SECURITIES ACT OF 1933
Release No. 8121 / August 13, 2002
SECURITIES EXCHANGE ACT OF 1934
Release No. 46346 / August 13, 2002
ADMINISTRATIVE PROCEEDING
File No. 3-10863
In the Matter of RBC DAIN RAUSCHER Respondent. |
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ORDER INSTITUTING ADMINISTRATIVE AND CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS PURSUANT TO SECTION 8A OF THE SECURITIES ACT OF 1933 AND SECTIONS 15(b) AND 21C OF THE SECURITIES EXCHANGE ACT OF 1934 |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative and cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b) and 21C of the Securities Exchange Act of 1934 ("Exchange Act"), against Rauscher Pierce Refsnes, Inc. ("Rauscher Pierce"), now known as RBC Dain Rauscher Incorporated ("Dain Rauscher" or "Respondent").
II.
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the "Offer") which the Commission has determined to accept. Solely for the purpose of this proceeding and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party and without admitting or denying the findings herein, except as to the Commission's jurisdiction over it and the subject matter of these proceedings, and the findings contained in Section III.B. below, which are admitted, Respondent consents to the entry of this Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions Pursuant to Section 8A of the Securities Act of 1933 and Sections 15(b) and 21C of the Securities Exchange Act of 1934, as set forth below.
III.
On the basis of this Order and Respondent's Offer, the Commission finds1 that:
A. SUMMARY
1. Rauscher Pierce was either the underwriter or the financial adviser to the issuer in twelve securities offerings that are the subject of this Order. The subject offerings were conducted in 1993 and 1994 by issuers located in Orange County, California ("Orange County" or the "County") and totaled over $680 million. The issuers were: the Cities of Anaheim and Irvine, the Irvine Unified School District ("Irvine USD"), the Newport-Mesa Unified School District ("Newport-Mesa USD"), the North Orange County Community College District ("NOCCCD"), and the Orange County Board of Education ("OC Board") (the latter four collectively, the "Four Districts").
2. The offerings were conducted to issue taxable notes. These notes were issued for the purpose of investing the proceeds in the Orange County Investment Pools ("Pools") and generating profits therefrom. The securities were sold to investors using Official Statements, which were the documents that should have provided investors with all material information upon which they could rely to make an informed investment decision. The Official Statements were materially misleading because they omitted to disclose that the offering proceeds would be invested in the Pools and the risks of that investment. In addition, the Official Statements for the six 1994 offerings omitted material information on the Pools' declining investment results.
3. Rauscher Pierce, through its investment bankers Kenneth Ough and Virginia Horler, participated in drafting these Official Statements and approved the final versions of these documents. At that time, Rauscher Pierce knew or should have known material information about the Pools. Rauscher Pierce should have known that, by omitting to disclose this material information, the Official Statements for all the transactions were misleading. As a result, Rauscher Pierce violated Sections 17(a)(2) and (3) of the Securities Act and Section 15B(c)(1) of the Exchange Act and Municipal Securities Rulemaking Board ("MSRB") Rule G-17.
B. RESPONDENT
4. RBC Dain Rauscher Incorporated is registered with the Commission as a broker-dealer (File No. 8-45411) and is based in Minneapolis, Minnesota. During the relevant time period, Rauscher Pierce Refsnes, Inc., was registered with the Commission as a broker-dealer (File No. 8-27271). Subsequently, Rauscher Pierce merged into Dain Rauscher Incorporated on January 3, 1998. Dain Rauscher Incorporated was then acquired by the Royal Bank of Canada on January 10, 2001, and currently operates as its wholly owned subsidiary, RBC Dain Rauscher Incorporated.
C. RELATED PARTIES
5. Kenneth D. Ough ("Ough") resides in Post Falls, Idaho, and, at the time of the offerings, was a Senior Vice President with Rauscher Pierce. Ough was the lead investment banker for nine of the taxable offerings and the financial adviser for one of the taxable offerings.
6. Virginia L. Horler ("Horler") is retired and resides in Moraga, California. Horler was a Senior Vice President and Co-Managing Director of Rauscher Pierce's San Francisco, California, public finance office. Horler was the lead investment banker for two of the taxable offerings.
D. FACTS
1. The Orange County Investment Pools
7. The Pools operated as an investment fund managed by the Orange County Treasurer-Tax Collector ("County Treasurer" or "Treasurer"), Robert Citron. As Orange County school districts, the Four Districts were mandatory Pool Participants because state law required them to deposit their funds with the County Treasurer; Anaheim and Irvine, cities within Orange County, were voluntary Pool Participants. As of December 6, 1994 (the date the County and the Pools filed bankruptcy petitions), the Pools held approximately $7.6 billion in Participant deposits, which the Treasurer had leveraged to an investment portfolio with a book value of over $20.6 billion.
8. The Commingled Pool was the principal investment pool and consisted of $6.126 billion in Participant deposits. The proceeds from eight of the offerings that are the subject of this Order were deposited into the Commingled Pool. The proceeds from the remaining four offerings were invested in Specific Investments.
a. The Pools' Investment Strategy
9.From at least April 1992 until December 1994, the Treasurer's investment strategy for the Pools involved: (1) using a high degree of leverage by obtaining funds through reverse repurchase agreements on a short-term basis (less than 180 days); and (2) investing the Participants' deposits and funds obtained through reverse repurchase agreements in debt securities (issued by the United States Treasury, United States government-sponsored enterprises, and highly-rated banks and corporations) with a maturity of two to five years, many of which were derivative securities.
10. The Pools' investment return was to result principally from the interest received on the securities in the Pools. Leverage enabled the Pools to purchase more securities to generate increased interest income. This strategy was profitable as long as the Pools were able to maintain a positive spread between the long-term interest rate received on the securities and the short-term interest rate paid on the funds obtained through reverse repurchase agreements.
b. The Pools' Portfolio
11. During 1993 and 1994, the Treasurer, using reverse repurchase agreements, leveraged the Participants' deposits to amounts ranging from 158% to over 292% of the amounts deposited. As of the end of June 1994, the Pools held $19.8 billion in securities, with approximately $7.2 billion in Participant deposits and about $12.6 billion in reverse repurchase agreements, resulting in leverage of approximately 274%.
12. Many of the Pools' securities were derivative securities, comprising from 27.6% to 42.2% of the Pools' portfolio and from 31% to 53% of the Commingled Pool's portfolio. In particular, the Pools were heavily invested in derivative instruments known as inverse floaters, which paid interest rates inversely related to the prevailing market interest rate. Inverse floaters are negatively affected by a rise in interest rates.
c. The Rise in Interest Rates During 1994 and its Effect on the Pools
13. The composition of the Pools' portfolio made it sensitive to interest rate changes. As interest rates rose, the market value of the Pools' securities fell, and the interest received on the Pools' inverse floaters also declined. Thus, the Treasurer's investment strategy was profitable so long as interest rates, including the cost of obtaining funds through reverse repurchase agreements, remained low, the market value of the Pools' securities did not decline, and the Pools had the ability to hold securities to maturity. Indeed, the Treasurer's 1992-93 Financial Statement for the Pools stated that the investment strategy was "predicated on interest rates to continue to remain low for a minimum of the next three years."
From April 1992 through 1993, U.S. interest rates remained low and relatively stable. Due to the low interest rates and the Pools' investment strategy, the Pools earned a relatively high yield of approximately 8%. Beginning in February 1994, interest rates began to rise. This rise in interest rates resulted in: (1)
14.an increase in the cost of obtaining funds under reverse repurchase agreements; (2) a decrease in the interest income on inverse floaters; (3) a decrease in the market value of the Pools' debt securities; (4) collateral calls and reductions in amounts obtained under reverse repurchase agreements; and (5) a decrease in the Pools' yield.
2. Orange County's Bankruptcy
15. On December 6, 1994, Orange County and the Pools each filed a petition for Chapter 9 bankruptcy (the petition filed on behalf of the Pools was later dismissed). The petitions followed the County's public disclosure on December 1, 1994, that the Pools had suffered a "paper" loss of approximately $1.5 billion on an investment portfolio of $20.6 billion. Between mid-December 1994 and January 20, 1995, the County liquidated the Pools' securities portfolio. Ultimately, the Pools realized a loss of about $1.7 billion on Participants' deposits of $7.6 billion, a loss of approximately 22.3%.
3. The Municipal Securities Offerings
a. Description of the Taxable Offerings
16. In 1993 and 1994, Anaheim, Irvine, and the Four Districts conducted a total of twelve taxable note offerings. The purpose of these offerings was to invest the proceeds in the Pools for profit. All of these notes were repaid in full and on time.
17. Anaheim's two offerings were: the 1993 $66 Million Notes, issued on April 8, 1993; and the 1994 $95 Million Notes, issued on April 5, 1994. These offerings represented a significant portion of Anaheim's annual budget of $245 million. Irvine's two offerings were: the 1993 $60 Million Notes, issued on May 6, 1993; and the 1994 $62.455 Million Notes, issued on July 27, 1994.
18. The Four Districts issued a total of $200 million in taxable notes on June 23, 1993, and another $200 million on June 14, 1994. In both 1993 and 1994, Irvine USD issued $54.575 million in notes; Newport-Mesa USD issued $46.96 million; NOCCCD issued $56.285 million; and OC Board issued $42.18 million. The proceeds of the 1993 Four Districts' offerings were invested in Specific Investments with the County Treasurer. The proceeds of the 1994 Four Districts' offerings were invested directly into the Commingled Pool.
b.The Omissions Regarding Investment of Proceeds
19. The Official Statements for these offerings contained very similar disclosures. In the section entitled "Purpose of Issue," the Official Statements for eight of the offerings represented that the proceeds of each offering would provide funds to meet the issuer's current fiscal year expenditures, including current expenses, capital expenditures, investment and reinvestment and the discharge of other obligations or indebtedness of the issuer. The Official Statements for three offerings (Anaheim's two offerings and Irvine's 1993 offering) failed to include the phrase "investment and reinvestment" in the description of the purpose of the issuance. In addition, a separate section of the Official Statements, entitled "Security for the Notes and Available Sources of Repayment," represented that the offering proceeds would be deposited into a repayment account.2 A third section, "Deposit and Investment of Repayment Fund," stated that the repayment account would be invested as permitted by state law.
20. The disclosure in the Official Statements was misleading because it omitted the material information that the intended purpose of the debt offerings was to invest the note proceeds into the Pools for profit. Furthermore, the Official Statements misleadingly recited information typically used in tax and revenue anticipation note offerings, which are another type of municipal securities offering, such as statements that the taxable notes were issued "in anticipation of the receipt of taxes, revenue and other moneys" to be received by the issuer.
21. The Official Statements failed to disclose any information about the investment of the note proceeds in the Pools. Specifically, the Official Statements failed to disclose that:(1) the Pools' investment strategy was predicated upon the assumption that prevailing interest rates would remain at relatively low levels; (2) the Pools' use of leverage through reverse repurchase agreements was constant, high, and a major part of the Pools' investment strategy; and (3) the Pools had a substantial investment in derivative securities, including inverse floaters.
22. The Official Statements also failed to disclose the risks of the investment strategy. In particular, the Official Statements failed to disclose that rising interest rates would have a substantial negative impact on the Pools in several respects: (1) the Pools' cost of obtaining funds under reverse repurchase agreements would increase; (2) the Pools' interest income on the inverse floaters would decrease; (3) the Pools' securities would decline in market value; (4) as the value of the securities fell, the Pools would be subject to collateral calls and reductions in loan amounts obtained under reverse repurchase agreements; (5) the Pools' earnings would decrease; and (6) the Pools would suffer losses of principal at certain interest rate levels.
23. The proceeds of the Four Districts' 1993 taxable notes were invested in Specific Investments with the County Treasurer. The Official Statements for these offerings similarly failed to disclose the risks of this investment, including the high degree of leverage due to the use of reverse repurchase agreements, and the effect that increasing interest rates would have on this investment.
24. In addition, the Official Statements for the 1994 offerings omitted to disclose certain material information concerning the Pools' declining investment results to date. In particular, the Official Statements failed to disclose that as a result of rising interest rates in 1994: (1) the Pools' cost of obtaining funds had increased while the income earned from inverse floaters had decreased; (2) the Pools had suffered substantial market losses in the overall value of the portfolio; and (3) the Pools had suffered losses on the reverse repurchase transactions through collateral calls and reductions in loan amounts, which in turn, had a negative impact on liquidity.
4. The Role of the Respondent in the Offerings
25. Rauscher Pierce underwrote eleven of the offerings: Anaheim's 1993 taxable offering; Irvine's two taxable offerings; and the eight offerings conducted by the Four Districts. In addition, the firm was the financial adviser for Anaheim's 1994 taxable offering. With the exception of the two Irvine offerings, Ough participated in drafting the Official Statements for the offerings and also approved the final versions of these documents on behalf of Rauscher Pierce. Horler participated in drafting the Official Statements for the Irvine offerings and also approved the final versions of the documents on behalf of Rauscher Pierce.
5. The Knowledge of the Respondent
26. As discussed below, Rauscher Pierce (through Ough and Horler) knew that the proceeds of the taxable offerings were to be invested in the Pools for profit. Rauscher Pierce also knew or should have known certain information about the County Treasurer's investment strategy, the risks of that strategy and, for the 1994 offerings, the Pools' declining investment results. Rauscher Pierce's knowledge about the Pools' strategy and related risks increased during the course of the offerings.
27. For all of the taxable offerings, Rauscher Pierce and, with respect to the two Irvine offerings, Horler, knew that the purpose of the offerings was to invest the proceeds in the Pools for profit. With regard to the 1993 Four Districts' offerings, Ough knew that the proceeds were to be invested by the County Treasurer, but did not know specifically how the Treasurer intended to invest the proceeds. Ough failed to make a reasonable inquiry concerning the Pools for any of the offerings in 1993. Prior to the 1994 offerings, Ough knew that the offering proceeds would be invested in the Pools for profit.
28. Before the issuance of Irvine's 1993 taxable notes, Horler reviewed the Pools' portfolio as of March 31, 1993. This document set forth the Pools' securities holdings, categorized by type. From this information, Horler knew that the Pools were leveraged. Horler also knew or should have known that the Treasurer employed reverse repurchase agreements to obtain a higher rate of return, and that the value of the investments held by the Pools would be at risk in a period of rising interest rates. Horler subsequently conveyed the March 31, 1993 Pool's portfolio, draft Official Statement, and other marketing materials to the firm's Fixed Income Commitment Committee. This committee then notified Horler that the firm would underwrite the Irvine 1993 taxable notes.
29. In November 1993, Ough and Horler each received and reviewed the Treasurer's 1992-93 Financial Statement, which Horler subsequently distributed to others at Rauscher Pierce. In this report, the Treasurer stated that the Pools' investment strategy involved the use of leverage of approximately two to one and structured or floating rate securities, including inverse floaters, and was predicated on interest rates remaining low over the next three years. The report further advised that if interests rates were to rise, the overall performance of the Pools would decline.
30. By May 1994, before the Four Districts' 1994 offerings, Ough knew or should have known that: the Pools' investment strategy entailed a high degree of leverage through the use of reverse repurchase agreements; the Pools' portfolio included substantial amounts of inverse floaters; and the Pools' performance would decline if interest rates were to rise. Ough also knew or should have known that concerns had been expressed about the maturity length of the portfolio, recent collateral calls and the Treasurer's ability to meet future collateral calls if interest rates continued to rise.
31. Before Irvine's 1994 offering, Horler also knew that interest rates had been rising in the spring and summer of 1994 and knew from newspaper articles that it was reported that the Pools had suffered some loss in value as a result of rising interest rates.
E. RESPONDENT WILLFULLY VIOLATED SECTIONS 17(a)(2) AND (3) OF THE SECURITIES ACT AND SECTION 15B(c)(1) OF THE EXCHANGE ACT AND MSRB RULE G-17
32. As a result of the conduct described above, Rauscher Pierce acted negligently, willfully violating Sections 17(a)(2) and (3) of the Securities Act, which prohibit, in the offer or sale of any securities, "obtain[ing] money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading," and "engag[ing] in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser"; and willfully violating Section 15B(c)(1) of the Exchange Act and MSRB Rule G-17, which requires that "In the conduct of its municipal securities business, each broker, dealer, and municipal securities dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest, or unfair practice."
IV.
In view of the foregoing, the Commission deems it appropriate and in the public interest to impose the sanctions specified in Respondent's Offer.
ACCORDINGLY, IT IS ORDERED that:
A. Pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, Respondent shall cease and desist from committing or causing any violations and any future violations of Sections 17(a)(2) and (3) of the Securities Act, Section 15B(c)(1) of the Exchange Act, and MSRB Rule G-17.
B. IT IS FURTHER ORDERED that Respondent shall, within thirty (30) days of the entry of this Order, pay a civil money penalty in the amount of $500,000 to the United States Treasury. Such payment shall be: (A) made by United States postal money order, certified check, bank cashier's check or bank money order; (B) made payable to the Securities and Exchange Commission; (C) hand-delivered or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Alexandria, VA 22312-0003; and
(D) submitted under cover letter that identifies Dain Rauscher as a Respondent in these proceedings, the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Karen Matteson, Senior Trial Counsel, Pacific Regional Office, Securities and Exchange Commission, 5670 Wilshire Boulevard, Suite 1100, Los Angeles, CA 90036.
By the Commission.
Jonathan G. Katz
Secretary
Footnotes
1 The findings herein are not binding on anyone other than Respondent.
2 According to the Official Statements, the issuers pledged the invested funds (the note proceeds plus funds equal to the estimated interest on the notes) to secure repayment of the taxable notes. The Official Statements also represented that, if the pledged funds were insufficient to pay principal and interest, the issuers would satisfy any deficiency with other moneys lawfully available to repay the notes in the respective issuer's general fund attributable to the fiscal year in which the notes were issued.