United States of America
In the Matter of
Pryor, McClendon, Counts & Co., Inc.;
|Order Making Findings and Imposing Remedial Sanctions and a Cease-and-Desist Order Against Raymond J. McClendon|
On April 29, 1999, the Commission instituted public administrative and cease-and-desist proceedings against Raymond J. McClendon ("McClendon") pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b)(6), 19(h)(3), and 21C of the Securities Exchange Act of 1934 ("Exchange Act").
McClendon 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 without admitting or denying the findings contained in this order (except that McClendon admits that the Commission has jurisdiction over him and over the subject matter of these proceedings), McClendon consents to the entry of the findings and the imposition of the remedial sanctions and the cease-and-desist order set forth below.
On the basis of this order and McClendon's Offer, the Commission finds the following:1
Respondent McClendon was at all relevant times associated with, and vice-chairman of, Pryor, McClendon, Counts & Co. ("McClendon's firm"), which was at all relevant times registered with the Commission as a broker-dealer pursuant to Section 15(b) of the Exchange Act.
This matter concerns a series of federal securities law violations by McClendon and others scheming with him. From at least March 1992 through April 1994, the City of Atlanta's Investment Officer directed to McClendon's firm approximately $9.8 billion in purchases and sales by the City of zero-coupon securities issued by the United States Treasury ("Separate Trading of Registered Interest and Principal Securities" or "STRIPS"). The City's STRIPS transactions through McClendon's firm accounted for more than 90 percent of the City's STRIPS transactions during that period.
McClendon's firm's competition for Atlanta's STRIPS business was virtually eliminated by the Investment Officer by concealing the City's STRIPS holdings from other broker-dealers. In that period, the Investment Officer and McClendon also caused the City to turn over the STRIPS portion of its securities portfolio more than eight times. From this activity, McClendon's firm received approximately $15.3 million in compensation. Throughout this period, McClendon and the Investment Officer's husband maintained a financial and business relationship that was not disclosed to the City. That relationship included a $30,000 payment that the Investment Officer's husband received from McClendon's firm, at McClendon's direction, through a conduit. Separately, during the period between December 1992 and August 1993, McClendon caused his firm to make four concealed payments, totaling $135,000, to an official of the City of Atlanta through a conduit. In or around that same period, McClendon's firm sought municipal bond underwriting business from the city and underwrote City bonds. By engaging in these activities, McClendon willfully violated the antifraud provisions of the federal securities laws as well as the Municipal Securities Rulemaking Board's ("MSRB") fair-dealing rule, and willfully aided and abetted and caused McClendon's firm to violate the books-and-records provisions of the Exchange Act and of the MSRB rules.
The City's Investment Officer's duties and responsibilities included evaluating securities transactions proposed by broker-dealers to determine whether they enhanced the City's portfolio. The City maintained a list of broker-dealers with whom it could engage in securities transactions. On a monthly basis, the City mailed to those broker-dealers a report known as a "swap report." The purpose of the swap report was to inform the broker-dealers of the City's securities holdings so that they could propose securities transactions beneficial to the City.
From March 1992 to April 1994, the value of the City's securities portfolio ranged from approximately $1 billion to $1.4 billion, with approximately 40 percent to 60 percent of the portfolio consisting of STRIPS. Generally, the remaining securities in the portfolio were other United States Treasury and government agency securities. During this period, the City's Investment Officer caused the City to engage in approximately $9.8 billion in STRIPS purchases and sales with McClendon's firm. All or nearly all of the City's STRIPS transactions with McClendon's firm were done at McClendon's recommendation. The City's STRIPS transactions with McClendon's firm accounted for approximately 92 percent of the dollar amount of all STRIPS purchased and sold by the City.
At some point prior to March 1992, and before the City had acquired the majority of the STRIPS, the Investment Officer instructed her assistant to delete from the swap report all references to the STRIPS before mailing the swap report to broker-dealers each month. Throughout the period of the scheme, the Investment Officer knew that the City's STRIPS did not appear on the swap report mailed to broker-dealers. She also knew that by causing the deletion of the STRIPS from the swap report, she had virtually eliminated McClendon's firm's competition for Atlanta's STRIPS business. In addition, McClendon regularly received an internal City report known as a "security recall report," which showed all of the securities in the City's portfolio, including all STRIPS. No other broker-dealer received the security recall report or knew of the City's substantial holdings in STRIPS.
Beginning no later than March of 1992, the Investment Officer and her husband began to receive financial benefits from McClendon's firm. In March 1992, the Investment Officer's husband received $30,000 from McClendon's firm, funneled through a conduit. The Investment Officer's husband used some of that money to capitalize, and set up office space for, his newly formed company, Montclaire Financial Group, Inc. ("Montclaire"). From May 1992 until April 1994, McClendon's firm subcontracted substantial work to Montclaire, and paid Montclaire $286,560 for services, $31,044 for expenses, and another $7,642 not designated as either. McClendon's firm's payments to Montclaire accounted for nearly all of Montclaire's revenue during that period. The Investment Officer never disclosed, and the City never learned of, the financial and other benefits that the Investment Officer and her husband received from McClendon's firm at McClendon's direction.
McClendon and the Investment Officer, with others, compounded the benefits that McClendon's firm received from the scheme by churning the STRIPS portion of the City's portfolio. The City's stated investment policy was to pursue "a prudent, yet aggressive investment policy of maximizing investment income while minimizing risk" and to "hold investments until maturity." Yet from March 1992 until February 1994, the Investment Officer caused the City to engage in transactions with McClendon's firm that turned over the STRIPS portion of the City's portfolio 8.6 times, or at an annual rate of 4.5 times. The Investment Officer effected frequent exchanges, or "swaps," of one STRIPS for another STRIPS with a longer or shorter maturity. Generally, these series of STRIPS-for-STRIPS exchanges merely increased, then decreased, back and forth, the maturities of the STRIPS within a narrow range of short-term maturities. That course of trading provided McClendon's firm with approximately $15.3 million in revenues from markups and markdowns charged on the STRIPS transactions.2 The trading, however, provided no benefit to the City, but instead materially diminished the City's investment returns, essentially through unnecessary transaction costs in the form of markups and markdowns received by McClendon's firm.3
Separate and apart from the STRIPS scheme outlined above, McClendon caused his firm to make four concealed payments, totaling $135,000, to an official of the City of Atlanta during the period beginning in or around December 1992 and ending in or around August 1993. McClendon caused his firm to funnel these payments to the Atlanta official through a conduit, and to mischaracterize the payments in the firm's books and records. In or around that same period, McClendon's firm sought municipal bond business from the City, and underwrote City bonds.
The conduct of McClendon in connection with securities transactions in the City of Atlanta's fixed-income portfolio violated the antifraud provisions of the federal securities laws in two distinct ways. First, McClendon, with others, willfully violated the antifraud provisions by engaging in a scheme to defraud. Second, McClendon, with others, willfully violated the antifraud provisions by churning the City of Atlanta's account.
Generally, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit the use of schemes, practices or courses of business that operate as frauds, or the making of material misrepresentations or omissions in connection with the purchase or sale of securities. Section 17(a) of the Securities Act prohibits similar conduct in the offer or sale of securities.
By engaging in the conduct described above, McClendon breached his duty, under the shingle theory, to deal with the City fairly and consistent with industry practice. See, e.g., In re Duker & Duker, 6 S.E.C. 386, 388 (1939); In re Thomas D. Pixley, 44 S.E.C. 1462, 1463 (1989) (registered representative who schemed with another to influence directing of pension fund investment business to the registered representative violated Section 10(b) of the Exchange Act and Rule 10b-5); In re E.H. Rollins & Sons, Inc. v. Walter Cecil Rawls, 18 S.E.C. 347, 385-86 (1945) (registered representative who provided secret payments to fund fiduciary who provided fund investment business to the registered representative violated Section 17(a) of the Securities Act). When McClendon dealt unfairly with the City and inconsistent with industry practice by giving benefits to the City's Investment Officer, the City's agent, he owed a duty to disclose to the City, the Investment Officer's principal, all material information concerning the transactions.4 Moreover, the circumstances of McClendon's dealings with the City's Investment Officer and the City gave rise to a duty of disclosure on McClendon's part under Georgia law as well.5
Thus, McClendon had a duty to disclose to the City various facts, including (1) that McClendon's firm maintained an ongoing business relationship with the City's Investment Officer's husband, (2) that McClendon's firm had funneled a $30,000 payment through a conduit to the City's Investment Officer's husband, (3) that the City's Investment Officer was effectively funneling to McClendon's firm all the securities purchase-and-sale business in a substantial portion of the City's portfolio, and (4) that McClendon was recommending a course of securities trading that generated substantial revenue for McClendon's firm at the City's expense.
The scheme to eliminate McClendon's firm's competition, funnel securities purchase-and-sale business to McClendon's firm, and pursue a course of securities trading to benefit McClendon's firm at the City's expense, with the firm all the while providing undisclosed benefits to the City's Investment Officer and her husband, was plainly "in connection with" the purchase or sale of securities. Moreover, had the City's Investment Officer or McClendon disclosed their private dealings, the City would have restricted the City's Investment Officer's discretion to deal with McClendon's firm and many, if not all, of the transactions would have never occurred. These considerations satisfy the "in connection with" requirement. Section 10(b) of the Exchange Act "must be read flexibly, not technically and restrictively" and reaches "deceptive practices touching [the] sale of securities." Superintendent of Insurance v. Bankers Life & Cas. Co., 404 U.S. 6, 12-13 (1971) ("in connection with" requirement satisfied where investor was deceived into authorizing sale of securities by misrepresentation about what would be done with proceeds, reversing lower court ruling that the requirement was not met because the "purity of the security transaction and the purity of the trading process were unsullied").6
Finally, as part of the scheme, the City's Investment Officer, with others, churned the STRIPS portion of the City's portfolio for the benefit of McClendon's firm. Churning refers to excessive turnover in a controlled securities account for the purpose of increasing the amount of compensation received by a broker-dealer. See, e.g., Armstrong v. McAlpin, 699 F.2d 79, 90 (2d Cir. 1983). Proof of churning requires a showing (1) that the churner had either explicit or de facto control over trading in the account, (2) that trading in the account was excessive in light of the investor's objectives, and (3) that the churner acted with scienter. See, e.g., Miley v. Oppenheimer & Co., 637 F.2d 318, 324 (5th Cir. 1981); In the Matter of Donald A. Roche, Exchange Act Rel. No. 38741 (June 16, 1997), 64 SEC Dkt. 2042, 2048.
a. The Control Element is Satisfied
First, because the City authorized its Investment Officer to engage in securities transactions on its behalf, that Officer had actual control over the City's securities portfolio. Armstrong, 699 F.2d at 90; Ruiz v. Charles Schwab & Co., 736 F. Supp. 461, 462-63 (S.D.N.Y. 1990) (While churning typically involves a violation by a broker-dealer or its associated persons, when an investor has an agent making its investment decisions, the agent is a "potential churner."). By engaging with the City's Investment Officer in the scheme to defraud, McClendon shared control of the trading. That shared control renders McClendon liable for churning along with the City's Investment Officer if the other elements of a churning violation are met. See Smith v. Petrou, 705 F. Supp. 183, 187 (S.D.N.Y. 1989). The Smith court held that proof of a scheme between the broker-dealer and the customer's investment advisor would establish the requisite control on the part of the broker-dealer, even though the advisor "alone made the investment decisions."7 Id. at 186-87. See also In the Matter of Moore and Co., 32 S.E.C. 191 (1951) (broker effecting transactions directed by customer's agent without disclosing to customer facts known to broker about agent's self-dealing "was guilty along with [agent] of violations of the antifraud provisions); In the Matter of William I. Hay, et al., 19 S.E.C. 397 (1945) (broker effecting transactions directed by customer's agent without disclosing to customer facts known to broker about agent's self-dealing violated antifraud provisions; noting that customers were victimized by "two agents, one with discretionary power over their accounts acting faithlessly and the other, a broker, knowing of the faithlessness yet claiming to be free of any duties").
b. Trading in the Account was Excessive
Second, the City's Investment Officer and McClendon caused the City to turn over the STRIPS portion of its portfolio at an annual rate of approximately 4.5 times. Excessive trading under the securities laws is not measured against some "magical per annum percentage" that establishes per se excessiveness. In the Matter of Gerald E. Donnelly, Exchange Act Rel. No. 36690 (Jan. 5, 1996), 61 SEC Dkt. 47, 51. Instead, excessive trading is determined based on the investment objectives of the customer.8 The turnover of Atlanta's STRIPS portfolio exceeded the City's investment objectives and was inconsistent with the City's stated policy of "maximizing investment income while minimizing risk" and holding "investments until maturity." The Investment Officer's frequent buying and selling of STRIPS back and forth within a narrow range of short-term maturities provided no benefit to the City but instead diminished the City's investment returns. See, e.g., In the Matter of Russell Irish, 42 S.E.C. 735, 736 (1965) (churning found in frequent switching back and forth between mutual funds or between different series in the same mutual fund). While harming the City, the trading enriched McClendon's brokerage firm, and McClendon.
c. McClendon Acted with Scienter
Third, the City's Investment Officer and McClendon knew or was reckless in not knowing that the turnover they caused in Atlanta's accounts was inconsistent with the City's investment objectives, provided no benefit to the City, and generated revenue for McClendon's brokerage firm at the City's expense by diminishing the City's investment returns. See In the Matter of Donald A. Roche, Exchange Act Rel. No. 38741, 64 SEC Dkt. at 2049 (fact that customer's losses were apparent to broker shows at least reckless disregard for customers' interests).
By his conduct in connection with the undisclosed payments to the Atlanta City Official during the period between December 1992 and August 1993, McClendon not only willfully violated the MSRB's fair dealing rule, but also willfully aided and abetted and caused his firm's violations of the books and records provisions of the Exchange Act and the MSRB rules.
Section 15B(b) of the Exchange Act established the MSRB and empowered it to propose and adopt rules with respect to transactions in municipal securities by brokers, dealers and municipal securities dealers. As an associated person of his firm, McClendon was bound by the MSRB rules. Pursuant to Section 15B(c)(1), a broker-dealer or municipal securities dealer is prohibited from using the mails or any instrumentality in interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any municipal security in violation of any rule of the MSRB. As a municipal securities dealer, McClendon's firm was subject to Section 15B(c)(1) of the Exchange Act and the MSRB rules. MSRB rule G-17 is a fair dealing rule. The failure to disclose financial and other relationships between a fiduciary of an issuer-which the Atlanta City Official was-and an underwriter that create potential or actual conflicts of interest violates MSRB rule G-17. See Lazard Freres & Co. LLC and Merrill Lynch, Pierce, Fenner & Smith Incorporated, Exchange Act Rel. No. 36419 (Oct. 26, 1995); SEC v. Ferber, Lit. Rel. No. 15193 (December 19, 1996); First Fidelity Securities Group, supra; SEC v. Busbee, Lit. Rel. Nos. 14387 (January 23, 1995) and 14508 (May 24, 1995)); SEC v. Rudi, Lit. Rel. Nos. 14421 (February 23, 1996) and 15202 (December 30, 1996). By failing to disclose the payments to the Atlanta City Official, McClendon willfully violated MSRB rule G-17.
2. McClendon Aided and Abetted and Caused His Firm's Violations of the Books and Records Provisions of the Exchange Act and MSRB Section 17(a)(1) of the Exchange Act requires brokerage firms to create and maintain books and records reflecting their operations and dealings as required by rules promulgated by the Commission. Rule 17a-3 specifies the books and records that brokerage firms must create pursuant to Section 17(a). The MSRB's books and records provisions parallel the Commission's. MSRB rule G-8 is the provision requiring municipal securities dealers to make certain books and records concerning their municipal securities business. The rule requires that the information be recorded "clearly and accurately." MSRB rule G-8(b). The Commission has described the records maintained by broker-dealers as "the basic source documents and transaction records of a broker-dealer," and the "keystone of the surveillance of brokers and dealers by our staff and by the securities industry's self-regulatory bodies." Edward J. Mawod & Co., 46 S.E.C. 865, 873 n. 39 (1977) aff'd sub nom. Edward J. Mawod & Co. v. SEC, 591 F.2d 588, 594 (10th Cir. 1979).
McClendon's conduct caused the books and records of his firm to be inaccurate with respect to the payments to the Atlanta City Official. With respect to each of these payments, McClendon's firm's books and records failed to accurately record the true nature of the payments, and characterized them in a misleading manner.
Based on the foregoing, the Commission finds that:
McClendon willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and MSRB Rule G-17, and willfully aided and abetted and caused his firm's violations of Sections 15B(c)(1) and 17(a) of the Exchange Act and Rule 17a-3 thereunder and MSRB Rule G-8.
In view of the foregoing, the Commission finds that it is appropriate in the public interest for the protection of investors to impose the relief agreed to in McClendon's offer of settlement.
Accordingly, pursuant to Section 8A of the Securities Act and Sections 15(b)(6), 19(h)(3), and 21C of the Exchange Act:
1. IT IS ORDERED that McClendon cease and desist from committing or causing any violations, and any future violations, of Section 17(a) of the Securities Act, Sections 10(b), 15B(c)(1) and 17(a) of the Exchange Act and Rules 10b-5 and 17a-3 thereunder, and MSRB Rules G-8 and G-17.
2. IT IS FURTHERED ORDERED that McClendon be, and hereby is, barred from association with any broker or dealer.
By the Commission.
Jonathan G. Katz
1 The findings herein are made pursuant to McClendon's offer of settlement and are not binding on any other person or entity in these or any other proceedings.
2 When a broker-dealer acts as a principal rather than an agent in a securities transaction with a customer, instead of charging a commission, the broker-dealer receives compensation (1) by adding a markup to the prevailing wholesale market price of the security in a sale to the customer and (2) by subtracting a markdown from the prevailing wholesale market price in a purchase from the customer. In re Lehman Bros. Inc., Exchange Act Release No. 37673 (Sept. 12, 1996), 62 SEC Dkt. 2324, 2330.
3 For example, on March 12, 1993, Atlanta's general pension fund held STRIPS that had a market value that day of $27,389,030 and matured in May 1994. Through a series of STRIPS-for-STRIPS exchanges, the Investment Officer caused the City to turn that investment over six times in 194 days, while adding $105 in new money to the investment. At the end of that period, on September 22, 1993, the City held STRIPS that matured in February 1995 and had a market value of $27,525,520. The City received $136,385 in total return from these exchanges, which translates into an annual rate of return of less than 1 percent. However, to effect this series of swaps, the City paid transaction costs to McClendon's brokerage firm (in the form of markups and markdowns) totaling $491,776-more than 3½ times the City's total return from those swaps.
4 See, e.g., SEC v. Feminella, 947 F. Supp. 722, 732 (S.D.N.Y. 1996) (broker had duty to disclose to customer that consideration paid by customer included money that broker intended to provide as kickback to customer's agent). The Commission has held that a broker-dealer's disclosure duty includes a duty to disclose to its customer information indicating that the customer's agent is engaged in fraud with respect to the customer's investments. In failing to make that disclosure, the broker-dealer shares in the agent's liability to the customer with respect to any transactions involving the broker-dealer. See In the Matter of Moore and Co., 32 S.E.C. 191, (1951); In the Matter of William I. Hay, et al., 19 S.E.C. 397 (1945).
5 See O.C.G.A. § 23-2-53; Thompson v. Smith Barney, Harris Upham & Co., 539 F. Supp. 859, 864 (N.D. Ga. 1982) (duty to disclose under Georgia law arises "even absent a fiduciary relationship, where there is active concealment" or where one "takes advantage of a party he knows to be laboring under a delusion") (citing Young v. Hirsch, 187 Ga. 1, 9, 199 S.E. 179 (1938)); Reeves v. Williams & Co., 160 Ga. 15, 127 S.E. 293 (1925).
6 The evidence also establishes that the facts not disclosed by the City's Investment Officer and McClendon were material. An undisclosed fact is material if there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available." Basic v. Levinson, 485 U.S. 224, 231-32 (1988) (quoting TSC Industries v. Northway, Inc., 426 U.S. 438, 449 (1976)). The testimony of the City's Investment Officer's superiors establishes that the payments and business relationship were in fact material to them, as they would have been to any reasonable investor. See, e.g., Beaudine v. United States, 368 F.2d 417 (5th Cir. 1966) (noting "the principle so well grounded in morality and equity that the servant cannot serve two masters and that when this is done without complete disclosure, the law considers that the master-principal's interests either will, or are apt to, suffer").
7 In Smith, the advisor was not alleged to have received any kickbacks or other compensation but only to have acted out of a desire to generate brokerage business for a friend. 705 F. Supp. at 186-87.
8 In other enforcement actions, the Commission has found annual turnover rates of 4.5 times and lower to be excessive. See, e.g., In the Matter of Laurie Jones Canady, Exchange Act Rel. No. 41250 (April 5, 1999) (annual turnover rates ranging from 3.83 to 7.28 times held excessive); In the Matter of Donald A. Roche, 64 SEC Dkt. 2047-48 (annual turnover rates of 3.3, 4.6, and 7.2 times held excessive); In the Matter of Gerald E. Donnelly, 61 SEC Dkt. 50-51 (annual turnover rates ranging from 3.1 to 3.8 times held excessive); In the Matter of the Application of John M. Reynolds, Exchange Act Rel. No. 30036 (Dec. 4, 1991), 50 SEC Dkt. 624, 625 (annual turnover rate of 4.81 times held excessive).
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