UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 39165 / September 30, 1997 ADMINISTRATIVE PROCEEDING File No. 3-9466 : In the Matter of : : ORDER INSTITUTING PROCEEDINGS, : MAKING FINDINGS, AND IMPOSING : REMEDIAL SANCTIONS PURSUANT FRANK KLAUS : TO SECTIONS 15(b) AND 19(h) : OF THE SECURITIES EXCHANGE : ACT OF 1934. Respondent. : : I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public proceedings be, and hereby are, instituted pursuant to Sections 15(b) and 19(h) of the Securities Exchange Act of 1934 ("Exchange Act") against Frank Klaus ( Klaus ). In anticipation of the institution of these proceedings, Klaus has submitted an Offer of Settlement to the Commission, which the Commission has determined to accept. Solely for the purposes of this proceeding and any other proceeding brought by or on behalf of the Commission or in which the Commission is a party, prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R.  201.1 et seq., and, without admitting or denying the findings contained herein, except those contained in paragraph II. A., which is admitted, Klaus consents to the issuance of this Order Instituting Proceedings, Making Findings, and Imposing Remedial Sanctions, and to the entry of the findings and the Order set forth below. Accordingly, IT IS ORDERED that administrative proceedings pursuant to Sections 15(b) and 19(h) of the Exchange Act, be, and hereby are, instituted against Frank Klaus. II. On the basis of this Order and the Offer submitted by Klaus the Commission finds that<(1)>: A. Frank Klaus ("Klaus") was, at relevant times, Executive Vice President, Chief of Staff, Compliance Director, general principal and a director of Government Securities Corporation ( GSC )(File No. 8-36869), which has been registered with the Commission as a broker-dealer since July 25, 1987. B. During the period from at least March 1989 through March 1993, three of GSC s registered representatives (other than Klaus) and two other GSC employees willfully violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b- 5 thereunder while engaged in offering and selling to public clients certain collateralized mortgage obligation securities ( CMOs ). These CMOs were sold to public clients, including municipalities and state educational institutions, whose investment objectives stressed safety of principal, liquidity, market stability, short maturities and low risk. GSC, through its representatives, sold these clients Interest Only strips ( IOs ), Inverse IOs, and Inverse Floater CMOs. IOs and Inverse IOs are highly sensitive to changes in interest rates and prepayment speeds, and thus subject investors to risks, including loss of principal, market, extension and liquidity risks. Although Inverse Floaters provide guaranteed return of principal, these instruments are extremely sensitive to changes in interest rates and prepayment speeds and thus subject investors to various risks, including market, extension and liquidity risks. C. To induce the public clients to purchase high-risk CMOs, three of GSC s registered representatives and two other employees made various misrepresentations and omissions to them, including the following: 1. misrepresenting the high-risk CMOs as suitable investments which were consistent with clients objectives of safety of principal, liquidity, market stability, short duration and low risk; 2. referring to the high-risk CMOs as "Fannie Mae," "Freddie Mac," or "FNMA" securities, while omitting to disclose that the instruments were volatile CMO tranches; <(1)>/ The findings herein are not binding on anyone other than Respondent. ======END OF PAGE 2====== 3. misrepresenting the IOs and Inverse IOs as government guaranteed and that their principal was fully protected; 4. failing to disclose that the IOs and Inverse IOs carry an inherent risk of loss of principal and illiquidity; 5. failing to disclose that the market value and yield of the IOs and Inverse IOs are highly sensitive to changes in interest rates and prepayment speeds; 6. guaranteeing one public client that the client "would not lose a dime" on the Inverse IOs; 7. failing to disclose that the characteristics of the Inverse Floaters, including duration and yield, were highly sensitive to changes in interest rates; 8. failing to disclose that the Inverse Floaters were subject to extension risk of as much as 30 years; D. In March 1994, one of the GSC registered representatives and two other GSC employees induced a public client to enter into an adjusted trade, pursuant to which GSC purchased from the client, at above-market prices, three conservative securities and sold to the public client, through numerous oral and written misrepresentations, an Inverse Floater at an undisclosed markup of more than 10 percent above market value ("March Swap"). E. One of the employees involved in the conduct set forth in Paragraphs II. B. through D. was barred by the Commission from being associated with any registered broker or dealer with the right, after one year, to reapply to become associated with a broker-dealer as a supervised employee in a non-supervisory capacity. As a consequence, he was subject to a statutory disqualification from exercising supervisory responsibility over GSC's sales personnel. In violation of Section 15(b)(6)(B)(i) of the Exchange Act, he became Sales Manager of GSC and, in 1993, he accepted a promotion to the position of Executive Vice President and Managing Director of GSC. In these positions, he was the person chiefly responsible for supervising GSC registered representatives. III. A. During the time period relevant to this Order, Klaus served as Compliance Director, Executive Vice President, Chief of Staff, a general principal, and a director of GSC. As a result of holding these positions, Klaus had significant responsibility for making major decisions regarding the management and direction of GSC, including responsibility for ensuring that GSC developed adequate compliance and supervisory procedures. Klaus had direct supervisory responsibility over the statutorily disqualified individual referred to in Paragraph II.E. and supervisory authority over all employees with respect to compliance matters. Moreover, during the ======END OF PAGE 3====== relevant period, Klaus was vested with overall supervision of GSC's government securities business. B. Klaus failed to reasonably supervise GSC registered representatives and other employees, who were subject to his supervision, including the statutorily disqualified individual referred to in Paragraph II.E., within the meaning of Section 15(b)(4) of the Exchange Act, with a view toward preventing the violations described in Paragraphs II. B. through D. by the registered representatives of the federal securities laws and by failing to correct a number of inadequate policies and procedures that persisted over a significant period of time, in that: 1. GSC written supervisory policies failed to designate a particular partner, officer or manager with overall supervisory responsibility and failed to provide adequate written guidance concerning responsibility for enforcing various policies and procedures, with the result that GSC supervisors often assumed that one of the other supervisors had responsibility for enforcing various policies and procedures; 2. GSC had inadequate procedures for monitoring accounts to detect unsuitable transactions; 3. GSC's policies and procedures were inadequate to control or monitor the quality of written and oral disclosure to clients concerning the characteristics and risks of CMOs. 4. Klaus permitted the statutorily disqualified individual referred to in Paragraph II.E. to act as the person chiefly responsible for supervising registered representatives with nearly unfettered discretion, even though he was aware that the employee was statutorily disqualified. Moreover, GSC and Klaus represented in an application filed with the NASD that the employee would have no supervisory duties, and agreed to provide the employee with adequate supervision. The statutorily disqualified individual was one of the GSC employees who engaged in the conduct that was violative of the federal securities laws delineated in Paragraphs II. B. through D. C. There were ample "red flags" which were sufficient to alert Klaus that GSC's compliance and supervisory policies were inadequate and to place any reasonable supervisor on notice of the possibility of violations of the federal securities laws. These "red flags" included, but were not limited to, the following: 1. Klaus was aware throughout the relevant period that GSC registered representatives were offering and selling IOs, Inverse IOs, and Inverse Floaters to public clients with conservative investment objectives; 2. Klaus was warned on several occasions by other GSC employees that the mortgage derivative securities being sold to public clients appeared to be inconsistent with the investment policies and objectives specifically delineated by these clients in written investment policies or account opening forms and were also inconsistent with certain internal GSC ======END OF PAGE 4====== policies; 3. Klaus was repeatedly warned by other GSC employees that there were unusually high concentrations of high-risk CMOs in the accounts of public clients; 4. Klaus was aware that a GSC registered representative had repeated disagreements with one of GSC's department heads about how to present the characteristics of mortgage derivative securities in written documents; 5. Klaus was informed, prior to the settlement of the March swap, about serious questions concerning the terms of the transaction and the oral and written representations made to the client, but did not take reasonable steps to make certain that the trade comported with the federal securities laws. IV. In view of the foregoing, the Commission deems it appropriate and in the public interest to impose the sanctions that are set forth in the Offer submitted by Klaus. Accordingly, IT IS ORDERED that: A. Klaus be, and hereby is, suspended from association with any broker, dealer, municipal securities dealer, investment adviser or investment company for a period of 6 months, effective on the second Monday following the entry of this Order. Klaus agrees to deliver an affidavit of compliance to the Securities and Exchange Commission, Fort Worth District Office, 801 Cherry Street, Suite 1900, Fort Worth, Texas 76102, within ten (10) days following the suspension period stating that he has complied fully with the terms of the suspension; and B. Klaus be, and hereby is, barred from association in a supervisory capacity with any broker, dealer, investment company, investment adviser or municipal securities dealer, immediately following the period of his suspension from association; provided that after a period of one year Klaus may make application to reapply to the appropriate self-regulatory organization, and where there is none, to the Commission; and C. Klaus shall, within 21 days of the entry of this Order, pay a civil money penalty in the amount of $15,000.00 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 Comptroller, Securities and Exchange Commission, 6432 General Green Way, Stop 0-3, Alexandria, Virginia 22312; and (D) submitted under cover letter that identifies Klaus as a Respondent in these proceedings, and the file number of these proceedings, a copy of which cover letter and money order ======END OF PAGE 5====== or check shall be sent to Harold F. Degenhardt, the District Administrator of the Fort Worth District Office, Securities and Exchange Commission, 801 Cherry Street, Suite 1900, Fort Worth, Texas 76102. By the Commission. Jonathan G. Katz Secretary