UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7257 / January 17, 1996 SECURITIES EXCHANGE ACT OF 1934 Release No. 36724 / January 17, 1996 ADMINISTRATIVE PROCEEDING File No. 3-8928 ____________________________________ : In the Matter of : : ORDER INSTITUTING PAINEWEBBER INCORPORATED; : PUBLIC ADMINISTRATIVE : PROCEEDINGS, MAKING : FINDINGS, IMPOSING : REMEDIAL SANCTIONS, AND Respondent. : ISSUING CEASE : AND DESIST ORDER : ____________________________________: I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b), 21B, and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against PaineWebber Incorporated ("PaineWebber"). In anticipation of the institution of these administrative proceedings, PaineWebber has submitted an Offer of Settlement, 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 prior to a hearing pursuant to the Commission's Rules of Practice, 17 CFR  201.100 et seq., PaineWebber, by its Offer of Settlement, consents to the entry of this Order Instituting Public Administrative Proceedings, Making Findings, Imposing Remedial Sanctions, And Issuing Cease And Desist Order ("Order") without admitting or denying the ==========================================START OF PAGE 2====== Commission's findings except for those contained in Section III.A., which are admitted. ==========================================START OF PAGE 3====== II. Accordingly, IT IS HEREBY ORDERED that proceedings pursuant to Section 8A of the Securities Act and Sections 15(b)(4), 21B, and 21C of the Exchange Act be, and hereby are, instituted. III. On the basis of this Order and PaineWebber's Offer of Settlement, the Commission finds the following:-[1]- A. RESPONDENT PaineWebber is a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act. PaineWebber is a member of the New York Stock Exchange, Inc., the National Association of Securities Dealers, Inc., and all other major stock, options, and futures exchanges. PaineWebber has approximately 6,000 registered representatives ("RRs") in 300 retail branch offices. B. SUMMARY This proceeding involves PaineWebber's conduct in two areas. The first area involves PaineWebber's offer and sale of certain public limited partnership interests and other public investments, referred to by PaineWebber as "direct investments," between 1986 and 1992. As explained below, sales and marketing materials for four families of direct investments -- PaineWebber/Geodyne oil and gas programs, PaineWebber Insured Mortgage Partners, PaineWebber/Independent Living Mortgage, and Pegasus Aircraft Partners -- overstated benefits and understated risks of the investments, and characterized certain direct investments as suitable for conservative investors without sufficiently disclosing the risk of loss of principal. In addition, PaineWebber sold direct investments (including, but not limited to, those mentioned above) to numerous investors for whom they were unsuitable and in concentrations too high given the investors' age, financial condition, sophistication and investment objectives. As a result of the foregoing, PaineWebber violated the antifraud provisions of the federal securities laws, Section 17(a) of the Securities Act and Sections 10(b) and 15(c)(1) of the Exchange Act and Rules 10b-5 and 15c1-2 -[1]- The findings herein and the entry of this Order are solely for the purposes of this proceeding and shall not be binding on any other person or entity named in any other proceed- ing. ==========================================START OF PAGE 4====== thereunder. PaineWebber also violated Section 17(a) of the Exchange Act and Rule 17a-3 thereunder by failing to make and keep certain required records of purchases and sales of direct investments on the secondary market. In addition, PaineWebber failed reasonably to supervise certain RRs and other PaineWebber employees who sold these products. The second area involves PaineWebber's failure reasonably to supervise ten RRs (two of whom were branch office managers ("BOMs")) in eight branch offices, who engaged in fraudulent sales practices in connection with certain retail customer accounts. C. PAINEWEBBER'S DIRECT INVESTMENT SALES PRACTICES 1. Background Between 1986 and 1992, PaineWebber sold approximately $3 billion in public direct investments. Generally, the direct investments were designed to enable investors to buy interests in real estate, oil and gas, airplane leases, and other assets. Most direct investment programs were organized as limited partnerships, with the program sponsor acting as general partner and investors purchasing limited partnership units. Most of the public direct investments sold by PaineWebber were sponsored by subsidiaries or affiliates of PaineWebber. In instances where the sponsor was not affiliated with PaineWebber, PaineWebber generally acted as an administrative general partner or served in a comparable role. Most direct investments were illiquid over their multi-year lives. Direct investments were sold to retail customers through PaineWebber's branch office sales force, but the marketing effort was coordinated primarily by the Direct Investment Department headquartered in New York. The Direct Investment Department, also at times called the Tax Shelter Department and the Private Investment Department (hereinafter the "Direct Investment Department"), was responsible for researching and selecting the direct investments to be sold by PaineWebber, and for managing the sales and marketing efforts. At the outset of each direct investment program, the sponsor and PaineWebber typically prepared: (a) a prospectus; (b) a sales brochure or "wrapper" that was provided to investors with the prospectus; and (c) a marketing guide, intended for internal distribution to PaineWebber RRs, that contained suggested scripts and other sales tips. During the life of the program, the sponsor and PaineWebber prepared and distributed public sales materials such as videotapes and slide shows, and internal marketing materials to RRs. ==========================================START OF PAGE 5====== RRs received significant incentives to sell direct investments. The sales credit for direct investments sold to retail customers was typically 7%, substantially more than the typical commissions for exchange-listed equities or bonds. The amount the RR received (called the "payout") was between 40% and 50% of the sales credit, depending on the amount of direct investments the RR sold. This "payout" was almost always higher than the standard PaineWebber payout for bond and equity sales, which ranged from 30% to 45%, and was comparable to the payout for other PaineWebber proprietary products. In addition to higher commission income, RRs were offered free vacations and other prizes for meeting sales goals. Among the incentives were free trips for top sellers and their spouses to Monte Carlo, Monaco; Vail, Colorado; Marbella, Spain; and Banff, Canada; weekend retreats at local hotels; dinners; and VCRs. 2. Misrepresentations: Geodyne Between 1984 and 1991, PaineWebber sold approximately $568 million of units, to thousands of investors, in twenty-nine oil and gas limited partnerships variously called the PaineWebber/Geodyne Energy Income Programs and PaineWebber/Geodyne Institutional Pension Programs ("IP") (collectively referred to as "Geodyne"). The programs were offered in five different series with sales as follows: Program Dates Amount Sold Geodyne I 1984-86 $90 million Geodyne II 1987-89 $218 million Geodyne III 1989-91 $154 million IP 1 1988-90 $61.2 million IP 2 1990-92 $44.8 million The general partners and sponsors of the Geodyne programs were several wholly-owned subsidiaries of Geodyne Resources, Inc. ("GRI"). From 1986 to 1993, PaineWebber owned between 40% and 49% of GRI's common stock. From 1984 forward, PaineWebber received approximately $48 million in sales fees, and GRI received approximately $38.5 million in management and other front-end fees. The majority of Geodyne units were sold to individual investors, many of whom had expressed an interest in conservative, income-oriented investments. The Geodyne programs were designed to acquire interests in producing oil and gas properties in order to provide investors with periodic cash distributions. After front-end fees to PaineWebber and GRI, approximately 85% of a unit-holder's investment was available to purchase oil and gas properties. The unit-holders were then to receive a share of net revenues from oil and gas production, distributed on a quarterly basis. In ==========================================START OF PAGE 6====== addition, at the end of the partnership period, which was expected to last approximately ten years, the investors were to receive a share of the proceeds from the sale of remaining oil and gas reserves. The quarterly cash distributions had two components: (1) income (or return on investment) from the sales of oil and gas, and (2) a partial return of the investors' capital. (The excess of cash distributions over return on investment is generally referred to as "return of capital.") The return of capital component was substantial because the oil and gas reserves owned by the partnerships were depleting assets and, in a typical program, more than 30% of gas reserves and one-half of oil reserves were exhausted in the first three years. Certain sales and marketing material approved and distributed by PaineWebber misrepresented the fundamental risks and rewards of investing in Geodyne programs. The materials (1) suggested that cash distributions received by investors reflected current income or yield, when in fact a substantial part of such distributions was return of capital; (2) characterized Geodyne programs as investments with a high degree of safety of principal and suitable for conservative investors without sufficiently disclosing the risk that an investor could lose a portion of principal; (3) represented that the investments would perform well whether oil and gas prices went up or down, when in fact substantial and early increases in oil prices were essential to the programs' success; and (4) misrepresented tax benefits associated with the cash distributions. i. Misrepresentation of Cash Distributions as Income Geodyne's quarterly cash distributions were touted to investors as one of its major benefits. Investors were repeatedly told that they would receive at least 12% annually and RRs were told to emphasize this benefit. Certain sales and marketing materials both stated and implied that the partner- ship's quarterly cash distributions reflected income, yield or return on investment, obscuring the fact that a substantial portion of the distributions was a return of investment. A public videotape used in selling Geodyne I (between 1984 and 1986) stated that the partnerships provided investors with "Current Income" in the form of quarterly cash distributions, and listed "Current Income" as the first of five reasons to invest in Geodyne. The marketing slogan for Geodyne I and II, used in public slide presentations and on marketing materials given to RRs between 1984 and 1989, was: "WHEN YOU THINK OF INCOME . . . THINK OF GEODYNE." The public sales brochure for Geodyne II listed as the first partnership objective "Generating Income" and stated that due to tax changes "you'll be able to keep more of ==========================================START OF PAGE 7====== partnership income." Certain sales materials also referred to the cash distributions as "yield" or "return." Certain sales and marketing materials further reinforced the impression that cash distributions were solely a return on investment by comparing the rate of distributions to returns on alternative investments. For example, the internal marketing guide for the first IP program, offered between 1988 and 1990, instructed RRs to make a sales pitch to income-oriented investors that explicitly equated IP's cash distributions with return on other investments: The Sales Presentation Ask your client or prospect what his or her portfolio's average annual yield is. - Point out that IP offers high current income targeted at 12+%, and that could be even higher. This is higher than typical yields and can raise the portfolio's average. The sales pitch continued by stating that the cash distributions would "compound" over a period of years: - IP's quarterly payout makes funds available for reinvestment and maximum compounding. Since pension funds are invested for the long term, the power of compounding should be particularly attractive to the fund manager. The guide included a chart showing that a $10,000 investment at a "12% constant rate of return" compounded annually for thirty years will result in a value of $3 million. This was a false analysis because cash distributions would provide a compound return only if, unlike Geodyne, the underlying principal remained intact. The marketing guide for Geodyne II (distributed to RRs between 1986 and 1989) suggested that RRs make a similar sales pitch to income-oriented investors: "As your investment advisor, it is my responsibility to maximize your cash flow.... By investing in [Geodyne] your cash flow should increase from what you are presently getting on this money." Nothing in the marketing guide suggested that RRs inform investors that the "cash flow" from Geodyne was fundamentally different from divi- dends, interest, or other forms of income. Neither the public marketing materials nor the prospectus for the Geodyne programs offered through 1988 stated that the cash distributions, which they called "income," ==========================================START OF PAGE 8====== reflected in part a return of capital. In May 1989, in connection with the introduction of the Geodyne III program, changes were made in the prospectus and some marketing materials to state for the first time that cash distributions might include a return of capital component. By this time, PaineWebber customers had invested almost $300 million in Geodyne programs. The public sales brochure for Geodyne III stated, in a fine print footnote to a paragraph describing the cash distribution: "This is not necessarily a 12% rate of return. See Prospectus for details." The prospectus for Geodyne III stated on page 5, in the last sentence of a paragraph entitled "No Guarantee of Return," the following: "Even if the General Partner's objective of cash distributions of 12% per annum or more of Unit Holders' Subscription is attained in the early years of the Partnership's operations, the actual economic return to a Unit Holder might not be competitive with certain other types of investment because oil and gas reserves are depleting assets and a substantial portion of the cash distributions consists of a return of the Unit Holders' capital investment in the reserves." In June 1989, an amended prospectus and marketing materials were issued for the IP 1 program, which did not mention that cash distributions included return of capital. Certain marketing materials continued to be circulated to RRs that created the impression that cash distributions reflected real return on investment. RRs were told to contact Geodyne investors shortly after cash distributions were mailed out, and to encourage them to reinvest based on prior results. In the early fall of 1989, a leaflet was distributed to RRs entitled "GREAT OFFICE SALES IDEA NO. 2." The leaflet encouraged RRs to increase sales of Geodyne "through repeat business with satisfied clients." The leaflet then stressed the clients were satisfied because they were "currently receiving quarterly distributions ranging from 13% annualized to 18% annualized, 60% to 70% non-taxable. . . . Subsequent partnerships are expected to follow the same trend." A computer printout was attached listing prior purchasers of Geodyne and the leaflet stressed that "these investors offer excellent potential for repeat business." The leaflet did not instruct RRs to caution investors that cash distributions were not indicative of ultimate returns, that cash distributions were high primarily because most partnerships were still in their early years, or that absent dramatic increases in oil and gas prices, cash distributions in existing partnerships would soon begin to decline.-[2]- It -[2]- As stated above, a substantial portion of the oil and gas was produced in the first three to five years. As the production level declined in subsequent years, cash distributions (continued...) ==========================================START OF PAGE 9====== also did not instruct RRs to inform investors that the reason distributions were "60% to 70% non-taxable" was that a portion of the distributions were not income, or that the projected returns on partnerships were less than prevailing rates on corporate bonds, treasury bonds, and comparable fixed-income investments. Similar marketing materials were repeatedly sent to RRs, usually at the time of cash distributions. Each quarter, PaineWebber RRs received a report on cumulative distributions for all the existing limited partnerships. The report typically had a headline containing the words "Results" or "Track Record." In February 1991, PaineWebber's newsletter sent to its retail sales force suggested that cash distributions be used to attract repeat business. These suggestions were followed, as shown by one RR's letter to customers in 1990: "As you know, your Geodyne Energy Income Fund, L.P. just paid its latest distribution in May [1990], and the next distribution is due August 15, 1990. For many of you, it will be higher than May's. Geodyne is one of the best performing assets you have in your portfolio! That's evident by the distributions of income!" (emphasis in original) This letter was sent to the RR's customers even though GRI's own projections, which were shared with PaineWebber, indicated that unless energy prices increased significantly, the ultimate rate of return for most partnerships would be negligible. In August 1990, a "bullet sheet" was sent to BOMs in the Southeast Region and North Central (Midwest) Region for distribution to RRs for use in sales presentations. At the time, PaineWebber was sponsoring "Revenue Days" at branch offices, in which RRs, including those not formerly active in selling limited partnerships, were encouraged to focus for a day on selling Geodyne. Thus, the bullet sheet was being used in part by RRs who were not familiar with Geodyne. The document contained a series of bullet points that characterized Geodyne as a high- income investment: 1. PROJECTED 12% CURRENT YIELD ... a high income check every quarter... 2. TAX-FREE INCOME Approximately 70% of the income in the first 4 to 6 -[2]-(...continued) would also decline unless the production decreases were offset by price increases. ==========================================START OF PAGE 10====== years is non- taxable... 3. GROWTH POTENTIAL FOR INCOME From rising energy AND RESERVES. prices. * * * AN INVESTMENT OPPORTUNITY OFFERING HIGH TAX- FAVORED INCOME WITH GROWTH POTENTIAL. . . In seven weeks in August and September of 1990, PaineWebber sold $63 million in Geodyne units. Of the 923 RRs who sold units, 210 were first time sellers. PaineWebber further reinforced investors' impressions that Geodyne's cash distributions reflected return on investment in monthly account statements sent to customers. Before 1989, account statements listed the price of direct investments as "unavailable." Beginning in 1989, PaineWebber began listing a price on most statements. For Geodyne, it listed as the current price the original purchase price of the program and used this price in valuing the customer's portfolio. Beginning in 1990, monthly statements stated that the valuation for some direct investments was based on the initial offering price, and stated on the reverse side that the price "may or may not reflect current or future market value." However, the statements did not disclose that the direct investments were being sold at a significant discount to the original price in secondary market sales. ii. Misrepresentation of Safety of Investment PaineWebber mischaracterized Geodyne as a safe and conservative income-oriented investment without sufficiently informing prospective investors of the risk of loss of principal. For example, the first page of the sales wrapper for Geodyne II (sent to prospective investors between 1986 and 1989) listed as one of the three major objectives of the investment: High Degree of Safety of Principal, enhanced through the expertise of Geodyne and the support of PaineWebber Incorporated -- one of America's leading investment organizations -- making PaineWebber/Geodyne Energy Income Program II appropriate even for the most conservative individual and qualified retirement plans. ==========================================START OF PAGE 11====== In addition, PaineWebber recommended in marketing guides that Geodyne be sold to "Investors seeking above average income," "Municipal and Corporate bond buyers," and "Preferred stock and GNMA buyers." RRs were told that Geodyne was an excellent alternative to municipal bonds and other income-producing investments. These statements, which were passed on to investors, were misleading because returns from the Geodyne programs fluctuated significantly based on changes in energy prices, and the investors' principal was returned over the life of the partnership. iii. Misrepresentation of Effect of Energy Prices Sales and marketing literature addressing the effect of energy prices on a Geodyne investment frequently understated or failed to state the importance of an early rise in energy prices, and thereby understated the investment's risk. Price increases were essential to the success of an investment in Geodyne because expected price increases were reflected in the original cost of oil and gas reserves. PaineWebber knew that returns to Geodyne investors would be substantially and adversely affected if anticipated price increases did not occur in the first two to four years of the program because of the rate of depletion of oil and gas. GRI's internal studies, shared with PaineWebber, show that its goal in purchasing oil and gas properties was to provide an annual return to limited partners of approximately 10-11 per cent if energy prices increased at the rates predicted by GRI. Throughout the period, GRI was predicting substantial natural gas prices increases, often as high as 10 per cent annually, and substantial oil price increases. However, certain sales materials implied that investors would receive attractive returns even if prices did not rise, and that rising energy prices would serve to increase these expected returns further. Sales brochures and scripts repeatedly stressed as a major benefit to Geodyne investors, in addition to current income, future growth in value of the investment if energy prices increased over the long term. These presentations falsely led many investors to believe that any energy price increase would be a bonus, when in fact they were an essential prerequisite to achieving even minimal returns. The sales wrapper for Geodyne II, for example, stated that "[t]he value of a [Geodyne II] investment should grow over time if the prices of oil and gas increase during Partnership life." A script entitled "Great Sales Idea No. 2" provided to RRs in late 1989 suggested that they call customers and ask whether they thought energy prices would go up or down over "the next few years." The script then provided two different sales pitches, one for investors ==========================================START OF PAGE 12====== expecting increases and the other for persons expecting decreases. Both ended by recommending the purchase of Geodyne, again leading investors to believe that price increases were not essential to the success of the investment. RRs were provided a set of "most commonly asked questions" with suggested answers to give to customers.-[3]- One question asked what would happen if oil and gas prices declined. Until late 1990, the suggested answer stated that if oil and gas prices declined over the ten year life of the partnership, returns would suffer. In late 1990, the suggested answer was refined to state that returns would suffer if oil and gas prices remained level or declined over the ten year period. Both answers then stressed that this was unlikely because many oil and gas analysts were projecting price increases. Neither answer informed investors that returns would suffer substantially if oil and gas prices did not rise in the first two to four years of the partnership, even if they rose in later years. Thus, even when customers asked about the risk of energy price fluctuations, RRs were instructed to mention only the risk of long term price declines. iv. Misrepresentation of Tax Benefits Associated with Cash Distributions Certain marketing materials that discussed tax ramifications of investments in Geodyne were misleading in that they stated or implied that investors would receive partially tax-free income. For example, scripts provided to RRs in the Marketing Guide for Geodyne II stated: "The initial income is projected at 12%+ of which 60-75% is non-taxable." Other materials distributed to RRs referred to cash distributions as "substantially non-taxable," "substantial portion tax-free," and providing "excellent after tax income, targeted 11% plus (25% tax bracket)." (Emphasis in original.) By not explaining that cash distributions were partially non-taxable only to the extent that they were a return of the investor's capital, by characterizing this tax treatment as a benefit, and by using terms such as after-tax income, the marketing materials falsely implied that the distributions were comparable to interest on a tax-exempt security such as a municipal bond. The public sales brochure for Geodyne III (distributed between 1989 and 1991) included a revised -[3]- Sales scripts, public slide shows, and videotapes distributed by PaineWebber did not typically mention price declines as a risk, relying on the customer to raise questions about this risk. ==========================================START OF PAGE 13====== description of the program's tax treatment which stated that the partnership would generate "passive income" which could be offset by passive losses, and that "... over the life of the Partnership, investors are allowed to recover their investment tax-free." However, misleading marketing materials continued to be distributed to PaineWebber RRs. For example, the 1990 "bullet sheet" described above characterized Geodyne as "an investment opportunity offering high tax-favored income with growth potential..." and characterized cash distributions as "tax-free income." As a result, PaineWebber marketing materials continued to create the misimpression that Geodyne generated untaxed income. 3. Insured Mortgage Partners 1-A and 1-B From April 1987 through May 1989, PaineWebber sold $139 million of units of PaineWebber Insured Mortgage Partners 1- A and 1-B ("IMP 1-A and 1-B") to approximately 8,000 investors. The proceeds from the sale of the limited partnership interests were to be used to purchase participating and non-participating mortgage loans and GNMA mortgage-backed securities. IMP 1-A and 1-B were sponsored by PaineWebber Properties, a PaineWebber wholly-owned subsidiary. Through this subsidiary, PaineWebber received approximately $20 million in sales, management, and other upfront fees from sales of IMP. Certain sales and marketing materials for IMP misrepresented: 1) that quarterly cash distributions for IMP constituted income, when in fact the distributions were in part return of capital; 2) that the income was guaranteed never to fall and could only increase; and 3) that the partnership investment itself was backed by the full faith and credit of the U.S. government. In fact, the return on investment to investors dropped significantly as borrowers defaulted and forced refinancings and prepayments at lower interest rates in the early 1990s. Certain marketing materials for IMP 1-A promised investors a "predictable, insured yield." Sales materials for IMP 1-B stated that "Base income is anticipated to be 8 1/2 - 9%," which was the annualized equivalent of the projected quarterly cash distributions. Other sales materials stated that "[t]he U.S. government guarantees the investor will never earn less than 8 1/2 [%]." However, the cash distributions that were characterized as "yield," "base income," or earnings were not solely income or yield, but also included return of the investor's capital. Cash distributions were derived not only from interest on the underlying mortgages, but also payments made to retire principal. Some investors were not told that part of their "income" included a return of capital. ==========================================START OF PAGE 14====== Some IMP marketing materials stated that "the base income [for the partnerships] can only increase", and that the "base yield can increase but never drop." The investments were consistently touted as providing advantageous returns in both high and low interest environments. One marketing document compared the IMP programs favorably with CDs, stating that they provided no downside risk with added upside benefit. These statements were false because, among other things, investors' returns could decline as a result of default, prepayment, or the renegotiation of mortgage loans held by the partnership. In fact, returns for both IMP programs declined considerably below the so-called "guaranteed rate" as the result of mortgage defaults and prepayments in an environment of declining interest rates in the early 1990s. These defaults or prepayments caused the partnerships to return capital sooner to investors, causing the base income to decrease. The yield for IMP 1-B was as low as 5.89% due to the reduction of the investor's underlying capital. From 1988 through June 1993 the IMP 1-B yield averaged 6.44% per year - below the anticipated yield of 8.25%. The yield generated by IMP 1-A (which was liquidated) has averaged approximately 5% annually, also below the so-called guaranteed base income. Finally, some marketing materials for IMP stated that investors' "principal and interest [were] insured by the U.S. Government", and that the investment was "backed by full,[sic] faith and credit of the U.S. Government." Contrary to these representations, an investment in IMP was not insured, guaranteed, or backed by the U.S. Government. The mortgage- backed securities that were purchased by the partnerships were issued by GNMA, the obligations of which were backed by the full faith and credit of the U.S Government; however, the investor's underlying partnership interest and partnership returns were not guaranteed. This was a significant distinction because the return to investors could be affected by, among other things, administrative expenses and the manner in which the underlying loans were administered. In fact, cash distributions to investors were ultimately reduced as the result of management decisions to renegotiate several problem loans. 4. Pegasus Aircraft Partners Between 1988 and 1990, PaineWebber sold at least $225 million of units to approximately 13,400 investors in two limited partnerships formed to acquire and lease commercial aircraft, Pegasus Aircraft Partners L.P. and Pegasus Aircraft Partners II, L.P. (collectively, "Pegasus"). The stated purpose of the Pegasus partnerships was to acquire used commercial aircraft subject to triple-net leases ==========================================START OF PAGE 15====== in order to provide regular cash distributions to investors. The anticipated holding period for the partnerships was estimated to be eight to twelve years. PaineWebber subsidiaries acted as the administrative general partner for the Pegasus partnerships. Some of PaineWebber's sales and marketing materials stated and implied that the partnership's quarterly cash distributions reflected solely income, when cash distributions could also include a return of capital. For example, in the Pegasus I brochure which was disseminated to the public, the investment benefits summarized in the brochure include "Current Income," "Safety" and "Preservation of Capital." Some marketing materials encouraged RRs to stress the regularity and predictability of the cash distributions. One slogan used for Pegasus in internal marketing materials was "S.D.I.: Safe Dependable Income." The cash distributions were represented to be "like clockwork." Contrary to PaineWebber's marketing materials however, these distributions were not a measure of an investor's actual return on investment, because they could include a return of capital. While the disclosure relating to the cash distributions was revised in the prospectus and brochure for Pegasus II to state that a portion of the distributions could be a return of capital, PaineWebber's marketing strategy for the partnership remained unchanged. In the Pegasus II "Sales Profile" which was distributed to PaineWebber RRs for internal use only, PaineWebber continued to tout "High Current Income: Quarterly cash distributions to investors from lease income are expected to be 12% annually..." The Sales Profile targeted "Investors Looking For... Income" and emphasized "Safety & Preservation of Capital" while failing to state that a portion of the cash distributions could include a return of capital. A June 1990 internal PaineWebber newsletter encouraged RRs to place investors in Pegasus and "[l]ock in your 12% now." Consistent with this encouragement, some RRs described Pegasus as paying 12%, qualified by a reference that this "yield is approximate"; have stated that "[t]his income is partially tax deferred"; and have made reference to "high Tax Free income." As recently as 1992, a PaineWebber RR prepared letters to clients representing that "the yields of 12% [on Pegasus] ... are excellent as are the investment[s]...." As a result, some investors were misled with respect to the nature of the cash distributions and the safety of the investment. After December 1990, Pegasus failed to pay annual distributions of 12% as a result of several major airlines defaulting under their lease obligations and filing for bankruptcy protection and, as a result of these and other developments, the value of the investment has declined. ==========================================START OF PAGE 16====== 5. Independent Living Mortgage I and II From June 1989 through May 1991, PaineWebber offered and sold approximately $127 million in interests in PaineWebber/Independent Living Mortgage, Inc. I and II ("ILM I and II") to approximately 9,500 investors. ILM I and II were created as real estate investment trusts ("REITS") to invest in participating mortgage loans on apartment communities specially designed for independent senior citizens. The mortgage loans that were purchased were loans to a subsidiary of Angeles Corporation ("Angeles"), a California-based investment management company, for the development of these senior centers. The investment was marketed with a guaranty of payment of a 10% annual return for six years and a total return of 125% of the original investment from Angeles. In some marketing materials, PaineWebber highlighted the guaranty from Angeles, suggesting that it rendered the investment safe and conservative. Angeles was described as a $4 billion company, suggesting size and stability. In fact, the $4 billion referred to assets controlled by Angeles and did not include its liabilities. Angeles was a highly leveraged company with a marginal net worth that was highly vulnerable to small changes in asset valuations. In March 1993, less than 18 months after the last sale of ILM II, Angeles filed for bankruptcy and failed to make payments under the guaranty. Investor distributions plummeted from the guaranteed 10% per annum to 4% per annum. Angeles had not performed on its guaranty as was marketed in sales materials. 6. Unsuitable Sales of Direct Investments Marketing materials for certain direct investments, including but not limited to those mentioned above, paid little attention to suitability determinations to be made in selling direct investments. Most marketing materials discussed limitations on suitability only in specifying minimum income and net worth requirements imposed by various state laws: typically an annual income of $30,000 or more and net worth, excluding house, automobile and furnishings, of $30,000 or more (or a net worth of $90,000 with no minimum income). These minimum requirements were not a substitute for the suitability determination that a broker is required to make because, among other things, they did not consider a customer's individual investment objectives or the nature of the customer's other investments. The language in certain marketing materials resulted in RRs ignoring suitability concerns by indicating that the investment was appropriate for substantially all PaineWebber clients without sufficiently disclosing the risks and in ==========================================START OF PAGE 17====== disregard of investors' age, financial condition, sophistication and investment objectives. In some instances, marketing materials encouraged RRs to sell these cash flow generating investments to income-oriented investors, including persons investing largely in bank CDs and government bonds, without cautioning them to warn investors of higher risks involved in the direct investments. As a result of these practices, PaineWebber sold direct investments to numerous investors for whom they were unsuitable and in concentrations too high given the investors' age, financial condition, sophistication and investment objectives. 7. Secondary Market Sales of Direct Investments Most direct investments were not traded on any national exchange or other public secondary market. However, from the late 1980s through November 1991, PaineWebber offered an informal "matching service" through which it would match owners of direct investments who wanted to sell their interests with interested buyers. The matching service was subject to very few rules and virtually no supervision. The Direct Investment Department maintained on a computer screen, accessible firm-wide, a list of interested sellers for each direct investment, with the seller's offering price (if any). Brokers for buyers were not required to consult the list of interested sellers; they could match the buyer with one of their own customers, negotiate a sale with a customer of another broker known to be involved in the secondary sales, or consult the computer screen. After the sale was privately negotiated, it was not processed through PaineWebber's trading system. No trade ticket was prepared, no record of the trade was entered on a trade blotter, no confirmation of the transaction was prepared, and no inventory records were kept. The Direct Investment Department was notified of the transaction only if a commission was to be paid. Largely as a result of these flaws in the matching service, numerous sales abuses occurred in connection with secondary sales of direct investments. In fact, identical units of the same direct investment were sold on the same day at prices that varied as much as 100 per cent. In many instances, buyers were not given the best price available because the broker did not consult the Direct Investment Department's computer screen. In some instances, PaineWebber settled customer complaints by agreeing to buy back direct investment units at the original purchase price, while avoiding any loss on the settlement by reselling the units to an unsuspecting customer at an inflated price. In these instances, PaineWebber failed to disclose to the ==========================================START OF PAGE 18====== purchasing customers that the units could be purchased at a lower price. D. SALES PRACTICE VIOLATIONS AND RELATED SUPERVISORY FAILURES Between 1989 and 1993, ten PaineWebber RRs, two of whom were BOMs, in eight branch offices engaged in serious violations of the antifraud provisions of the federal securities laws.-[4]- In each branch office, the BOM and PaineWebber failed reasonably to supervise these individuals with a view toward preventing or detecting such violations. 1. Miami, Florida Between January 1989 and February 1992, an RR in PaineWebber's Miami, Florida office engaged in fraudulent practices with respect to at least seventy customers. These customers, many of whom were retired or close to retirement, generally informed the RR that they wanted liquid, income- producing, low-risk investments. Despite these conservative objectives, he recommended and sold large quantities of Geodyne units to many of his customers. In several instances, the RR concentrated all or most of his customers' liquid assets in these illiquid limited partnerships. The RR made numerous false and misleading statements to customers regarding the risks, liquidity, and profitability of Geodyne. He told several customers, both orally and in writing, that the limited partnerships were liquid, even though there was no public market for the partnerships. Additionally, he misrepresented the Geodyne partnerships' level of risk and, in some cases, guaranteed a minimum 12% return for the life of the investment. Finally, he led his customers to believe that the Geodyne partnerships were high income-producing investments by characterizing the distributions they would receive from the partnerships as income or return. He also misappropriated hundreds of thousands of dollars from at least eight customer accounts by forging his cus- tomers' signatures on letters of authorization ("LOAs") to effect the transfer of client funds to himself and bank accounts in which he held personal interests. The BOM of the Miami office during the relevant time period failed reasonably to supervise the RR's activities -[4]- As of the date of this Order, these RRs are no longer employed by PaineWebber. by: (1) failing to conduct an adequate inquiry into the suitability of certain direct investment sales; (2) failing to take reasonable measures to investigate clear signs of overconcentration in accounts of the RR's customers; and (3) failing to conduct an adequate review of LOAs relating to the RR's customers. First, the heavy concentrations of Geodyne in numerous customer accounts, and the customers' conservative investment objectives, were apparent from the RR's customer records, which, under PaineWebber procedures, the BOM was required to review quarterly. Moreover, the RR received numerous awards and was publicized in PaineWebber literature as a leading seller of Geodyne. Notwithstanding signs of excessive concentration of Geodyne, the BOM failed to conduct a reasonable inquiry into sales of Geodyne. Such an inquiry was particularly appropriate because, by 1990, the BOM was informed of at least three customer complaints against the RR relating to Geodyne. Had the BOM contacted the RR's customers and discussed the suitability of their investments in Geodyne in light of their conservative investment objectives, he could have learned that the RR was inaccurately representing Geodyne to his customers. With regard to the LOAs, many bore signatures that were obviously different from the signatures in PaineWebber customer account records. Moreover, many of the LOAs authorized transfers of substantial amounts of money to accounts of other customers of the RR, or to entities controlled by the RR.-[5]- The BOM should have given these transfers special scrutiny. Such scrutiny would have uncovered the RR's forgeries, and his unauthorized trading and misappropriation. 2. Flint, Michigan Between 1989 and 1991, an RR in PaineWebber's Flint, Michigan office engaged in fraudulent trading in several customer accounts. He made unsuitable sales of PaineWebber direct investments, including Geodyne, Pegasus, and ILM, to elderly, conservative investors; engaged in unauthorized trading in certain customer accounts; and made material -[5]- In one instance, the RR forged his customer's name on 15 letters of authorization causing over $200,000 to be wired from the customer's brokerage account to several bank accounts controlled by the RR. In another instance, the RR forged a customer's signature on a letter of authorization designating the transfer of $12,100 to be used for the unauthorized purchase of certain limited partnerships for another customer. ==========================================START OF PAGE 19====== misrepresentations to customers concerning liquidity, risk, and income of investments. For example, the RR concentrated nearly $150,000 of an elderly, disabled customer's $200,000 portfolio in direct investments. He also purchased leveraged U.S. Treasury Bonds in the customer's account without her approval and materially misrepresented the safety, liquidity, and income component of the direct investments he sold to her. Between March 1989 and August 1991, the RR engaged in unauthorized trading in the account of a young couple with little investment experience by purchasing leveraged GNMA Pool Certificates in their account. Also in that time period, he sold various direct investments, including Pegasus, to the couple by misrepresenting that the direct investments were like mutual funds, implying that these illiquid investments could be easily sold. He forged a margin account agreement for this couple and traded in their account on margin without their knowledge or approval. In another instance, he prepared and mailed false account valuations to certain customers that materially overstated values of direct investments, thus inducing these customers to make additional purchases of direct investments. The Flint office was a four broker satellite office of the Farmington Hills, Michigan branch office. Flint's resident manager was responsible for, among other duties, signing investment representation forms which memorialized sales of direct investments, reviewing new account forms and order tickets, and monitoring incoming and outgoing mail. The resident manager in place in and after March 1990 failed reasonably to supervise the RR referred to above by (1) failing to do any independent checks on the suitability of direct investments for the various customers; (2) failing to monitor the outgoing mail to prevent the RR from sending out false valuations; (3) signing and approving the mailing of one false account valuation without verifying its contents; and (4) failing to conduct adequate quarterly portfolio reviews of the RR's customers, which would have alerted him to the extensive overconcentration and unsuitability of the direct investments in many of these accounts. 3. Naples, Florida Between 1986 and November 1991, the BOM of PaineWebber's Naples, Florida office sold at least $8 million of direct investments, including Geodyne, Pegasus, and IMP, to dozens of his clients. Many of the customers were elderly investors for whom a long-term illiquid direct investment was unsuitable, and many expressed conservative investment ==========================================START OF PAGE 20====== objectives. Nonetheless, the BOM persuaded numerous customers to invest between 50% to 100% of their portfolios in direct investments. The high concentrations of illiquid direct investments in accounts of conservative investors who needed liquidity were unsuitable in light of the customers' age, financial condition and investment objectives. Between 1986 and November 1991, the BOM misrepresented to dozens of investors that the direct investments he was selling were liquid and could be redeemed without loss, and that periodic distributions on the direct investments were risk-free and "guaranteed like a bond." In fact, the direct investments he sold were illiquid, with no established exchange or market. Moreover, none of the distributions for direct investments were guaranteed. In at least two instances, he sold direct investments from one of his customers to another one of his customers at their original purchase price when, at the time, the investments could be purchased through PaineWebber's matching service at a substantially lower price. By effecting these trades at the expense of the unwitting purchasing customers, he reinforced the false impression among the selling customers that direct investments could be redeemed without loss. Finally, he made unauthorized trades in at least two customer accounts. From at least 1989 until November 1991, PaineWebber's supervision of the BOM was deficient in several respects. First, his customer accounts were not subjected to periodic review by his supervisor, as was the case for customer accounts of non-supervisory personnel. BOMs reported directly to their regional division managers, most of whom supervised at least 50 BOMs in geographically disparate locations. PaineWebber did not have a supervisory manual that formally articulated the supervisory duties of the division managers with regard to BOMs. Second, exception reports designed to monitor unusual trading at the branch level were inadequate to detect suitability or concentration problems in direct investments in a BOM's accounts. Third, the direct investment trading process circumvented any review in the retail branch system because all orders were sent directly to the Direct Investment Department and were not seen by the division managers' office. Fourth, PaineWebber had no procedures requiring complaints concerning BOMs to be routed to the division manager. Fifth, there were no formal controls of the direct investment matching service at the division level. At least in part due to these deficiencies, the BOM was able to perpetrate his fraud without detection for several years. 4. Grand Rapids, Michigan ==========================================START OF PAGE 21====== Between July 1989 and July 1991, an RR in PaineWebber's Grand Rapids office churned the accounts of at least two customers, engaged in unauthorized trades for the account of one of these customers, and made unsuitable trades in options in the account of a third customer. Each of the customers had conservative investment objectives, and two specifically told the RR that they only wanted trades in tax-free municipal bonds with a small portion of money to be invested in stocks. Between August 1990 and July 1991, the RR engaged in excessive trading in the accounts of two customers. Over a ten month period, the accounts of the two customers had annualized portfolio turnover ratios of 7:1 and 3.5:1, and generated sales commissions amounting to 25% and 10.5% of the value of the customers' portfolios. When the customers inquired about the trading, they were told by the RR that there was an accounting mix-up at PaineWebber. In March 1991, the RR forged the signatures of these two customers on account activity letters which stated that the customers were aware of the activity in their accounts. In June 1991, one of the customers specifically told the RR that he wanted no more stock trades. Yet, within weeks the RR purchased stock for the customer against his instructions. From at least July 1989 until July 1991, the RR sold risky investments, including options, to an unsophisticated widow who worked as a retail sales clerk. The options and other risky investments were unsuitable due to her limited income, lack of sophistication and investment objectives. From at least July 1990 through July 1991, the BOM of the Grand Rapids office failed reasonably to supervise the RR. In particular, he failed to notice or inquire into significant inconsistencies between information contained in the customers' account records and the RR's explanations of active trading. In addition, he ignored repeated "red flags" in five different monthly active account reports relating to the RR's two biggest customers, and failed to contact the customers in person after receiving multiple active account reports and a Compliance Department memorandum concerning activity in their accounts. Finally, he failed to follow PaineWebber practice by allowing the RR to deliver letters intended to alert the two customers to active trading in their accounts, instead of mailing them himself. This allowed the RR to intercept the letters, forge the customers' signatures on responses, and thus avoid alerting the customers to excessive trading. 5. Tampa, Florida ==========================================START OF PAGE 22====== Between 1988 and 1992, two RRs in PaineWebber's Tampa, Florida office defrauded several customers. One of the RRs sold a 70 year old retired widow direct investments that were unsuitable because of her age, conservative investment objectives, and financial status. He materially misrepresented the liquidity, risk, and benefits of the direct investments, placed more than half of her portfolio in direct investments, and traded on margin without authorization. The other RR in the Tampa office sold direct investments to an 80 year old infirm widow which were unsuitable in light of her age and conservative investment objectives. The direct investments constituted 75% of her portfolio. The RR also made material misrepresentations to the customer concerning the direct investments. In addition, the RR engaged in unauthorized option and margin trading, first by obtaining the customer's signature on an option and margin agreement without explaining the risks associated with option and margin trading, and then by engaging in numerous margin and options trades that were unsuitable given her age, lack of sophistication and investment objectives. From October 1990 to November 1992, the RR misappropriated another customer's funds and effected unauthorized trades in the customer's account. The RR transferred funds pursuant to a signed LOA indicating that the transfer of funds was in exchange for certain investments held in other clients' accounts serviced by the RR. On several occasions, at the RR's direction, the customer signed blank LOAs in order to facilitate the purchase of direct investments on the secondary market. Although the customer's funds were transferred, the customer never received the corresponding investments. In fact, two of the investments which the customer purportedly purchased by LOAs were not even owned by the customers who received the funds. The RR also purchased direct investments on the secondary market at an inflated purchase price for the same customer. The RR represented both the buyer and the seller in these transactions, without their knowledge or approval. In at least one instance, the direct investments belonged to a customer who had filed a complaint against the RR alleging that the partnerships were unsuitable, and these direct investments were sold to other customers at the purchase price in order to settle the complaint. The RR also failed to seek the best terms available under the circumstances in several other secondary market transactions. The BOM for the Tampa office during the relevant time period failed reasonably to supervise the two RRs in that ==========================================START OF PAGE 23====== he: (1) did not subject the RR to meaningful special supervision despite the RR's record of prior customer complaints; (2) failed to take adequate actions in response to active account reports relating to certain customers of the RRs; (3) failed to review adequately the RRs' customer books, which would have revealed problems in the above customers' accounts; and (4) failed to review LOAs used to transfer investments or funds out of a customer's account. With respect to the RR's transfer of funds out of the customer's account, the customer's account statements indicated several transfers of money into the accounts of customers also serviced by the RR. These transfers were "red flags" which should have triggered further investigation. 6. Omaha, Nebraska Between 1988 and 1991 an RR in PaineWebber's Omaha, Nebraska office sold direct investments to numerous investors for whom the investments were not suitable in light of their age, financial condition and conservative investment objectives, and misrepresented to customers the liquidity, risks and benefits of direct investments. Many of his customers were retired or close to retirement. Additionally, almost all of the customers to whom he sold direct investments had informed him that they desired liquid, low-risk, and income producing investments. In several instances the RR concentrated high percentages of his customers' investments in direct investments. For example, a retired couple with little investment experience and no financial background invested their life savings with the RR and depended on these sums to supplement their social security and pension income. They told the RR that they were interested in safe, income-producing investments that would protect their principal. Nevertheless, by October 1990, the RR had invested over 72% of the elderly couple's portfolio in direct investments. He convinced them that these direct investments were consistent with their investment objectives by misrepresenting that they were safe, liquid, and income- producing. The BOM of PaineWebber's Omaha office during the relevant time period failed reasonably to supervise the RR. The overconcentration of numerous customer accounts in unsuitable and illiquid direct investments was readily apparent from a review of the RR's customer books, which the BOM was obligated to perform. Nonetheless, the BOM failed to conduct a reasonable inquiry into the apparent overconcentration and therefore failed to detect the RR's unsuitable trading. 7. Spokane, Washington ==========================================START OF PAGE 24====== Between January 1990 and May 1992, an RR in PaineWebber's Spokane, Washington office engaged in a pattern of unsuitable trading in customers' accounts. In numerous instances, he recommended that customers who expressed a desire for safe investments make purchases of stocks in high risk emerging technology companies, and illiquid direct investments. He also engaged in unauthorized trading and unsuitable margin trading. For example, he recommended that a retired couple in their late eighties, whose primary investment objective was income, place more than 50% of their account value in an illiquid limited partnership which involved a significant degree of risk, and provided an uncertain return. The RR misrepresented that the limited partnership would pay higher than market interest rates. In at least two instances, after the RR persuaded customers with conservative investment objectives to open margin accounts, the RR began making unauthorized and unsuitable trades on margin, causing substantial losses. The BOM for the Seattle, Washington office failed reasonably to supervise this RR. The Spokane office was affiliated with the Seattle "complex" of branch offices, for which the BOM was responsible. The relationship between offices in a complex was not formally defined by PaineWebber procedures. However, between at least November 1989 and June 1992, the BOM was responsible for supervising the Spokane office. The BOM failed reasonably to supervise the RR in that, among other things, he: (1) failed to conduct an adequate inquiry into the suitability of the RR's trades; (2) did not place the RR under any meaningful special supervision despite the information brought to his attention about the level and nature of activity in the RR's customer accounts; and (3) failed reasonably to review the RR's customer books. The presence of speculative stocks, high concentrations of direct investments, and trading on margin in certain accounts with conservative objectives would have been apparent from quarterly reviews of the RR's accounts. These discrepancies should have caused the BOM at the very least to contact additional customers to determine whether their investment objectives were being met. 8. Sioux City, Iowa Between 1985 and 1990, an RR and a BOM in PaineWebber's Sioux City, Iowa office engaged in fraudulent trading in several customers' accounts. The RR, who had been the ==========================================START OF PAGE 25====== BOM of this office until he was suspended by PaineWebber for six months in December 1985 in connection with a questionable commodity transaction with a customer, returned to the Sioux City office as an RR. In June of 1990, the RR transferred to PaineWebber's Scottsdale, Arizona branch office, where he was employed until January 1993. The BOM was initially employed as an RR in the Sioux City office until 1985, when he was promoted to resident manager. He was promoted to BOM in January 1987, and remained in that position until June 1990. Both the RR and the BOM offered and sold PaineWebber direct investments to elderly investors for whom these investments were unsuitable. The RR and BOM also made material misrepresentations about these direct investments concerning liquidity, income and risk. In addition, the RR also engaged in unauthorized trading, misappropriated customer funds, and forged a limited partnership subscription agreement. For example, between 1987 and 1991, the RR concentrated 100% of a 60 year old, widowed homemaker's investment portfolio in direct investments. This investor represented that she had only a modest income and that her net worth consisted of her deceased husband's life insurance proceeds, approximately $140,000. Over 60% of this investor's portfolio was invested in Geodyne. In addition to the conduct described above, the BOM failed reasonably to supervise the RR in that, among other things, he: (1) failed to conduct an adequate inquiry into the suitability of the RR's direct investment sales; (2) did not place the RR under special supervision despite customer complaints and the RR's past disciplinary record; (3) failed to perform reviews of the RR's customer books; and (4) did not systematically review or initial outgoing office correspondence and advertisements. E. PAINEWEBBER'S FAILURE REASONABLY TO SUPERVISE CERTAIN REGISTERED REPRESENTATIVES PaineWebber failed to adopt procedures reasonably designed to detect and prevent violations of the federal securities laws described above. First, three of the offices described above - Flint, Spokane, and Sioux City - were at some times satellites or affiliates of larger branch offices. PaineWebber began establishing multi-office "complexes" in the late 1980s, but did not establish firm-wide procedures clarifying supervisory responsibilities. PaineWebber defined some offices as "satellite" offices (which lacked operations staff) and others as "associate" offices (which had operations staff), but did not specify the responsibilities of the resident managers in these ==========================================START OF PAGE 26====== offices. Indeed, satellite and associate offices occasionally went without resident managers. In the absence of firm-wide procedures, the task of defining the responsibilities of the resident manager was accomplished, if at all, by the BOM of the central office of the complex. As a result, considerable confusion existed and some supervisory functions simply were not performed. Second, as described above with reference to the Naples and Sioux City offices, PaineWebber had no written procedures and inadequate systems to ensure adequate supervision of BOM's sales practices. In the absence of firm-wide procedures, the division manager of each geographic region was left with the task of developing adequate procedures and systems, and PaineWebber had no method for ascertaining whether such procedures and systems had been developed. Third, although PaineWebber actively marketed and sold direct investments, and provided substantial financial incentives to large sellers of the products, it developed virtually no special procedures to ensure that the products were marketed properly. PaineWebber had no exception reports that focused supervisory attention on high concentrations of direct investments in accounts. PaineWebber allowed the circulation of volumes of marketing materials that overstated the safety of direct investments, and insufficiently alerted RRs and supervisory personnel to suitability issues. Furthermore, its method of screening sales and marketing literature was inadequate. Internal marketing literature was not always subject to compliance review. Although beginning sometime in 1989, PaineWebber had an informal procedure for compliance review of publicly disseminated materials relating to direct investments, it failed to devote adequate resources to this function. For example, between 1989 and 1991, PaineWebber assigned responsibility to review sales and marketing material to an individual who had failed the Series 7 broker examination. PaineWebber failed to provide that individual with training or sufficient support to perform the review function. For the foregoing reasons, PaineWebber failed reasonably to supervise its RRs and BOMs. IV. A. ANTIFRAUD VIOLATIONS ARISING OUT OF PAINEWEBBER'S OFFER AND SALE OF LIMITED PARTNERSHIP INTERESTS The Commission has repeatedly stressed the obligation of broker-dealers to assure that retail sales activities comply with the antifraud provisions of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. See, e.g., In the Matter of Prudential ==========================================START OF PAGE 27====== Securities, Inc., Exchange Act Rel. No. 34-33082 (October 21, 1993); In the Matter of PaineWebber, Inc., Exchange Act Rel. No. 34-31889 (February 18, 1993); In the Matter of Smith Barney, Harris, Upham & Co., Inc., [1984-85 Transfer Binder] Fed. Sec. L. Rep. (CCH) 83,745 (March 5, 1985); In the Matter of Thomson McKinnon Securities, Inc. et al., [1984 Transfer Binder] Fed. Sec. L. Rep. (CCH) 83,620 (Apr. 30, 1984). Section 15(c)(1) of the Exchange Act expressly prohibits a broker or dealer from employing any manipulative, deceptive or other fraudulent device or contrivance, as defined in Rule 15c1-2 thereunder, to induce or attempt to induce the purchase or sale of any security. These sections prohibit material misrepresentations, omissions or any act, practice or course of business which operates as a fraud or deceit upon any person. 1. False Statements and Omissions As set forth above, PaineWebber made material misstatements and omitted to state material facts in the sale of Geodyne, Pegasus, ILM and IMP direct investments relating to the risks and rewards of such investments, including the nature of the cash distributions, potential returns on investment, safety, and the nature of certain guarantees pertaining to some of the investments. These misstatements were communicated to investors through jurisdictional means. As described above, investors had few if any reliable sources of information other than PaineWebber concerning direct investments and were therefore vulnerable to misleading sales presentations from RRs willing to disregard any determination whether the recommended security was suitable for the purchaser. See generally Limited Partnership Reorganizations and Public Offerings of Limited Partnership Interests, Interpretative Rel. Nos. 33-6900; 34-29314 (June 17, 1991); Suitability Requirements for Transactions in Certain Securities, File No. S7-3-89 (SEC), Exchange Act Rel. No. 34-26529 (February 8, 1989). Based on the foregoing, PaineWebber violated the antifraud provisions of Section 17(a) of the Securities Act, Sections 10(b) and 15(c)(1) of the Exchange Act and Rules 10b-5 and 15c1-2 thereunder in the offer and sale of direct investments. See, e.g., In the Matter of Jessup & Lamont Securities Co., Inc., Exchange Act Rel. No. 34-16985 (July 18, 1980); In the Matter of Marsh, Mead, Hill & Associates, Inc., Exchange Act Rel. No. 34-9523 (March 9, 1972); In the Matter of Powell & McGowan, Inc., 41 SEC 933, 935 (1964). 2. Suitability ==========================================START OF PAGE 28====== As stated above, certain marketing materials which were prepared and disseminated by PaineWebber emphasized the safety of these direct investments, without sufficiently disclosing the risks. In many instances, PaineWebber RRs failed to make required determinations, in recommending and selling direct investments, that the investments were suitable for investors in light of their individual financial status and investment goals. PaineWebber RRs also recommended, often in disregard of the investors' individual needs and financial goals, that investors, including some who were elderly or retired, purchase direct investments in over-concentrated amounts. As a result, PaineWebber violated Section 17(a) of the Securities Act, Sections 10(b) and 15(c)(1) of the Exchange Act and Rules 10b-5 and 15c1-2 thereunder. See In the Matter of Prudential-Bache Securities, Inc., 48 SEC 372, 288 (1986); In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Exchange Act Rel. No. 34-18923 (July 26, 1982). B. INADEQUATE BOOKS AND RECORDS Section 17(a) of the Exchange Act requires that every broker-dealer "make and keep for prescribed periods such records, furnish such copies thereof, and make and disseminate such reports as the Commission, by Rule, prescribes as necessary or appropriate..." Rule 17a-3 of the Exchange Act requires, among other things, the maintenance of a memorandum of each brokerage order, daily trade blotters, and securities records or ledgers reflecting all long and short positions. During the time period from at least 1988 to November 1991, in operating the matching program, PaineWebber failed to make and keep sufficient books and records of its resale transactions. Specifically, it failed to make and keep: 1) a memorandum of each brokerage order; 2) a blotter containing an itemized record of the purchase and sale of securities on the secondary market system; and 3) a securities record or ledger reflecting for each of the direct investments the firm's long or short positions. Based on the foregoing, PaineWebber violated Section 17(a) of the Exchange Act and Rule 17a-3 thereunder. C. FAILURE REASONABLY TO SUPERVISE Section 15(b)(4) of the Exchange Act authorizes the Commission to order sanctions against broker-dealers who fail reasonably to supervise, with a view to preventing violations of the federal securities laws. "The responsibility of broker-dealers to supervise their employees by means of effective, established procedures is a critical component of the federal investor protection scheme regulating securities markets." Smith Barney, Harris Upham & Co., Inc., Exchange Act Rel. No. 34-21813, [1984-1985 Transfer Binder] Fed. Sec. L. Rep. ==========================================START OF PAGE 29====== (CCH) 83,745 at 87,331. As the Commission has observed: "[I]n large organizations it is especially imperative that the system of internal control be adequate and effective." In the Matter of Shearson, Hammill & Co., 42 SEC 811, 843 (1965). As described above, PaineWebber failed to develop supervisory procedures and controls adequate to define supervisory responsibilities in branch office complexes and over satellite offices. In addition, it failed to develop procedures adequate to ensure effective supervision of producing BOMs. Finally, PaineWebber failed reasonably to supervise RRs and others involved in the sale of direct investments. PaineWebber did not adequately review, supervise or control its sponsor subsidiaries and direct investment marketing personnel with a view towards preventing the creation, distribution and use of false and misleading promotional materials in selling direct investments. PaineWebber's supervisory failures permitted violations to continue for years. V. On the basis of this Order and the Offer of Settlement submitted by PaineWebber, the Commission finds that: A. PaineWebber willfully violated Section 17(a) of the Securities Act, Sections 10(b), 15(c)(1), and 17(a) of the Exchange Act and Rules lOb-5, 15c1-2, and 17a-3 thereunder; B. PaineWebber failed reasonably to supervise individuals subject to its supervision with a view to preventing and detecting violations of Section 17(a) of the Securities Act, Sections 10(b) and 15(c)(1) of the Exchange Act and Rules 10b-5 and 15c1-2 thereunder. VI. In view of the foregoing, it is in the public interest to impose the sanctions specified in the Offer of Settlement. Accordingly, IT IS HEREBY ORDERED that PaineWebber: A. be, and hereby is, censured; B. pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, cease ==========================================START OF PAGE 30====== and desist from committing or causing any violation, and any future violation, of Section 17(a) of the Securities Act, Sections 10(b), 15(c)(1) and 17(a) of the Exchange Act, and Rules 10b-5, 15c1-2, and 17a-3 thereunder; C. comply with its representation that it has paid and its obligation to pay an aggregate of $292.5 million for the benefit of purchasers of direct investments sold by PaineWebber, as follows: 1. PaineWebber has paid $120 million and will pay an additional $ 7.5 million by January 26, 1997, to resolve individual investor claims relating to direct investments, payment of which is to be verified at PaineWebber's expense by an independent public accountant acceptable to the Commission. To the extent that the verified amount paid is greater than or less than $120 million, the additional amount to be paid shall be adjusted accordingly; 2. PaineWebber has paid, pursuant to a settlement of the class actions entitled In re: PaineWebber Limited Partnerships Litigation, Master File, 94 Civ. 8547, S.D.N.Y. (SHS), and Sidney Neidich v. Geodyne Resources, Inc., No. 94-052860, Harris County, Texas, 127th Judicial District (the "Class Actions"), $125 million in cash into a separate account in the Court Registry Investment System ("CRIS"), which monies are to be used to settle claims asserted in those actions relating to direct investments sold by PaineWebber. If a settlement is not approved by the United States District Court in the Class Actions by January 26, 1997, or within an additional three month extension for good cause shown, such $125 million plus accrued interest, less any taxes on income generated by the fund or court administration fees attributable to the fund, shall be transferred, upon notice to the parties herein, to the CRIS account established ==========================================START OF PAGE 31====== in paragraph Section VI.C.3. hereof and placed under the control of the Claims Administrator designated in Appendix A. As soon as practicable thereafter, the Claims Administrator shall propose a plan of distribution of these funds. After an opportunity for interested parties to be heard and upon approval of the plan of distribution by the Court in the Commission's action against PaineWebber, the Claims Administrator shall distribute these funds to inves- tors in direct investments, which may include class members in the Class Actions. Any residual amount shall go to the United States Treasury; 3. within ten business days of the entry of this Order, PaineWebber shall deposit $40 million in cash into a separate CRIS account to be established in accordance with the Commission's  21(e) Petition in the District Court and Appendix A. These monies shall be paid to investors to satisfy claims in accordance with the claims resolution process set forth in Appendix A hereto; 4. under no circumstances shall any of the monies referred to in Section VI. herein be returned to PaineWebber; and 5. in the event that the Commission's  21(e) Application is not granted by the Court (i) any monies to be transferred to the CRIS account under control of the Claims Administrator and subject to the jurisdiction of the Court, shall be transferred to an appropriate account under the control of the Claims Administrator, subject to the jurisdiction of the Commission and (ii) any plan of distribution proposed by the Claims Administrator shall be subject to approval by the Commission after an opportunity for interested parties to be heard; provided however, that if PaineWebber and the Commission agree, they may jointly move a United States District Court for approval and ==========================================START OF PAGE 32====== implementation of any such plan of distribution. D. pay a civil penalty in the amount of $5 million in cash pursuant to Section 21B of the Exchange Act. 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, within 10 days of the date of this Order, to the Comptroller, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549; and (D) submitted under cover letter identifying PaineWebber as a Respondent in these proceedings, the file number of these proceedings, and the Commission's case number (C-2701), a copy of which shall be sent to Mary E. Keefe, Regional Director, Midwest Regional Office, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661; E. implement, at PaineWebber's expense, a claims resolution process in accordance with the procedures set forth in Appendix A hereto; F. pursuant to this Order and in connection with the settlement terms of the Class Actions, waive or assign for the benefit of the participants in the Class Actions any and all fees or compensation (including but not limited to general partner distributions, management and administrative fees) in which PaineWebber has, or will in the future have, any right, title, or interest originating from any of the direct investment programs listed in Appendix A; G. provide satisfactory compensation to the identified customers who were subject to the conduct of the RRs referred to in Sections III.D.1. through III.D.8. above; and H. comply with its undertakings to: 1. retain within 30 days of the date of this Order, at PaineWebber's expense, an Independent Consultant ("Consultant"), not ==========================================START OF PAGE 33====== unacceptable to the Commission's staff to, among other things: (a) conduct a comprehensive review of PaineWebber's policies and procedures concerning: (i) retail brokerage operations, including but not limited to its policies and procedures for supervision of satellite and associate offices, and procedures for supervision of the sales activities of branch office managers, as is appropriate in light of the findings in this Order; and (ii) publicly-disseminated sales materials and broker-only sales and marketing materials; (b) review the policies and procedures that PaineWebber has advised the Commission it has adopted and implemented since the activities described in this Order, in determining whether and to what extent there is a need for additional policies and procedures designed reasonably to prevent and detect, insofar as practicable, violations of the federal securities laws; (c) recommend policies and procedures (or amendments to existing policies and procedures) designed reasonably to prevent and detect, insofar as practicable, violations of the federal securities laws; and (d) prepare a written report to PaineWebber's Board of Directors of its findings and recommendations within six months of the entry of this Order. PaineWebber shall be provided a reasonable opportunity to comment on the Consultant's review and recommendations. 2. adopt and implement, no later than 60 days after receipt of the report (or such other time as the Consultant believes is necessary), such policies and procedures as recommended by the Consultant; provided ==========================================START OF PAGE 34====== however that as to any of the Consultant's recommendations that PaineWebber determines is unduly burdensome and impractical, PaineWebber may propose an alternative procedure reasonably designed to accomplish the same objectives. The Consultant shall reasonably evaluate such alternative procedure and, if appropriate, either approve the alternative procedure or amend the recom- mendation. PaineWebber shall abide by the decision of the Consultant and adopt and implement the alternative procedure or amended recommendation within the time period set by the Consultant in light of the nature of the procedures; 3. authorize the Consultant to provide copies of the written report referenced above promptly to the Commission's Midwest Regional Office; 4. PaineWebber and its affiliates shall cooperate fully with the Consultant, including obtaining the cooperation of PaineWebber employees or other persons under its control; 5. require the Consultant to enter into an agreement, providing that: (a) for the period of the engagement and for a period of two years from the completion of the engagement, the Consultant shall not enter into any employment, consulting, or attorney-client relationship with PaineWebber, or any of its present or former affiliates, directors, officers, employees, or agents acting in their capacity as such; and (b) 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 Commission, enter into any employment, consulting or other professional relationship with PaineWebber, or any of its present or former directors, officers, employees, or agents in their capacity as such for the period of the engagement and for a period of two years after the engagement. ==========================================START OF PAGE 35====== 6. maintain for a period of at least five years after the effective date of this Order a Committee of its Board of Directors (the "Committee"), consisting of no fewer than three persons, which shall (a) set policy relating to the achievement of compliance with applicable federal securities laws and the rules and regulations of all national securities exchanges, the MSRB, and self- regulatory organizations of which PaineWebber is a member ("applicable rules and regulations"); (b) monitor PaineWebber's implementation of any changes in PaineWeb- ber's policies and procedures adopted as a result of the Consultant's review process described in paragraph VI.H.1. above; and (c) monitor PaineWebber's efforts to detect, correct, and prevent failures to comply with applicable rules and regulations. The Committee shall require the General Counsel of PaineWebber to submit quarterly to the Committee a written report which shall include a summary of: government and SRO investigations involving PaineWebber or its employees; internal disciplinary actions; employee terminations for cause; sales practice complaints; deficiencies in supervision and controls identified in any internal audit at PaineWebber. In addition, the Committee shall provide a quarterly report to the Board of Directors of PaineWeb- ber and to the Audit Committee of PaineWebber Group, Inc., which report shall include a summary of the activities of the Committee in ensuring the fulfillment of its responsi- bilities under this Order; and 7. reasonably cooperate, and use all reasonable efforts to cause its present or former officers, directors, agents, servants, employees, attorneys-in-fact, assigns, and all persons in active concert and partici- pation with them to reasonably cooperate with ==========================================START OF PAGE 36====== investigations, administrative proceedings and litigation conducted by the Commission arising from or relating to direct investments. By the Commission. ____________________________________ Jonathan G. Katz Secretary ==========================================START OF PAGE 37====