeeze, or about any other risks associated with Cedar Group. Barbato also did not provide Gordon with a prospectus or any other written information concerning Cedar Group.
Instead, despite the unusual circumstances surrounding the stock and despite known risks, Barbato predicted to Gordon in April 1990 that the price of Cedar Group stock was going to go "sky high" and would double or triple in value in six months. Barbato also told Gordon that Stuart-James had "inside information" that, among other things, Cedar Group was going to merge with or be bought out by another company. He further stated that other brokers did not have this information.
Barbato encouraged Gordon to sell the 500 shares of National Media stock that she had purchased the preceding month on the basis of Barbato's previous recommendation in order to finance the purchase of 315 shares of Cedar Group stock at $12 per share. Barbato assured Gordon that Cedar Group was a better investment than National Media. Five days later, he told Gordon that the Cedar Group merger or buy-out was imminent and convinced her to sell another stock in her Stuart-James account. On April 23, 1990, Gordon bought an additional 415 shares of Cedar Group at $12.375 per share. Although she had received a $2,000 profit in her sale of National Media, the sale of this second stock resulted in a $3,975 loss. During April 1990, Cedar Group stock was trading between $9 and $12 per share. By December 1990, the stock was trading for less than $2 per share. 6
Gordon invested about $11,000 with Barbato at Stuart-James. When she closed her account, she received about $25 from her investments.
B. William Riley Allen
At the time of the events at issue, William Riley Allen, an attorney, had no prior experience investing in stock. His investments had been limited to money market funds, certificates of deposit, and church bonds. He had previously refused to open accounts with brokers because he did not trust them. Allen testified that he opened his account with Barbato because Barbato claimed to be a "Christian stockbroker."
In May 1990, Barbato recommended that Allen purchase both Cedar Group and National Media. When he made these recommendations to Allen, Barbato failed to inform Allen about the substantial risks of investing in these two securities. Barbato did not provide Allen with prospectuses describing Cedar Group or National Media.
Barbato enthusiastically recommended that Allen purchase Cedar Group because it was going to become "one of the biggest nuts and bolts compan(ies)" through acquisitions of smaller companies. On May 7, 1990, however, Barron's financial magazine published an article noting that Cedar Group's stock price seemed to be accounted for by "hype," rather than fundamentals. Barbato failed to inform Allen about the short squeeze in Cedar Group stock initiated by his Stuart-James supervisor or about the recent negative press reports about Cedar Group. On May 30, 1990, Allen purchased 500 shares of Cedar Group stock at $7.38.
At the same time, Barbato told Allen that the price of National Media stock would increase from more than $13 per share to "the low $20 range" in a few months. Barbato did not mention the risks associated with National Media's financial condition or its need for new products. In addition, Barbato asserted that he had personally invested in National Media. In fact, the previous month, Barbato had both sold the 2,000 shares of National Media stock that he had held and recommended that Gordon sell her holdings of National Media. Relying on Barbato's recommendation, Allen purchased 250 shares of National Media at $13.25 per share on May 22, 1990.
In September 1990, Barbato convinced Allen to purchase an additional 750 shares of National Media at $7.63 per share. Allen described that conversation as "having some urgency to it, that I was going to miss an opportunity." Although the price of National Media had declined by almost half, Barbato told Allen that the company was doing well, and he would "make more money because my overall cost basis was lower." He purchased the stock because Barbato was "persistent."
Allen invested about $16,000 with Stuart-James. When he cashed out his account, it was worth only $2-3,000.
C. Rosalie Harrison
Rosalie Harrison, a widow with a high school education, became a Barbato customer in 1988. Although Harrison had been a homemaker for most of her adult life, investing in stocks had been (as she characterized it) her "number one hobby" for over thirty years. Harrison had maintained accounts at other broker-dealers before opening her Stuart-James account and often had several brokerage accounts at the same time. However, she had never invested with a brokerage house that specialized in penny stocks. Barbato called Harrison on several occasions. His reports were "always glowing." He would tell Harrison that the stocks he recommended were "good opportunities" and "would make money" and that she did not want to "miss out on this."
In the fall of 1989, Barbato began urging Harrison to purchase common stock of The Meadow Group, Inc. At the time of its initial public offering ("IPO") in March 1989, Meadow Group was a "blind pool" company. For the year ending July 31, 1989, Meadow Group reported a loss of $82,067. Meadow Group's IPO prospectus identified several risk factors, including its recent formation and lack of operating history, and its inability to assure that its business strategy would be successful. In September 1989, this Commission received a merger proxy stating that a wholly-owned subsidiary of Meadow Group had agreed to merge with Direct Action Marketing, Inc. ("DAMI"), a direct marketing company. Among the risk factors identified in the merger proxy were the facts that Meadow Group would be incurring (i) high levels of debt to consummate the merger, (ii) significant interest and principal payments, which might require application of a "significant amount" of the surviving corporation's cash flow, and (iii) significant limitations on Meadow Group's ability to produce earnings, which could impact its ability to withstand competitive pressures.
At the time of Harrison's investments in Meadow Group, Barbato did not provide her with any written disclosure documents about Meadow Group or inform her of any risks involved in investing in Meadow Group. Barbato also did not disclose that he had sold his holdings in Meadow Group a few days earlier. Barbato instead predicted to Harrison that Meadow Group's stock price would triple in "three or four months," rising eventually to 75 cents per share. In October 1989, Harrison purchased 10,000 shares of Meadow Group at $.1875 per share.
In May 1990, in order to induce her to purchase additional Meadow Group stock, Barbato again specifically predicted to Harrison that the stock would double or triple in price and that Meadow Group was "big." Meadow Group's quarterly reports on Form 10-Q for late 1989 and early 1990, however, reported declining net sales and revenues for Meadow Group. Although Barbato testified that he examined financial reports for the companies that he recommended, Barbato did not disclose any of this negative information about Meadow Group to Harrison. When Harrison told Barbato that she did not have any money, Barbato induced Harrison to sell her shares of another stock previously purchased at Stuart-James to fund the purchase of Meadow Group. Harrison purchased an additional 80,000 shares of Meadow Group at $.0625 per share based on Barbato's price prediction. By December 1990, Harrison's investment of approximately $6,900 in Meadow Group (accounting for a 40-for-1 reverse stock split in August 1990), was worth approximately $1,500.
D. William Camacho
William Camacho, a certified public accountant, opened an account with Stuart-James in August 1986 after seeing a newspaper advertisement placed by Barbato. Camacho had maintained accounts for several years with various discount brokerage firms before opening his account with Stuart-James.
When Camacho first opened his Stuart-James account, his income was approximately $30,000 a year, from which he paid monthly child support. Camacho told Barbato at that time that he had only $2,000 to $5,000 to invest. In April 1988, he took a new position, and his salary increased to $60-70,000 a year. On his new account forms with Stuart-James, Camacho indicated that his investment objective was "Long Term Growth with Safety." Without Camacho's consent, Barbato altered Camacho's new account form to increase the amounts stated for Camacho's income and net worth.
In contrast to his actions with respect to other customers, Barbato provided Camacho with prospectuses for some of the stocks he recommended. However, Barbato told Camacho not to pay "too much attention" to the financial reporting portions of a prospectus and otherwise to ignore prospectuses and to rely instead on Barbato. Camacho testified that Barbato's sales presentations were "forceful." Barbato would urge Camacho to "seize the moment" or "grab at the opportunity." If Camacho did not have the money to invest, Barbato would urge Camacho to sell other securities in his Stuart-James account. Barbato told Camacho that he would have to act quickly to buy stocks because Stuart-James was going to increase the stock's price soon.
Barbato recommended that Camacho purchase several speculative stocks, including Warrantech Corporation, Meadow Group, Europa Cruises Corporation, and Cedar Group. Warrantech was engaged in developing, marketing, and administering manufacturers' written warranties. 7 Between January 1987 and February 1990, Camacho acquired 58,000 shares of Warrantech stock in ten separate transactions. 8 Prior to Camacho's initial purchase of 7,000 shares of Warrantech stock, Barbato told Camacho that he would make more money on Warrantech than on all the other stocks in his portfolio combined. Barbato also told Camacho that Stuart-James had an "inside pipeline" to Warrantech. In an effort to get Camacho to purchase more Warrantech stock, Barbato predicted to Camacho that Warrantech's stock would reach the five to ten dollar range within three years. During June 1988, Camacho purchased an additional 6,000 shares of Warrantech stock for $.78 per share and 4,000 shares for $1.01 per share. Trading in Warrentech from January 1987 through February 1990 resulted in a trading loss of $8,722 for Camacho.
Barbato also pressured Camacho to move his retirement ("IRA") account to Stuart-James. Camacho had invested his IRA in money market funds and certificates of deposit. Camacho stated that his investment objectives for the IRA were "long term growth with safety." In March 1989, however, Barbato urged Camacho to buy Meadow Group for his IRA account. Barbato told Camacho that a company "on the big board" was going to acquire Meadow Group imminently. Barbato did not tell Camacho that Meadow Group was a blind pool. Meadow Group did not merge with DAMI, which was listed on the Amex, until September 1989.
Camacho also purchased, on Barbato's recommendation, a total of 9,000 shares of Europa Cruises Corporation common stock in August and September 1989. Europa Cruises was a company that offered gambling and other entertainment from two vessels located off Florida's Gulf Coast. Barbato told Camacho that several "important" people were "interested" or "taking a substantial interest" in Europa Cruises, including Merv Griffin. Stuart-James underwrote Europa Cruises' IPO in June 1989. Among the many high-risk factors identified in Europa Cruises' prospectus, filed on June 26, 1989, were: (i) the company's recent formation and limited operating history, (ii) its inability to assure that it would be able to compete effectively with other cruise and recreational competitors, (iii) then-pending legislation in the Florida legislature that would place severe restrictions on vessels offering gambling, (iv) the potentially adverse effect of gaming and maritime regulations, 9 (v) existing liens on the company's two vessels, and (vi) the then-pending administrative proceeding in which the Division sought to terminate the broker-dealer registration of Stuart-James, Europa's underwriter. During August and September 1990, Europa Cruises common stock was trading for less than a dollar. Camacho suffered a net loss of $3,765 from his investment in Europa Cruises.
Barbato also enthusiastically recommended that Camacho purchase Cedar Group stock, claiming it was "the one" to make up for earlier trading losses. On March 19, 1990, Camacho purchased 1,000 shares of Cedar Group common stock at $12.30, and on May 4, 1990, Camacho purchased another 1,000 shares at $9.88. Barbato told Camacho that Cedar Group had captured a niche in the market. Barbato's enthusiasm for Cedar Group was not qualified in any way by any discussion of risk factors, negative information, the short squeeze by Stuart-James, or by the highly critical news articles that were appearing in the financial press. In May, Camacho saw a report in the Wall Street Journal of a substantial short position in Cedar Group. Barbato told Camacho not to worry because nobody understood Cedar Group like Stuart-James.
Camacho's investments in these speculative securities were not profitable. Camacho lost approximately $37,625 during the almost four years that he invested with Stuart-James.
E. Henry Schneider
Henry Schneider was a disabled former roofing contractor, who attended high school through the tenth grade. While Schneider had purchased mutual funds, he had limited experience investing in stocks before opening his account with Stuart-James in October 1989. Schneider did not indicate an investment objective on his Stuart-James new account form, but he testified that he possessed a low or medium tolerance for risk. Barbato knew that Schneider was working only part-time and that his investment funds came primarily from a trust created for his benefit, which generated approximately $22,500 per year. 10 When Schneider opened his Stuart-James account, he had less than $40,000 in assets, was living in a trailer, and was being supported by a friend. Without Schneider's consent, Barbato altered Schneider's new account form to reflect an annual income of between $75,000 and $100,000.
Barbato recommended several high-risk stocks to Schneider, including Europa Cruises, Warrantech, and Meadow Group. Barbato was always upbeat and told Schneider that the stock he was recommending would make money. Barbato predicted to Schneider that Europa Cruises stock would increase in price from $2.23 per share to $5 per share in six months to a year. Barbato told Schneider that Europa Cruises was a good company and that Schneider would make money in it. Although Schneider received a prospectus for Europa Cruises, he did not read it before investing in the stock. From October 1989 to February 1990, based on Barbato's recommendation, Schneider purchased 2,500 shares of Europa Cruises at prices ranging from $1.69 to
$2.23. 11 Schneider subsequently visited one of Europa's cruise ships and discovered that it was old and rusty. Schneider testified before the law judge that he lost approximately $7,000 in three months trading on penny stocks with Barbato at Stuart- James.
F. Thomas Castronovo
At the time of the events at issue, Thomas Castronovo was an architect. In 1986, he responded to a Stuart-James advertisement featuring Barbato. When Castronovo opened his Stuart-James account, he informed Barbato that he was planning for retirement and that he wanted only low-risk investments.
Nonetheless, Barbato recommended that Castronovo buy high-risk stocks, including Europa Cruises and Warrantech. Barbato was always "upbeat." He informed Castronovo that the issues had to be purchased "right then and there" or else Castronovo would be too late. Barbato told Castronovo that the stocks he recommended were going to "double, triple, quadruple, ten times, whatever" in a matter of months. Barbato did not disclose to Castronovo any information about the high degree of risk associated with these companies or any negative information about them. Nor did Barbato provide Castronovo with prospectuses or other detailed financial information. In fact, Barbato told Castronovo that these companies were "screened," were "the cream of the crop," and were "going places."
In September 1989, Barbato recommended that Castronovo purchase Europa Cruises stock because gambling had "just" been legalized, and Europa would become a "booming" business. Barbato failed to disclose the risks associated with Europa. Barbato also failed to disclose that, at around the time he was recommending that Castronovo purchase Europa Cruises stock, he was recommending that other Stuart-James customers sell this same security. Based on Barbato's recommendation, Castronovo sold another stock that Barbato had previously recommended in order to purchase 1,500 shares of Europa Cruises.
Castronovo invested approximately $30,000 with Barbato at Stuart-James. He ended up owning only 1,350 shares of Warrentech, which were worth 1-7/8.
G. Ted Spangenberg
Ted Spangenberg was a civil engineer when he opened his Stuart-James account in 1986 in response to a cold call from Barbato. At the time he determined to open his account, Spangenberg was making $40,000 per year. His investment objectives were for "growth with income," and he wanted to invest in medium-risk securities. Shortly thereafter, Spangenberg told Barbato that he had retired. Upon retirement, Spangenberg's income declined to $30,000 per year, plus his wife's income as a teacher of between $16,000 to $20,000 per year. Barbato, however, recommended that Spangenberg purchase Warrantech, Meadow Group, and other speculative stocks. Barbato was always positive, and Spangenberg "never did receive any negative remarks about any stock I was buying." Barbato sometimes told Spangenberg that he had only a limited amount of a stock to sell.
While Barbato did not have discretionary trading authority, he initiated all transactions in the account, and Spangenberg habitually followed Barbato's recommendations. Barbato called Spangenberg only if he wanted Spangenberg to buy or sell a stock. Barbato made all the recommendations about what to buy or sell; Spangenberg initiated no transactions. Spangenberg "was relying on (Barbato) to manage my account." When Barbato recommended that Spangenberg sell a stock, Barbato would "turn around and buy some more stock." Spangenberg agreed to the trades when Barbato called and did not seek additional time to consider the proposed transactions. 12
Spangenberg kept a notebook in which he recorded his trades. Spangenberg thought that commissions on the trades were variously between $5 and $15 because the confirmations he received from Stuart-James listed a miscellaneous expense charge of that amount for each transaction. The Stuart-James confirmations had a space for commissions, which was blank. 13 Barbato did not disclose that his commission, which was based on the mark-up, was much higher. For example, on August 22, 1989, Spangenberg bought shares of Europe Cruises and indicated in his notebook that the commission was $10. The actual commission as indicated in Stuart-James' records was $420.
During the period from March 1988 through July 1990, Barbato caused purchases in the Spangenberg account totalling $214,889, which generated commissions totalling $38,884. The average equity in the Spangenberg account over this period was $42,359. During the sub-period from July 1989 through July 1990, Barbato caused purchases in the account totalling $123,558, generating total commissions of $17,314. The average equity in the Spangenberg account over this narrower period was $27,608.
The Division's expert witness, Dr. Stewart L. Brown, a professor of finance at Florida State University, analyzed Spangenberg's account and found, from March 1988 through July 1990, a turnover ratio of 2.1 and a break-even cost factor of 38 percent. Dr. Brown noted that trading increased toward the end of the period. Looking only at the sub-period between July 1989 and July 1990, the turnover ratio was 4.1 and the break-even cost ratio was 57.9 percent. The break-even cost factor determines the rate of return that the account would have to earn on an annual basis in order to break even and cover commission costs. Thus, given this break-even cost factor, Spangenberg needed to earn annual returns ranging from 38 percent to 57.9 percent just to recoup his losses and cover the costs of Barbato's trading of the account.
A. Unwarranted Price Predictions
We have long held that predictions of specific and substantial price increases for a speculative security within a relatively short period of time are a "hallmark of
fraud." 14 Barbato admits that he had reviewed the due diligence materials for these issuers. He also admitted that to say speculative stock is going to increase two hundred percent is improper. Given their limited financial and operational histories and the risk factors associated with those issuers, Barbato's predictions of substantial price increases were at least reckless and willfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. 15
B. Material Misrepresentations and Omissions
In spite of his access to disclosure materials about the companies at issue here, Barbato with scienter made material misrepresentations to his customers. For example, he claimed to have "inside information" about supposed merger and acquisition transactions. He also asserted that Merv Griffin was interested in Europa Cruises. He claimed that Cedar Group was going to become "one of the biggest" nut and bolt companies when, in fact, it was a small distributor. He represented that various of these issuers were booming and that certain mergers or acquisitions shortly would be effected. He also claimed to both Allen and Harrison that he owned a stock that he was recommending when, in fact, he had previously sold his holdings.
Where a registered representative omits to disclose material information necessary to make his statements not misleading to customers about an investment he is recommending, including known risk factors and negative information about the stock, the representative violates the antifraud provisions. 16 Barbato recommended securities while omitting the material information his customers needed to make informed investment decisions. Among other things, he failed to disclose what he knew about the Stuart-James short squeeze of Cedar Group and the adverse publicity surrounding that company. He also failed to disclose the risks and financial and operational limitations of the issuers. He failed to disclose the compensation he earned to Spangenberg. Barbato's price predictions, misstatements, and omissions were repeatedly accompanied by high-pressure sales tactics: making persistent telephone calls, warning that the customer would miss an opportunity, or urging the customer to act quickly or the prices would rise soon or the stock would be sold out. We conclude that he violated the antifraud provisions of the Securities Act and the Exchange Act.
For his part, Barbato denies that he made aggressive predictions or omitted material information. Rather than challenging the facts presented at the hearing to support these findings, Barbato attempts to characterize each of these customers as "greedy," and claims that they invested with Stuart-James with the expectation of making a higher rate of return than that available with other, more established, brokerage firms. The law judge, however, stated that his findings were based, in part, on his observations of the witnesses' demeanor. Barbato, furthermore, had ample opportunity to cross-examine each of these witnesses at the hearing. None of them changed his or her testimony in any fundamental way. 17
Moreover, the customers' testimony is very similar regarding Barbato's statements. The customers' descriptions of Barbato's statements about the prices of the securities and their potential, his enthusiasm and insistence that they decide immediately, and his suggestions that they sell an existing holding in order to purchase his newest recommendation, were consistent. We believe these similarities further support our and the law judge's conclusions that Barbato willfully engaged in the alleged violative conduct. 18
C. Unsuitable Recommendations
A broker willfully violates Exchange Act Section 10(b) and Rule 10b-5 thereunder when he or she makes recommendations that are unsuitable in light of the customer's stated investment objectives, in connection with actual misrepresentations and omissions. 19 Barbato with scienter made unsuitable recommendations of highly speculative securities to Camacho, Schneider, Spangenberg, and to Castronovo. All four had told Barbato that they wanted low- to medium-risk investments. Camacho and Schneider both had limited financial assets when they opened their accounts with Barbato. Schneider was disabled, living in a trailer park, and had only periodic income, and Camacho had limited income from which he had to pay child support. Barbato, however, changed their new account cards, without permission, to increase both their incomes and Camacho's net worth. Spangenberg was retired at the time that he opened his account with Barbato, and his income had declined to $30,000, plus his wife's salary. Similarly, Castronovo informed Barbato that he intended to retire shortly after he opened his account. Both Spangenberg and Castronovo made clear that they were dependent on their accounts for retirement assets.
Barbato claims that some investors were more sophisticated about investing than their testimony indicates. We believe, however, that the record shows that these customers had little investing experience. Barbato, nonetheless, knowingly recommended speculative securities that were unsuitable for these accounts.
Churning occurs when a broker enters into transactions and manages a client's account for the purpose of generating commissions rather than furthering his client's interests. 20 Churning requires a showing that: (i) trading occurred in an account that was excessive in light of the customer's investment objectives, (ii) the broker exercised control over the account, and (iii) the broker acted with the intent to defraud or with willful and reckless disregard for the interests of the
client. 21 We find that each of these elements was satisfied with regard to Spangenberg's account.
Despite the fact that Spangenberg was retired, Barbato traded numerous speculative securities in and out of Spangenberg's account. Purchases in the Spangenberg account totaled $214,899 and generated $33,884 in commissions on an average account equity of $42,359. From March 1988 through July 1990, the account had turnover ratio of 2.1 and a break-even cost factor of 38 percent, and for the sub-period between July 1989 and July 1990, the turnover ratio was to 4.1 and the break-even cost ratio was 57.9 percent.
Barbato argues that a turnover ratio of between 2 and 4 is not presumed to be excessive. We have found, however, excessive trading where the annual turnover ratio was 4 or less. 22 The turnover ratio, moreover, is one of several measures we can consider when determining whether an account has been excessively traded. Another measure that we have considered is the break-even cost factor. 23 In the case of penny stock trading, where the costs of trading are higher relative to the price of the securities traded, the break-even cost factor may be a more effective measure of excessive trading. Here, Spangenberg's account would have had to increase 38 percent over the period at issue (or 57.9 percent over the sub-period) in order merely to break even. For an individual who is dependent on the account for retirement, this rate of trading is clearly excessive.
We further conclude that Barbato had de facto control over Spangenberg's account. 24 Spangenberg testified that he placed his trust and confidence in Barbato and allowed him to decide what to buy or sell in the account. We further conclude that Barbato acted with scienter in that he knew that his recommendations of these many high-risk speculative securities to Spangenberg, a retired engineer, were excessive in light of Spangenberg's investment objectives.
Barbato asserts that the Order Instituting Proceedings alleges that he churned accounts from "in or about August 1989 to September 1990." He asserts that the law judge found that Spangenberg's account was churned between March 1988 and July 1990. As discussed above, the highest rate of churning was between July 1989 and July 1990, a period that is consistent with the Order Instituting Proceedings. Barbato cannot claim surprise about the nature of Spangenberg's testimony as Barbato originally identified Spangenberg as one of his witnesses in his own witness list. We find that Barbato churned Spangenberg's account, in willful violation of Section 10(b) of the Exchange Act and
Rule 10b-5 thereunder.
A. We initiated these proceedings on December 14, 1994. Barbato claims that this proceeding is barred by the five-year statute of limitations found in 28 U.S.C. õ 2462 and by the decision of the United States Court of Appeals for the District of Columbia Circuit in Johnson v. SEC. 25
Barbato first contends that 28 U.S.C. õ 2462 mandates dismissal of this proceeding because the law judge imposed sanctions based on conduct that is "almost entirely" outside of the five-year limitations period. Barbato seems to argue that because some of his complained-of misconduct first occurred in 1986 and the proceedings here were commenced after 1991, no action can be maintained for other separate misconduct occurring any time after 1986 because that was when the claim first accrued. As discussed above, while Barbato was employed by Stuart-James from 1985 to 1990, a number of our (and the law judge's) findings of violation with respect to each of the customers described above occurred during the period from December 1989 to September 1990. In any event, we may consider conduct outside the limitations period to determine motive, intent, or course of conduct. 26
Barbato also asserts that disgorgement should not be predicated on conduct outside the 28 U.S.C. õ 2462 limitations period. We believe, however, that 28 U.S.C. õ 2462 does not preclude disgorgement under these circumstances. The Johnson court observed that, where the effect of the SEC's action is to restore the status quo ante, such as the award of restitution or disgorgement of ill-gotten profits, 28 U.S.C. õ 2462 will not apply. 27
B. Barbato claims that the disgorgement amount ordered by the law judge is unreasonable because it is not causally related to the wrongdoing found below. The law judge ordered Barbato to disgorge a total of $623,020 in commissions, based on an estimate of Barbato's total commissions earned from all of his customers during his entire tenure at Stuart-James.
The Division attempted, through its expert witness, to demonstrate a pattern of conduct, based on the seven witnesses who testified, extending to all of Barbato's customers over the years he was at Stuart-James. The nature of the misconduct at issue, however, requires specific and particular facts about each customer. For example, we cannot determine whether there was churning or some other violative trading pattern in any particular account without knowing whether the customer consented to the trading. Similarly, whether transactions were suitable for specific customers depends on evidence relating to their financial conditions and investment objectives. 28
Based on the record here, we have determined to award disgorgement with respect to the commissions received only for violations with respect to the seven customers who testified at the hearing. We note that the law judge rejected some of the Division's allegations of violation with respect to these customers. 29 Moreover, Barbato presented customer witnesses at trial who testified that he had not engaged in the same type of conduct found here with respect to their accounts and that they were satisfied with his performance.
We assess disgorgement in the amount of $45,142.20, reflecting the extent of Barbato's fraudulent conduct demonstrated on this record. This figure approximates the total amount of commissions Barbato earned from the accounts of the seven Stuart-James customers he was found to have defrauded, both within and outside the five-year limitations period.
Barbato now argues that he should be granted a waiver of disgorgement and prejudgment interest because of his financial inability to pay. Initially, we note that Barbato did not raise this claim of his inability to pay before the law judge. 30
Barbato has, on appeal, submitted financial disclosure forms as of February 1997 that purport to show his inability to pay. The Division maintains that Barbato's financial disclosure forms are incomplete because they do not disclose Barbato's finances extending back to December 1989 (the date of the first alleged violation). The Division also stresses that Barbato failed to have the forms properly certified.
At oral argument, we questioned Barbato's counsel about Barbato's current employment status and financial condition. Barbato apparently ceased working as a registered representative in May 1997. While we questioned Barbato's counsel, he did not explain specifically Barbato's current employment nor did he offer updated financial information. We probed Barbato's counsel about certain expenses included in Barbato's February 1997 financial statements, such as $2,471 for golf. His counsel indicated that these types of expenses were commensurate with Barbato's lifestyle at the time that Barbato was employed at Stuart-James.
As noted above, Barbato did not update us regarding his current financial status. It seems that, based on the last financial information available to us, Barbato has the ability to reallocate his cash flow towards disgorging his commissions in connection with the violative transactions described above involving these seven customers. We find that Barbato has not demonstrated an inability to pay this disgorgement amount.
The Division argues that we should find that Barbato continued his violative conduct after leaving Stuart-James. The law judge did not make findings concerning these allegations and expressly limited his findings of violation to the period ending September 1990. The Division did not appeal this determination. In any event, given the scope of Barbato's conduct, we do not need to reach these issues concerning alleged conduct after Barbato left Stuart-James to determine the appropriate sanctions.
Barbato's conduct in the period between December 1989 and September 1990 warrants the imposition of the broker-dealer and penny stock bars and the cease-and-desist order. 31 Barbato's fraudulent conduct was egregious and victimized several customers. He showed a repeated disregard for the interests of his customers and improperly favored his self-interest over the interests of those customers. Because we have found that Barbato violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and for the reasons discussed infra, we further believe that it is in the public interest to order that Barbato cease and desist from violations of those provisions in accordance with section 8A of the Securities Act and 21C of the Exchange Act.
The Division also asserts that Barbato improperly made attempts to contact several of his former customers who were identified on the Division's witness list. For example, Castronovo provided an affidavit declaring that, after he had testified in the administrative proceedings in this matter, Barbato contacted him and asked him to change his testimony concerning Barbato's predictions that certain stocks would "double, triple, quadruple" in a relatively short period of time.
In March 1996, the law judge ordered Barbato to cease interfering with witnesses. We believe this conduct provides further indication that Barbato may engage in additional violative conduct in the future and have considered it in our analysis of what sanction lies in the public interest.
An appropriate order will issue. 32
By the Commission (Chairman LEVITT and Commissioners JOHNSON, CAREY and UNGER); Commissioner HUNT not participating.
Jonathan G. Katz
UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
SECURITIES ACT OF 1933
Rel. No. 7638 / February 10, 1999
SECURITIES EXCHANGE ACT OF 1934
Rel. No. 41034 / February 10, 1999
Admin. Proc. File No. 3-8575
In the Matter of
JOSEPH J. BARBATO
867 Normandy Trace Road
Tampa, FL 33602
ORDER IMPOSING REMEDIAL SANCTIONS
On the basis of the Commission's opinion issued this day, it is
ORDERED that Joseph J. Barbato be, and he hereby is, barred from association with any broker or dealer or from participating in any penny stock offering; and it is
ORDERED that Joseph J. Barbato 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 Rule 10b-5 thereunder; and it is further
ORDERED that Joseph J. Barbato disgorge ill-gotten gains, plus prejudgment interest thereon, as set forth below: * 33
Barbato shall disgorge a total of $45,142.00, representing profits earned from his fraudulent conduct, which we deem to have occurred as of September 1990. Barbato also shall pay prejudgment interest in the amount of $45,690.05, calculated in accordance with Commission Rule 600(b) and due from October 1, 1990 through February 9, 1999. Interest shall continue to accrue on all funds owed until they are paid.
By the Commission.
Jonathan G. Katz
-- / 15 U.S.C. § 77q.
-- / 15 U.S.C. § 78j.
-- / 17 C.F.R. § 240.10b-5.
-- / This proceeding was conducted under the Commission's former Rules of Practice, which were in effect when the case was docketed. Under the "Transition Provision" set forth in the Federal Register notice for the new Rules of Practice, the former Rules govern since the case was docketed prior to June 23, 1995. See 60 Fed. Reg. 32,738 (1995).
-- / A "short squeeze" occurs when an issuer or promoter of a stock attempts to move the price of that stock upward in order to force persons who hold short positions in that stock (who are betting that the stock price will fall) to cover their short positions and prevent losses. The sudden surge of buying leads to even higher prices, further aggravating the losses of short sellers who have not covered their positions. See Downes, John, and Goodman, Jordan E., Barron's Finance and Investment Handbook , (2d ed.) at 461. See also SEC v. Lorin , 877 F. Supp. 192, 200 (S.D.N.Y. 1995), aff'd in part, vacated in part , 76 F.3d 458 (2d Cir. 1996).
-- / The law judge found that Barbato misrepresented to Gordon the amount of commissions that he earned from her Stuart- James purchases. The law judge also found that Barbato failed to make disclosures to each of the other customer witnesses who testified at the hearing regarding the level of his commissions. The Division's expert analyzed data for Barbato's trading between December 1986 and November 1989 and calculated that Barbato's customers were charged, on average, 12.8 percent commission on all buys and sells. For conduct after November 1989, the law judge estimated Barbato's commissions based on information relating to Barbato's 1986-1989 trades. The record does not include commission data for the majority of the transactions at issue here. We therefore make no finding of violation in connection with Barbato's alleged failure to disclose information about his commissions, except in connection with Ted Spangenberg's account. See infra , II.G. and III.B.
-- / Unlike some of the other issuers whose stock Barbato recommended, Warrantech was modestly profitable at the time that he was recommending it.
-- / During this same period of time, Barbato recommended that other customers, including Ted Spangenberg, sell Warrentech stock.
-- / While the company had obtained legal opinions that it was in compliance with relevant gaming and maritime laws, the company's prospectus disclosed that violations of such regulations might result in the forfeiture of its ships, monetary sanctions, or costly modifications to its vessels.
-- / Schneider was also to have received a lump sum of approximately $200,000 after a trust created for the benefit of his mother was liquidated upon her death. It is unclear from the record when he received this bequest.
-- / At the same time that Barbato was recommending Europa Cruises to Schneider, Barbato was selling shares in the company for another customer, Ted Spangenberg. On October 3, 1989, Schneider purchased 750 shares, and on October 18, 1989, another 1,250 shares. On October 13, 1989, Spangenberg sold 3,200 shares.
-- / With respect to some securities, Barbato arranged for Spangenberg to sell shares while Barbato was purchasing that security for his own account. For example, on October 27, 1988, Spangenberg sold 5,000 shares of Warrentech, and on November 15, 1988, Barbato bought 5,000 shares for his own account. On February 21, 1989, Spangenberg sold 15,000 shares of Warrentech, and on February 22, 1989, Barbato bought 5,000 shares. Barbato did not inform Spangenberg about these purchases.
-- / On three trade tickets in 1990, shortly before Barbato left Stuart-James, the actual commission amount was disclosed.
-- / See , e.g. , Donald A. Roche , Securities Exchange Act Rel. No. 38742 (June 17, 1997), 64 SEC Docket 2042, 2044-45; C. James Padgett , Securities Exchange Act Rel. No. 38423 (March 20, 1997), 64 SEC Docket 319, 330, aff'd sub nom. , Sullivan v. SEC , 159 F.3d 637 (D.C. Cir. 1998); see also Lester Kuznetz , 48 S.E.C. 551, 553 (1986) (predictions of specific and substantial increases in the price of any security that are made without a reasonable basis are fraudulent).
-- / Section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and Section 17(a) of the Securities Act prohibit fraudulent practices in connection with transactions in any security.
-- / See , e.g. , Richard J. Puccio , Securities Exchange Act Rel. No. 37849 (October 22, 1996), 63 SEC Docket 158 (broker failed to provide any negative information about stocks he recommended, thereby violating the antifraud provisions); V.F. Minton Securities, Inc. , 51 S.E.C. 346, 351 (1993), aff'd mem. , 18 F.3d 937 (5th Cir. 1994) (a broker's recommendation implies that he has done a reasonable investigation and that his recommendation is based on such investigation).
-- / Even if his customers were sophisticated, it would not change our conclusion about Barbato's violations involving price predictions, material misrepresentations, or omissions. We have previously rejected arguments that customers were not defrauded because they were "sophisticated or wished to speculate." James F. Novak , 47 S.E.C. 892, 895 (1983). See also Jay Houston Meadows , Securities Exchange Act Rel. No. 37156 (May 1, 1996), 61 SEC Docket 2444, 2454, aff'd , 119 F.3d 1219 (5th Cir. 1997) (rejecting argument that antifraud provisions do not apply to experienced or sophisticated customers); William L. Kicklighter, Jr. , 51 S.E.C. 1, 5 (1991), aff'd sub nom , Brown v. SEC , 992 F.2d 328 (11th Cir. 1993) (Table) (same); cf . Henry J. Faragalli , Securities Exchange Act Rel. No. 37991 (November 26, 1996), 63 SEC Docket 826, 834 (a customer's wealth does not give a salesperson a license to disregard the customer's investment objectives).
-- / At the oral argument before us, Barbato's counsel claimed that Barbato was prejudiced by the witnesses' failing memories. Barbato's counsel made only generalized allegations of prejudice, and it appears from the record that the witnesses clearly remembered many details from their dealings with Barbato. We similarly reject Barbato's argument that witnesses testified because the Division held out a "carrot" that if they testified there might be a fund of money from which they might be reimbursed. The Division stated that it had made no promises of getting reimbursement. Moreover, the law judge found these witnesses credible.
-- / See , e.g. , Martin H. Engelman , Securities Exchange Act Rel. No. 35729 (May 18, 1995), 59 SEC Docket 1038, 1054 n.40, aff'd sub nom. , Isen v. SEC , 87 F.3d 1319 (9th Cir. 1996) (Table) (stock recommendations made in disregard of an investor's professed investment objectives violate the antifraud provisions when they are coupled with false representations that such securities meet those objectives); Richard N. Cea , 44 S.E.C. 8, 18 (1969) (it is incumbent on salesmen to make only such recommendations as they have reasonable grounds to believe meet their customers' expressed needs and objectives). See also Brown v. E.F. Hutton Group, Inc. 991 F.2d 1020, 1031 (2d Cir. 1993) (suitability claim under Section 10(b) and Rule 10b-5 in private securities litigation); Stephen T. Rangen , Securities Exchange Act Rel. No. 38486 (April 8, 1997), 64 SEC Docket 731 (suitability claim under NYSE rules).
-- / Mihara v. Dean Witter & Co., Inc. , 619 F.2d 814, 820 (9th Cir. 1980).
-- / Donald A. Roche , 64 SEC Docket at 2046-49; Albert V. O'Neal , 51 S.E.C. 1128, 1130 (1994).
-- / See , e.g. , Donald A. Roche , 64 SEC Docket at 2045 (annual turnover ratio of 3.3); Samuel B. Franklin & Co. , 42 S.E.C. 325, 328 (1964) (annual turnover ratio of 2.9).
-- / E.g. Shearson Lehman Hutton Inc. , 49 S.E.C. 1119, 1121 (1989) (measures of excessive trading include relationship between account opening balance and the amount of markups, commissions, and margin charges, and the break-even cost factor).
-- / See Donald A. Roche , 64 SEC Docket at 2048-49; Michael D. Sweeney , 50 S.E.C. 761, 766 (1991) (the requisite degree of control in a non-discretionary account is met where the client routinely follows the recommendations of the broker); see also Tiernan v. Blyth, Eastman, Dillon & Co. , 719 F.2d 1, 3 (1st Cir. 1983) (broker controls the account if his customer is unable to evaluate his recommendations and to exercise independent judgment).
-- / 87 F.3d 484, 486 (D.C. Cir. 1996). Section 2462 provides, in pertinent part, that any proceeding for the enforcement of any civil fine, penalty, or forfeiture must be commenced within five years from the date when the claim first accrued. 28 U.S.C. § 2462. In Johnson v. SEC , the D.C. Circuit held that Section 2462 applies to certain forms of relief sought in administrative proceedings by the Commission.
-- / Statutes of limitation do not act as an evidentiary bar. Therefore courts may admit evidence of misconduct outside of an applicable limitations period. See , e.g. , United States v. Gavin , 565 F.2d 519, 523 (8th Cir. 1977) (evidence of events extending beyond statute of limitations admissible to show motive, intent, a continuing scheme, and lack of inadvertent action).
-- / See Johnson , supra , 87 F.3d at 491. Barbato contends that the Division should be estopped from arguing that disgorgement is not a penalty because the Division argued that disgorgement is a penalty in the context of a bankruptcy proceeding. In SEC v. Telsey , 144 Bankr. 563, 565 (Bankr. S.D. Fla. 1992), the Division argued that disgorgement constituted a "fine, penalty, or forfeiture" within the meaning of the Bankruptcy Code. Soon after the bankruptcy court reached its decision, however, we reconsidered our position and asked the court to withdraw its opinion. Although the decision is still reported, our motion was granted, and an order vacating the decision was entered on October 25, 1993.
-- / We appreciate the practical difficulties faced by the Division when balancing the number of witnesses it wishes to call to testify against unnecessary duplication of testimony and use of judicial resources. However, other indicia, such as declarations, could be used to provide sufficient evidence to demonstrate violations without requiring each and every customer to testify. Moreover, other violations, such as mark-ups, are more amenable to proof by expert witness compilations of customer information.
-- / The Division alleged that Barbato also engaged in excessive and unsuitable trading in Camacho's account. The law judge dismissed this charge, and we make no findings about such allegations.
-- / Recently, we held that, absent changed circumstances, failure to assert an inability to pay disgorgement before the law judge can constitute a waiver precluding this Commission's consideration of inability to pay on appeal. Terry T. Steen , Securities Exchange Act Rel. No. 40055 (June 2, 1998), 67 SEC Docket 837. Because the decision in Steen had not been issued at the time Barbato was before the law judge, we will not rule that a claim of inability to pay has been waived.
-- / We have previously stated that we are guided by the factors cited by the court in Steadman v. SEC , 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd , 450 U.S. 91 (1981): (T)he egregiousness of the defendant's actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant's assurances against future violations, the defendant's recognition of the wrongful nature of his conduct, and the likelihood that the defendant's occupation will present opportunities for future violations. See also Donald T. Sheldon , 51 S.E.C. 59, 81 (1992), aff'd , 45 F.3d 1515 (11th Cir. 1995).
-- / All of the contentions advanced by the parties have been considered. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed herein.
-- / Although the Commission's new Rules of Practice were not applicable to this proceeding, we see no reason not to issue this disgorgement order according to the format prescribed by Commission Rule 600.