UNITED STATES OF AMERICA
Before the
SECURITIES AND EXCHANGE COMMISSION
Investment Advisers Act of 1940
Release No. 1765 / September 29, 1998
Administrative Proceeding
File No. 3-9744
____________________________________
) ORDER INSTITUTING PROCEEDINGS
In the Matter of ) PURSUANT TO SECTIONS 203(e)
) AND 203(f) OF THE INVESTMENT
RHUMBLINE ADVISERS and ) ADVISERS ACT OF 1940, MAKING
JOHN D. NELSON, ) FINDINGS AND IMPOSING REMEDIAL
) SANCTIONS
Respondents )
____________________________________)
I.
The Securities and Exchange Commission ("Commission") deems
it appropriate and in the public interest that public
administrative proceedings be, and hereby are, instituted
pursuant to Sections 203(e) and 203(f) of the Investment Advisers
Act of 1940 ("Advisers Act") against RhumbLine Advisers
("RhumbLine"), and John D. Nelson, ("Nelson") (collectively, the
"Respondents").
II.
In anticipation of the institution of these administrative
proceedings, the Respondents have submitted Offers of Settlement
("Offers"), which the Commission has determined to accept.
Solely for the purpose of these proceedings, and any other
proceedings brought by or on behalf of the Commission, or to
which the Commission is a party, and without admitting or denying
the findings contained herein, except those findings pertaining
to the jurisdiction of the Commission over them and over the
subject matter of these proceedings, which they admit, the
Respondents each consent to the entry of the findings and the
Order set forth herein.
III.
On the basis of this Order and the Offers submitted by the
Respondents, the Commission finds that: [1]
A. Respondents
1. RhumbLine is located in Boston, Massachusetts and is
registered with the Commission as an investment adviser. (File
No. 801-37845). The firm has approximately nine employees, 50
clients and $3.7 billion of assets under management. RhumbLine's
business consists primarily of managing equity index funds for
public and private pension plans.
2. Nelson is the founder and was at all relevant times the
chief executive officer ("CEO") of RhumbLine. During the times
relevant herein, Nelson was responsible for all of RhumbLine's
operations and investment management activities.
B. Other Relevant Person and Entities
1. From 1991 through October 1996, RhumbLine employed a
chief investment officer ("CIO") who was responsible for
developing and implementing an options trading program to
complement RhumbLine's management of equity index funds.
2. AT&T Corp., a New York corporation engaged in the
telecommunications business, administered during the relevant
time employee benefit and pension plan assets through its
subsidiary, AT&T Investment Management Corporation ("AT&T").
From 1992 through September 1996, AT&T was a client of
RhumbLine's options trading program. AT&T also was a client of
another RhumbLine investment program not involved in this matter.
3. Massachusetts Pension Reserves Investment Trust
("PRIT") contains the assets of the Massachusetts state employee
and teachers retirement system. From 1992 through September
1996, PRIT was a client of RhumbLine's options trading program.
PRIT also was a client of other RhumbLine investment programs not
involved in this matter.
C. Findings
1. Summary
This matter involves RhumbLine's and Nelson's failure
adequately to supervise the CIO. From January 1995 through
September 1996, the CIO engaged in certain unauthorized trading
and concealed and misrepresented losses in the AT&T options
account, and engaged in certain unauthorized trading in the PRIT
account in violation of the antifraud provisions of the
Securities Act of 1933 ("Securities Act"), the Securities
Exchange Act of 1934 ("Exchange Act"), and the Advisers Act. As
a result, the AT&T options account, sustained losses through
September 23, 1996 of approximately $150 million.[2] The PRIT
options account sustained losses of approximately $12 million.
The CIO was able to place unauthorized trades and misrepresent
losses in part because RhumbLine and Nelson failed to respond to
certain red flags, which should have alerted them to the CIO's
activities. Further, RhumbLine did not have procedures to
monitor the CIO's trading or his reporting of performance.
Consequently, RhumbLine and Nelson failed reasonably to supervise
the CIO with a view to detecting and preventing his securities
law violations.
2. Unauthorized Trading and Misstatements
of Losses in the AT&T Options Account
In 1991, RhumbLine hired the CIO, who had presented to
RhumbLine a plan to develop the options trading program.
RhumbLine eventually obtained four clients for the options
program, including AT&T and PRIT. Prior to retaining the CIO and
after his departure, RhumbLine did not engage in options trading
on behalf of its clients.
The investment objective for the AT&T options account was to
earn consistent, incremental premium income by writing: (1) call
options on stocks and sector indices contained in a $165 million
Standard & Poor's ("S&P") portfolio; and (2) put and call option
spreads on the S&P 100 and S&P 500 indices. AT&T and RhumbLine
executed written account guidelines, which prohibited certain
trades, including in-the-money options; naked, short S&P 100 and
S&P 500 options; S&P 100 and S&P 500 options that exposed the
account to a risk of loss greater than $6 million; and options
written against greater than approximately $25 million in
technology sector assets.
From January 1995 through September 1996, the CIO engaged in
unauthorized trading in the AT&T account by placing options
trades that represented attempts to profit on the future
direction of the market. When his strategy was not successful,
the CIO rolled positions forward and thereby avoided having to
realize losses. Such trading was inconsistent with AT&T's
investment objective of seeking only premium income. Some of the
CIO's trading also violated the written guidelines governing the
account. He wrote naked, short S&P 100 and S&P 500 index
options, and he exposed the account to a risk of loss greater
than its $6 million loss constraint. The CIO wrote options
against hundreds of millions of dollars of technology sector
assets, instead of the approximately $25 million permitted by the
guidelines.
During the third quarter of 1996, the CIO concealed his
unauthorized trading by misrepresenting and failing to disclose
losses in the AT&T options account. On July 19, 1996; August 6,
1996; and August 29, 1996, in written and oral performance
reports to representatives of AT&T, the CIO falsely understated
losses by approximately $26 million to $43 million. The CIO did
not disclose the account's mounting losses to representatives of
AT&T. Upon learning of the losses, Nelson informed AT&T on
September 19, 1996. AT&T thereafter suspended trading in the
account. Total losses in the AT&T options account from January
1996 through September 23, 1996 were approximately $150 million.
[3]
3. Unauthorized Trading in the PRIT Account
The investment objective for the PRIT options account was to
earn incremental premiums by writing S&P 100 and S&P 500 index
option spreads. PRIT and RhumbLine executed written guidelines,
which prohibited, among other things, writing options that
exposed the account to a risk of loss greater than four percent
of the value of PRIT's underlying stock portfolio, as of the
beginning of the year.
In the PRIT account, as in the AT&T account, beginning in
April 1995, instead of following the investment objective of
earning incremental premium income, the CIO attempted to profit
on the future direction of the market. He wrote in-the-money and
at-the-money options, and he rolled positions forward to avoid
realizing losses. On at least three occasions, the CIO violated
PRIT's written guidelines by exceeding the account's four percent
loss constraint. On September 18, 1996, Nelson, who had not
previously known that the CIO had exceeded PRIT's loss
constraint, informed PRIT of the losses. Total 1996 losses in
the PRIT options account were approximately $12 million. [4]
By the conduct described above, the CIO violated Section
17(a) of the Securities Act and Section 10(b) of the Exchange Act
and Rule 10b-5 thereunder, and he aided and abetted violations of
Sections 206(1) and 206(2) of the Advisers Act.
4. Nelson Failed to Detect the CIO's Unauthorized Trading
Certain red flags should have alerted Nelson to the CIO's
activities. During the spring of 1995, Nelson reviewed the
positions in the clients' accounts and determined that the CIO
had written uneven numbers of put and call option spreads on the
S&P 100 and S&P 500 indices. Although this was an indication
that the CIO was trading in a manner that was inconsistent with
the accounts' investment objectives, Nelson took no additional
steps to detect or prevent unauthorized trading by the CIO.
During the summer of 1996, Nelson noticed options written against
technology sector assets in the AT&T account in an amount in
excess of the $25 million limit contained in AT&T's written
guidelines. He questioned the CIO, who asserted that AT&T had
authorized him to write the positions. Despite knowing that the
written guidelines prohibited positions of the size written,
Nelson failed unreasonably to verify the CIO's assertion.
Finally, Nelson knew that, in early 1996, the AT&T account had
sustained large losses, and that AT&T had expressed concern about
those losses. Despite this knowledge, he did not institute
additional procedures to monitor the CIO's trading.
Nelson allowed the CIO to exercise complete control over all
aspects of the options trading program, and no one regularly
checked his trades to ensure that they complied with client
guidelines. In addition, the CIO had complete control over
calculating and reporting performance for the options accounts.
5. RhumbLine Lacked Controls and Procedures
Relating to Options
RhumbLine had no policies or procedures designed to detect
or prevent unauthorized trading in the options clients' accounts.
The firm had no system for risk management or for monitoring the
CIO's trading. Nelson relied exclusively on unverified oral
reports from the CIO to monitor the options trading program.
There was no segregation of responsibility for placing and
valuing trades. Moreover, there was no procedure to ensure that
the CIO correctly calculated or adhered to client loss
constraints.
D. Failure Reasonably to Supervise
1. Standards of Supervision
Under Sections 203(e)(6) and 203(f) of the Advisers Act, the
Commission may seek sanctions where an investment adviser or an
associated person has failed reasonably to supervise, with a view
to preventing violations of the federal securities laws and rules
thereunder, another person subject to the investment adviser's or
associated person's supervision who commits such violations. See
Van Kampen American Capital Asset Mgmt., Advisers Act Rel. No.
1525 (Sept. 29, 1995), 60 SEC Docket 1284; Kemper Fin. Serv.,
Inc., Advisers Act Rel. No. 1494 (June 6, 1995), 1995 SEC LEXIS
1311 (settlement). The Commission has repeatedly emphasized that
the duty to supervise is a critical component of the federal
regulatory scheme. See John H. Gutfreund, Exchange Act Rel. No.
31554 (Dec. 3, 1992), 52 SEC Docket 4370, 4386. Management bears
responsibility for ensuring that procedures reasonably designed
to prevent and detect wrongdoing are adopted, and to take
appropriate steps if it receives indications that such procedures
are not working. First Capital Strategists, Advisers Act Rel.
No. 1648 (Aug. 13, 1997), 1997 SEC LEXIS 1646 (investment adviser
and its partners failed to supervise trader who engaged in
unauthorized trading; noting that it was insufficient to rely on
trustworthiness of trader without independently reviewing
positions); Van Kampen American Capital Asset Mgmt., 60 SEC
Docket at 1284 (finding that investment adviser failed to
supervise because it gave complete control over pricing
procedures to portfolio manager).
Supervisors must respond vigorously to indications of
possible wrongdoing. See Kemper Fin. Serv., Inc., 1995 SEC Lexis
1311; see also Gutfreund, 52 SEC Docket at 4386-87; Wedbush Sec.,
Inc., 48 S.E.C. 963, 967 (1988) (especially imperative that those
in authority exercise particular vigilance when indications of
irregularity reach their attention). Red flags and suggestions
of irregularities demand inquiry as well as adequate follow-up
and review. When indications of impropriety reach the attention
of those in authority, they must act decisively to detect and
prevent violations of the federal securities laws. Kemper Fin.
Serv., Inc., 1995 SEC Lexis 1311 (quoting Edwin Kantor, Exchange
Act Rel. No. 32341 (May 20, 1993), 54 SEC Docket 293, 301); see
also Michael H. Hume, Exchange Act Rel. No. 35608 (Apr. 17,
1995), 1995 SEC Lexis 983 (a failure to supervise can arise where
a supervisor was aware only of red flags or suggestions of
irregularity); Frederick H. Joseph, Exchange Act Rel. No. 32340
(May 20, 1993), 54 SEC Docket 283, 291. The Commission has
consistently stressed the importance of vigilant supervision.
See, e.g., Smith Barney, Harris Upham & Co., Exchange Act Rel.
No. 21813 (March 5, 1985), 32 SEC Docket 999, 1010.
2. RhumbLine And Nelson Failed Reasonably
to Supervise the CIO
As a result of the conduct described above, RhumbLine and
Nelson failed reasonably to supervise the CIO, who was subject to
their supervision within the meaning of Section 203(e)(6) of the
Advisers Act, with a view to preventing his violations of Section
17(a) of the Securities Act and Section 10(b) of the Exchange Act
and Rule 10b-5 thereunder, and his aiding and abetting of
violations of Sections 206(1) and 206(2) of the Advisers Act.
IV.
In view of the foregoing, the Commission deems it
appropriate and in the public interest to accept the Offers of
Settlement submitted by RhumbLine and Nelson and to impose the
sanctions agreed to in the Offers.
V.
Accordingly, IT IS HEREBY ORDERED, pursuant to Sections
203(e), 203(f) and 203(i) of the Advisers Act, that:
A. Nelson be, and hereby is, suspended from association
with any investment adviser for a period of three months,
effective on the second Monday following the entry of this Order;
B. Nelson be, and hereby is, suspended from acting in any
supervisory or proprietary capacity with any investment adviser
for a period of nine months immediately following the period of
his suspension from association;
C. Nelson shall, within 30 days of the entry of this
Order, pay a civil money penalty in the amount of $10,000 to the
United States Treasury. Such payment shall be: (a) made by
United States postal money order, certified check, bank cashier's
check or bank money order; (b) made payable to the Securities and
Exchange Commission;(c) hand-delivered or mailed to the Office of
the Comptroller, U.S. Securities and Exchange Commission, 6432
General Green Way, Stop 0-3, Alexandria, Virginia; and (d)
submitted under cover of a letter which identifies Nelson as a
Respondent in these proceedings, the file number of these
proceedings and the Commission's case number. A copy of the
cover letter and money order or check shall be sent to Juan
Marcel Marcelino, District Administrator, Securities and Exchange
Commission, Boston District Office, 73 Tremont Street, Suite 600,
Boston, Massachusetts, 02108;
D. RhumbLine be, and hereby is, censured;
E. RhumbLine shall, within 45 days of the entry of this
Order, pay a civil monetary penalty in the amount of $50,000 to
the United States Treasury. Such payment shall be: (a) made by
United States postal money order, certified check, bank cashier's
check or bank money order; (b) made payable to the Securities and
Exchange Commission; (c) hand-delivered or mailed to the Office
of the Comptroller, U.S. Securities and Exchange Commission, 6432
General Green Way, Stop 0-3, Alexandria, Virginia; and (d)
submitted under cover of a letter which identifies RhumbLine as a
Respondent in these proceedings, the file number of these
proceedings and the Commission's case number. A copy of the
cover letter and money order or check shall be sent to Juan
Marcel Marcelino, District Administrator, Securities and Exchange
Commission, Boston District Office, 73 Tremont Street, Suite 600,
Boston, Massachusetts, 02108;
F. RhumbLine shall comply with its undertakings to:
1. retain, at its own expense, within 30 days of the entry
of this Order, the services of an independent consultant (the
"consultant") who is not unacceptable to the Commission staff and
who shall review RhumbLine's supervisory, compliance and other
policies and procedures designed to prevent and detect federal
securities law violations of the nature and type involved in this
matter and recommend policies and procedures designed reasonably
to prevent and detect such violations.
2. provide to the Commission staff, within 10 days from
the date of engagement, a copy of an engagement letter detailing
the consultant's responsibilities pursuant to subparagraph 1.,
above;
3. require the consultant to make his or her conclusions
and recommendations within three months from the date of the
engagement in the form of a report, which shall set forth in
detail the nature and scope of the review conducted, as well as
the conclusions and recommendations of the consultant. RhumbLine
shall cooperate fully with the consultant and provide such person
with access to its files, books, records and personnel as
reasonably requested for such person's review;
4. require the consultant promptly to provide copies of
its report, referenced above, to the Commission staff, and to
discuss the findings therein with the Commission staff;
5. take all necessary and appropriate steps to adopt and
to implement all recommendations of the consultant, provided,
however, that as to any of the consultant's recommendations that
RhumbLine determines is unduly burdensome or impractical,
RhumbLine may suggest an alternative procedure designed to
achieve the same objective, by submitting it in writing to the
consultant and the Commission staff. The consultant shall
reasonably evaluate RhumbLine's alternative procedure. RhumbLine
shall abide by the consultant's determination with regard thereto
and shall adopt those recommendations deemed appropriate by the
consultant: and
6. ensure that for the period of engagement and for a
period of two years from completion of the engagement, the
consultant shall not enter into any employment, consultant,
attorney-client, auditing or other professional relationship with
RhumbLine, or any of its present or former affiliates, directors,
officers, employees, or agents acting in their capacity. Any
firm with which the consultant is affiliated or of which he/she
is a member, and any person engaged to assist the consultant in
performance of his/her duties under this Order shall not, without
prior written consent of the Boston District Office, enter into
any employment, consultant, attorney-client, auditing or other
professional relationship with RhumbLine, or any or its present
or former affiliates, directors, officers, employees, or agents
acting in their capacity as such for the period of engagement and
for a period of two years after the engagement; and
G. RhumbLine shall comply with its undertaking to appoint
a director of compliance, whose employment shall be pursuant to a
written contract approved by RhumbLine's Advisory Board, and
whose compensation shall be set by the Board; shall define the
duties of such officer, including the development of a written
manual of firm compliance procedures for approval by the CEO and
the Board; and shall ensure that such officer is subject to the
direct supervision of, and reports to, RhumbLine's CEO.
IT IS FURTHER ORDERED that, within nine months from the
entry of this Order, RhumbLine shall provide an affidavit via
certified mail to Juan Marcel Marcelino, District Administrator,
Securities and Exchange Commission, Boston District Office, 73
Tremont Street, Suite 600, Boston, Massachusetts 02108, that it
has complied with its undertakings set forth in paragraphs F. and
G., above. Such affidavit shall contain a statement describing
the procedures adopted and implemented in compliance with
paragraph (4) above.
**FOOTNOTES**
[1]: The findings herein are not binding on anyone other than
the Respondents.
[2]: Total pension assets held by AT&T during the relevant time were
approximately $47 billion.
[3]: The other AT&T account at RhumbLine was not affected by the matters
discussed in this paragraph.
[4]: The other PRIT accounts at RhumbLine were not affected by the matters
discussed in this paragraph.
IT IS FURTHER ORDERED that, within 30 days after the
expiration of the suspensions described in paragraphs B. and C.,
above, Nelson shall provide an affidavit via certified mail to
Juan Marcel Marcelino, District Administrator, Securities and
Exchange Commission, Boston District Office, 73 Tremont Street,
Suite 600, Boston, Massachusetts 02108, setting forth with
particularity the details of his compliance with the suspensions.
Respondent Nelson shall not act in a supervisory or proprietary
capacity until he delivers such affidavit.
By the Commission.
Jonathan G. Katz
Secretary