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Initial Decision of an SEC Administrative Law JudgeIn the Matter of
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In the Matter of WARREN G. TREPP |
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INITIAL DECISION August 18, 1997 |
APPEARANCES:
William H. Kuehnle, Linda C. Thomsen, and Joaquin M. Sena for the Division of Enforcement, Securities and Exchange Commission
William C. Hundley, Larry S. Gondelman, and John J. Hoffman for Respondent Warren G. Trepp
BEFORE:
Carol Fox Foelak, Administrative Law Judge
I. INTRODUCTION
The Securities and Exchange Commission (Commission) initiated this proceeding by an Order Instituting Public Proceedings and Notice of Hearing (OIP) on September 28, 1995, pursuant to Section 8A of the Securities Act of 1933 (Securities Act) and Sections 15(b)(6) and 21C of the Securities Exchange Act of 1934 (Exchange Act). The OIP alleged that in 1986 Warren G. Trepp willfully aided, abetted, and caused violations by Drexel Burnham Lambert Incorporated (Drexel) of Section 17(a) of the Exchange Act and Rule 17a-3 thereunder, and violations by Reliance Group Holdings, Inc. (Reliance) of Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder, and Section 17(a)(2) of the Securities Act, in connection with an alleged parking scheme.
I held a hearing in Washington, D.C., on February 13, 14, 15, 22, and 23, 1996. The Division of Enforcement (Division) called six witnesses from whom testimony was taken. The Respondent called five witnesses. A number of exhibits were received into evidence. 1
Pursuant to the requirements of the Administrative Procedure Act (APA), 2 I considered the following post hearing pleadings: (a) the Division's Posttrial Brief and Proposed Findings of Fact and Conclusions of Law, dated April 8, 1996; (b) the Respondent's Posttrial Brief, Proposed Findings of Fact and Conclusions of Law, and Response to Division's Proposed Findings of Fact, dated May 8, 1996; and (c) the Division's Response to Respondent's Proposed Findings of Fact and Posttrial Reply Brief dated May 31, 1996. Additionally, I considered the two findings of fact contained in the Division’s Motion for Leave to File Supplement to Proposed Findings of Fact dated September 13, 1996.
The Division is seeking an order to cease and desist, as well as a bar from association with any broker, dealer, municipal securities dealer, investment advisor, or investment company. The Respondent contends that the Division failed to prove the violations alleged, that the finding of the United States Court of Appeals for the District of Columbia Circuit in Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996), reh'g den., Aug. 28, 1996, precludes the imposition of a bar, and that to order Respondent Trepp to cease and desist from further violations would be an illegal, retroactive application of the Remedies Act.
My findings and conclusions are based on the record and my observations of the witnesses' demeanor. I have applied preponderance of the evidence as the applicable standard of proof. I have considered and rejected all the arguments and proposed findings that are inconsistent with this decision.
A. Violations
The OIP alleged that in 1986 Respondent Trepp purchased and resold a series of bonds for the benefit of a customer during second and third quarter "programs," under an agreement which eliminated market risk and whose purpose was to record gains on the books of the customer. As a consequence, the OIP alleged that Mr. Trepp willfully aided, abetted, and caused: 1) Drexel’s violations of Section 17(a) of the Exchange Act and Rule 17a-3 thereunder, by failing to ensure that Drexel’s trade tickets reflected the terms and conditions of the agreement between Drexel and the customer; 2) the customer’s violations of Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder, by executing the transactions according to the agreement but recording them as bona fide purchases and sales, knowing that the customer would use the false information to record gains in its financial statements; and 3) the customer’s violations of Section 17(a)(2) of the Securities Act in connection with the offer and sale of securities, by executing and concealing the second quarter program knowing that the customer would use the results to materially overstate income in its financial statements.
B. Available Sanctions
1. Bar
The authority cited in the OIP for a bar is Section 15(b)(6) of the Exchange Act. While this proceeding was pending, the United States Court of Appeals for the District of Columbia Circuit held in Johnson v. SEC, 87 F.3d 484, that a Commission "proceeding resulting in a censure and a six-month disciplinary suspension of a securities industry supervisor was a proceeding 'for the enforcement of any civil fine, penalty or forfeiture, pecuniary or otherwise,' within the meaning of (28 U.S.C.) § 2462." As a result, the court found that the section's five-year statute of limitations "does apply to SEC proceedings under Section 15(b) of the Securities and (sic) Exchange Act of 1934 which seek to censure and suspend a securities supervisor." Id. at 492.
The parties filed additional pleadings to address issues raised by Johnson v. SEC. 3
Mr. Trepp’s alleged activities that are the subject of this proceeding occurred more than five -- in fact, more than nine -- years before the proceeding was initiated. Therefore, pursuant to Johnson v. SEC, a bar from association with any broker or dealer is not an available sanction. 4 Further, the sanctions of a bar from association with any municipal securities dealer, investment adviser, or investment company are unavailable for the additional reason that they are authorized in statutory sections other than Section 15(b)(6) of the Exchange Act, the sole authority for a bar in this proceeding.
The Division now argues that acts of fraudulent concealment by the Respondent tolled the five-year statute of limitations period until January 1992. Because the OIP was issued on September 28, 1995, the Division claims that a bar remains as an available remedy. The Division offered additional material explaining its theory, but claimed that the material was not actually necessary to meet its burden of proof. The Respondent moved to strike the additional material from the record, or, if I decided to reopen the record, that he be given an opportunity to respond with his own evidence and arguments regarding fraudulent concealment. 5
"Reopening an evidentiary hearing is a matter of agency discretion, and is reserved for extraordinary circumstances." Cities of Campbell v. FERC, 770 F.2d 1180, 1191 (D.C. Cir. 1985) (internal citations omitted). If the record were to be reopened to receive the new evidence, the Respondent would have the right to cross examination and rebuttal. Whether a party committed an act of fraudulent concealment involves questions of fact. I decline to reopen the record to take evidence on these questions at this late stage of the proceedings for the two reasons articulated below. Additionally, I grant in part the Respondent’s motion to strike, in order to exclude from the record the Declarations of James T. Coffman and Joaquin M. Sena and attached exhibits which were part of the Division’s February 14, 1997, Supplemental Brief Addressing the Application of the Johnson Decision to Section 15(b)(6) Relief.
First of all, the Division did not meet its burden of proof in claiming that it exercised due diligence in discovering the cause of action at issue. In a claim of fraudulent concealment, the Division must "show (1) that (the Respondent) engaged in a course of conduct designed to conceal evidence of (his) alleged wrongdoing and that (2) (the Division) was not on actual or constructive notice of that evidence, despite (3) its exercise of diligence." Larson v. Northrop Corp., 21 F.3d 1164, 1172 (D.C. Cir. 1994) (quoting Foltz v. U.S. News and World Report, 663 F. Supp. 1494, 1537 (D.C. 1987), aff’d 865 F.2d 364 (D.C. Cir. 1989), cert. denied 490 U.S. 1108 (1989)). Once the Division shows fraudulent concealment, a Respondent wishing to assert "a defense based on the (Division’s) lack of due diligence must show something closer to actual notice than the merest inquiry notice that would be sufficient to set the statute of limitations running in a situation untainted by fraudulent concealment." Riddell v. Riddell Washington Corp., 866 F.2d 1480, 1491 (D.C. Cir. 1989).
Assuming arguendo that the Respondent engaged in a course of conduct designed to conceal evidence of his alleged wrongdoing and that Division did not have notice of the evidence earlier than January 1992, a claim that this was despite exercise of diligence is not compelling. A Division witness testified at the hearing that in 1989 Drexel supplied the SEC with seven years of trading files for the SEC’s continuing investigation of Drexel’s trading, including the year at issue, 1986. Tr. 12, 14-15. The SEC expended substantial resources in an effort to uncover securities violations at Drexel, and parking was a noted feature in 1980s securities cases related to Drexel. See SEC v. Drexel Burnham Lambert, 837 F. Supp. 587, 590-93 (S.D.N.Y. 1993), aff’d sub nom. SEC v. Posner, 16 F.3d 520 (2d Cir. 1994), cert. denied, 513 U.S. 1077 (1995).
Second, reopening the record at this late date would impede the orderly administration and conclusion of these proceedings. The Division could have foreseen the need to develop more fully the record on the issue of when they became aware of the current cause of action. It was clear from the hearing and from the first round of posthearing pleadings that this issue was of import, both as to the issue of the old age of these proceedings and as to available sanctions.
The Court of Appeals decided Johnson in June 1996 and denied rehearing en banc in August 1996. The Division’s first, oblique, reference to its discovery of the cause of action was after the hearing, in one paragraph of its May 31, 1996, Posttrial Reply Brief. Reply Brief at 52. After the Court of Appeals denied rehearing en banc, the Division barely mentioned the doctrine of fraudulent concealment in its September 13, 1996, Brief on the Impact of Johnson v. SEC on This Action. The Division waited until a February 14, 1997, posthearing brief to develop fully its fraudulent concealment theory. The undersigned did not order the February round of briefs until January 21, 1997, and there was no expectation that this subsequent briefing would be granted.
Both parties claimed in posthearing pleadings that further development of the record on this issue would cause a wasteful delay. Division’s Response to Respondent Trepp’s Motion to Strike, March 4, 1997, at 9; Respondent Trepp’s Motion to Strike, February 25, 1997, at 6. To reopen this issue would require further investigation and filings which would prohibitively extend the duration of these proceedings.
A brief survey of administrative proceedings in the last several years indicates that most, if not all, were instituted between several months and six years from the end of the respondent’s violative activity period, injunction, or conviction. I am influenced in reaching this decision to not reopen the record by the fact that this proceeding was brought nine years after the Respondent’s violations are alleged to have occurred, in 1986.
2. Cease and Desist
The Respondent argues that a cease and desist order is not an available sanction in this case because: 1) it would be a retroactive application of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (Remedies Act); 2) a cease and desist order requires a finding of likelihood of future violation; and 3) a cease and desist order is a penalty and is therefore barred by the five-year statute of limitations pursuant to Johnson v. SEC.
Section 8A of the Securities Act and Section 21C of the Exchange Act provide that:
If the Commission finds, after notice and opportunity for a hearing, that any person is violating, has violated, or is about to violate any provision of this title, or any rule or regulation thereunder, the Commission may publish its findings and enter an order requiring such person, and any other person that is, was, or would be a cause of the violation, due to an act or omission the person knew or should have known would contribute to such violation, to cease and desist from committing or causing such violation and any future violation of the same provision, rule, or regulation.
Retroactivity
First, the Respondent claims that the imposition of a cease and desist order in this case would be an illegal, retroactive application of provisions of the Remedies Act, because the violations alleged occurred before the Act’s effective date, October 15, 1990. 6 The Commission addressed the issue in Richard H. Morrow, and held that a cease and desist order can be issued against a respondent after the effective date of the Remedies Act where violations complained of occurred before the effective date. Order Denying Motion to Strike and Dismiss, 58 SEC Docket 2939 (March 17, 1995). Relying on Landgraf v. USI Film Products, 511 U.S. 244, 273-279 (1994), the Commission held that if a cease and desist "order were granted, it would require only that Morrow cease from conduct that violates the Securities Act and the Exchange Act in the future, forward-looking relief akin to that granted in an injunction. Thus, Morrow would be directed not to do in the future that which he should not do now -- violate the federal securities laws. It is therefore not retroactive in application." Richard H. Morrow, 58 SEC Docket at 2940-41. Similarly, in Landgraf v. USI Film Products, the Supreme Court stated:
Even absent specific legislative authorization, application of new statutes passed after the events in suit is unquestionably proper in many situations. When the intervening statute authorizes or affects the propriety of prospective relief, application of the new provision is not retroactive.
511 U.S. at 273.
Likelihood of Future Violation
Neither the Commission nor any court of appeals has ruled on whether the Commission must find a likelihood of future violation to issue a cease and desist order. The courts have, however, ruled that a likelihood of future violation is required when considering the cease and desist authority of other administrative agencies. Precious Metals Assocs. v. CFTC, 620 F.2d 900, 912 (1st Cir. 1980); Borg-Warner Corp. v. FTC, 746 F.2d 108, 110-11 (2d Cir. 1984); NLRB v. Savin Business Machines Corp., 649 F.2d 89, 93 (1st Cir. 1981); Citizens State Bank v. FDIC, 751 F.2d 209, 214-15 & n.9 (8th Cir. 1984). Cease and desist authority was added to the sanctions available to the Commission in administrative proceedings by the Remedies Act of 1990. As noted in the House Report on the legislation, other federal agencies, e.g., the Commodity Futures Trading Commission (CFTC), Federal Trade Commission (FTC), National Labor Relations Board (NLRB), and each of the federal bank regulatory agencies, were empowered to issue cease and desist orders; a cease and desist order was described as an administrative remedy comparable to an injunction. H. Rep. 101-616, at 23-24 (1990). A likelihood of future violation is required for an injunction. SEC v. Steadman, 967 F.2d 636, 647-48 (D.C. Cir. 1992); United States v. W.T. Grant Co., 345 U.S. 629, 633 (1953).
The Steadman court summarized the law in this area as follows:
"‘The ultimate test’" of whether an injunction should issue "‘is whether the defendant’s past conduct indicates . . . that there is a reasonable likelihood of further violation(s) in the future.’" There must be "some cognizable danger of recurrent violation, something more than the mere possibility which serves to keep the case alive." The relevant factors we consider when assessing the likelihood of recurrent violation include "whether a defendant’s violation was isolated or part of a pattern, whether the violation was flagrant and deliberate or merely technical in nature, and whether the defendant’s business will present opportunities to violate the law in the future." Injunctive relief is reserved for willful lawbreakers or those whose operations are so extremely or persistently sloppy as to pose a continuing danger to the investing public.
SEC v. Steadman, 967 F.2d at 647-48 (citations omitted) (quoting SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1168 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979); W.T. Grant Co., 345 U.S. at 633; SEC v. First City Fin. Corp., 890 F.2d 1215, 1228 (D.C. Cir. 1989)).
Therefore, it is concluded that the Commission must find a likelihood of future violation to issue a cease and desist order.
Statute of Limitations
Finally, the Respondent argues that a cease and desist order is a penalty akin to a civil penalty, and thus the five-year statute of limitations applies pursuant to Johnson v. SEC. The Commission recently granted a motion to dismiss a proceeding that included a cease and desist order by a respondent who argued that the proceeding was time-barred pursuant to Johnson v. SEC. Richard M. Kulak, 64 SEC Docket 1615 (May 20, 1997). The Commission’s brief Order dismissing the proceeding did not disclose its reasoning and thus cannot be construed as a Commission ruling that cease and desist proceedings are subject to the five-year statute of limitations under Johnson v. SEC. The statute of limitations in Section 2462 applies to "the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise." A prospective cease and desist order that the Respondent not violate the securities laws in the future is not a penalty. A respondent is not entitled to break the law.
C. Due Process Violations
The Respondent moved to dismiss this action on the ground that the Commission predetermined adjudicative facts when it made findings based on the transactions at the heart of this proceeding in the settlement of Reliance Group Holdings, Inc. and John H. Pankratz, 56 SEC Docket 197 (February 17, 1994). 7 The Respondent contends that the Commission’s process lacks fundamental fairness because if the initial decision is appealed to the Commission, it will have already decided relevant issues. The Commission has considered and rejected this very argument on several occasions. The Stuart James Co., 50 S.E.C. 468, 469-72 (1991); Steadman Securities Corp., 46 S.E.C. 896, 920 n.82 (1977); Edward Sinclair, 44 S.E.C. 523, 528-29 (1971), aff’d sub nom. Sinclair v. SEC, 444 F.2d 399 (2d Cir. 1971); Atlantic Equities Co., 43 S.E.C. 354, 366 (1967), aff’d sub nom. Hansen v. SEC, 396 F.2d 694 (D.C. Cir. 1968) cert. denied, 393 U.S. 847 (1968).
It is well established that the Commission may combine administrative and adjudicatory functions and remain consistent with due process, including when it considers settlement as to one or more respondents, but reviews an initial decision as to another respondent based on similar facts. A policy prohibiting settlements during the pendency of a multi-party proceeding would be contrary to the Administrative Procedure Act (APA), 5 U.S.C. § 551 et seq., which provides that an agency give all interested parties the opportunity for the submission and consideration of offers of settlement, when time, the nature of the proceeding, and the public interest permit. 5 U.S.C. § 554(c)(1). Further, while agency staff are obligated under the APA to be separated according to investigatory, prosecution, and adjudicatory functions, or in other words by virtue of an internal separation of functions, 5 U.S.C. § 554(d), the APA exempts Commission members from this separation of functions requirement. 5 U.S.C. § 554.
Finally, the attempt to raise a due process defense is premature. Courts do not normally consider assertions of administrative bias before the completion of administrative proceedings and the exhaustion of administrative remedies. SEC v. R.A. Holman & Co., 323 F.2d 284, 286-87 (D.C. Cir. 1963). The court will interrupt the progress of an adjudicative hearing only in the exceptional case where it is presented with undisputed allegations of fundamental prejudice. Amos Treat & Co. v. SEC, 306 F.2d 260 (D.C. Cir. 1962). The appropriate time to raise the issue is when a party seeks judicial review of the Commission’s action. SEC v. R.A. Holman & Co., 323 F.2d at 287-88; United States v. Litton Industries, 462 F.2d 14, 18 (9th Cir. 1972). Administrative regularity is presumed. Id.
D. Unwarranted Delay
The Respondent also argued that this proceeding should be dismissed under the doctrine of laches, because of the Division’s delay in bringing these charges until "almost ten years" after the violative acts. The violative acts occurred in 1986, and the OIP was dated September 28, 1995, or nine years after the period at issue. The defense of laches is not available against a United States government agency acting in the public interest. United States v. Summerlin, 310 U.S. 414, 416 (1940); United States v. Alvarado, 5 F.3d 1425, 1427 (11th Cir. 1993); David Disner, 63 SEC Docket 2246, 2255 (February 4, 1997).
II. FINDINGS OF FACT
A. Drexel Burnham Lambert Incorporated
Drexel was, until its bankruptcy in 1990, a registered broker dealer headquartered in New York City. Tr. 131, 645. Its high yield bond (HYB) department was located in Beverly Hills, California. Tr. 131-32, 716-17. HYBs, also known as junk bonds, have ratings of BB or lower and pay higher yields to compensate for greater risk. Tr. 128-29; John Downes, Dictionary of Finance and Investment Terms 241, 284 (4th ed. 1995). Michael Milken, the 1980s junk bond figure, was the founder and head of Drexel’s HYB department. Tr. 132, 134-35, 677. In the mid-1980s Drexel was a major underwriter and market maker in HYBs, and as such would price HYBs for brokers. Tr. 618; 688-89; 832-34. The junk bond market subsequently collapsed. Michael Milken pleaded guilty to six felony securities and tax law violations, and the firm entered a civil global settlement with the SEC. Tr. 645-51; 655-56; SEC v. Drexel Burnham Lambert Inc., 837 F. Supp. 587 at 596; United States v. Michael R. Milken, S 89 Cr. 41 (S.D.N.Y. 1990). Its bankruptcy was the biggest bankruptcy the financial community had until then. Tr. 651.
Drexel’s Beverly Hills office trading floor featured a large X-shaped trading desk for bond traders and salesmen. Tr. 132, 137; Div. Ex. 27. Mr. Milken sat in the middle of the desk. Tr. 140. Respondent Trepp, the head HYB trader, sat on Mr. Milken’s right, next to him. Tr. 718. William Tobey, a salesman who traded through Mr. Trepp, sat on Mr. Milken’s left, on the other side of a leg of the X, also in the center. Div. Ex. 27. Mr. Milken brought Mr. Tobey to Los Angeles from Drexel’s Chicago office in 1982 because he was trading a significant amount of HYBs. Tr. 126-34.
Mr. Trepp began working in the investment industry in 1968 or 1969, as an accountant. Tr. 674-75. He came to Mr. Milken’s attention after he bested Drexel in a trade; Mr. Milken then hired him in 1979, and in 1980 or 1981 he became head HYB trader. Tr. 675-76, 713-14, 719. His salary, which was set by Mr. Milken, was initially between $500,000 and $1 million, and rose to about $25 million. Tr. 715-16. He was about 35 at the time of the events at issue, in 1986. Tr. 704. He had traders under him, and he and his traders, as well as the salesmen on the trading floor, reported to Mr. Milken. Tr. 676-78. Although Mr. Milken was not a trader per se, he could and did make trades. Tr. 720-21. As the head trader Mr. Trepp handled the larger, more risky HYB trades. Tr. 676-78. He was very busy, doing 250 to 1,000 transactions, amounting to some $200 million to $2 billion, a day. Tr. 702. He reviewed the department’s trading tickets several times a day, and reviewed the previous day’s trading runs at the beginning of each trading day. Tr. 678-80, 722, 731-32. He had a general awareness of Drexel’s HYB inventory -- of about 1,000 securities -- and reviewing the daily trading runs informed him of substantial changes and client interests. Tr. 731-35. He could also check Drexel’s positions on daily inventory runs and on a computer. Tr. 733-36. After Drexel’s bankruptcy, Mr. Trepp was asked to stay on to liquidate its HYB positions. Tr. 647-52, 673-74. He left in 1992 and has been out of the industry since then. Tr. 674, 711. He contributed somewhere between $17 million and $19 million to Drexel’s civil global settlement. Tr. 793-94.
B. Reliance Group Holdings, Inc.
Reliance Group Holdings, Inc. (Reliance), was and is an insurance company holding company whose investment department is located in New York. Tr. 152-54, 342. Reliance had other business interests in addition to its insurance operations, but the transactions at issue in this proceeding were in the portfolios of the insurance operating subsidiaries. Tr. 397. Div. Ex. 14 at 2; Div. Ex. 15 at 3. John Pankratz has been employed by Reliance since 1985 as director of fixed income securities, overseeing Reliance’s fixed income investment portfolios. Tr. 342-43. Mr. Pankratz preferred to purchase "the higher tier in high yield bonds," Tr. 151, 345-46, and dealt with Mr. Tobey at Drexel to buy and sell such bonds. Tr. 151-52.
Some Reliance and Drexel employees were well acquainted with each other. Saul Steinberg, the chief executive officer of Reliance, was a friend and business colleague of Mr. Milken. Tr. 154-55, 220-21, 682. Mr. Steinberg would call or visit Mr. Milken on the trading floor in Beverly Hills. Tr. 154-55; 754-55. Mr. Tobey had done business with Mr. Pankratz, in his previous position with a Chicago financial services company, since 1978, so Mr. Tobey was assigned to cover the Reliance account when Mr. Pankratz moved. Tr. 150, 343. Occasionally, Mr. Milken would call Mr. Pankratz directly to give him unsolicited investment advice. Tr. 419-20.
C. Credibility
The fact witnesses included Mr. Tobey at Drexel, his opposite number at Reliance, Mr. Pankratz, and Respondent Trepp. Mr. Tobey testified in the Division’s direct case, and Mr. Pankratz in that of the Respondent. There were some differences in the testimony of Mr. Tobey and Mr. Pankratz as to events in which both participated. Each party argues that the other’s witness was subject to bias -- the Division arguing that Mr. Pankratz, who is still employed by Reliance, would not want to admit illegality on the part of himself or his employer, and the Respondent pointing out that Mr. Pankratz has settled with the Commission whereas Mr. Tobey could still have been charged with wrongdoing and had a motive to propitiate the Division. To the extent that there is any bias, the fact that Mr. Pankratz and his employer, Reliance, have already settled would reduce any tendency to refrain from admitting to acts which might constitute wrongdoing, whereas, as the Respondent points out, at the time of the hearing the Commission’s position was that there was no statute of limitations applicable to possible charges against Mr. Tobey. See Tr. 227-28. In general, however, any otherwise unexplained difference in their testimony is due to the fact that approximately ten years had elapsed since the events about which they were testifying.
D. Gains Program
During the second quarter of 1986, either Mr. Steinberg, or Steven Peck, Reliance’s chief investment officer, directed Mr. Pankratz to sell bonds in Reliance’s portfolio in order to realize gains on the sales. Tr. 156-57, 346-47, 372. There is scant evidence in the record as to the purpose of the gains program, and no finding can be made as to its purpose. Mr. Pankratz’s vague understanding was that it was for "statutory accounting" pertaining to state regulation of insurance companies. Tr. 348, 414. The Division urges that it was to improve Reliance’s financial statements 8 in connection with two initial public offerings (IPO) that took place in the fall of 1986 and for which Drexel was underwriter. Div. Ex. 11; Div. Ex. 23.
Mr. Pankratz developed and engaged in a three-part strategy which consisted of: 1) swapping approximately $302 million in investment grade bonds, 9 2) swapping approximately $218 million in HYBs, and 3) selling approximately $366 million in HYBs and repurchasing them 31-40 days from the original trade date. Tr. 346-47, 351-52, 358-61, 374-88; Resp. Ex. 6.
At issue is the third part of the gains program strategy, which was described on Mr. Pankratz’s outline of the program as "‘Artificial’ swaps -- to be reversed." Resp. Ex. 6. These included upper tier HYBs which Mr. Pankratz had painstakingly accumulated and which he could not easily swap for like issues. Tr. 152-53; 345-49; 370-71; 379; 382-85; 388. Mr. Pankratz turned to Mr. Tobey in Drexel’s HYB department to sell these low volatility junk bonds 10 and to repurchase the bonds from him at least 31-40 days 11 from the original trade date, during two "programs," one in the second quarter and one in the third quarter. Tr. 156-57; 174, 180, 348, 409.
Mr. Pankratz outlined this part of the program as follows:
- - "Artificial" swaps - - to be reversed
• Versus other low grades
• Versus Treasury issues
• Approximately $366.2 million with $29.7 million in gains
• 41% of total
• At risk to market???
• Will attempt to roll on weekly basis through week of 6/16
• This is a residual alternative - - very important
Resp. Ex. 6. The phrase "at risk to market???" expressed concern whether there would be market risk. Mr. Pankratz testified that the question marks "were there to reiterate that we were at risk to the market and the uncertainty that that entails." Tr. 352, 381. His testimony is not convincing. Three question marks connote the opposite of affirmative reiteration. Additionally, Mr. Pankratz testified, "my vague recollection is that (I prepared the memo) prior to my conversations with Mr. Tobey." Tr. 351-52. If his recollection of when he prepared it is vague, his recollection of the meaning of the question marks is likely less than reliable as well.
1. Terms
The terms were established before they commenced the program and were approved by Mr. Milken. Tr. 156-61; 348-51; 394; 683-84; 762-63; 767-68. Mr. Pankratz proposed the program to Mr. Tobey, explaining he wanted to take profits on the bonds. Mr. Tobey relayed the proposal to Mr. Trepp. Thereafter, Mr. Trepp told Mr. Tobey he could engage in the program. Tr. 161. Mr. Trepp does not consider that there was anything wrong with the program. Tr. 705. Mr. Milken’s role in the program -- his continuing interest and the importance he placed on it -- is shown in a conversation he had with Mr. Tobey following news that Ivan Boesky had pleaded guilty to criminal charges and that the SEC was investigating Drexel’s junk bond operations. Mr. Milken suggested that Mr. Tobey confer with Mr. Pankratz to coordinate their stories concerning Reliance. Tr. 190-93, 210-11. Mr. Milken was not a witness at the hearing.
Artificial Swaps - Sale and Repurchase
As the description "‘Artificial’ swaps -- to be reversed" implies, Reliance desired to sell selected bonds before the June 30, 1986, end of the second quarter, and subsequently repurchase them. Tr. 156-57, 348, 762-63, 768-79. The repurchases were to take place after more than 30 days had elapsed from the dates of the sales. The Respondent described an "interest" and Mr. Pankratz described a "hope" by Reliance in repurchasing the bonds. Tr. 348, 683, 693, 698-99, 766, 769. Respondent Trepp conceded that he was expected to and did keep them in inventory, Tr. 765-70, and that other traders were informed that the bonds were not for sale. Tr. 238, 772-74.
Prices Within Market Levels
They agreed to buy and sell at market levels, and that Drexel would receive the carry 12 on the bonds while they were on the HYB department’s books. Tr. 156-58; 196, 348. There is no evidence in the record to suggest that any of the prices were not within market levels. The spreads on such junk bonds were approximately one point. Tr. 384, 742. The prices were set by, or through Mr. Trepp, without negotiation; 13 the bonds were sold at the rate of approximately one a day, Tr. 353; Mr. Trepp would inform Mr. Tobey of the price, Tr. 198, and Mr. Tobey would inform Mr. Pankratz. Tr. 353, 723, 773. Mr. Pankratz could check the price with other sources, Tr. 353-54, but there is no indication of haggling over price. Tr. 161-62, 167-68, 353-54, 386-87. The record shows that Mr. Trepp’s contacts in this matter were Mr. Milken and Mr. Tobey at Drexel. Tr. 683 et seq. Mr. Trepp and Mr. Pankratz might have met in passing, for example at Drexel’s "Predators’ Ball," but they never had any business dealings. Tr. 347, 369, 681, 756-57.
Zero Balance
The program included an agreement to come out even. They hoped to come out even at the end of the trades in the program, but discussed adjusting later, unrelated trades to compensate for any eventual loss. Tr. 156-60, 184-85, 350. Mr. Tobey did not affirmatively assure Mr. Pankratz that they would come out even, stating, "John, we’ll simply have to see where it ends up." Tr. 206, 217, 350-51. This indicates an understanding that they would come out even at the end of the program. Mr. Tobey’s apparent unwillingness to commit himself in advance merely indicates that, if the transactions were priced properly, make-up trades would not be necessary. In implementing the plan each kept a running total of the results of the trades and compared notes frequently. Tr. 168, 355-56, 361, 408. There would be no purpose to keeping these calculations except to see whether they came out even.
The Fee
Drexel was to receive a fee of 1/16 point, or 62.5 cents per bond. Tr. 156. Mr. Tobey testified that they agreed to this term, while Mr. Pankratz does not recall it. Tr. 156, 401. Mr. Pankratz, however, recalled that the second quarter program came out about even. Tr. 408. With the inclusion of a 1/16 fee, which amounted to around $175,000, the second quarter program came out almost exactly even. Tr. 95, 408-09. This testimony from Mr. Pankratz confirms Mr. Tobey’s recollection of a 1/16th fee.
During the same time period as the "‘Artificial’ swaps," Reliance sold similar higher quality junk bonds, Cordis and Harte-Hanks, to Drexel, which thereafter sold them away to third parties. Tr. 406, 695-701. However, a large quantity of bonds -- some 33 issues in the second quarter and 10 in the third quarter were sold and repurchased. Tr. 37-39, 60-67; Div. Ex. 5; Div. Ex. 7. Close to 99 percent of the bonds went over and came back in the same amounts. 14 Tr. 87-91; Div. Exs. 4, 5, 6, and 7. Mr. Tobey considered the program "unusual," as did Mr. Pankratz. Tr. 176, 373. Mr. Trepp and Mr. Tobey considered the program an "accommodation" to a client. Tr. 176, 199, 686. Reliance was a good client, from whom Drexel made a "fortune" -- around $15 million in 1986 alone. Tr. 702, 782-83.
2. Second Quarter Program
The bonds and transactions that were in the second quarter program are summarized in Division Exhibits 4 and 5. The total is over $300 million worth of bonds, or eight to nine percent of Drexel’s HYB inventory, and Drexel received $3-4 million in carry during that period. Tr. 767, 781; Div. Ex. 4 and 5. The Respondent claims that the Division’s selection of bonds is arbitrary, in that some bonds on Division Exhibit 5 were out longer than 40 days. Tr. 530; Respondent’s Posttrial Brief at 10-11. Mr. Pankratz, however, had confirmed that all the bonds that were sold in the second quarter and then repurchased were part of the program. Tr. 404. Additionally, he confirmed that while the bonds had to be out at least 31 days, and he generally recovered them within 40 days, some were out longer. Tr. 403. Also, Mr. Trepp controlled the timing as well as the price of the returns and would sometimes delay after Mr. Pankratz asked for the bonds back. Tr. 235.
At the rate of about one a day, Tr. 353, 685; Div. Ex. 4, the transactions went through Mr. Trepp. Tr. 161, 167-68, 198-99, 775, 786. Mr. Pankratz listed the bonds he wanted to sell to Mr. Tobey; Mr. Tobey conveyed this to Mr. Trepp, who would select from the list and set the price; then Mr. Tobey would get back to Mr. Pankratz with the price. Tr. 235, 353. For the return trip of each issue, Mr. Pankratz would contact Mr. Tobey, who would talk to Mr. Trepp, who would agree to do it then or in a few days and set the price. Tr. 235. Mr. Tobey and Mr. Pankratz each kept a running total, and when they compared notes periodically, they agreed on the totals. Tr. 168, 355-56, 408. Repurchases on two days towards the end of the second quarter program, of MacAndrews and Forbes, reduced a $136,241 deficit to $18,460. Div. Ex. 4. Pricing of MacAndrews and Forbes bonds was particularly within Drexel’s province and difficult to confirm from other sources because they had been brought public by Drexel in a blind pool. Tr. 834, 847.
The second quarter program came out close to even. Taking into account a 1/16th fee, amounting to $175,000, Tr. 95, 702, Drexel had a loss of $3,922.42, on transactions in over $300 million of bonds. Tr. 86, 408; Div. Ex. 4. Mr. Trepp described this result as a coincidence. Tr. 779-80. Normally, a trader would try to maximize profit on trading and try to make Drexel come out ahead. Tr. 779-80. Salvatore Cioffalo testified for the Division as an expert witness on HYBs, and opined that normally a trader would try to maximize profit on trading. Tr. 826, 830. He opined that normally one would expect Drexel to have come out ahead overall on trades in the Reliance program. Tr. 848-49; Div. Exs. 4, 5, 6, and 7.
3. Third Quarter Program
Reliance and Drexel entered a third quarter program similar to that of the second quarter, identified on Division Exhibits 6 and 7. Tr. 180, 354-56. It was smaller, involving the bonds of ten issuers, and amounting to over $120 million. Div. Ex. 6; Div. Ex. 7. This program did not come out even and resulted in a balance in Drexel’s favor of about $406,000. Tr. 91-92, 180, 356; Div. Ex. 6.
The reason for the imbalance is unclear. One factor is Mr. Trepp’s absence from October 28 to November 8 on a cruise; several of the repurchase transactions occurred during this period, and a preexisting balance in Drexel’s favor almost doubled. Tr. 709-10; Div. Ex. 6; Resp. Ex. 1. The Division argues that interest rate changes affected prices such that it was not possible to make the third quarter program come out even. While there is some support in the record for this theory, Tr. 180-81, 411, 826-27; Div. Ex. 22, interest rate movements were larger during the second quarter program than the third quarter program. Tr. 543-45, 566-68. Additionally, the actual sale and repurchase prices display a spread of within one point for eight of the ten bonds and within two points for the remaining two bonds. Div. Ex. 6. An adjustment of a fraction of a point would have removed the imbalance. Div. Ex. 6.
Whatever the reason for the imbalance, attempts were made to redress it. Mr. Pankratz discussed the loss a couple of times with Mr. Tobey and that at least one make-up trade occurred after the third quarter program. Tr. 356-57. He attempted to negotiate a 1/8 or 1/4 price improvement on several other unrelated trades but was refused. Tr. 357. Additionally, at Drexel’s initiative, Reliance engaged in profitable short term trading in American Maize bonds at the end of the third quarter program. Tr. 222-24, 363-65, 417-20, 706-10. Subsequent events made it impossible to conduct further make-up trades.
4. Fourth Quarter
On November 14, 1986, there was a public announcement that Ivan Boesky, the widely-known arbitrageur, had settled insider trading charges with the SEC for sanctions that included a $100 million payment and had agreed to plead guilty to one felony count. It was widely reported that his plea bargain was lenient because he had implicated other major Wall Street figures. His violations were linked with Drexel’s Dennis Levine, who had been arrested and charged with securities violations the previous May. Div. Ex. 24 at Wall Street Journal, Nov. 17, 1986. It was also reported that the SEC was investigating Drexel’s junk bond operations, that Mr. Boesky had been wearing a wire and that his phones had been tapped during the preceding weeks, and that the SEC had issued subpoenas to Mr. Milken and other Drexel HYB personnel; prices of junk bonds declined even though prices of Treasury bonds rose. Div. Ex. 24 at Wall Street Journal, Nov. 18, 1986.
Mr. Milken’s demeanor around the office did not change, but he suggested to Mr. Tobey that he confer with Mr. Pankratz to coordinate their stories concerning Reliance. Tr. 190-91, 210. When Mr. Tobey responded that compliance officer Kevin Madigan had assured him that the Reliance trades were not a problem, 15 Mr. Milken explained that circumstances had changed. Tr. 191, 210-11. After "Boesky Day," November 14, Mr. Pankratz asked Mr. Tobey to do a fourth quarter program; Mr. Trepp refused. Tr. 192, 358, 415, 704-05. Make-up trades for the third quarter also ceased. Tr. 185, 187, 411-13.
E. Records and Derivative Uses
Drexel’s trade tickets reflecting the transactions in the programs recorded them as buys and sells and did not indicate the agreement for repurchase without loss or the fee. Div. Ex. 16. These inaccurate tickets were used to develop confirmations of trades which Drexel sent to Reliance; Reliance’s auditors would have examined such confirmations in testing for the existence of transactions reflected in its financial statements. Tr. 142, 316-17, 595, 611. Respondent Trepp initialed at least 139 of about 242 tickets for trades alleged to be part of the gains program. 16 Tr. 330-33; Div. Exs. 4, 6, 16, 16A.
Reliance recorded gains from the sales to Drexel as income on its financial statements. Tr. 268-70; Div. Exs. 25, 26. These financial statements were included in Reliance’s second and third quarter Forms 10-Q and annual 10-K filed with the SEC, as well as in its Annual Report. Tr. 270-72; Div. Exs. 12, 13, 14, 15. Reliance had two IPOs, for which Drexel was underwriter, following the second quarter -- in September 1986, for the issuance of common stock; and in November 1986, for the issuance of high yield senior sinking fund notes and subordinated sinking fund debentures. 17 Div. Ex. 11; Div. Ex. 23. Amended Forms S-2 and S-3, which were submitted to the SEC in connection with the two IPOs, incorporated the 1986 second quarter Form 10-Q by reference. Div. Ex. 11 at 2; Div. Ex. 23 at 3.
The impact of including the gains in income on Reliance’s financial statements is as follows:
Second Third
Quarter Quarter
Quarterly Pre-Tax Income As Reported: $16,410,000 $6,595,000
Quarterly Pre-Tax Income Without Parking Gains: ($9,990,000) ($2,205,000)
Difference: $26,400,000 $8,800,000
Tr. 270-74; Div. Ex. 10; see also Div. Exs. 12, 13, 14.
F. GAAP
The Division and the Respondent presented expert witnesses who opined on whether the gains at issue were recorded in accordance with Generally Accepted Accounting Principles. The Division’s expert, Dr. Terry Warfield, stated that while there was no authority on point, analogies could be drawn to more general concepts such that, in his opinion, the capital gains from the program were not accounted for in accordance with GAAP. Tr. 251 et seq. Given a hypothetical that Reliance had an agreement with Drexel to sell and repurchase the bonds after at least 31 days, and to come out even by make-up trades if necessary, the bonds were not at risk in the interim and the transaction was not in substance a sale. Tr. 251 et seq. The Respondent’s expert, Ernest Ten Eyck, CPA, cited more specific concepts which he analogized to the transactions at issue. Tr. 425 et seq. He opined on a hypothetical embodying a different version of the facts that Reliance’s obligation was closer to a right of first refusal than an obligation to repurchase, and thus the gains were properly recorded in accordance with GAAP. Tr. 425 et seq. Both experts agreed that if there were an agreement to repurchase, Reliance’s recognition of the transactions as sales was not in accordance with GAAP. Tr. 251-68, 473-74, 511.
G. Trepp’s Role
As discussed above, Mr. Milken, an associate of Reliance’s Saul Steinberg, approved the program and maintained an interest in it. Mr. Trepp carried the program out on Drexel’s side by selecting the bonds offered for sale, timing the sales and repurchases, setting the prices within market levels, and making the bonds available for repurchase.
1. Trepp’s Role in Carrying Out the Program
The trades went through Mr. Trepp. Tr. 198, 677, 775. Mr. Tobey would advise Mr. Trepp of the trades that Mr. Pankratz wanted to make. Tr. 685-86, 775. After agreeing to make a trade, Mr. Trepp set the price himself within spreads of about one point. Tr. 384, 687-89, 742, 786. He kept the bonds in inventory awaiting their return to Reliance. Tr. 769-770. Mr. Pankratz would advise Mr. Tobey when it was time for the return trip, and Mr. Trepp would choose the time and price for the return. Tr. 235, 775-76. Some repurchases and make-up trades in the third quarter program occurred during Mr. Trepp’s absence from the office October 28 through November 8, 1986. Tr. 362-65, 709-10; Resp. Ex. 1; Div. Ex. 6, Div. Ex. 17 at WT4109 and WT4128. Mr. Trepp was the head trader over other traders and customarily initialed or reviewed trading tickets. Tr. 676-80, 722.
2. Knowledge of Program Details
Mr. Trepp was uniquely knowledgeable and talented in the HYB business; he knew the customers, the value of the bonds, how the market would react to events; he had an institutional memory of Drexel’s HYB trading. Tr. 657-58, 661, 663. He was aware of the contents of Drexel’s HYB inventory and trading activity. Tr. 731-36. James Davin, who oversaw compliance at Drexel following its settlement with the government, Tr. 636-37, observed that Mr. Trepp was respected as a leader in the trading room. Tr. 641-45, 661-62. He highly valued Mr. Trepp’s expertise in liquidating the HYB portfolio after Drexel’s bankruptcy. Tr. 641-45.
Mr. Trepp had some knowledge of legal requirements from the nature of his job. It was he, for example, who reviewed most of the trading tickets for HYBs. Tr. 678-80, 722. He also tried to dissuade Mr. Milken from excessive mark-ups. Tr. 746-47. Mr. Trepp realized that the Reliance program might be legally questionable. This is shown by his refusal to do third quarter make-up trades or a fourth quarter program after Boesky Day. Tr. 185, 187, 192, 358, 411-15, 704-05.
Mr. Trepp first learned of the program from Mr. Milken or Mr. Tobey; he could not recall which. Tr. 683, 767, 770-71. He acknowledged an understanding that Reliance was interested in selling a group of better quality HYBs and had an interest in buying them back at a future date. Tr. 683, 690, 698-99, 763. He was happy to accommodate a customer in this way. Tr. 686. The HYB department had had similar "accommodations" with other customers. Tr. 748-51. He also acknowledged that he was expected to and did keep bonds in inventory, Tr. 765-70, and made other traders aware that they were not for sale to other customers. Tr. 772-74. Although, as he points out, there were some bonds that he purchased from Reliance and did not sell back, Tr. 765-66, 770, 786, over $300 million in bonds were purchased and resold to Reliance. Div. Exs. 4, 5, 6, 7. He conceded that it would have been possible to do the trades for the second quarter program at market levels between the bid and ask in such a way as to make it come out even. Tr. 777-79.
There is conflict in the record evidence concerning whether and how Mr. Trepp learned of the remaining terms of the program. Mr. Trepp testified that he never discussed with Mr. Milken, Mr. Tobey or anyone else, a 1/16th fee, an intention to come out even, or adjusting unrelated trades, and that he was unaware of these elements of the program. Tr. 683-85.
Mr. Tobey testified that he went to Mr. Trepp’s location on the X-shaped desk and conveyed all elements of the program to Mr. Trepp when he first relayed Mr. Pankratz’s proposal; Mr. Trepp’s only response was that he would get back to him. Tr. 160-62, 213-14, 217-18, 233. Mr. Tobey could not recall some details of the conversation, for example, whether Mr. Milken, who sat next to Mr. Trepp, was there. Tr. 213-14. He did recall that the environment was very noisy: "there were people constantly yelling at the trading desk and, specifically, at (Mr. Trepp)." Tr. 214. The undersigned observed Mr. Tobey to be quite soft-spoken throughout his testimony over the course of two days. 18
Mr. Tobey did not advise Mr. Trepp of the running balance or that he was keeping an accounting. Tr. 198, 693. Mr. Trepp also testified that he did not keep an accounting and would not have had time to do so. Tr. 694.
Mr. Milken, the director of Drexel’s junk bond operation, placed Mr. Trepp at his right hand, and paid him a salary that increased annually, up to $25 million. Tr. 675-76, 716, 718, 719; Div. Ex. 27. Sitting next to him, Mr. Trepp could hear some of his conversations, including his telephone conversations with Reliance’s Saul Steinberg, depending on the noise level and how busy they were. Tr. 726, 754-55. Whether Mr. Trepp first learned of the program from Mr. Tobey or Mr. Milken, Mr. Milken’s approval was required. Tr. 684, 763, 768. Mr. Trepp understood that Mr. Milken’s approval was related to his association with Mr. Steinberg. Tr. 754, 770. Mr. Trepp’s only question to Mr. Milken concerned the size of the program. Tr. 683-84.
The record shows that Mr. Tobey attempted to inform Mr. Trepp of all elements of the program. He sought Mr. Trepp’s approval because he could not have carried out the program on his own. Tr. 783. It was in his interest to convey all the terms of the $300 million program so that he would not be blamed for any costly problems. The noisy environment could have detracted from Mr. Trepp’s comprehension of what was said. Yet it would have been in his interest as well to listen carefully to the terms unless he was already aware of them from another source or was so accustomed generally to such programs from his experience at the HYB department that it was unnecessary to listen closely.
It is found that Mr. Trepp knew all three features of the program: sale and repurchase, coming out even, with make-up trades if needed, and 1/16th fee. This finding rests on his admitted awareness of a plan to accommodate a good client, by agreeing to purchase bonds from the client and to make them available for repurchase approximately 31 days later, along with the subsequent facts of the sales and repurchases being carried out in the second quarter in accord with an arrangement containing all three features. He had some knowledge of the balance of accounts between Reliance and Drexel as well. It is undisputed that Mr. Trepp carried the $330 million program out on Drexel’s side by selecting the bonds offered for sale, timing the sales and repurchases, setting the prices, and making the bonds available for repurchase. Further his position in the organization and his relationship with Mr. Milken indicate that his role in carrying out the program was a responsible one and not that of a clerk or technician.
In the alternative, crediting Mr. Trepp’s testimony that he did not know of the agreement to come out even or the fee, he was reckless in not knowing these features in view of his position in the organization and his role in executing the program. A failure to listen carefully to Mr. Tobey or to question Mr. Tobey or Mr. Milken shows a conscious avoidance of learning key facts.
Mr. Trepp’s knowledge or reckless lack of knowledge of the program’s features carries over into the third quarter program, in which he participated as well.
3. Knowledge of Reliance’s SEC Filings
Mr. Trepp testified that he had no knowledge of how Reliance or any other client reported the trades or gains or losses. Tr. 705-06. The record contains no evidence to show that he knew Reliance’s purpose for the trading program was to take gains. Instead, it shows a marked lack of curiosity as to the purpose. When Mr. Tobey relayed Mr. Pankratz’s proposal to him, his only response was to say that he would get back to him. Tr. 161. His only question to Mr. Milken concerned the size of the program. Tr. 683-84. Even if he did not know Reliance’s purpose, however, he would have known generally that the results of the transactions would be reflected on its financial statements and that the financial statements would be part of periodic filings such as Forms 10-K and 10-Q with the SEC. A bond trader would know this as common knowledge.
4. Knowledge of Reliance’s IPOs
Mr. Trepp first learned about the IPOs when they occurred. Tr. 791. There is no evidence in the record to contradict his testimony to this effect or to suggest that he knew about any planned Reliance IPO during the gains programs. There is no evidence concerning the planning of the IPOs either at Drexel or Reliance, much less evidence that would connect Mr. Trepp to the planning. Additionally, while the November IPO was of junk grade debt, the September 1986 IPO was of equities, and even farther removed from Mr. Trepp’s activities at Drexel.
III. CONCLUSIONS OF LAW
A. Parking
"Parking" of securities was prominent in the scandals and illegalities of the 1980s in which Ivan Boesky, Drexel, Milken, and other broker-dealers and associated persons were involved and were sanctioned criminally and civilly. Parking, however, is not defined in any securities statute or Commission Rule, and is not, in itself, illegal. The illegality arises from the circumstances, such as net capital requirements, SEC v. Kidder, Peabody & Co., (1987 Transfer Binder) Fed. Sec. L. Rep. (CCH) ¶ 93,271 at 96,349 (S.D.N.Y. June 4, 1987), and requirements of Section 13(d) of the Exchange Act related to takeover attempts, SEC v. First City Financial Corp., 890 F.2d 1215 (D.C. Cir. 1989). Parking has been defined, in the case of a Drexel employee convicted of obstruction of justice in connection with a case involving parking to obtain false tax losses, as "a purported transfer of ownership in securities combined with a secret agreement providing the ‘seller’ with the right to repurchase them at a later date. The ‘seller’ receives the tax benefits of a loss realized by the ‘sale’; the ‘buyer’ is compensated for the ‘cost of carrying’ the securities. Since the agreement to resell ensures that the ‘seller’ never loses control of the securities, the government considers ‘parking’ a form of tax and securities fraud." United States v. Jones, 900 F. 2d 512, 515 (2nd Cir. 1990).
Parking has been defined in recent Commission orders that implemented settlements as "the sale of securities subject to an agreement or understanding that the securities will be repurchased by the seller at a later time and at a price which leaves the economic risk on the seller." See, e.g., Dale E. Barlage, 63 SEC Docket 1277, 1278 n.2 (December 19, 1996). The Respondent accepts the market risk test. See Respondent’s Postrial Brief at 17.
By its very nature a parking agreement for an illegal purpose is not in the form of a legally enforceable written contract with clearly specified terms. The Fishbach parking arrangement involving Michael Milken, Ivan Boesky, and Victor Posner, described in SEC v. Drexel Burnham Lambert, 837 F. Supp. at 587, is illustrative. Boesky accumulated stock at Milken’s encouragement and assurance that he would be held harmless in a scheme to break a standstill agreement and benefit Posner. The parties to the arrangement used shorthand utterances and circumlocutions to set the terms of the deal. Boesky was "encouraged" to accumulate stock and told "Don’t worry about it" when the market price of the stock he accumulated declined by millions of dollars. Then, after the goal of the scheme was achieved, Boesky pestered Milken for months before he was able to get the latter to arrange transactions whereby Boesky could unload the stock and be made whole for the decline in price.
The Reliance program presents some indications of legitimacy. The sale and repurchase transactions were actually settled, the prices were within market levels, and the length of time the bonds were out was over 30 days. Drexel also received the carry during the time it held the bonds.
On the other hand, there are stronger indications that market risk was not intended to be passed. Mr. Pankratz was concerned whether there would be market risk. This is shown by by his selection of nonvolatile cushion bonds for the "‘Artificial’ swaps," and by the phrase "At risk to market???" in his outline of the gains program. The heading in the outline, "‘Artificial’ swaps - - to be reversed," in itself suggests that the transactions were not bona fide. The plan as outlined was carried out to eliminate risk. As discussed between Mr. Pankratz and Mr. Tobey, ratified by Mr. Trepp and Mr. Milken, and executed by and under the direction of Mr. Trepp, the arrangement called for the sale and repurchase of over $300 million in junk bonds, with a side agreement to come out even, using make-up trades if necessary. As is characteristic of a parking agreement these terms were articulated orally in an indirect manner in the Pankratz-Tobey and Tobey-Trepp conversations, for example, Mr. Tobey’s statement "John, we’ll simply have to see where it ends up" in response to Mr. Pankratz’s request for a commitment to make-up trades.
While the 1/16th fee was relatively small compared to the $3 or 4 million in carry, fees qua fees are more commonly found in riskless principal or agency trades than in straightforward principal trades where the trader expects to make his profit off the spread. This adds support to the conclusion that these were riskless transactions for Drexel.
Drexel received the carry as compensation along with the 1/16th fee. It was legally free to sell the bonds. It may even have sold a few bonds that Reliance would have liked to have back. Additionally, although 99 percent of the bonds went over and back in the same amounts, some were returned in different amounts. These discrepancies are not inconsistent with a parking arrangement, as contrasted with a legally enforceable contract. The bonds were held in inventory while awaiting return and were not for sale.
Finally, the fact that the second quarter program came out close to even is remarkable. Normally a trader would try to profit from trades with a customer. The fact that the bonds were nonvolatile cushion bonds with a one point spread would increase the likelihood of Trepp’s obtaining a modest profit from the series of trades. Whatever the reason the third quarter program did not come out even, the change in the regulatory climate at Drexel after Boesky Day made it impossible to adjust the imbalance by make-up trades as originally planned.
A parking agreement, to sell and repurchase bonds and come out even with a 1/16 fee, was carried out between Reliance and Drexel. Further, Respondent Trepp had a responsible role in approving and executing the program. The compensation to Drexel, rather than the possibility of profit or loss from trading within the spreads deriving from market risk, was the guarantee of receiving the carry, amounting to $3 or 4 million, and the 1/6th fee, amounting to around $175,000.
B. Alleged Violations
1. Exchange Act Section 17(a) and Rule 17a-3 Violations
Exchange Act Section 17(a)(1) provides that brokers and dealers "shall 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 in the public interest." Rule 17a-3 requires brokers and dealers to make and keep current certain books and records, including blotters, ledgers, ledger accounts, memoranda, confirmations, and other business records and forms. Specifically, Rule 17a-3(a)(6) requires the maintenance of memoranda "of each brokerage order, and of any other instruction, given or received for the purchase or sale of securities, whether executed or unexecuted. Such memorandum shall show the terms and conditions of the order or instructions and of any modification or cancellation thereof." Implicit in the requirement to make these memoranda is the requirement that the memoranda be accurate. James F. Novak, 47 S.E.C. 892 (1983).
The Commission has emphasized the importance of the recordkeeping rules as "the basic source documents and transaction records of a broker-dealer," Statement Regarding the Maintenance of Current Books and Records by Brokers and Dealers, Exchange Act Release No. 10756 (April 26, 1974), and "a keystone of the surveillance of brokers and dealers by our staff and by the security industry’s self-regulatory bodies." Edward J. Mawod & Co., 46 S.E.C. 865, 873 n.39 (1977), aff’d, 591 F.2d 588 (10th Cir. 1979). Scienter is not a required element in proving a violation of Section 17(a)(1) of the Exchange Act, and the rules thereunder. SEC v. Drexel Burnham Lambert Inc., 837 F. Supp. at 610; Stead v. SEC, 444 F.2d 713, 716-17 (10th Cir. 1971), cert. denied, 404 U.S. 1059 (1972).
Drexel violated Section 17(a)(1) of the Exchange Act and Rule 17a-3 thereunder, because it did not disclose the parking agreement on its trading tickets. Respondent Trepp agreed to the parking program, determined the trading prices, assured that bonds were kept in inventory, executed the trades, directed the preparation of and initialed trade tickets, and reviewed the trade tickets and trade runs each day. Thus, he knew that his role was part of an overall activity that was improper, and substantially assisted Drexel’s primary violation of Exchange Act Section 17(a)(1) and Rule 17a-3. He therefore willfully aided and abetted and caused the violation.
This lack of disclosure was significant because it affected other records of the firm and of clients, and potentially misled internal record keepers and auditors, as well as regulators.
2. Exchange Act Section 13(a) and Rules 13a-1 and 13a-13 Violations
Exchange Act Section 13(a) provides that issuers of securities registered under Section 12 of the Exchange Act must file such information, documents, and reports in accordance with rules and regulations prescribed by the Commission "as necessary or appropriate for the proper protection of investors and to insure fair dealing in the security." Rules 13a-1 and 13a-13 require such an issuer to file annual and quarterly reports with the Commission, known as Forms 10-K and 10-Q. "The purpose of requiring issuers of securities to file reports with the Commission is to insure that investors receive adequate periodic reports concerning the operation and financial condition of corporations." SEC v. Kalvex, 425 F. Supp. 310, 316 (S.D.N.Y. 1975) (citing In Re Penn Central Securities Litigation, 347 F. Supp. 1327, 1340 (E.D. Penn. 1972)).
Reliance's 1986 Form 10-K and Forms 10-Q for the second and third quarters contained financial statements that reflected gains from sales of bonds in the program. However, the transactions were not sales in substance, and recognizing gains from the sales was inconsistent with GAAP. The sales and repurchases after 30 or more days of selected bonds at market, with an agreement to come out even, and a fee per bond, were sham transactions. Experts for both sides agreed that if there were no legitimate, arms-length sales transactions in transferring the bonds, the gains resulting from the second and third quarter parking programs should not have been recorded. Therefore the financial statements in the SEC filings were inaccurate and misleading.
The resulting differences in the SEC filings were not only misleading but material. A change in Reliance’s pre-tax bottom line from a negative to a positive which involves millions of dollars is a material fact that a reasonable investor or potential investor would consider important in making his or her investment decision. SEC v. Koenig, 469 F.2d 198, 200 (1972).
Accordingly, Reliance’s filings violated Exchange Act Section 13(a) and Rules 13a-1 and 13a-13.
It is concluded that Respondent Trepp did not aid and abet Reliance’s primary violation. This is because of his remoteness in the chain of causation. He carried out the transactions of the parking program, his customer used the fruits of the transactions to overstate its income in financial statements, and the customer then incorporated the inaccurate and misleading financial statements in its violative filings with the SEC. He did not know that the purpose of the program was to create gains. Although he would know generally that the results of transactions are reflected on a customer’s financial statements, this is not sufficient actual knowledge of Reliance’s plan to create misleading and inaccurate filings with the SEC for public disclosure by recording gains from the parking transactions. There is no support in the record for concluding that he had actual knowledge of this plan and of when and to what degree he was furthering it. IIT v. Cornfeld, 619 F.2d 909, 923 (2d Cir. 1980); Woodward v. Metro Bank of Dallas, 522 F.2d 84, 95 (5th Cir. 1975).
There is no precedent case in which a trader was held liable for aiding and abetting or causing a customer’s Section 13(a) violations in circumstances like this case.
Similarly, because of his remoteness in the chain of causation, it is concluded that Respondent Trepp did not cause Reliance’s violation of Exchange Act Section 13(a) and Rules 13a-1 and 13a-13.
3. Securities Act Section 17(a)(2) Violations
Securities Act Section 17(a)(2) makes it unlawful "to obtain 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 the light of the circumstances under which they were made, not misleading." Scienter is not a required element in proving a Section 17(a)(2) violation; a finding of negligence is adequate. SEC v. Steadman, 967 F.2d 636, 643 & n.5 (D.C. Cir. 1992) (citing Aaron v. SEC, 446 U.S. 680, 701-02 (1980); Newcome v. Esrey, 862 F.2d 1099, 1102 n.7 (4th Cir. 1988)).
Misrepresentation
Reliance’s Amended Forms S-2 and S-3, which were submitted to the SEC in connection with the second and third quarter IPOs, incorporated by reference its Form 10-Q for the quarter ending June 30, 1986. The Form 10-Q contained misrepresentations of Reliance’s income because it improperly recorded as gains the results of the transactions in the second quarter program. These documents were used to obtain money in the sale of equity and debt securities to investors. These misrepresentations were also incorporated into Reliance’s Annual Report, which is provided to its investors, as well as into its 1986 Form 10-K which was submitted to the SEC.
Materiality
The standard of materiality is whether or not a reasonable investor or prospective investor would have considered the information important in deciding whether or not to invest in Reliance. See SEC v. Steadman, 967 F.2d at 643; see also Basic Inc. v. Levinson, 485 U.S. 224, 240 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). A change in Reliance’s pre-tax bottom line from a negative to a positive which involves millions of dollars is a material fact that a reasonable investor or potential investor would consider important in making his or her investment decision. SEC v. Koenig, 469 F.2d at 200. On balance, it is concluded that this misrepresentation would be considered important information to a reasonable investor. Additionally, a reasonable investor would consider the use of questionable accounting techniques, in contravention of GAAP and pursuant to an illegal parking arrangement with a brokerage firm, and used to make financial statements look better, to be important information.
It is concluded that Reliance violated Securities Act Section 17(a)(2) because it misrepresented to investors and prospective investors material facts in its offering materials for IPOs which took place in September and November 1986.
Aiding and Abetting
It is concluded that Mr. Trepp did not aid and abet Reliance’s primary violation of Securities Act Section 17(a)(2). Mr. Trepp did not know about Reliance’s 1986 IPOs at the time of the gains program transactions. The record does not contain evidence to support a conclusion that the purpose of the gains program was to prepare for the IPOs. Mr. Trepp was even more remote in the chain of causation of Reliance’s violation of the antifraud provisions than with its violation of Exchange Act Section 13(a). To conclude he was aiding and abetting, because of his remoteness in the chain of causation of this violation, he would have had to have actual knowledge of the fraud and how he was furthering it. IIT v. Cornfield, 619 F.2d at 923; Woodward, 522 F.2d at 95. Nor was the substantial assistance requirement proven in light of his lack of knowledge and remoteness from the violation. IIT v. Cornfield, 619 F.2d at 923, 925-27; Woodward, 522 F.2d at 96-97.
Because of his remoteness in the chain of causation, it is concluded as well that he was not a "cause" of Reliance’s violation within the meaning of Securities Act Section 8A.
III. PUBLIC INTEREST
A. Administrative Sanctions
The imposition of administrative sanctions requires consideration of:
the egregiousness of the defendant's actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant's assurances against future violations, the defendant's recognition of the wrongful nature of his conduct, and the likelihood that the defendant's occupation will present opportunities for future violations.
Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981). The amount of a sanction depends on the facts of each case and the value of the sanction in preventing a recurrence. Berko v. SEC, 316 F.2d 137, 141 (2d Cir. 1963); Richard C. Spangler, Inc., 46 S.E.C. 238, 254 n.67 (1976); Leo Glassman, 46 S.E.C. 209, 211-12 (1975).
Respondent Trepp's violations were egregious, recurring, and intentional. As Drexel’s head trader, he facilitated the sale and repurchase of numerous bonds over a seven-month period, knowing that the combined transactions amounted to a covert parking agreement. There have been, however, no previous enforcement actions against him. Nor is there any evidence of recurring violations in the nine years that elapsed between the date of his violations and the institution of this proceeding.
In refusing to do a fourth quarter program and to do further make-up trades after Boesky Day, the Respondent recognized to some extent the wrongful nature of his conduct. Consistent with the vigorous defense he has mounted against the charges laid against him, the Respondent has not otherwise recognized the wrongful nature of his conduct or offered assurances against future violations of the securities laws.
Regarding the likelihood that the defendant's occupation will present opportunities for future violations, the Respondent has not worked in the industry since 1992. It is not clear whether he intends to trade in the future. He has not forsworn trading, and the possibility remains open to him in view of his age and experience.
B. Cease and Desist Order
As concluded supra, the only sanction available in this case is a cease and desist order, which, in light of the proven violations, is authorized under Exchange Act Section 21C. Similar to an injunction, there must be a likelihood of future violation to issue a cease and desist order, requiring consideration of the following:
"‘whether the defendant’s past conduct indicates . . . a reasonable likelihood of further violation(s) in the future.’" There must be "some cognizable danger of recurrent violation, something more than the mere possibility which serves to keep the case alive." The relevant factors (to) the likelihood of recurrent violation include "whether a defendant’s violation was isolated or part of a pattern, whether the violation was flagrant and deliberate or merely technical in nature, and whether the defendant’s business will present opportunities to violate the law in the future."
SEC v. Steadman, 967 F.2d at 647-48 (citations omitted) (quoting SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1168 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979); W.T. Grant Co., 345 U.S. at 633; SEC v. First City Fin. Corp., 890 F.2d 1215, 1228 (D.C. Cir. 1989)).
The Respondent’s violations in implementing the parking program extended over several months and were thus not isolated. Also, they were closer to "flagrant and deliberate" than "merely technical." On the other hand, the violations occurred nine years before this proceeding was instituted, there is no evidence to suggest recurrent violations during the interim, and the Respondent has not even been in the securities business since 1992. The Division argues that the Respondent could reenter the securities business in view of his age and experience, but even reentering the securities business is a "mere possibility" rather than a "likelihood." On balance, it is concluded that there is not a reasonable likelihood of future violations, and a cease and desist order should not be issued.
IV. CERTIFICATION OF RECORD
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), I hereby certify that the record includes the items set forth in the Revised Record Index issued by the Secretary of the Commission on April 28, 1997.
V. ORDER
Based on the findings and conclusions set forth above, I ORDER that this adminisrative proceeding IS DISMISSED.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360 (1996). Pursuant to that rule, a petition for review of this initial decision may be filed within 21 days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within 21 days after service of the initial decision upon the party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the initial decision shall not become final as to that party.
Carol Fox Foelak
Administrative Law Judge