UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Investment Advisers Act of 1940 Release No. 1653 / September 2, 1997 Accounting and Auditing Enforcement Release No. 948 / September 2, 1997 ADMINISTRATIVE PROCEEDING File No. 3-9382 - - - - - - - - - - - - - - - x : In the Matter of : : ORDER INSTITUTING PUBLIC : PROCEEDINGS, MAKING S. DONALD SUSSMAN : FINDINGS, CEASE-AND-DESIST : ORDER, AND ORDER IMPOSING : REMEDIAL SANCTIONS Respondent. : : - - - - - - - - - - - - - - - x I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest to institute public administrative proceedings pursuant to Sections 203(f) and 203(k) of the Investment Advisers Act of 1940 ("Advisers Act"), against S. Donald Sussman ("Sussman"). In anticipation of the institution of these proceedings, Sussman has submitted an Offer of Settlement (the "Offer") to the Commission, 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 in which the Commission is a party, and without admitting or denying the findings contained herein, except as to the Commission's jurisidiction over him and over the subject matter of this proceeding, which is admitted, Sussman has consented to the entry of the findings and remedial sanctions set forth below. Accordingly, IT IS ORDERED that proceedings pursuant to Sections 203(f) and 203(k) of the Advisers Act be, and hereby are, instituted. II. On the basis of this Order Instituting Public Proceedings, Making Findings, Cease-and-Desist Order, and Order Imposing Remedial Sanctions ("Order") and the Offer, the Commission makes the following findings: RESPONDENT A. Sussman was registered with the Commission as an investment adviser pursuant to Section 203(c) of the Advisers Act from February 22, 1988, until March 24, 1994, when he voluntarily withdrew his registration by filing a Form ADV-W.<(1)> Sussman's principal place of business is Greenwich, Connecticut. One of Sussman's investment advisory clients is Paloma Partners, L.P. ("Paloma Limited"), to which he provides advisory services in his capacity as the general partner of Paloma Limited. As of December 31, 1993, Paloma Limited had assets of approximately $1.5 billion. INTRODUCTION B. This proceeding involves two different violations of Section 206(2) of the Advisers Act. The first violation concerns Sussman's failure to provide adequate disclosure regarding potential conflicts of interest arising from his purchase of a building using funds borrowed from Paloma Limited. The second violation concerns Sussman's failure to charge certain employee bonuses as expenses in the year in which those expenses were incurred. THE BUILDING PURCHASE C. In or about April 1991, Sussman, through Lamda Capital Holdings, Ltd. ("Lamda Holdings"), a corporation Sussman wholly owns, purchased a building located at 99 River Road in Cos Cob, Connecticut ("99 River Road"), for $2.3 million. Sussman purchased 99 River Road to house the operations of Paloma Limited and other entities advised by or affiliated with Sussman. D. Sussman personally made the $230,000 down payment. He borrowed the remaining $2.07 million from Paloma Limited to make the purchase (the "Initial Loan"). Sussman authorized this loan in his capacity as general partner of Paloma Limited. The Initial Loan was listed as a receivable due to Paloma Limited in its general ledger, but there was no formal loan documentation setting forth the Initial Loan's terms or providing Paloma Limited with a security interest or any other interest in 99 River Road. Legal title to 99 River Road was, and is, held by Lamda Holdings. Although Sussman later stated that it was his intention that Paloma Limited would receive any gain, or bear any loss, on a resale of 99 River Road, there was no contemporaneous documentation reflecting such terms. <(1)> Throughout the relevant period, Sussman conducted his advisory business through a sole proprietorship, known as Paloma Partners Management Company ("Paloma Management"). ======END OF PAGE 2====== E. At the time of the purchase, the Amended and Restated Limited Partnership Agreement of Paloma Partners, L.P. dated as of December 1, 1988 (the "Partnership Agreement") was in effect. Pursuant to the Partnership Agreement, Sussman, as Paloma Limited's general partner, had "full and complete charge of all affairs of the Partnership, and the management and control of the Partnership's business and its assets shall rest exclusively with the General Partner, subject to the terms and conditions of this Partnership Agreement." The Partnership Agreement's statement of the partnership's purpose included the ability to "transact such other business as shall be necessary, advisable of [sic] incidental to the business of the Partnership, all as determined by the General Partner." The Partnership Agreement neither specifically authorized nor prohibited Paloma Limited from lending money to Sussman. F. In December 1991 Lamda Holdings obtained a mortgage on 99 River Road from a commercial bank. Lamda Holdings used the entire $2.05 million in mortgage proceeds to repay most of the Initial Loan in December 1991. Lamda Holdings made no interest payment to Paloma Limited. Sussman provided the mortgagee-bank with a personal guaranty on the mortgage. Sussman never disclosed the Initial Loan, its terms, or its repayment to the limited partners of Paloma Limited. G. Lamda Holdings rented 99 River Road to Paloma Limited. The parties have operated under a ten year lease that is dated as of April 30, 1991, but was never executed. The lease is a "triple net lease," which means that Paloma Limited bears all the expenses of running the building, including the costs of any mortgage interest and improvements to the property. Actual rental payments did not commence until January 1992, after the bank mortgage was in place. The operations of Paloma Limited, Sussman's other advisory clients and Paloma Partners Management Company, a Delaware Corporation ("Paloma Delaware"), were moved from New York City to 99 River Road in late 1991 or early 1992.<(2)> Rent expense was allocated among the investment advisory clients housed at 99 River Road. H. During 1991 and early 1992, Paloma Limited loaned Lamda Holdings an additional $700,000 to make improvements to 99 River Road. Sussman authorized this loan in his capacity as general partner of Paloma Limited. Paloma Limited has made other payments on Lamda Holdings' behalf related to 99 River Road, including the quarterly mortgage payments to the bank. The amount of money Lamda Holdings owed to Paloma Limited has been reduced by the monthly rent payments due to Lamda Holdings on the triple net lease. The cumulative amount due and owing from Lamda Holdings to Paloma Limited (the "Lamda Receivable") was approximately $1.1 million as of June 30, 1995. The amount due does not include any interest charge. There was no agreement concerning when or how this receivable would be repaid. <(2)> Paloma Delaware provides administrative services for Sussman's advisory clients, including Paloma Limited. Paloma Delaware's expenses, including rent expenses, are allocated and charged to the investment advisory clients. ======END OF PAGE 3====== I. As of year end 1991, the Lamda Receivable was approximately $870,000. Paloma Limited's audited financial statements for the year ended December 31, 1991, did not separately disclose the existence of the Lamda Receivable; it was instead included in the more general category of "Other Assets". J. The first time that any specific information concerning the Lamda Receivable was disclosed to the limited partners was in a footnote to Paloma Limited's financial statements for the year ended December 31, 1992, as follows: Included in other assets is a receivable arising from the reimbursement of various expenses of approximately $893,000 from a company owned by the general partner. K. In the financial statements for the year ended December 31, 1993, the footnote disclosure to the limited partners regarding the Lamda Receivable was changed to read as follows: [Sussman] owns a company which owns a building occupied solely by [Paloma Limited] and related limited partnerships. Included in other assets is a demand loan of approximately $963[,000] as of December 31, 1993, that [Paloma Limited] has made to this company. It is the intention of [Sussman] that any gain recognized on the disposition of the building will inure to [Paloma Limited]. This was the first time that Sussman communicated to the limited partners an intention to pass on any benefit from the sale of 99 River Road to Paloma Limited. There is no document that formalizes a legal obligation from Sussman to provide this benefit. The financial statements do not discuss what entity will bear the risk of loss on resale. L. Paloma Limited, and the operations of related entities, moved out of 99 River Road in or about October 1994. Paloma Limited and the related entities continued to pay rent to Lamda Holdings for 99 River Road. M. In the financial statements for the year ended December 31, 1994, the footnote disclosure to the limited partners regarding the Lamda Receivable stated as follows: [Sussman] owns a company which owns a building rented solely by [Paloma Limited] and some subsidiaries. Included in other assets is a demand loan of approximately $1,036[,000] as of December 31, 1994, that [Paloma Limited and subsidiaries] has made to this company. It is the intention of [Sussman] that any gain recognized on the disposition of the building will inure to [Paloma Limited]. N. Each year, Sussman signed a certification accompanying Paloma Limited's financial statements, which stated, "To the best of the knowledge ======END OF PAGE 4====== and belief of the undersigned, the information contained in the audited financial statements of [Paloma Limited] . . . is accurate and complete." THE BONUS ACCOUNTING O. At year end 1992, Paloma Limited and Paloma Partners Holdings, L.P. ("Paloma Holdings") paid bonuses to certain key employees. Half of each bonus was for work done in 1992, and the other half was a prepayment of bonuses for 1993. P. This entire bonus payment was included as a prepaid asset in the financial statements for the year ended December 31, 1992, for Paloma Limited and for Paloma Holdings, a limited partnership through which a substantial portion of Paloma Limited's assets were invested. Paloma Holdings' results of operation have a dollar for dollar effect on Paloma Limited's results. Of the bonus payment, $3.6 million was recorded as an asset of Paloma Limited and $3.1 million as an asset of Paloma Holdings. Q. The entire bonus payment was charged as an expense in 1993. Because half the bonus was for 1992 work, that half should have been charged as an expense in 1992. Failure to do so meant that the 1992 Paloma Limited financial statements understated operating expenses, and consequently overstated income, by $3.35 million. If stated accurately, operating expenses would have increased from $5.7 million to $8.9 million;<(3)> net income would have declined from $81 million to $77.65 million; and the rate of return for investors in Paloma Limited would have declined from 11% to 10.6%. R. Sussman signed a certification accompanying the financial statements that stated, "To the best of the knowledge and belief of the undersigned, the information contained in the audited financial statements of [Paloma Limited] for the year ended December 31, 1992 is accurate and complete." S. Sussman either directed that the entire bonus be charged as a 1993 expense or acted with reckless disregard as to whether the bonus was so charged. III. LEGAL ANALYSIS <(3)> Because the salary of one of the employees who received a bonus was charged to Paloma Holdings in 1992, his bonus of $150,000 also should have been charged to Paloma Holdings. Thus, expenses for Paloma Limited were understated by $3.2 million, not $3.35 million. The full $3.35 million would nevertheless have been reflected in Paloma Limited's overall net income and rate of return. ======END OF PAGE 5====== A. Section 206(2) establishes a statutory fiduciary duty for investment advisers to act for the benefit of their clients. Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979); Chancellor Capital Management, Inc., Investment Advisers Act Rel. No. 1447, 57 SEC Docket 2489, 2500 (Oct. 18, 1994). This fiduciary duty includes the duty to exercise the utmost good faith in dealings with clients, to disclose all material facts, and to employ reasonable care to avoid misleading clients. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963); Chancellor Capital, 57 SEC Docket at 2500. Actual injury is not required for a Section 206(2) violation. Capital Gains, 375 U.S. at 192. An investment adviser's failure to disclose a material conflict of interest violates Section 206. Id. at 194. Proof of scienter is not required to establish a violation of Section 206(2). Id. at 195. B. An investment adviser has a duty to disclose to clients all material information which might incline an investment adviser consciously or unconsciously to render advice which is not disinterested. Id. at 191- 92. See Kingsley, Jennison, McNulty & Morse, Inc., Investment Advisers Act Rel. No. 1396, 55 SEC Docket 2434, 2441 (Dec. 23, 1993) ("An adviser has a duty to . . . disclose information that would expose any conflicts of interest. Indeed, disclosure is required even where there is only a potential conflict.") C. Sussman violated Section 206(2) in the following manner. As to 99 River Road, Sussman failed to disclose the Initial Loan that enabled him to buy 99 River Road for his wholly-owned corporation and the potential conflicts of interest that resulted. Sussman's interests were in potential conflict with those of his clients in that the documentation concerning the building indicated that Sussman was now Paloma Limited's landlord and stood to profit on any resale of the building, even though Paloma Limited had loaned to Sussman, interest free, the money needed to purchase the building. This conflict created a risk that Sussman's decisions regarding 99 River Road would not be disinterested and that the arrangement at 99 River Road might as a result be less favorable to Paloma Limited than an arrangement reached at arms' length with a third party would be. Sussman should have disclosed these potential conflicts to the limited partners of Paloma Limited. Sussman's subsequent statement in the Paloma Limited financial statements that he intended for the limited partners to benefit on resale did not inform them that there were no formal documents legally binding Sussman to provide them with this benefit. Sussman also failed to inform the limited partners that they were at a risk of loss if there were insufficient funds from a resale to enable Lamda Holdings to repay the mortgage or the Lamda Receivable. Information concerning these potential conflicts of interest and Sussman's use of Paloma Limited's funds for his own benefit would be material to a limited partner. D. With respect to the bonus expense accounting, Sussman violated Section 206(2) by failing to charge $3.35 million in expenses in 1992, which resulted in a 36% understatement of operating expenses. If it had been charged in 1992, it would have reduced the investors' rate of return for the year from 11% to 10.6%. ======END OF PAGE 6====== IV. As a result of the foregoing, Sussman willfully violated Section 206(2) of the Advisers Act. V. 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 Sussman: A. shall cease and desist from committing or causing any violation and any future violation of Section 206(2) of the Advisers Act; B. shall, within ten days of any sale of 99 River Road, disgorge to Paloma Limited any net profits earned on such sale; C. shall comply with his undertakings, as specified in his Offer of Settlement: 1. not to impose on Paloma Limited any losses incurred in connection with the resale of 99 River Road; 2. not to impose on Paloma Limited any future costs of future capital improvements, if any, to 99 River Road; and 3. within ten days of any sale of 99 River Road, to pay any remaining indebtedness due from Lamda Holdings to Paloma Limited;<(4)> and D. shall, within ten days of the date of this Order, pay a civil money penalty in the amount of $40,000 to the United States Treasury. Such payment shall be: (1) made by United States postal money order, certified check, bank cashier's check or bank money order; (2) made payable to the Securities and Exchange Commission; (3) hand delivered or mailed to the Office of the Comptroller, Securities and Exchange Commission, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312; and (4) submitted under cover of a letter which identifies Sussman 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 Daniel J. Goldstein, Assistant Regional Director, Northeast Regional Office, Securities and Exchange Commission, 7 World Trade Center, 13th Floor, New York, NY 10048. <(4)> The Commission notes that, subsequent to the commencement of this investigation but prior to entry of this Order, 99 River Road was sold and Sussman paid off all remaining indebtedness to Paloma Limited. There was a loss on the sale, and Sussman personally bore that loss. ======END OF PAGE 7====== By the Commission. Jonathan G. Katz Secretary ======END OF PAGE 8======