Initial Decision of an SEC Administrative Law Judge
|INITIAL DECISION RELEASE NO. 127
FILE NO. 3-8919
|UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
In the Matter of
ORLANDO JOSEPH JETT
APPEARANCES: Jonathan A. Gottlieb, Petra T. Tasheff, and Herbert J. Willcox for the Division of Enforcement, Securities and Exchange Commission
Kenneth E. Warner, John R. Cuti, and Richard A. Greenberg for Respondent Orlando Joseph Jett
BEFORE: Carol Fox Foelak, Administrative Law Judge
The Decision concludes that Mr. Jetts actions did not violate the antifraud provisions because they were not "in connection with the purchase or sale of any security" within the meaning of the securities laws. It further concludes that he caused and aided and abetted Kidders books and records violations when his illusory profits were reflected in its ledgers and in its FOCUS reports filed with the New York Stock Exchange and the Securities and Exchange Commission.
The Decision orders him to cease and desist from books and records violations, bars him from association with a broker-dealer, and orders disgorgement of $8.21 million in gains resulting from his violations and a $200,000 penalty.
A. Procedural Background
The Securities and Exchange Commission (Commission) initiated this proceeding by an Order Instituting Proceedings (OIP) on January 9, 1996, pursuant to Section 8A of the Securities Act of 1933 (Securities Act) and Sections 15(b), 19(h), and 21C of the Securities Exchange Act of 1934 (Exchange Act). 1 The OIP alleged that from July 1991 until April 1994 Respondent Jett willfully aided, abetted, and caused Kidder, Peabody & Co.s (Kidder) violations of Section 17(a) of the Exchange Act and Rules 17a-3(a)(1), 17a-3(a)(2), 17a-3(a)(7), and 17a-5 thereunder, willfully violated Section 17(a) of the Securities Act, and willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. 2
I held a hearing in New York City on May 20, 21, 22, 23, 24, 28, 29, 30, 31, and June 3, 4, 5, 10, 11, 12, 13, 18, 19, and 20, 1996. The Division of Enforcement (Division) called 16 witnesses from whom testimony was taken, including Respondent Jett. Respondents counsel called six witnesses, including the Respondent. A vast number of exhibits were received into evidence. 3
My findings and conclusions are based on the record. I applied preponderance of the evidence as the standard of proof. 4 Pursuant to the Administrative Procedure Act, 5 I considered the following post hearing pleadings: (a) the Divisions October 17, 1996, Post-Hearing Brief and Proposed Findings and Conclusions; (b) the Respondents February 21, 1997, Post-Hearing Memorandum and Proposed Findings and Conclusions; and (c) the Divisions April 22, 1997, Reply Brief and Appendix. I considered and rejected all arguments and proposed findings and conclusions that are inconsistent with this decision.
B. Allegations and Arguments of the Parties
The OIP alleged that from July 1991 until about April 17, 1994, Respondent Jett exploited an anomaly in Kidders trading and accounting systems to create the appearance of $348 million in profits. He did this, the OIP alleged, by entering instructions on Kidders systems for the exchange, at future dates, of U.S. Treasury bonds and their zero coupon components with the Federal Reserve Bank of New York (Fed) in transactions known as STRIPS and reconstitutions (recons). Thus, the OIP alleged, Respondent Jett willfully aided, abetted, and caused books and records violations by Kidder of Section 17(a) of the Exchange Act and Rules 17a-3(a)(1), 17a-3(a)(2), 17a-3(a)(7), and 17a-5 thereunder -- by failing to make and keep current and accurate transaction journals (blotters), ledgers, and order tickets, and filing materially inaccurate FOCUS Reports. 6 Additionally, the OIP alleged that Respondent Jett willfully violated the antifraud provisions of the securities laws, Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
The Division argues that the evidence shows that the Respondent engaged in fraud by exploiting an anomaly in Kidders trading and accounting systems to book over $300 million in fictitious profits and then misrepresented and omitted to state material facts to Kidder employees in furtherance of the fraud. As a result, it states, he received $11.4 million in bonuses. Additionally, it argues that by these actions he willfully aided and abetted and caused books and records violations by Kidder. The Respondent claims there was no fraud in that he was open about his actions, that Kidder knew and approved his actions, and that his actions were part of a legitimate trading strategy. Additionally, he claims that much of his forward activity resulted from Kidders efforts to window dress 7 its balance sheet for the quarter ending in September 1993 and thereafter. In reply the Division argues that the records that Jett asserts disclosed his actions provided insufficient information to disclose his actions and their profit and loss (P&L) effect on Kidders books and records, and that Kidder did not in fact know of these things.
The Division seeks an order to cease and desist, disgorgement of $11.4 million plus prejudgment interest, civil penalties of $11.4 million, and a bar from association with any broker or dealer, without a right to reapply. The Respondent contends that the proceeding should be dismissed because the Division did not prove its fraud allegations or that the Respondent knew of Kidders books and records violations.
A. Kidder, Peabody and Its Employees
Kidder was, until it ceased to exist in 1994-95, a registered broker-dealer with offices in New York City and was ultimately a subsidiary of General Electric Company (GE). 8 Div. Ex. 50 at B03. Kidders Fixed Income Division (Fixed Income or FI) had 12 trading desks, one of which was the Government Securities Trading Desk (Government Desk). Respondents Answer (Feb. 7, 1996). The Government Desk did proprietary and customer market-making trades in Treasury bills, notes, bonds, STRIPS, government agency securities, and money market instruments. 9 Tr. 827. The Zero Coupon Trading Desk, also referred to as the Zero Desk or STRIPS Desk, was part of the Government Desk. Tr. passim; Respondents Answer.
The Respondent was born in 1958. Div. Exs. 52, 55, 56, 57. After receiving graduate and undergraduate degrees in chemical engineering from the Massachusetts Institute of Technology and working as an engineer for several years, he completed the M.B.A. program at Harvard University. 10 Div. Ex. 52, 55. He worked in mortgage-backed securities in the New York offices of Morgan Stanley for about two years and at CS First Boston for about one year, but was let go by both firms. Tr. 470, 472-73, 643; Div. Exs. 41, 43, 44, 56, 57. He started work as a trader on Kidders Zero Desk in July 1991 at a salary of $75,000 per year. Tr. 470-71. He received a disappointing evaluation and bonus at the end of 1991, but showed dramatically increasing profits and rewards from early 1992 until the events that led to his termination in April 1994, as shown in the chart below. Tr. 471, 481-82, 489-94, 838-51, 869-72; Div. Exs. 86, 87, 88, 89, 121.
Hired at $75,000 as Vice President
1991 Total Reported Profit (7/91-12/91)
Raise to $150,000
Promoted to Senior Vice President
1992 Total Reported Profit
$2.1 million bonus
Promoted to head of Govt Desk
1993 Total Reported Profit
$9.3 million bonus
Named Kidders Man of the Year
1994 Total Reported Profit (1/94-3/94) )only)
Melvin Mullin, head of the Government Desk, was Mr. Jetts first supervisor. Tr. 477, 826-27, 830. Mr. Mullins supervisor was Edward Cerullo, head of Fixed Income. Tr. 916, 918-19. In February 1993, Mr. Mullin moved to a different position and Mr. Jett was appointed head of the Government Desk, reporting directly to Mr. Cerullo. 11 Tr. 489-93, 850-51, 916-17. His hard work, drive, and discipline attracted favorable notice. Tr. 868-72, 921, 967; Div. Exs. 87, 88, 89. On Mr. Cerullos recommendation, he was given Kidders Man of the Year Award. Tr. 493-94, 923-24; Div. Ex. 118. His January 8, 1994, acceptance speech showed his thorough knowledge of bond-trading concepts. Div. Ex. 118 (transcribed at Tr. 641-56).
In the first quarter of 1994, Kidder examined Mr. Jetts trading more closely than before. On April 17, 1994, Kidder fired him and announced that it had recorded about $350 million of nonexistent profits as the result of his fraudulent trading and would take a $210 million charge to its first quarter earnings. 12 Tr. 596, 939; Div. Ex. 50 at B01, B03; Resp. Ex. 600. Kidder hired the Davis, Polk & Wardwell law firm to investigate the situation with the help of the GE Corporate Audit Staff (GE CAS); this effort resulted in an August 4, 1994, report, known as the Lynch report, which was made public. Tr. 1815-2428, 2525-2650; Div. Ex. 50 at B03; Div. Ex. 153; Resp. Ex. 600. Several legal proceedings, including this administrative proceeding, ensued. See In re Kidder Peabody Securities Litigation, 94 Civ. 3954 (S.D.N.Y.); In re General Electric Securities Litigation, 94 Civ. 4024 (S.D.N.Y.); Arbitration Between Joseph Jett and Kidder, Peabody & Co., Case No. 94-01696 (NASD Regulation, Inc.).
B. The Fixed Income Government Desk
1. Zero Coupon Bonds, Stripping and Reconning
U.S. Treasury securities are debt obligations of the United States on which interest is paid. Div. Ex. 119 at A1; see also Tr. 116. There are two categories of Treasury securities, coupon securities and zero coupon securities (also known as discount securities or zeros); they differ in the form in which the holder receives interest and, correspondingly, in the price at which they are issued. Div. Ex. 119 at A1. Coupon securities are issued at approximately their redemption value (also known as par, principal or face value); the interest is fixed as a percentage of the face value, and is paid periodically (usually every six months) during the life of the security. Div. Ex. 119 at A1, B1. Zero coupon securities are issued at a discount to their redemption value; the interest is paid at maturity when the security is redeemed and the Treasury remits the full face value; the interest is the difference between the face value received at maturity and the purchase price. Div. Ex. 119 at A1, B2. Treasury securities with original maturities of ten years or more are called bonds and are issued as coupon securities. 13 Div. Ex. 119 at A1-A2.
There is a secondary market for Treasury securities; it is the most liquid and the most actively traded financial market in the world. Div. Ex. 119 at A2; see also Div. Ex. 118 (Tr. 642-43). The standard or "regular way" settlement date for transactions in U.S. Treasury securities is one business day after trade date. (Regular way settlement for corporate stocks and bonds (corporate settlement), now three days, was five business days at the time of the events in question.) Tr. 537; Div. Ex. 119 at B10; John Downes & Jordon Elliot Goodman, Barrons Dictionary of Finance and Investment Terms 527 (4th ed. 1995); see also Tr. 891, 2472.
Coupon bonds and zeros are priced differently in the secondary market as well, because of the difference in the way the holder receives interest. Div. Ex. 119 at B1-B9. Prices of coupon securities are commonly quoted as a percentage of par. Div. Ex. 119 at B2. Additionally, if a bond is sold in the middle of a coupon period, the buyer, who will receive the next coupon, pays the seller for the pro-rated portion of the coupon period during which the seller held the bond, up to settlement date; this adjustment to the price of the bond is called accrued interest. Div. Ex. 119 at B3; Marcia L. Stigum & Franklin L. Robinson, Money Market and Bond Calculations 76 (1996). Accrued interest is accounted for separately from the price paid for the bond principal on books and records, such as confirms. Marcia L. Stigum, After the Trade: Dealer and Clearing Bank Operations in Money Market and Government Securities 133-36 (1988). In the case of zero coupon bonds, there is no accrued interest since there are no periodic coupon payments. Div. Ex. 119 at B2-B3.
Various factors affect the market prices of Treasury securities. Div. Ex. 199 at B1-B22. The prices of Treasury securities have an inverse relationship to the movement of U.S. Government interest rates. Div. Ex. 119 at B1-B2, B8-B9. Because zeros pay no interest, they tend to rise in value over time ("accrete") such that they approach their face value as they near maturity. Tr. 507-08, 1873; Div. Ex. 119 at 7-8, B7-B8. The price of zeros is also affected by supply and demand and other market conditions. Tr. 507; Div. Ex. 119 at 7-8, B7-B9. The farther the time to maturity, the more likely market factors such as interest rates will dominate the effect of accretion on prices. Div. Ex. 119 at 7-8, B9.
The U.S. Treasury has programs administered largely by the Federal Reserve Bank of New York (Fed) whereby the coupons and principal payments of certain U.S. Treasury bonds can be separated ("stripped") or reconstituted ("reconned") after being stripped. Tr. 509, 783-86, Div. Ex. 119 at 7, A3-A4. "STRIPS" 14 are the zero coupon securities created from the interest payments and principal piece of a stripped bond, and these STRIPS are traded in the secondary market for U.S. Treasury securities. Tr. 506-07; Div. Ex. 119 at 7, A3.
The Fed plays a clerical role and is not a true counterparty in stripping and reconning; they are "exchanges," not "trades" or "transactions." Div. Ex. 119 at 15-16. The Fed does not make advance commitments to make the exchanges; it charges a standard processing fee and does not otherwise profit or lose from the exchanges. Tr. 784-88; Div. Ex. 119 at 8-9, 15-16, A5-A7; Div. Ex. 153. The actual exchanges are via the FedWire connection between the Fed and a clearing bank; Kidders clearing bank was the Bank of New York (BONY). Tr. 784-85, 1901-02, 2045. At the time at issue the Fed required delivery by 11:30, and the turn-around time was about three hours. Tr. 786-87, 2487; Div. Ex. 100 at 9.
An arbitrage opportunity may be created for traders when the value of the component parts is greater or less than the value of the bond as a whole. Tr. 538, 836, 2958; Div. Ex. 119 at D2-D9. The government securities market is highly liquid with virtually no bid-offer spread. Tr. 687-88, 3062-65; Div. Ex. 118 (Tr. 643). Correspondingly, profits that can be made from arbitrage between STRIPS and bonds are limited; in the 1991-92 time frame, profit opportunities varied from time to time and issue to issue but it was not unusual to find profit opportunities in the range of $2,000 per million, or about 6/32nds. Tr. 837-38, 874-75; see also Div. Ex. 119 at 18, D8; Tr. 550; cf. Resp. Ex. 1000 at 22-26; Tr. 875-76, 2779-89, 3048-56. It is axiomatic that high risk is usually associated with high profit potential; low risk, with low profit potential. Tr. 473; Div. Ex. 119 at 30-32. Generally when traders believe they can create substantial profit at low risk from a trading strategy, they do as much of the trade as they can because low risk, high profit, opportunities in highly liquid and monitored markets do not persist; others exploit the opportunity, the price of the securities changes, and the opportunity disappears. Tr. 1645-46, 3061-65; Div. Ex. 96; Div. Ex. 96A at 25; Div. Ex. 119 at 32-33.
2. Kidder Systems
The Government Desks trades flowed through three computer systems at Kidder: Government Trader (GT), used directly by traders; Tandem, which maintained and processed information concerning GTs trades during the day as they occurred; and the IBM mainframe, into which Tandems data was moved at the end of the day and maintained. Tr. 324-48; see generally Div. Ex. 153.
GT was a stand-alone computerized analytical system with multiple touch screen menus which facilitated trading in Treasury notes, bonds, STRIPS and options. Tr. 533-35, 1832, 1865-68; Div. Ex. 153 at 5-6. GT was designed by Mr. Mullin and Mike Benatar, a computer programmer at Kidder, to help traders to identify and track relative values among similar securities and identify market opportunities, manage risk, and monitor profits and losses and trade date positions. Div. Ex. 153 at 5-7; Tr. 533, 827-28, 834, 1059, 1832-33, 1862-63, 1875-76. Thus, a trader used GT to identify profitable STRIP and recon arbitrage opportunities. Tr. 1048, 1865-68. A trader also used GT to enter his instructions for trades, STRIPS and recons. Tr. 535, 1831; Div. Ex. 153 at 5-7. GT contained prices, which were either updated by the trader as to a particular security or based on their assumed relationship to another security that had been updated (matrix pricing). Tr. 1602, 1837-39, 3092-93; Div. Ex. 153 at 5-8 & nn.2, 4. There is no suggestion in the record that the Respondent entered inappropriate price marks.
Tandem was a real-time on-line processor that captured and maintained transactions as they occurred; it kept positions on a real-time basis; it posted positions and kept current during the day. Tr. 326-27, 338. Data from trade tickets, which were prepared manually or generated by GT, was entered manually into Tandem. Tr. 329-33, 828, 1831, 1881-84. Additionally, end-of-day price data from GT was downloaded automatically into Tandem at the end of each day. Tr. 828, 1838-39, 1884-85. Tandem moved data from each days activities onto the IBM at the end of that day; it also saved certain files to tape. Tr. 333-34.
The IBM, a batch processor, received data from Tandem starting about 6:30 p.m. each day; the data resided on the IBM, which processed it in various ways. Tr. 333, 336-49, 1831, 1896.
Information fed from GT into Tandem and IBM was incorporated into financial and accounting reports generated by the two systems. Tr. 1831. Tandem generated the Daily Profit/Position Report #2 (PPR-2 Report), 15 which showed profit and loss (P&L) by CUSIP number, 16 and the Daily Transaction Journal, 17 which recorded every transaction by ledger and CUSIP number. Tr. 1831, 1885-86, 1894. The IBM maintained all of the firms trading information. Tr. 336-37. It generated the FI 12 Trade Date Inventory Report 18 and the FI 10 Settlement Date Inventory Report; these autonymous reports of firm inventory were by ledger and CUSIP number. Tr. 343-44, 380, 1831, 1896-98. It generated the KPPS-98 Report and the FI STAT Report. Tr. 342-44, 344, 391, 1831. The FI STAT Report was a transaction history file that broke down transactions in the greatest detail. Tr. 344-45, 1831, 1901. The KPPS-98 Report 19 was a month-end exception report developed in September 1993 that captured unsettled forward transactions, including forward exchanges with the Fed. Tr. 1900-01. Government Desk trade information was fed to order tickets, transaction journals, ledgers, income statements, and FOCUS Reports. 20 Tr. 147-66, 533-35, 1831, 1885-86, 2296-97; Div. Exs. 23-37.
See Div. Ex. 155.
Rule 17a-3(1), which the OIP alleges the Respondent violated, pertains to blotters. The Daily Transaction Journal was the blotter for trades entered in GT. Tr. 135, 191, 1831; see, e.g., Div. Ex. 1D.
3. Execution of STRIPS and Recons on Government Trader
After a trader on the Government Desk negotiated a purchase or sale of a security with a counterparty, he entered the trade on GT, indicating the security to be bought or sold, quantity, price and counterparty. Tr. 534-35, 1865-69; Div. Ex. 153 at 6-7. To initiate a STRIP or recon, a trader entered the bond, quantity and whether it was a STRIP or recon; no price or counterparty was entered because these are non-negotiated exchanges for which there is no counterparty; GT automatically defaulted to house accounts that recorded STRIP (08708910) and recon (08708909) activities. Tr. 534-35, 1865-69; Div. Ex. 153 at 6-7.
After a trader entered a trade, STRIP, or recon, GT immediately updated his P&L for the day and his inventory. Tr. 1875-76, 2374-75; Div. Ex. 153 at 6-7. Thus, he could see the immediate effect of a trade or entry on his gross P&L position. Tr. 540-42, 1875-76, 2999-3003, 3015-16; Div. Ex. 92; Div. Ex. 92A at 1-2, 4, 7. Traders understand and watch their P&L closely since their compensation is largely based on P&L. Tr. 3059-61. The process of selecting a bond to be reconned, entering instructions for the recon, and then checking the P&L effect took about 10 to 14 seconds. Tr. 1875-76. GT did not show net interest or cost of carry. Tr. 2683-84. This could, however, be estimated. 21 See, e.g., Div. Ex. 92; Div. Ex. 92A at 1.
GT defaulted to next-day (regular way) settlement for trades, STRIPS, and recons. 22 Tr. 537-38, 1865-69; Div. Ex. 153 at 6. Until November 1992, a trader was limited to changing the settlement date for a trade or exchange to same day, skip day, or corporate (five day) settlement; then an upgrade was introduced that permitted a trader to select any future date. Tr. 536-38. There is no economic reason to enter an exchange greater than one day forward. 23 Tr. 853-54, 877-78; Div. Ex. 119 at 32-33.
GT treated a recon as the purchase of a bond and the sale of a group of STRIPS, and vice versa, and created theoretical prices such that the bond plus interest that would accrue on it as of settlement date equaled the sum of all the STRIPS (TINTs plus corpus). Tr. 1533, 1868-69, 1881, 2316, 2904; Div. Ex. 119 at 16. GT created the prices based on the spot price (price for next day settlement) of the bond and STRIPS and assumed the current yield held constant. Thus GT recorded the purchase of a bond priced for next-day settlement, but the sale of a group of STRIPS theoretically priced for forward settlement. The difference between the (spot) price of the bond plus accrued interest and the sum of the forward priced STRIPS was added to the principal piece (corpus). Since interest is built into the purchase price of a STRIP, a zero coupon bond, and is not part of the principal price of a coupon bond, such an exchange for forward settlement would appear to show a profit on the trade date. A profit appeared on the trade date because the forward price assigned to a STRIP was higher than the price of the STRIP for next day settlement; a profit was recorded on GT and Tandem when the position was marked to market each day. Tr. 1869-71, 1884-85; Div. Ex. 119 at 16-17, F1-F4.
Conversely, a forward STRIP entered into GT was treated as the sale of a bond and the purchase of a group of STRIPS. Tr. 1868-69. In that case the higher forward price for the STRIPS as compared with the price of the bond would cause a loss to appear on trade date and gradually disappear as settlement date approached. Tr. 1869-71.
Because GT calculated the forward price of the STRIPS by adding accrued interest to the price of the bond principal, the apparent profit when the forward recon was booked would be higher the larger the bond value, the higher the bond coupon, and the greater the number of days to settlement; Mr. Jett knew this. Tr. 546-47; Div. Ex. 96; Div. Ex. 96A at 19; Div. Ex. 100 at 8. The profit deteriorated as settlement date approached, because of the accretion effect, as the STRIPS were marked to market each day. Tr. 1872-73; Div. Ex. 119 at 18-19, F4-F8; see also Div. Ex. 153 at 7-9. Mr. Jett knew this. Tr. 532, 541; Div. Ex. 78 at Bates 04674-78.
A profit discrepancy resulting from entry of a forward exchange on GT -- the difference between the theoretical forward price of STRIPS recorded in GT and Tandem, and the lower current market price of STRIPS -- was recorded daily by Kidders P&L accounting system in marking to market. Tr. 1869-71, 1884-85, 2323. Thus, profits and losses which had not yet accrued were recorded in the firms books and records. Tr. 533-34, 2296-97. Such forward booking of planned but unexecuted exchanges required an accounting adjustment to be in accordance with Generally Accepted Accounting Principles (GAAP). Tr. 2728, 2735-38, 2747; Resp. Ex. 1000 at 7.
It was against a traders self interest to request such an adjustment that reduced his reported profits, 24 but the record does not show that Kidder had a policy requiring a trader to do so. There was no written policy. Tr. 873. Although Mr. Mullin recalled, generally, instructing traders in department meetings to advise the accounting department of forward transactions, he could not recall any specifics, including who was present at such meetings. Tr. 830, 873-74. He did not discuss the issue with Mr. Jett. Tr. 874. Mr. Mullin and Mr. Cerullos assistant David Bernstein adverted to a general understanding that an accounting adjustment was necessary to correct P&L distortion arising from a forward transaction, but Mr. Bernstein waffled on whether it was a traders responsibility to come forward or the accounting groups responsibility to notice forward settling trades. Tr. 830, 874, 1430-35, 1466-67, 1470-74. The existence of a compliance officer was noted briefly on the record, but there was no evidence that she addressed the adjustment issue while the Respondent worked at Kidder. Tr. 2955. Kidder staff, however, in May 1993, had discussions with him related to this issue, as addressed below. Kidder later discovered unrealized profits requiring adjustment in the Respondents ledger, resulting in a large write-off for the first quarter of 1994. Tr. 1972-74, 2262, 2412-16; Div. Ex. 50 at B01, B03; Div. Ex. 121.
C. Jetts Trading Strategy
Respondent Jett traded and booked exchanges with the Fed in the G-1 ledger at Kidder, along with other traders whom he supervised. Tr. 485, 534-35, 693, 988-89, 1328, 1476, 1983-84, 3001-05; Div. Exs. 92, 92A. He entered many thousands of forward recons and STRIPS. Tr. 580-82. Because he traveled frequently, he also instructed traders under him, such as Kevin McLaughlin, Jeff Unger, and Joe Ossman, to enter transactions or book exchanges with the Fed in his absence. Tr. 485, 534-35, 693, 988-89, 1328, 1476, 1983-84, 3001-05; Div. Exs. 92, 92A.
In addition to trades with counterparties, beginning in November 1991, Mr. Jett also booked forward recons and STRIPS with the Fed, which generated apparent profits as described above. Tr. 533-35, 538-39, 2101-05; Div. Exs. 58-73, 121, 122, 152; Div. Ex. 153 at J. About 90% of G-1 ledger activity from July 1991 through March 1994 was recons and STRIPS. Div. Ex. 153 at 11-12. The P&L effects of the forward exchanges were reflected on Kidders books and records, including the Daily Transaction Journal, ledgers, order tickets, and FOCUS Reports. The effects were also reflected on the PPR-2 Report, the FI-10 and FI-12 Reports, the KPPS-98 Report, the FI STAT Report, the FISEQ file, the Fixed Income Daily Report, P&L in trial balances, income statements, and statements of financial condition, the BONY Clearance Report, and the Inventory Control/Haircut Estimate Report. Tr. 125-66, 202, 207-08, 224-25, 269, 533-34, 2009-12; see generally testimony of Jeffrey Bornstein, Tr. 1815-2428; Div. Exs. 1-37, 58-73, 75, 121-24, 130, 135, 152, 154-56; Div. Ex. 153 at 10-11.
Before the November 1992 upgrade to GT, Mr. Jett was limited to changing the default, regular way, settlement date to five days forward. Tr. 536-38. Thereafter, he entered forward recons for settlement up to 203 days in the future. Tr. 537; Resp. Ex. 604.
The Respondent claims that his execution of this strategy on GT merely involved an accelerated recognition of profit for internal management reporting purposes only, described as "Trade Date Early Recognition of Profit" or "TDERP," when Kidder estimated unaccrued interest as profit in advance, and recognized it up front. Tr. 2797-2800, 2909-10; Resp. Ex. 1000 at 3-4, 7-8.
Indeed, since the initial profit recognized from a forward recon rolled off, approaching zero on settlement date, a single forward recon by itself had a minimal effect on the accuracy of Kidders books and records. The Respondent, however, entered an increasing number of forward recons in a pyramid-like manner that prevented an overall loss in his portfolio; the amount of unrealized profit from forward recons in his ledger grew over time. Tr. 1971-72; Div. Ex. 153 at F. He increased the quantity, dollar amount and number of days forward, thus hiding losses from settling positions. 25 Tr. 2112-13, 2118-21; Div. Ex. 119; Div. Ex. 153 at D, H. Additionally, he used higher coupon bonds, thus generating higher paper profits, than for trades with customers; during his tenure at Kidder the average coupon of his customer trades was 8.03%, of his STRIP/recon exchanges, 10.25%. Tr. 2114-17; Div. Ex. 153 at G. This pyramid also masked real trading losses in the Respondents ledger. Tr. 2148-49; Div. Exs. 121, 124, 153.
This chart shows the P&L effect of a series of hypothetical forward recons; negative accretion of profit from existing recons is offset by adding new recons:
Mr. Jett did not advise the accounting group to adjust for forward recons. Tr. 542-45. He knew that the P&L effects of his forward exchanges would affect Kidders books and records. Tr. 533-34. His bonuses also showed him that the P&L effects were on Kidders books and records and were otherwise considered by Kidder to be real.
Mr. Jett stated that the forward recons were just one part of a three part arbitrage strategy: 26 1) the purchase of a collection of STRIPS, 2) the sale of bond futures, and 3) a forward reconstitution. Tr. 524, 529-30; Div. Ex. 78; Div. Ex. 119 at 10-11, G. Arbitrage is profiting on price differences between the bond and the sum of its parts. Tr. 538-39, 836-38, 860, 2720, 3050. The Respondent defines "arbitrage" in an unusual way. Tr. 2958-60. He adds to the "instantaneous" price differences "a time-related element," described as "accretion" (of STRIPS) or "accrual (of interest) on the bond" between trade and settlement date. Tr. 2959. He refers to "early recognition of profit" by saying "the forward reconstitutions had a time value of money embedded in them." Tr. 538, 2958-59.
Mr. Jett also claims that a forward recon "hedged" with the purchase of underlying STRIPS locked in the profit from a forward recon, preventing negative accretion. Tr. 532, 2904-05, 2907-08. However, any profit from owning STRIPS for a period and then reconning them would occur with or without a forward recon, since the Fed does not agree to make exchanges in the future. Further, a long position in STRIPS must be financed and hedged. Mr. Jett acknowledged but disregarded the significant costs of futures hedging and repo financing in explaining his trading strategy. Tr. 2917-18; Div. Ex. 78 at Bates 04685; Div. Ex. 119. Nor did he purchase all the STRIPS necessary to settle his forward recons. Tr. 2114-30; Div. Ex. 153 at 29-31, C, D, E, G. In fact, from July 1993 to March 1994, the amount of reconstitutions open at month-end in the G-1 ledger for the 11¾% bond maturing 11/15/2014 equaled or were up to 3.8 times greater than the amount of stripped principal pieces that were outstanding on a global scale as reported by the U.S. Treasury Department. Tr. 2117-20; Div. Ex. 153 at 30-31, D. Mr. Jett demonstrated his in-depth understanding of the market in U.S. Treasury securities in his January 1994 Man of the Year Award speech. Div. Ex. 118.
1. Early Trading Under Mullin
Mr. Mullin supervised Mr. Jett from the time he was hired in July 1991 until he became head of the Government Desk in February 1993. Tr. 477, 830-31. Until GTs November 1992 upgrade Mr. Jett could not enter STRIPS or recons for more than five days forward. Tr. 536-39, 889. Mr. Jett characterized himself as becoming aware at that point in late 1992 that "forward reconstitutions had a time value of money embedded in them." Tr. 538. However, his trading behavior throughout 1992 already showed an increased tendency to use forward recons and STRIPS, and not counterparty trades, to generate profit. Tr. 2092-94; Div. Exs. 121, 122; Div. Ex. 153 at 29-30, 35-36, C, F, J. Out of $27.8 million in reported profits through October 1992, before the upgrade, he recorded over $17 million in unrealized profits from forward exchanges. Tr. 1972-74; Div. Exs. 121, 122.
Mr. Mullin and Respondent Jett discussed his trading strategy frequently; they discussed such topics as the uses of GTs various screens, the firms risk policy that trades be hedged, the choice of products for hedging, stripping and reconning, and customer business. Tr. 834-37, 852-54, 878-79. He understood Mr. Jetts profitability to be derived from increased customer business and increased STRIPS and recon activity to take advantage of opportunities discovered on the screens of GT; he did not realize the effect of the Respondents forward recons on profitability. Tr. 852-54. Mr. Mullin did not know that Mr. Jett entered forward recons for more than five days forward after November 1992. Tr. 830-31, 853-54, 866. They did not discuss settlement date at all. Tr. 853.
Mr. Mullin did not review trade tickets, which indicated unusual trading activity, particularly after Mr. Jett began trading for greater than five-day settlement in November 1992. Tr. 329-31, 861-62. Mr. Mullin did review the Fixed Income Daily Report, the Inventory Control Report, and the Daily Transaction Journal as supervisor of the Government Desk, but did not notice significant irregularity in the Respondents trading. Tr. 829-31, 876-77. The Daily Transaction Journal showed trade and settlement date. See, e.g., Div. Ex. 1D. For most of the time Mr. Mullin supervised him, Mr. Jetts profit levels were not out of line with what was expected of him; for 1992 he was expected to generate $1 million in profits per month, which he exceeded in 1992 and greatly exceeded in 1993 and 1994. Tr. 483-84, 840; Div. Ex. 121.
2. Head of the Government Desk Under Cerullo
Mr. Jett was made head of the Government Desk in February 1993 when Mr. Mullin moved to a different area. Tr. 492-93, 850-51. About this time Mr. Jetts forward exchanges and reported profits, including profits derived from forward exchanges, increased greatly. Tr. 491-94, 999-1000, 1020-23, 1631-34; Div. Exs. 121, 122; Div. Ex. 153 at F; Resp. Ex. 120. In 1992, he reported about $32.5 million in profits, including $40.4 million of profits from forward exchanges; in 1993, $150 million in profits, including about $198.2 million of profits from forward exchanges. Div. Exs. 121, 122. In 1993 Mr. Jett was responsible for a significant portion of the reported income of FI. Tr. 493-94, 715-16, 1113-14.
Mr. Cerullo supervised Mr. Jett from February 1993 until he was fired. Tr. 850-51, 916-17, 2944. Mr. Cerullo was in charge of Fixed Income, a billion dollar business with 750 employees throughout the world. Tr. 916, 960. He had conversations of a general nature with Mr. Jett and others concerning his strategies and the source of his profits. Tr. 1023-27, 1056-59. He delegated responsibility to investigate specific questions to David Bernstein, his assistant; Barry Finer, the FI Division Risk Manager; and others. Tr. 684-86, 694-96, 716-20, 924-29, 1025-28, 1056-58, 1341-42, 1353-54, 1358-60, 1627-29, 1677-78, 1769. Mr. Bernstein was Mr. Cerullos right-hand man. Tr. 675, 1308-09, 2459-60, 2915. He kept Mr. Cerullo au courant. Tr. 1418.
Information that raised questions about Mr. Jetts trading was known to Mr. Cerullo as early as the middle of 1993. He knew that Kidder was doing a larger volume of STRIPS and recons during 1993 than before. Tr. 1030. The reported profitability of the G-1 ledger, which had increased greatly in 1992, continued to increase dramatically each month in 1993, such that by April 1993 Mr. Jetts earnings had surpassed all of 1992. Tr. 999-1000, 1020-23. There was talk around the firm about his enormous profitability. Tr. 715-16, 1632-34, 1645-46, 2462. Mr. Cerullo acknowledged that there was no market-driven explanation for the dramatic increase in Mr. Jetts profits from 1992 to 1993, Tr. 1048-49, and thought that the profits came from trading STRIPS and bonds, market making and STRIP and recon arbitrage. Tr. 917-18.
Mr. Cerullo reviewed reports which gave indications of the Respondents profitability, trading limits, position risk exposure, and asset consumption, including the PPR-2 Report, the Daily Transaction Journal, the Government Daily P&L/Inventory Report, the Fixed Income Daily Report, the Risk Management Report, and the Inventory Control/Haircut Estimate. Tr. 706-07, 923, 985-86, 1033-35, 1043, 1055-56; Resp. Exs. 120, 121, 122, 123. These reports showed a dramatic, more than five-fold, increase in trading profits during the year 1993 for Mr. Jetts G1 ledger. Resp. Ex. 123. Mr. Cerullo did not review Mr. Jetts order tickets; the tickets disclosed trade and settlement dates; the account numbers on them showed the orders were STRIPS and recons. Tr. 957-59. When Mr. Jett exceeded capital limits in the spring and summer of 1993, Mr. Cerullo approved higher limits for him and did not question in depth the source of his profits. Tr. 706-09, 1033-35, 1041-47, 1060-61; Resp. Ex. 121.
Mr. Cerullos assistant Mr. Bernstein was alerted during the spring of 1993 that Kidders Repo Desk was having problems processing the Respondents exchanges, Tr. 2459, 2508-10, and that the accounting department was concerned about the P&L effects of the Respondents exchanges on Kidders balance sheet. Tr. 1314-16. Mr. Cerullo was involved in the balance sheet reduction program at Kidder beginning in September 1993, as discussed below. Mr. Bernstein specifically told Mr. Cerullo about the Respondents forward recons with the Fed in March 1994. Tr. 918, 924-25, 1769.
D. Revelation of the Problem
Mr. Jetts "outrageously high numbers" were the subject of conversation around the firm during 1993. Tr. 715-16, 1632-34, 1645-46, 2462. The Respondent points to several factors that highlighted his activities to argue that knowledge of his activities was widespread and that Kidder approved his strategy to book profits from forward recons.
1. The Repo DeskThe Red Books
Kidders Repo Desk financed FIs long positions and borrowed securities to cover FIs short positions. Tr. 960-61, 2444-45. Brian Finkelstein managed the desk; Jim Rizzi dealt directly with Mr. Jett. Tr. 2444-45, 2480-81.
In late 1992 the number of forward recons increased, and Mr. Rizzi sometimes had difficulty keeping up; at times he could not obtain the necessary STRIPS, and it was necessary, in effect, to cancel a recon by pairing it off with an equal and opposite STRIP. Tr. 2484, 2486-87. Mr. Rizzi usually learned of trades due to settle on a particular day by a Settlement Location Report provided to him that same day; to solve the problem caused by Mr. Jetts volume, he suggested advance notice. Tr. 2483-87. Beginning in 1993, Mr. Jett and his staff noted his STRIP and recon requirements in advance in large notebook calendars kept on Mr. Rizzis desk and known, from their red covers, as Red Books. 27 Tr. 612-14, 617-23, 2446-48, 2486-92; Resp. Exs. 102A (1993), 102B (1994). A STRIP or recon was listed on the page of its settlement date; the information included trade date, whether the entry was a STRIP or recon, the dollar amount, the coupon and maturity of the bond, and the number of STRIPS needed. Tr. 618-23, 2488-89; Resp. Exs. 102A, 102B. The P&L effects were not shown. Tr. 628-31. Not all STRIPS and recons were in fact noted in the Red Books, but they assisted the repo desk in preparing for settlement date. Tr. 2037-38, 2486-88, 2519; Div. Ex. 153 at 13-14 n.11.
In spring 1993 Mr. Rizzi complained to Mr. Finkelstein that: 1) the volume of Mr. Jetts recons was tremendous, 2) forward settlements would stay on the books until settlement date but often would not settle, even though Mr. Rizzi had obtained STRIPS in preparation for settlement, and 3) the desk would gather a large volume of STRIPS for a recon, only to have the same bond stripped a few days later. Tr. 2456-59, 2507-09, 2514-15. About this time, Mr. Rizzi also questioned whether Mr. Jetts trades were merely paper trades which did not settle with actual customers. Tr. 2509-10. Mr. Rizzi and Mr. Finkelstein met with Mr. Bernstein, who looked into the matter and later assured them that Mr. Jetts trades and customers were real. Tr. 2459, 2508-10. Apart from this inquiry, in 1993 Mr. Finkelstein frequently expressed concern to Mr. Bernstein, discussing operational issues and wondering how Mr. Jett achieved such high P&L trading figures. Tr. 2459-67. Mr. Bernstein alleviated his concern by saying that he had looked into the situation and was satisfied, and that Mr. Cerullo knew about Mr. Jetts trading. Tr. 1644-45, 2459-67.
The Red Books were kept open and available on the desk of Jim Rizzi. Tr. 617-20, 2446-48, 2491-92. Neither Mr. Mullin nor Mr. Cerullo knew about them. Tr. 855, 961. The Respondents claim at Tr. 2944-45 that he and Mr. Cerullo reviewed every STRIP and recon in the Red Book for May and June 1993 in connection with a contemporaneous inquiry from the Fed is not consistent with the record evidence that Mr. Cerullo as a manager delegated such specific tasks to others. Mr. Bernstein claimed that he was not aware of their use before 1994. Tr. 1518. However, the record shows that Mr. Bernstein reviewed the Red Books in his 1993 inquiries regarding the repo desk and in the May 1993 inquiry discussed below. Tr. 2510, 2910-11, 2914. Mr. Rizzis recollection to this effect is more persuasive than Mr. Bernsteins denial. The Red Books were important to Mr. Rizzi, so he would likely notice their use, and they would have been an obvious source to help Mr. Bernstein in his investigations. Information contained in the Red Booksespecially the far forward reconswas unusual and could have raised questions that would have revealed the facts associated with the Respondents trading. By May 1993, a glance at the Red Book showed forward recons of increasing length and size. Examples of entries made by then show an 18 week forward recon of $200 million of a 12% bond for May 11 settlement; a 25 week forward recon of $200 million of a 12% bond for May 18 settlement; a 29 week forward recon of $200 million of an 11 5/8% bond for June 8 settlement; and five to eight week forward recons totaling $900 million for July 2 settlement. Resp. Ex. 102A at May 11, May 18, June 8, July 2.
2. The May 1993 Inquiry
In May 1993, Mr. Jett told Mr. Bernstein that the forward positions in his ledger were forward reconstitutions with the Fed. Tr. 1317, 1425. Kidder accountant Charles Fiumefreddo was working on a project to identify forward, unsettled, positions, so that they would not be reported on the balance sheet; the KPPS-98 exception report was developed as a result of this project. Tr. 1314, 1427. He realized that Mr. Jett had forward positions and notified Mr. Bernstein. Tr. 1314-15, 1425-35, 1624. They questioned Mr. Jett about how trade prices were arrived at and whether there was a P&L effect to his trading in several conversations in May and June 1993. 28 Tr. 542-45, 563, 1316-23, 1475-78, 1624, 2903-05, 2909-10.
The Respondent and Mr. Bernstein testified concerning the meetings. 29 Tr. 542-44, 1475-1585, 1601-43, 1767-74, 2903-05, 2908-28, 2930-34. I evaluated the credibility of the testimony of each in light of his self interest. Mr. Jetts testimony was to the effect that Kidder management approved his booking unrealized profits from forward recons, which he characterized as "early revenue recognition." Mr. Bernsteins self interest was to show that he did not uncover improper recording of profits because Mr. Jett misled him. Nonetheless, his testimony avoided attributing affirmative misrepresentations to Mr. Jett. As he characterized it, he could have discovered the P&L distortion in May/June 1993 if he had asked different questions. Tr. 1491, 1496, 1780-81.
The result of the meetings was that Mr. Bernstein believed that there was no P&L effect from entering a forward recon. He relied on this May 1993 belief until March 1994. Tr. 1327-28, 1336-43, 1355-56, 1358-59.
Mr. Jett told him that GT would use the spot price of the bond and construct a price for the STRIPS such that "the sum of the dollar prices of all of the STRIPS would equal the dollar price of the bond plus accrued interest." Tr. 1318. This statement, which Mr. Bernstein attributed to Mr. Jett, is true. The statement discloses that the trade prices for STRIPS are higher than trade date prices because interest accrued up to settlement date on the bond is included in constructing the prices. Nonetheless, Mr. Bernstein left with the understanding that there would be no up-front automatic P&L effect of booking a forward recon. Tr. 1320. He did not attribute a specific affirmative statement to that effect to Mr. Jett. Tr. 1321-25.
Mr. Bernstein explained that his mistaken understanding arose from failure to recognize that "accrued interest" was accrued up to settlement date; instead he believed the reference was to interest accrued up to trade date. Tr. 1477-82, 1489, 1491. Such a misunderstanding is surprising, since "accrued interest" in a bond transaction always refers to interest accrued up to settlement date. Resp. Ex. 210 and Div. Ex. 79 support a finding that his understanding was that "accrued interest" was used in the normal way, that is, up to settlement date. Assuming, arguendo, that he did misunderstand, Mr. Jett cannot be faulted for not adding the phrase "up to settlement date" when he described how GT constructed the prices.
Mr. Bernstein summarized his understanding of the effects of a forward recon in Div. Ex. 79, a one page memo containing a few sentences of narrative and some T accounts. Tr. 1322. He claimed that he showed it to Mr. Jett, especially directing his attention to the T accounts and the absence of an entry for P&L on trade date, and that Mr. Jett agreed it recorded their conversations accurately. Tr. 1325. Mr. Jett denies having seen it then and states he first saw it in 1995 at a session at the U.S. Attorneys office. Tr. 2902. Assuming, arguendo, that Mr. Bernstein did discuss Div. Ex. 79 with Mr. Jett, this does not show that Mr. Jett made any affirmative misrepresentations concerning the P&L effect of entering a forward recon. While Mr. Bernstein stated that Mr. Jett seemed sure that he understood the P&L impact of the trades, he conceded that they did not discuss T accounting in detail and that the T accounts were his own creation. Tr. 1325-26. Further, other statements on Div. Ex. 79, while susceptible of more than one interpretation, are not inconsistent with the fact that GT used the price of the bond and constructed a price for the STRIPS that equaled the price of the bond plus accrued interest.
Mr. Jett describes the meetings differently. According to him Mr. Bernstein raised the issue of false profits resulting from forward recons and he addressed it by explaining that the forward recons were hedged by owning STRIPS so there could be no negative accretion. 30 Tr. 2903-05, 2909-10. Hedging and risk are, however, different subjects from accounting for P&L. Mr. Jett stated that the result of the inquiry was a determination that profits and losses from forward transactions should be posted on day one. Tr. 542-43. According to him, "the consensus (among Mr. Bernstein, Mr. Fiumefreddo, and himself) was that since I had ownership of the underlying STRIPS, there was no negative accretion. Rather it was . . . early revenue recognition from a forward reconstitution." Tr. 2909-10.
Mr. Jett argues that Resp. Ex. 214A, in conjunction with other evidence, including Resp. Ex. 211, shows that he and Mr. Bernstein discussed using dummy CUSIPs 31 to enter a different price that included cost of carry. Tr. 2924-28. Such a price would combine the P&L effects of a long position in STRIPS and a forward recon. Resp. Ex. 214A, an undated, handwritten note on the letterhead of Robert J. Chersi, Assistant Controller of Kidder, reads in its entirety: "Non-Regular Way Settlement = off B/S (balance sheet) -- Been approached By Bernstein to develop a LT (long term) approach to creating dummy CUSIPs for forward settling STRIPS (today use regular CUSIP #) Could, in ST (short term), manually remove them based on trader pointing them out (non-regular way settlement) OK." Mr. Jett claims that Mr. Chersi rejected the idea on the basis that he did not have the resources to implement it. Tr. 2927-28. Yet both he and Mr. Bernstein, who testified that he did not recall discussing dummy CUSIPs, recognized that using dummy CUSIPs in GT would affect Kidders books and records and make it impossible to reconcile them. Tr. 1609-10, 2928.
Mr. Chersi was not called as a witness. On its face Resp. Ex. 214A indicates that the writer understood dummy CUSIPs were being suggested as a way to remove forward settling STRIPS from the balance sheet and "OKed" a plan of manually removing them based on the trader pointing them out. In short, Resp. Ex. 214A does not support the Respondents claim that he, Bernstein and Chersi discussed using dummy CUSIPs to adjust the P&L effect of forward settling recons, and his testimony to this effect is undercut by his own recognition of the obvious: using dummy CUSIPs in GT would affect the books and records and make it impossible to reconcile them. Mr. Jett also claims that, because of the rejection of the dummy CUSIP plan at this time, Mr. Bernstein and Mr. Fiumefreddo told him to limit his forward trades to ninety days and that he abided by this limit through March 1994. Tr. 609-12, 2930-33. Other than his testimony at the hearing, there is no evidence to support a finding that this instruction occurred. See Tr. 1761-64. The Respondents connection of the ninety day limitation with the dummy CUSIP plan further supports the finding that there was no such limitation.
During 1993 Mr. Bernstein reported periodically on the Respondents trading to Mr. Cerullo, who had questions about the Respondents profitability because of a concern that he might be taking risk and because of a desire to duplicate his performance should he leave. Tr. 1025-28, 1056-59. Mr. Cerullo was not informed in any specific detail of the May/June investigation or alerted to possible P&L distortion; at most Mr. Bernstein mentioned P&L distortion in passing in a dismissive way. Tr. 1028, 1627-29. He did not show him Div. Ex. 79, his one-page memo. Tr. 1628. He told Mr. Cerullo in May 1993 that Mr. Jett had forward positions, but did not tell him they were reconstitutions with the Fed until March 1994. Tr. 1769. Mr. Jetts testimony that the May/June meetings included Mr. Cerullo, Tr. 2909, 2915, is not supported elsewhere in the record and is inconsistent with the record evidence that Mr. Cerullo as a manager delegated detail to others.
I find that Mr. Bernstein failed to understand and confront Mr. Jett with the fact that he was booking unrealized profits and that Mr. Jett failed to disabuse him of his misunderstandings. Mr. Jett knew that he was booking unrealized profits from forward recons and overcoming negative accretion by adding further unrealized profits in a pyramid like manner, but he did not make affirmative misrepresentations about this in the May/June meetings. He did know that Mr. Bernstein, and Mr. Fiumefreddo, to the extent he was involved, did not understand he was booking unrealized profits, and he omitted to disabuse Mr. Bernstein, or Mr. Fiumefreddo, of this misunderstanding. It is inconceivable that Mr. Fiumefreddo, if not Mr. Bernstein, would have agreed to "early revenue recognition" not in accordance with GAAP and approved his continuing to book enormous, increasing, unrealized profits that would, sooner or later, be unmasked. In sum, the result of the May/June inquiries was not approval by Kidder to recognize profit up front on forward recons as Mr. Jett claims. Nor was Mr. Cerullo sufficiently informed so that his inaction could be taken as approval of Mr. Jetts course of action.
3. Fed Inquiry
In 1993, Kidder was one of about 40 Primary Dealers of Treasury securities designated by the Fed. Tr. 410, 789-90, 2945. It reported its government securities activity to the Fed on Form 2004. Tr. 410, 2945-46. Mr. Cerullo knew Kidder had a larger volume than previously of STRIPS and recons during 1993. Tr. 1030. In May or June 1993 the Fed contacted him to question reporting procedures for the STRIPS and recons. 32 Tr. 1030-31, 2942-44. Mr. Cerullo spoke with Respondent Jett about this and set up a committee to resolve the issues. Tr. 1031-32, 2942-47, 2955. Kidder eventually engaged Coopers & Lybrand to audit its Fed reporting procedures in general; Coopers & Lybrands November 22, 1993, Report addressed a number of reporting and control issues. Tr. 2954-56; Resp. Exs. 14, 20. In January 1994, Kidders Legal Department reported on the status of corrective measures. 33 Resp. Ex. 39. There is no evidence to support the Respondents claim, Tr. 2942-45, 2951-53, that the Feds inquiry was prompted by the volume of his exchanges. Neither the volume of exchanges nor booking unrealized profits were issues addressed in the reports of Coopers & Lybrand and the Legal Department.
4. Internal Audit
In August and September 1993, Kidders Internal Audit Department performed a standard desk audit of the Zero Desk. Tr. 1166-68, 1210. The final report was issued in January 1994. Tr. 1167, 1182-83. The goal of the audit was to review overall control mechanisms and to identify risks. Tr. 1211, 1215-17, 1221-22; Resp. Ex. 79. P&L distortion was not a focus of the audit. Tr. 1219-20. Nor was trading strategy; there was a brief discussion with Mr. Jett for background only. Tr. 1169-71, 1212-14, 1258-59.
As to risk, Mr. Jett advised the auditors that forward transactions of one to three months comprised about 30% of his trading activity. 34 Tr. 1176-77, 1214-15; Resp. Ex. 90. Accordingly, the auditors identified risks associated with forward transactionscredit risk and comparison riskas risks that management should address. Tr. 1215. These are risks that a trade does not settle, leaving the firm with market risk from market movement between trade and settlement date. Tr. 1215-17. Credit risk is the risk that the counterparty has insufficient capital to settle the trade. Tr. 1215. Comparison risk is the risk that a trade on Kidders books and records is not on the counterpartys; thus there should be a comparison with a counterparty to make sure both parties agree on the trade information. 35 Tr. 1217.
As to controls, the auditors checked to ensure there was a mechanism to monitor P&L; they did not themselves check on the accuracy of the desks P&L or on how its positions were marked to market. Tr. 1219-20. GT was password protected by one password used by all the traders; for practical reasons, Mr. Jett rejected the auditors recommendation that each trader have an individual password. Tr. 1245-47; Resp. Exs. 85, 95.
In short, the audit was completely irrelevant to an understanding of Mr. Jetts strategy or his booking unrealized profits.
Barry Finer, the FI Division Risk Manager, was charged with monitoring potential P&L impact from the market exposure of FIs positions to changes in interest rates. Tr. 684-87. He collected summary information daily from the several trading desks, amounting to 50 to 100 ledgers, and prepared a summary report for Mr. Cerullo daily. Tr. 684-86, 689-93. Based on the numbers appearing on GTs risk summary screen, Mr. Jetts trading positions were virtually always within his market exposure limits. Tr. 690-94. Mr. Finer monitored the overall risk of positions, not individual trades; he did not consider settlement dates; because market risk arises at trade date, settlement date is not an issue. Tr. 684-86, 691-92. Nor did he ever review the Respondents individual trades or settlement dates. Tr. 693. In the second half of 1993, Mr. Cerullo told Mr. Finer to ask Mr. Jett about the sources of his profits; Mr. Cerullo was concerned that he might be taking market risk. Tr. 694-96, 716, 718-20, 1025-26. Mr. Finer did so, and Mr. Jett told him he had three roughly equal sources of profit: trading with customers and profiting on the bid/offer spread; arbitrage between STRIPS and bonds; and basis and yield curve trades. Tr. 695-96. Mr. Finer reported Mr. Jetts response to Mr. Cerullo. Tr. 718-20. This response did not identify forward recons with the Fed as the source of his profits. Mr. Finers inquiry did not advance Kidders knowledge of Mr. Jetts strategy or his booking unrealized profits.
6. The Balance Sheet Reduction Program
From September 1993 through March 1994, FI made a substantial effort to reduce its assets on Kidders balance sheet. Tr. 713-14, 1326-27; Resp. Exs. 128-39. The purpose of Kidders "window dressing" was to meet quarterly balance sheet targets for total assets -- $80 billion in September 1993, and to improve Kidders financial statements in connection with negotiations in 1994 with the Union Bank of Switzerland for a line of credit. Tr. 1061-63, 1068-76, 1096-98, 1730-31; Div. Ex. 96; Div. Ex. 96A at 17-18; Resp. Ex. 128 at Bates 42016; Resp. Ex. 218 at 2-3; Resp. Ex. 218A. The Respondent argues that his forward activity was part of the window dressing and had Kidders approval until it secured the line of credit. He also argues that Kidders reaction to balance sheet spikes that he caused during this period showed that it was aware of his forward recon activities.
Mr. Jetts involvement in the program started in September 1993 when Mr. Cerullos plan to reduce FI assets included reducing STRIPS by $5.3 billion. Tr. 1680, 2960; Resp. Ex. 129 at Bates 42116. The reductions were to be achieved by moving assets off the balance sheet by such means as trades for forward settlement and reducing outstanding repos. Tr. 713, 1075-76; Resp. Ex. 129 at Bates 42116. Mr. Bernstein was responsible for coordinating the balance sheet reduction efforts and was the liaison between Mr. Cerullo and FI traders. Tr. 713-14, 1646-49, 1668. He directed Mr. Jett to focus on settlement date inventory in order to achieve targets set for the third and fourth quarters of 1993, and in the first quarter of 1994. Tr. 1326-27, 1646-49, 1680-83, 1691-95, 2498-2500, 2961.
For balance sheet purposes, the assets captured as of the reporting date included settled transactions and pending regular way transactions. Resp. Exs. 215, 215A, 216, 216A. A transaction originally entered as a forward transaction remained forward throughout its life, including during the day before settlement date. Resp. Ex. 216 at 4; Resp. Ex. 216A.
a. Pair-Off Roll-Forwards -- Spikes
During the balance sheet reduction efforts, Mr. Jett engaged in "pair-off roll-forwards," which occurred when:
1) an existing exchange, such as a STRIP, was negated by inputting an equal and opposite exchange, such as a recon, to settle for the same amount on the same date; or, similarly, a settled position, such as a long settled STRIPS position, was exchanged for the opposite position, such as a long settled bond position ("pair-off"), and
2) the position was re-established to settle after the quarter end so that it did not appear as an asset on the quarterly balance sheet ("roll-forward").
Tr. 1328-29, 1677-79, 2961-62. Spikes, or sudden increases, in the firms balance sheet were caused when the pair-off transaction was regular way, so that it appeared on the balance sheet, while the equal and opposite forward transactions did not. Tr. 1678-79; Resp. Exs. 215, 215A, 216, 216A. Mr. Bernstein and the accounting department observed spikes in December 1993. Tr. 1677-80. He discussed the spikes with Mr. Cerullo in December or January. Tr. 1110-13, 1678. Since a spike would be caused by pairing any regular way and non-regular way transactions, the existence of spikes in themselves did not reveal anything new about the source of the Respondents profits, although they focused attention on him.
According to the Respondent, Mr. Bernstein told him to engage in pair-off roll-forwards beginning in September 1993, when he had trouble meeting the balance sheet target set for him. 36 Tr. 2961-62. Mr. Bernstein claims not to have known of the practice until he and the accounting department investigated the source of spikes in the balance sheet beginning in December 1993. Tr. 1332-33, 1677-82, 1692-93. Whoever originated the pair-off roll-forward idea, Mr. Bernstein was clearly familiar with the practice throughout the fourth quarter of 1993 and encouraged its use during the balance sheet reduction effort. Tr. 1329; Resp. Exs. 215-18A. Mr. Cerullo knew that the Respondent was using forward trades, but not that they were exchanges with the Fed. Tr. 1075-76, 1644-45, 1769.
b. Inventory Committee
Mr. Cerullo and Kidders CFO, Richard ODonnell, were on an Inventory Committee which met weekly to monitor Kidders balance sheet asset reduction. Tr. 1064-76; Resp. Exs. 128-29, 131-37, 139. Mr. Bernstein sometimes briefed Mr. Cerullo prior to the meetings, particularly towards the ends of the quarters. Tr. 1676-77. Participants received information packages that were an inch or two thick in advance of the meetings. Tr. 1066-67. Resp. Exs. 128-29, 131-37, and 139 are excerpts of a few pages from the packages. Tr. 1066-67, 1070-73, 1095. Starting January 17, 1994, notations in the packages referred to multibillion dollar "Disallowance of non regular way sales (strips)." Resp. Exs. 133-36. Mr. Cerullo did not know that this referred to forward exchanges with the Fed. Tr. 1092-95, 1152.
c. Forward Recons Continue
The Respondent complained about the balance sheet reduction effort but was required to continue through March 1994. Tr. 2982-84; Resp. Exs. 216-18A. He conceded that he entered a 90 day forward recon of relatively small size, avowedly to offset loss which he sustained to assist the firms window dressing. 37 Div. Ex. 96; Div. Ex. 96A at 18-19; Div. Ex. 100 at 8. The record, however, shows a large volume of forward recons during the balance sheet reduction period between September 1993 and March 1994 that is consistent with a continuation of a strategy of booking profits from such exchanges and with the necessity of an ever increasing volume to maintain the pyramid effect of the strategy. See Div. Ex. 152; Resp. Exs. 102A, 102B.
Between September 1993 and March 1994 the Respondent had a pattern of entering long-dated recons, for example, for 90 days, and successive short-dated STRIPS, for example, for seven days at a time, in equal amounts of the same bond. Tr. 2095-97, 2100-01; Div. Exs. 153-54. Because reverse positions were entered, trade date inventory would appear flat, but the remaining days, for example, 83 days, of accrued interest after the STRIP settled would be captured on the books and records of the firm. Tr. 2095-97, 2100-01; Div. Exs. 153-54. After September 1993, the volume of the Respondents exchanges increased greatly and 97% were paired off. Tr. 2105-08, 2112; Div. Ex. 153 at 34, H.
During the period of the balance sheet reduction Mr. Cerullo knew that Mr. Jett was engaging in a large volume of forward settling trades, and Mr. Bernstein knew that he had a high volume of forward exchanges. Kidders understanding that Mr. Jetts profits were unrealized and based on forward exchanges was not, however, advanced.
7. The Diary
The record contains two versions of a computerized diary Mr. Jett kept while employed at Kidder: the Jett version, Resp. Ex. 900, and the Kidder version, Div. Ex. 161. The Jett version was kept by him on his personal computer (PC); the Kidder version was an abbreviated version, kept on Kidders computer, that he uploaded to his secretary. Tr. 585-609, 2860-2901, 2988-89. He claimed that he omitted from the upload entries containing personal information, personnel matters or scandalous material. Tr. 595-96, 601-04, 2862-64, 2870-75. He had possession of his PC for a few weeks after his discharge. Tr. 607, 2865-2868, 2891-92. Many entries which support his testimony concerning various events and which are contrary to other credible record evidence appear only in the Jett version, yet pertain to business matters and do not fall within the criteria for the material that he claimed was omitted from the Kidder version. Tr. 2989-99; Div. Ex. 161; Resp. Ex. 900. While notations in a diary would be expected to reflect the viewpoint of the diarist, these facts indicate additional spin, whether the entries were made contemporaneously with the events they purport to describe or at a later time. Accordingly, no weight has been given to such entries in the findings of fact insofar as they support the Respondents version of disputed facts.
8. Transparency of Reporting
As discussed above, unusual facts amounting to red flags occurred in 1993. The Respondents high and ever increasing profits were widely known, including by Mr. Cerullo. Additionally, the fact that he was engaging in a high and ever increasing volume of forward exchanges with the Fed was known outside the Zero Desk, including by Mr. Bernstein. A general idea of this was easily accessible through the Red Books. Detail concerning these matters could be researched through reports generated and distributed by the firm, for example, the Daily Transaction Journal, the KPPS-98 Report, and the trade tickets. However, to discover the effect of the Respondents activity required more than a cursory glance at the reports.
Tandems Daily Transaction Journal (DTJ) recorded every transaction by ledger and CUSIP number. Tr. 1831, 1885-86, 1892-94; Div. Exs. 1D-8D, 9E-17E, 18F-22F, 130. It was distributed on the trading floor daily and made available to Mr. Mullin and Mr. Cerullo. Tr. 779, 876-77, 1055. It showed trade date and settlement date, identified STRIP and recon account transactions by the offset account number, and showed beginning quantity and ending quantity by CUSIP. Tr. 777, 1886, 1890-93, 2283. While it is possible to calculate the profit from a forward recon from the DTJ, the necessary analysis of the report and calculations are cumbersome. Tr. 1893-94. The component purchase and sale for each recon is recorded and posted separately by CUSIP, and thus in as many as 62 sections of the DTJ (i.e., for the recon of a recently issued 30 year bond, the buy of the bond and the sale of 60 TINTS and the principal piece). Tr. 1883-84, 1888-92; Div. Ex. 130. Thus, calculating profit requires identification of up to 62 entries followed by multi-step calculations for each. Tr. 1883-84, 1892-94.
By September 1993 the KPPS-98 (Version 1) report was in existence; it listed the forward trades that were open on a given date at month end, and was developed as a result of Mr. Fiumefreddos May 1993 project. Tr. 1723-25, 1900-01, 1970-71. It did not give P&L information. Tr. 1900-01, 1970-71. It listed every transaction by CUSIP, that is up to 62 entries for one forward recon. Tr. 1334-35. What is referred to as KPPS-98 Version 2 calculated unrealized P&L for each CUSIP. Tr. 1970-71. Version 2 was used by GE CAS after Mr. Jett was fired. Tr. 1970-71, 2043, 2051; Div. Exs. 1B-17B, 18C-22C. It was not in use during Mr. Jetts employment; Mr. Bernstein used the original version in March 1994. Tr. 1334-38. Thus the KPPS-98 available during Mr. Jetts employment did indicate a large volume of forward exchanges to the reader, but would in itself be only a step in research into uncovering unrealized profits.
The trade tickets, from which information was transferred to Tandem, listed trade date, settlement date, and STRIP or recon account number. Tr. 329-31, 828, 862, 958, 1831, 1881-84, 2490. For a recon they reflected the purchase of a bond and the sale of STRIPS, and priced the STRIPS at forward settlement date. Tr. 1883-85; Div. Ex. 135; Div. Ex. 153 at 7-8, 11-12. However, like the Red Books, the trade tickets did show a large volume of exchanges with the Fed with unusual settlement dates. Mr. Mullin did not review trade tickets, nor did Mr. Cerullo. Tr. 861-62, 955-59.
Other available reports included the:
See generally Div. Exs. 1-37. Given the lack of results from the May 1993 inquiry, which focused on the P&L effect of forward transactions and on the fact that the Respondents forwards were exchanges with the Fed, it is not clear that reviewing the DTJ, trade tickets, or the KPPS-98 would have caused a speedier unmasking of the problem.
E. The Beginning of the End
Mr. Jetts reported profits for 1993 were over $150 million, and he was awarded a bonus of $9.3 million and the Man of the Year Award. Tr. 493-94, 923-24; Div. Ex. 118. On January 8, 1994, Mr. Jett gave an acceptance speech about his trading philosophy to Kidders Management Council at a conference in Florida. Tr. 2984-85; Div. Ex. 118. He reviewed the speech in advance with Mr. Cerullo, who warned him against discussing municipal defeasances 38 (which Mr. Jett has analogized to forward recons in arguing that it is appropriate to book the profit from a transaction in advance of settlement date). Tr. 924, 971-72, 2984-85. The speech focused on the idea that he had broadened Kidders market share by expanding its customer base, a factor which was not related to his exchanges with the Fed. Div. Ex. 118.
In late February, Mr. Cerullo again asked Mr. Bernstein to investigate the source and risk of Mr. Jetts ever-increasing profits. Tr. 926. Mr. Bernstein finally did a thorough investigation, and by the end of March understood the size, nature, and negative P&L consequences of the Respondents forward recons, and told Mr. Cerullo. Tr. 924-29, 1328, 1333-78; Div. Exs. 80, 81, 83, 93, 94. He quantified unrealized profit associated with Mr. Jetts forward positions as exceeding $300 million. Tr. 1358-59. Mr. Cerullo notified Michael Carpenter, the CEO of the firm, who engaged substantial accounting and other staff to investigate the Respondents trading. Tr. 928-30.
In late March, Mr. Cerullo questioned Mr. Jett who offered a series of explanations regarding the alleged false profits, including that:
1) he rolled trades forward because the back office was unable to keep up with his volume of business;
2) Mr. Bernstein told him to do this to reduce the balance sheet; and
3) because of the balance sheet reduction effort he lost money and recouped profits by entering forward recons with the Fed.
Mr. Cerullo concluded that Mr. Jetts entire trading performance was an accounting illusion with no economic substance. Tr. 934, 938-89. He directed Mr. Jett to settle or pair-off his forward positions. Tr. 930-31, 935-36. When Mr. Jett agreed to comply but did not, Mr. Cerullo directed Mr. Bernstein and Mr. Finer to eliminate the positions. Tr. 935-36. The total loss recorded in the trading ledger was over $300 million. Tr. 936.
Similarly conflicting explanations were given in the next several days.
On April 1, 1994, CFO Richard ODonnell questioned Mr. Jett about his strategy; Mr. Jett referenced the hedging component of his strategy; he stated that at the time of the May 1993 discussions with Mr. Bernstein he was entering two week forward recons to allow time to collect the pieces; he correctly noted that there was no danger of the firm having to make a huge cash payment to the Fed when his positions were collapsed, while sidestepping the question of Kidders having to take a write-off. Tr. 1589-91; Div. Exs. 96, 96A. He drafted three memos on April 11 explaining his arbitrage strategy (which he now claims was only in effect from late 1992 to October 1993) and downplaying any P&L effects. Tr. 530-32; Div. Ex. 78.
On April 14, Mr. Jett met with Mr. ODonnell, Mr. Cerullo and others. Div. Ex. 100. Again he blamed the window dressing effort, stating that the problem arose when settled STRIPS positions were turned into forward STRIPS. Div. Ex. 100 at 2, 8-11. He stated that he felt he should not be penalized for the negative P&L effect of the window dressing, implying that he knowingly entered forward recons to counteract that effect. Div. Ex. 100 at 12. He referenced the May 1993 meetings and Mr. Bernsteins alleged approval of forward recons up to 90 days forward. Div. Ex. 100 at 5-6. He stated that the reason for the pair-offs was that his volume overwhelmed the back office in the September and December quarter end months. Div. Ex. 100 at 9. He conceded that the only opportunity for profit in his strategy is from positive carry derived from the hedge component. Div. Ex. 100 at 10-11. This, however, could not account for the huge profits that were booked. Div. Ex. 119 at 10-34. He also implied that his exchanges with the Fed were in furtherance of customer trades. Div. Ex. 100 at 11-12.
On April 15, members of the GE CAS were asked to analyze the situation. Tr. 1824-30. GE retained Davis, Polk as outside counsel. Tr. 1828. On April 17, the Respondent was fired and his account at Kidder was frozen. Tr. 939; Arbitration Between Joseph Jett and Kidder, Peabody & Co., Final Award, Case No. 94-01696 at 2, 6 (NASD Regulation, Inc., Jan. 28, 1998).
While Mr. Jett admitted that he knew that the profits which initially appeared at trade date rolled off each day and were ephemeral, Tr. 532, 541; Div. Ex. 78, he maintains that he never committed fraud or tried to hide anything from Kidder staff, Tr. 2985-86, and that he did nothing wrong given the information which was provided to him. Tr. 580-82. He wants to trade government securities again, but will not engage in forward reconstitutions. Tr. 580-82.
F. Jetts State of Mind
1. What Jett knew
Mr. Jett was aware of the P&L effect of forward recon and STRIP instructions entered on GT. Tr. 532, 541-42, 545-47, 933-34, 938-39; Div. Ex. 78; Div. Exs. 96, 96A; Div. Ex. 100 at 8, 12. He knew the P&L was reflected on Kidders books and records. Tr. 533-34. Further, despite extensive, rather convoluted testimony at the hearing and discussion in phone conversations and meetings with Kidder staff concerning the "time value of money" and "hedging," Tr. 517-47, 563-64, 575-80, 2903-05, 2909-10, 2917-18, 2958-60; Div. Exs. 90-100, he knew that the only real profit opportunity derived from financing and interest, and, therefore, was rather small. Tr. 530-32, 545-47, 2909-10, 2915-17, 2923-28, 3013-15; Div. Exs. 78, 96, 96A, 100. He knew he was credited by Kidder with high profits; it was easy to check the P&L effect of an individual instruction on GT and keep track of his P&L during the day. Tr. 540-42, 1875-76, 2999-3000, 3016; Div. Exs. 92, 92A. The high bonuses and Man of the Year Award confirmed that Kidder credited him with high profits.
Mr. Jett entered many thousands of trades into the G-1 ledger personally, and instructed subordinates to do so when he was away. Tr. 534-36, 582, 988-89, 1476, 3001-05; Div. Exs. 92, 92A, 152. He admits that he deliberately pursued profits booked through entering forward recons. Tr. 533-42, 580-82. The increase of forward recon profits over time, the use of higher coupon bonds for forward recons than for customer trades, and pyramiding corroborate this. Tr. 1971-73, 2095-2101, 2112-21, 2143-50; Div. Exs. 119, 121, 122, 124, 152, 154; Div. Ex. 153 at 31-32, D, F, G, H. There is no evidence to suggest that the high volume of exchanges with the Fed was in furtherance of customer trades. There was only a small percentage of customer trades, especially as time went on. Tr. 2101-04; Div. Ex. 153 at J.
Mr. Jett acknowledged that he knew the P&L effect of entering forward recons by November 1992, when he "became aware of the fact that the forward reconstitutions had a time value of money embedded in them." Tr. 538-39. This roundabout acknowledgment was borne out by his activity in 1993 when he was no longer constrained to corporate settlement. Tr. 536-39, 889; Div. Ex. 152. His discussions with Kidder staff in May 1993 and in 1994 as the profit scheme unfolded also show that he knew the P&L effect throughout 1993. The evidence also shows that he knew during 1992, when he was limited to entering forward recons to five business days forward. Tr. 1971-74, 2092-94, 2101-03; Div. Exs. 121, 122, 152; Div. Ex. 153 at 29-30, 35-36, C, J.
The Respondent argues that Kidder knew and approved of his strategy, then discarded him after his usefulness in obtaining bank financing ended, changed its accounting theories, and pilloried him for the resulting charge against earnings.
2. What Kidder knew
I find that Kidder management did not affirmatively approve the forward recon scheme and the associated unrealized profits. Nor did it know that Mr. Jett was booking unrealized profits through exchanges with the Fed that were recorded by exploiting an anomaly in GT.
Some factors to which the Respondent points were irrelevant to Kidders knowledge of his strategy or his booking unrealized profits: the 1993 Fed inquiry, Coopers & Lybrand audit, and Legal Department report; the 1993 audit by Kidders Internal Audit Department; and the 1993 risk inquiry by Barry Finer.
Additional factors which the Respondent argues show Kidder knew and approved require closer evaluation. The secondary market for U.S. Treasury securities is the most liquid and actively traded financial market in the world. Only limited profits can be made from trading U.S. Treasury bonds and STRIPS. Yet Kidder knew that Mr. Jett was posting enormous, record-breaking profits, purportedly from such trading. Further, Mr. Jett exploited an opportunity created by the operations of Kidders GT; he did not enter false marks into GT. The Red Books were out in the open and available and contained an easily understandable record of a sizable number of large and unusual recons -- dated weeks forward. Mr. Jetts volume of forward exchanges with the Fed was less widely known than his reported profits, but still well known outside the Zero Desk, including by Bernstein, Rizzi and Finkelstein as of May 1993. Mr. Cerullo knew he had forward settling trades of some kind. Mr. Jetts managers had a financial interest in his high profits. Mr. Cerullos compensation was largely based on performance. Tr. 1115-16. Kidders negotiations with the Union Bank of Switzerland during 1994 heightened the importance of high profits and attractive financial statements.
It is doubtful that Kidder would have knowingly allowed hundreds of millions of dollars in unrealized profits to build up and continue to grow over time until, inevitably, they were revealed, with predictably negative consequences for those involved. Yet, superficially these factors by themselves could suggest that Kidder management approved or at least knew that Mr. Jett was booking unrealized profits through forward recons. A closer look shows the contrary. The evidence shows only that Kidder failed to follow up on questions that were raised.
The only record or report that disclosed the existence of the forward exchanges at a glance were the Red Books, informal records kept in 1993 and 1994 calendar notebooks at the Repo Desk. The Red Books did not show P&L. Mr. Mullin and Mr. Cerullo did not know about the Red Books.
When Mr. Mullin supervised the Respondent, his profits were not out of line with his expected performance. When Mr. Cerullo supervised the Respondent, his profits attracted notice. During this period a glance at the Red Books showed a large number of exchanges with the Fed with unusual settlement dates weeks forward. However, Mr. Cerullo did not know about the Red Books. His assistant Mr. Bernstein learned about the forward exchanges and actually inquired into their P&L impact in May 1993. He failed to ask the right questions, and the Respondent did not disabuse him of his understanding that the forward exchanges were P&L neutral. Thereafter, neither Mr. Bernstein nor anyone else inquired into the P&L impact of the forward exchanges until 1994. During the balance sheet reduction program, from September 1993 to the end of the Respondents employment, Mr. Cerullo knew he was engaging in forward transactions, and Mr. Bernstein knew he was engaging in massive forward exchanges with the Fed. However, he continued to rely on his May 1993 understanding that they were P&L neutral, and neither he, nor anyone else, inquired into their P&L impact until late February 1994.
Kidder deployed substantial resources in discovering and investigating the profits when it finally discovered the problem. Tr. 1333-78; 1815-2428; Div. Exs. 1-37, 58-73. The magnitude of these efforts is consistent with the finding that Kidder did not previously approve or know of the forward recon scheme.
The Respondent, who is black, alluded obliquely to problematic race relations at Kidder, but did not otherwise make any allegations or arguments related to this. Tr. 472, 487, 496, 603, 2881-82; Div. Ex. 118. Nonetheless, because Wall Street has been described as lacking diversity, 39 I examined the record for, and did not find, evidence of discriminatory treatment in the firms dealings with him that would bear on its approval or knowledge of the forward recon strategy.
3. Jett knew Kidder did not know
Mr. Jett knew that Kidder had not approved and did not know the source of his profits. He knew that Mr. Bernstein was persuaded in the May 1993 inquiry that unrealized profits were not being booked. The issue of unrealized profits did not come up again until 1994. His explanations to Mr. Cerullo, Mr. ODonnell and others in March and April 1994 were evasive and conflicting, and he ultimately admitted that the only real source of profit was positive carry on a long position in STRIPS, the so-called hedge. This also shows that he knew previously that management did not approve or understand his scheme.
G. Missing Witnesses
The Respondent argues that an adverse inference should be drawn from the fact that the Division did not call what he denominates critical witnesses, Kidder employees Benatar, Fiumefreddo, Ossman, McLaughlin, Unger, and Chersi. He describes Messrs. Benatar and Fiumefreddo as particularly important, stating that the former designed GT, the latter personally investigated the forward recons for P&L distortion, and both were in discussions with Mr. Bernstein in which Mr. Benatar confirmed that Mr. Jetts explanation of how GT recorded profits on forward recons was accurate. Mr. Jett claims that they were unavailable to him as witnesses because the Division had a close relationship with Kidder, and because Kidder caused its employees to refuse to speak with his counsel. He states that they were "peculiarly available" to the Division because of this and that the Division interviewed each one and deposed each one except Messrs. Benatar and Chersi. Additionally, he asserts that Kidder enforced a directive of cooperation with the Division and noncooperation with him by paying legal fees associated with the Jett matter for its employees except him. In support of this argument the Respondent cites a number of cases discussing the "missing witness" jury instruction.
I have not drawn any inference adverse to the Divisions case, or to the Respondents, from the absence of the named witnesses. Additionally, as a matter of law, they were not unavailable to the Respondent as witnesses. United States v. Torres, 845 F.2d 1165, 1170 (2d Cir. 1988). He could have subpoenaed them pursuant to Rule 232 of the Commissions Rules of Practice, 17 C.F.R. § 201.232. Their investigative testimony and Commission interview notes were available to him long in advance of the hearing (unlike the situation in federal criminal cases 40 such as Torres), and he also obtained notes of interviews of Kidder employees conducted by the Davis, Polk law firm in its investigation of the Jett matter. See In re Kidder Peabody Securities Litigation, 168 F.R.D. 459 (S.D.N.Y. 1996). 41 Thus the possibility of surprise in their testimony would have been minimal. Further, when a party calls a hostile witness or a witness identified with an adverse party, interrogation may be by leading questions. Cf. Federal Rules of Evidence, Rule 611(c); 1 Charles T. McCormick, McCormick on Evidence § 6 (John W. Strong ed., 4th ed. 1992).
H. Harm Caused
1. Bonuses of Jett, Cerullo and Mullin
As shown previously, Respondent Jett received larger bonuses from Kidder as his reported profits increased. After a $5,000 bonus in 1991, he was awarded $2.1 million in 1992, and $9.3 million in 1993. There was a deferred component to Kidders bonuses. Tr. 1122-24, 1133; Resp. Ex. 127. Kidder did not, and will not in the future, pay Mr. Jett the deferred portions of the bonuses; it paid to him directly, or on his behalf as tax withholding, $1.54 million of the 1992 bonus and $6.67 million of the 1993 bonus. Arbitration Between Joseph Jett and Kidder, Peabody & Co., Inc., Final Award, Case No. 94-01696, at 4, 6 (NASD Regulation, Inc., Jan. 28, 1998). Of these sums, it paid him directly $950,000 in 1992 and $4.6 million in 1993. Tr. 500.
Mr. Jetts supervisors also received bonuses based in part on his performance. Mr. Mullins 1992 bonus was based in part on his profitability. Tr. 888-89. Mr. Cerullos bonuses were $11.4 million in 1992 and $15.4 million in 1993. Tr. 1115-16; Resp. Ex. 127; cf. Tr. 1135-36, 1153. However, when he resigned from Kidder, his severance payment of deferred compensation was reduced to offset any compensation based on Mr. Jetts activity that he had previously been awarded. Tr. 1118, 1141, 1151, 1154.
2. Damage to Kidders Reputation -- $210 Million Charge
As a result of the Respondents activities Kidder took a $210 million charge ($350 million before taxes) for the first quarter of 1994 to correct the erroneous accounting of the forward recon scheme. Tr. 1972-74, 2262, 2412-16; Div. Exs. 50 at B01, B03; Div. Exs. 121, 122. The charge and the events leading up to it were widely reported in the financial press as a "bond trading scandal." 42
In this section it is concluded that Mr. Jett did not violate the antifraud provisions, Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, but did aid and abet and cause Kidders books and records violations. He acted with scienter and made material misrepresentations, but his activities were not "in the offer or sale of any securities" or "in connection with the purchase or sale of any security" within the meaning of the antifraud provisions. He aided and abetted and caused Kidders books and records violations in that its ledgers and FOCUS Reports reflected his nonexistent profits.
A. Antifraud Provisions
The OIP charged Mr. Jett with violating Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, commonly referred to as the antifraud provisions. Sections 17(a)(1) and (2) of the Securities Act make it unlawful "in the offer or sale of" securities, by jurisdictional means, to:
1) employ any device, scheme, or artifice to defraud, or
2) obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary to make the statement made not misleading. 43
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder proscribe similar practices "in connection with" the purchase or sale of securities.
Scienter is required to establish violations of Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; it is "a mental state embracing intent to deceive, manipulate, or defraud." See Aaron v. SEC, 446 U.S. 680, 686 & n.5, 695-97 (1980); see also Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12 (1976). 44
Recklessness can satisfy the scienter requirement under Securities Act Section 17(a)(1) and Exchange Act Section 10(b) and Rule 10b-5 thereunder. David Disner, 63 SEC Docket 2246, 2254 & n.20 (Feb. 4, 1997); SEC v. Steadman, 967 F.2d 636, 641-42 (D.C. Cir. 1992); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990), cert. denied, 499 U.S. 976 (1991). Reckless conduct is conduct which is "highly unreasonable and which represents an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir.), cert. denied, 439 U.S. 1039 (1978) (quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977)).
The record shows the Respondents scienter; his intent was to deceive and defraud. He entered a series of forward recons in a pyramid like manner, in order to book profits which were in fact nonexistent and receive large bonuses based on the profits. He engaged in this activity for more than two years, until he was fired. To enter a forward recon and check the resulting status of his P&L for the day took only a few seconds. He knew that the P&L effect of his forward recons was unrealized and required adjustment. When questioned by Kidder management and accountants during his employment at Kidder, he did not fully disclose the details of his strategy and misled them as to the P&L consequences. He knew that Kidder did not understand the source of his profits. When the fraud was finally discovered, he denied wrongdoing and gave misleading and conflicting explanations. Only at the very end of his employment at Kidder did he concede that the only profit opportunity in his purported strategy was from positive carry in owning STRIPS and thus minuscule in comparison with the profits which he had booked.
The Respondent could not have believed that his profits were anything but nonexistent. He completed the M.B.A. program at Harvard University and worked in mortgage-backed securities for three years before coming to Kidder. His Man of the Year Award speech shows clearly that he understood the dynamics of the Government market and that such high profits are unheard of in STRIPS and bond trading. Any bond trader would have understood that a low risk high profit opportunity does not persist and that his purported three part strategy has costs which minimize profits.
In conclusion, the Respondent acted with scienter; his intent was to deceive and defraud. His large bonuses, which provide a motive, and his misleading Kidder staff seeking to investigate his profitability support this conclusion.
In the alternative, the Respondent was reckless in not knowing that his strategy was a "device, scheme, or artifice to defraud." Assuming arguendo that he did not intend to defraud Kidder, the unreal size of his profits was so obvious that he must have been aware that his strategy was questionable. Thus, he was reckless in relying on Kidders failing to stop him or to conduct a meaningful investigation into the source of his profits.
2. Material Misrepresentations
The record also shows material misrepresentations within the meaning of Securities Act Section 17(a)(2) and Exchange Act Section 10(b) and Rule 10b-5(2) thereunder. For the reasons stated above these were made with scienter.
Kidders financial statements included nonexistent, unrealized profits resulting from the Respondents forward recons. The record shows that these inaccuracies resulted from the intentional acts of the Respondent in entering a series of forward recons so as to book large profits and receive large bonuses as a result. Accordingly, his actions implementing the recon strategy were misrepresentations within the meaning of Securities Act Section 17(a)(2) and Exchange Act Section 10(b) and Rule 10b-5(2) thereunder.
The Respondent did not disclose his false profit strategy to Kidder management and accountants when asked. He did not fully disclose the details of his strategy, and misled them as to the P&L consequences. These dealings with Kidder staff also constituted intentional misstatements and omissions within the meaning of Securities Act Section 17(a)(2) and Exchange Act Rule 10b-5(2).
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 Kidder. See SEC v. Steadman, 967 F.2d at 643; see also Basic Inc. v. Levinson, 485 U.S. 224, 231-32, 240 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
The reasonable investor would consider a $300 million inaccuracy in a broker-dealers financial statements to be material, whether he were a potential investor in the broker-dealer or a customer making investments through the broker-dealer and relying on the accuracy of its accounting in handling his account. Accordingly, the Respondents misrepresentations in implementing the forward recon strategy and in his dealings with Kidders questions about it were material.
3. "In Connection With"
The Respondents fraudulent activities were not "in the offer or sale of any securities" or "in connection with the purchase or sale of any security" within the meaning of the antifraud provisions. 45 The actions of an employee of a broker-dealer are not "in connection with the purchase or sale of any security" merely because he defrauded his employer.
While the antifraud provisions are most often applied in cases of fraud against the investing public, they can also apply to fraud against broker-dealers. U.S. v. Naftalin, 441 U.S. 768, 774-77 (1979) (Section 17(a)); A. T. Brod & Co. v. Perlow, 375 F.2d 393, 396-97 (2d Cir. 1967) (Section 10(b) and Rule 10b-5). In those cases customers defrauded broker-dealers with "heads I win, tails you lose" schemes. 46 There is not, however, any precedent case that held fraudulent practices by an employee against his broker-dealer employer, in itself and not otherwise "in connection with the purchase or sale of any security," to violate the antifraud provisions.
The Division argues that the Respondents activities were in connection with the purchase or sale of securities. Its argument rests on broad, general, statements made in cases in which courts concluded fraud was "in connection with" specific purchases and sales of securities. It cites the well-known "touching" language from Superintendent of Insurance of New York v. Bankers Life & Casualty Co., 404 U.S. 6 (1971): "The crux of the present case is that (the fraud victim) suffered an injury as a result of deceptive practices touching its sale of securities as an investor." Id. at 12-13. 47 In that case the seller of securities was duped into thinking it would receive the proceeds of its sale but was deprived of the proceeds by a deceptive device. The Division further cites United States v. Newman to argue that the "in connection with" requirement is satisfied where accomplishment of a fraudulent scheme is "directly related to the trading process." United States v. Newman, 664 F.2d 12, 18 (2d Cir. 1981) (quoting Competitive Associates, Inc. v. Laventhol, Krekstein, Horwath & Horwath, 516 F.2d 811, 815 (2d Cir. 1975)). In the Newman case the court ruled favorably on the misappropriation theory of insider trading; the defendant had traded based on material, non-public information obtained by other individuals who misappropriated confidential information from their investment banker employers concerning planned mergers and acquisitions.
In opposition the Respondent cites the leading case of Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930 (2d Cir. 1984), cert. denied, 469 U.S. 884 (1984) and other cases from courts within the Second Circuit. 48 In Chemical Bank the court held that misrepresentations concerning the financial condition of a borrower were not made "in connection with" by the fact that stock, concerning which there was no misrepresentation, was pledged as security for the loan. The opinion by Judge Friendly examined "in connection with" at some length. Chemical Bank, 726 F.2d at 939-45. The court opined that "touching" was merely a variation of "in connection with" as a matter of literary style and urged that cases near the borderline be decided on a cautious case-by-case approach. Id. at 942-43.
b. Exchanges Were Not Purchases or Sales
In the cited cases, purchases or sales occurred. The issue was the connection of the fraud to the transactions. In the instant case there were no purchases or sales. Kidders internal recordkeeping created the opportunity for nonexistent profits by treating STRIP and recon exchanges with the Fed as a buy of one side of the exchange and a sell of the other. The exchanges were not, however, purchases and sales within the meaning of the antifraud provisions. A STRIP or recon exchange is not a "disposition of a security or interest in a security" within the meaning of the Securities Act and Exchange Act. See Section 2(a)(3) of the Securities Act and Section 3(a)(13) and (14) of the Exchange Act. As to those exchanges that were "settled," the record establishes that the Feds role was essentially clerical in converting securities from one form to another and that the exchanges were economic nullities. 49 After September 1993 almost none of the forward exchanges entered into GT even "settled." They were paired off and existed only in Kidders recordkeeping systems. Therefore the Respondents profits from forward recons were not "in the offer or sale" or "in connection with the purchase or sale" of securities within the meaning of the antifraud provisions.
c. "Directly related to the trading process"
The Division argues that the Respondents fraud was "directly related" to his real trading of STRIPS and bonds, referencing the phrase, quoted supra, from the (pre-Chemical Bank) Newman case. The Division reasons that the forward recons covered up losses in real trading and therefore were in connection with the real trading. 50 The profits from forward recons induced Kidder to continue allowing the Respondent to buy and sell bonds; without them, the Division implies, the Respondent would have been fired. The Division also points out that, for a time, netting with real purchases of STRIPS on the Respondents trade date inventory tended to mask his short STRIPS position caused by the forward recons. Indeed, the Division points out, the Respondent claimed (not altogether accurately) that part of his strategy was to purchase STRIPS.
Factually, rather than showing the forward recons were "directly related" to purchases and sales, the record shows a tenuous, indirect, relationship. The enormous, record-breaking, profits resulting from the forward recons dwarfed any losses from real trading. If some indications of the Respondents activities were masked by netting with real trading, other indications remained. The Respondent could have ceased real trading altogether without affecting his ability to create profits and obfuscate their source. The forward recon scheme existed independently from real trading and was not "in connection with" actual purchases and sales in which the Respondent engaged.
Legal analysis of the relationship of the Respondents forward recon scheme to his actual trading of STRIPS and bonds is aided by Judge Friendlys oft-quoted language from Chemical Bank:
The purpose of § 10(b) and Rule 10b-5 is to protect persons who are deceived in securities transactions -- to make sure that buyers of securities get what they think they are getting and that sellers of securities are not tricked into parting with something for a price known to the buyer to be inadequate or for a consideration known to the buyer not to be what it purports to be.
726 F.2d at 943. There is no evidence whatever to suggest that the parties to the Respondents real trading were deceived in those transactions by the Respondents forward recon scheme.
The Divisions quote of a general statement taken out of context does not support a conclusion that the Respondents forward recon activities were "in connection with." In the Newman case the fraudulent scheme enabled Newman to profit from purchases and sales of securities. It could also be said that Newmans counterparties were deceived as to the prices paid in the securities transactions. In any event, subsequent to the Chemical Bank case, reliance on "directly related to the trading process" as a standard is ill-advised because of its breadth and generality. In the instant case, the fraud was not directly related to purchases and sales; the only relationship to purchases and sales is that Respondent was in a position to engage in the fraud because he was employed to engage in the purchase and sale of Treasury securities.
B. Books and Records Violations
The OIP charged Mr. Jett with aiding and abetting and causing violations of Exchange Act Section 17(a) and Rules 17a-3(a)(1), 17a-3(a)(2), 17a-3(a)(7), and 17a-5 thereunder. 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." The requirement that records be kept embodies the requirement that they be accurate. James F. Novak, 47 S.E.C. 892, 897 (1983).
The Commission has emphasized the importance of the records required by 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, 1974 SEC LEXIS 3290 (Apr. 26, 1974). The recordkeeping rules are "a keystone of the surveillance of brokers and dealers by our staff and by the security industrys self-regulatory bodies." Edward J. Mawod & Co., 46 S.E.C. 865, 873 n.39 (1977) (citations omitted), affd, 591 F.2d 588 (10th Cir. 1979). Scienter is not required to prove a violation of Section 17(a)(1) of the Exchange Act and the rules thereunder. SEC v. Drexel Burnham Lambert Inc., 837 F. Supp. 587, 610 (S.D.N.Y. 1993), affd sub nom. SEC v. Posner, 16 F.3d 520 (2d Cir. 1994), cert. denied, 513 U.S. 1077 (1995); Stead v. SEC, 444 F.2d 713, 716-17 (10th Cir. 1971), cert. denied, 404 U.S. 1059 (1972).
1. Rules 17a-3(a)(1), 17a-3(a)(2) and 17a-3(a)(7)
Rule 17a-3 requires brokers and dealers to make and keep current certain books and records, including:
1) blotters containing an itemized daily record of all purchases and sales of securities, all receipts and deliveries, all receipts and disbursements of cash and all other debits and credits (Rule 17a-3(a)(1));
2) ledgers reflecting all assets and liabilities, income and expense and capital accounts (Rule 17a-3(a)(2)); and
3) memoranda of each purchase and sale of securities for the account of the member, broker, or dealer showing the price and, to the extent feasible, the time of execution (Rule 17a-3(a)(7)).
Kidder violated Section 17(a) of the Exchange Act and Rule 17a-3(a)(2) because its ledgers reflected Respondent Jetts nonexistent, unrealized, profits.
There was no violation of Rules 17a-3(a)(1) and 17a-(3)(a)(7). The blotters and order tickets accurately reflected the exchanges that the Respondent entered. 51
2. Rule 17a-5
Exchange Act Rule 17a-5(a)(2)(ii) requires brokers and dealers who clear transactions or carry customer accounts to file accurate quarterly FOCUS Reports, which contain statements of financial condition and income. Kidder filed inaccurate FOCUS Reports when it included Respondent Jetts nonexistent, unrealized, profits in the statement of income portion of the reports.
3. Aiding and Abetting; Cause
For aiding and abetting violations of the federal securities laws, three elements must be present: i) a primary or independent securities law violation that has been committed by some other party; ii) awareness or knowledge by the aider and abettor that his or her role was part of an overall activity that was improper; and iii) that the aider and abettor knowingly and substantially assisted the conduct that constitutes the violation. Woods v. Barnett Bank of Fort Lauderdale, 765 F.2d 1004, 1009 (11th Cir. 1985); Investors Research Corp. v. SEC, 628 F.2d 168, 178 (D.C. Cir.), cert. denied, 449 U.S. 919 (1980); IIT v. Cornfield, 619 F.2d 909, 922 (2d Cir. 1980); Woodward v. Metro Bank of Dallas, 522 F.2d 84, 94-97 (5th Cir. 1975); SEC v. Coffey, 493 F.2d 1304, 1316 (6th Cir. 1974), cert. denied, 420 U.S. 908 (1975); William R. Carter, 47 S.E.C. 471, 502-03 (1981).
The knowledge or awareness requirement can be satisfied by recklessness when the alleged aider and abettor is a fiduciary or active participant. See Ross v. Bolton, 904 F.2d 819, 824 (2d Cir. 1990); Cornfield, 619 F.2d at 923, 925; Rolf, 570 F.2d at 45-48; Woodward, 522 F.2d at 97.
The first and third elements, that a primary violation was committed by Kidder and that Mr. Jett knowingly and substantially assisted the conduct that constitutes the violation, are clearly present. 52 The second element, awareness or knowledge that his role was part of an overall activity that was improper, is present as well. He was well aware of the P&L effect of booking forward recons. He knew that the P&L effect of his forward recons required adjustment to be accounted for legitimately. He knew that his forward recons and the associated nonexistent profits were reflected on the books and records of the firm. Because of his education and work experience he was aware of the importance of a broker-dealers recordkeeping and that the P&L effect of his forward recons would affect financial records such as ledgers and FOCUS reports and thus cause them to be inaccurate. Based on the same reasoning, Mr. Jett was also a "cause," within the meaning of Exchange Act Section 21C, of Kidders violation of Section 17(a)(1) and Rules 17a-3(a)(2) and 17a-5(a)(2)(ii).
The Division requests sanctions pursuant to Sections 8A of the Securities Act and 15(b)(6), 21B, and 21C of the Exchange Act. The Commission must find willful violations to impose sanctions under Sections 15(b)(6) and 21B of the Exchange Act. It is well settled that a finding of willfulness does not require an intent to violate, but merely an intent to do the act which constitutes a violation. Steadman v. SEC, 603 F.2d 1126, 1135 (5th Cir. 1979), affd on other grounds, 450 U.S. 91 (1981); Arthur Lipper Corp. v. SEC, 547 F.2d 171, 180 (2d Cir. 1976), cert. denied, 434 U.S. 1009 (1978); Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965). The acts which constituted the Respondents violations were, as described above, clearly intentional. The acts included a series of entries into GT made by the Respondent or under his direction to carry out his forward recon strategy and his material misrepresentations and omissions. His violations were thus willful.
The Division requests a cease and desist order; a bar from association with any broker or dealer, without a right to reapply; disgorgement of $11.4 million plus prejudgment interest; and third-tier civil penalties of $11.4 million. The Respondent urges that this proceeding be dismissed and does not address possible sanctions.
For the reasons discussed below, these sanctions will be ordered: a cease and desist order; a bar from association with any broker or dealer; $8.21 million in disgorgement plus prejudgment interest; and $200,000 in third-tier civil penalties.
A. Sanction Considerations
When the Commission determines administrative sanctions, it considers:
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 at 1140 (quoting SEC v. Blatt, 583 F.2d 1325, 1334 n.29 (5th Cir. 1978)).
The Commission determines sanctions pursuant to a public interest standard. 53 Thus, in addition to issues related to the violator, it "weigh(s) the effect of (its) action or inaction on the welfare of investors as a class and on standards of conduct in the securities business generally." Arthur Lipper Corp., 46 S.E.C. 78, 100 (1975); Richard C. Spangler, Inc., 46 S.E.C. 238, 254 n.67 (1976).
I reviewed Commission opinions imposing sanctions in litigated 54 administrative proceedings that arose after the effective date of the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (Remedies Act) 55 as precedent for the appropriate sanction or combination of sanctions in the instant case. 56 The Commission has, however, "stated on numerous occasions that sanctions are determined on a case-by-case, facts and circumstances basis and cannot be precisely determined by comparison with action taken in other cases." Consolidated Investment Services, Inc., 61 SEC Docket 20, 32 (Jan. 5, 1996) (citing and quoting Frank J. Custable, Jr., 51 S.E.C. 855, 863-64 (1993); Richard R. Perkins, 51 S.E.C. 380, 388 (1993); Butz v. Glover Livestock Commission Co., 411 U.S. 182, 187 (1973); Hiller v. SEC, 429 F.2d 856, 858-59 (2d Cir. 1970)). 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); Leo Glassman, 46 S.E.C. 209, 211-12 (1975).
Most Commission opinions imposing severe sanctions such as the Division requests involved respondents who violated the antifraud provisions. No Commission opinion in a litigated case imposed such sanctions for aiding and abetting books and records violations. 57 The Commission has, however, imposed severe sanctions in cases where there were no violations of the antifraud provisions but where there was a lack of honesty and candor. See Ahmed Mohamed Soliman, 59 SEC Docket 356 (Apr. 17, 1995); 58 First Securities Transfer Systems, Inc., 60 SEC Docket 441 (Sept. 1, 1995). 59 Opportunities for dishonesty recur constantly in the securities business, and this necessitates special legal treatment. Richard C. Spangler, Inc., 46 S.E.C. at 252 (citing Arthur Lipper Corp., 46 S.E.C. at 101 n.7; Archer v. SEC, 133 F.2d 795, 803 (8th Cir.), cert. denied, 319 U.S. 767 (1943); Hughes v. SEC, 174 F.2d 969, 975 (D.C. Cir. 1949)); see also Benjamin G. Sprecher, 64 SEC Docket 720, 730 n.36 (April 8, 1997). The Respondents violative actions involved dishonesty and fraudulent intent. Thus, more severe sanctions are appropriate in the public interest than might usually be associated with books and records violations.
1. Cease and Desist
Section 21C of the Exchange Act authorizes the Commission to issue cease and desist orders if it finds that any person "is violating, has violated, or is about to violate" any provision of the Act or rule thereunder. It may enter a cease and desist order against "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."
As concluded above, Respondent Jett was a cause, within the meaning of Exchange Act Section 21C, of Kidders violations of Exchange Act Section 17(a) and Rules 17a-3 and 17a-5 thereunder. Further, the record shows a reasonable likelihood of such violations in the future. 60 The relevant factors to consider when assessing the likelihood of recurrent violation include "whether a defendants violation was isolated or part of a pattern, whether the violation was flagrant and deliberate or merely technical in nature, and whether the defendants business will present opportunities to violate the law in the future." SEC v. Steadman, 967 F.2d at 648 (quoting SEC v. First City Fin. Corp., 890 F.2d 1215, 1228 (D.C. Cir. 1989)).
The Respondents actions in furtherance of his forward recon scheme that caused the books and records violations extended over more than two years; thus his violation was not isolated but was part of a pattern. Also, the violation was closer to "flagrant and deliberate" than "merely technical." His business will present opportunities to violate the law in the future. A lack of recognition of the wrongful nature of his conduct adds to the likelihood of future violation. Accordingly, it is appropriate to order him to cease to cease and desist from committing or causing any violations or future violations of Exchange Act Section 17(a) and Rules 17a-3 and 17a-5 thereunder. 61
The Division requests that the Respondent be barred from association with any broker or dealer, without a right to reapply for such association. Based on the factors discussed in Steadman v. SEC, 603 F.2d at 1140, it is appropriate to bar the Respondent from association with a broker-dealer. The Respondents violations were egregious, as shown by the multimillion dollar bonuses that resulted from them and that were the purpose of his course of action. The violative activity was recurring, in that it continued for more than two years. A high degree of scienter is indicated by his education, experience in the securities business, drive, and work ethic, as well as the bonuses. Moreover, he knew that Kidder did not understand the source of his profits. There is a likelihood that his occupation will present opportunities for future violations. The Respondent has credibly disavowed any intent to engage in activities precisely like those at issue in the future. Consistent with his vigorous defense to the charges against him, he has not otherwise, in this proceeding, recognized the wrongful nature of his conduct. Nor did he do so in the course of his employment at Kidder; even when the fraud was finally discovered, he denied wrongdoing and gave misleading and conflicting explanations.
The phrase "without a right to reapply" will not be added to the bar. It does not appear in the authorizing statute, Exchange Act Section 15(b). Nor is there precedent for a bar "without a right to reapply." For example, the phrase does not appear in the bar imposed on Meyer Blinder, an unusually egregious securities law violator. Meyer Blinder, 65 SEC Docket 1970 (Oct. 1, 1997). Finally, such a phrase could never be more than hortatory.
Occasionally the Commission imposes a bar with a proviso that a respondent can reapply within a specified period of time. 62 The few litigated cases in which this has occurred since the Remedies Act provided the Commission with alternative sanctions do not establish standards for adding such a proviso to a bar. 63 Accordingly, none will be added in this case.
Exchange Act Section 21C(e) authorizes disgorgement in this proceeding. While that section refers to "payments to investors" in connection with disgorgement, "(t)he purpose of disgorgement is to force a defendant to give up the amount by which he was unjustly enriched rather than to compensate the victims of fraud." SEC v. Blavin, 760 F.2d 706, 713 (6th Cir. 1985) (quoting SEC v. Commonwealth Chemical Securities, Inc., 574 F.2d 90, 102 (2d Cir. 1978)). See also SEC v. Tome, 833 F.2d 1086, 1096 (2d Cir. 1987), cert. denied, 486 U.S. 1014 (1988); H. Rep. 101-616 (1990); Rule 600 of the Commissions Rules of Practice, 17 C.F.R. § 201.600, Comment; Rule 620, Comment. While the Commission has authority to provide for return of ill-gotten gains to investors, there is no requirement that it do so. Rule 611, Comment (c).
Disgorgement is an equitable remedy that requires a violator to give up wrongfully obtained profits. It returns him to where he would have been absent the violative activity. Mr. Jett booked over $300 million in illusory profits, and, as a consequence, was awarded $11.4 million in bonuses -- $2.1 million at the end of 1992, and $9.3 million at the end of 1993. 64 Mr. Jett would not have received such bonuses but for the forward recon scheme. The presence of the illusory profits in Kidders books and records caused Kidder to pay the bonuses; thus they are causally related to the proven wrongdoing. First City Fin. Corp., 890 F.2d at 1230-31; see also Hateley v. SEC, 8 F.3d 653, 655-56 (9th Cir. 1993). Accordingly, disgorgement is appropriate in this case.
Kidder actually paid $8.21 million of the $11.4 million; it held the remainder as deferred compensation and did not pay it after firing Mr. Jett. The $8.21 million was paid to Mr. Jett directly ($5.5 million) or on his behalf as tax withholding. Accordingly, $8.21 million is the appropriate disgorgement amount.
Kidders inaction increased the amount of the ill-gotten gains by the approximate amount of the 1993 bonus that it paid ($6.67 million). Mr. Jetts reported profits were not out of line with expectations in 1992, but they skyrocketed during 1993, and, even after being alerted by red flags, Kidders attempts to understand and investigate them were incomplete. Kidder did not, however, knowingly encourage the Respondent to pursue the forward recon scheme and book illusory profits. Thus the disgorgement amount will not be reduced from $8.21 million.
4. Civil Penalties
Exchange Act Section 21B authorizes the Commission to impose civil money penalties for willfully aiding and abetting violations of the Exchange Act or rules thereunder. In considering whether a penalty is in the public interest, the Commission may consider six factors: (1) fraud, (2) harm to others, (3) unjust enrichment, (4) previous violations, (5) deterrence, and (6) such other matters as justice may require. Section 21B(c).
The 1990 Remedies Act authorized civil money penalties (in addition to disgorgement) in proceedings by the Commission in the federal courts as well as penalties and disgorgement in administrative proceedings. There have been relatively few published opinions in litigated cases in any forum which quantified penalties or discussed the choice of penalties and/or disgorgement as sanctions. 65
As concluded above, Mr. Jett willfully aided and abetted Kidders violations of Exchange Act 17(a) and Rules 17a-3(a)(2) and 17a-5. His acts or omissions which constituted aiding and abetting Kidders books and records violations "involved fraud, deceit . . . or deliberate or reckless disregard of a regulatory requirement" within the meaning of Exchange Act Section 21B(c)(1). The harm to Kidder and his unjust enrichment are quantified in the $8.21 million in bonuses he received as a result of his course of action. Mr. Jett has no previous violations or disciplinary record. Nor is there any indication in the record of harm to customers or counterparties. With reference to "such other matters as justice may require," Kidders initial hesitant response to red flags is again noted. A more aggressive investigation of questions raised by the Respondents high profits would have reduced unjust enrichment and the harm to Kidder.
A penalty is appropriate in this case. Although the disgorgement amount is significant, it is the amount which the Respondent received as a result of his violative activity. Merely returning his gains with interest leaves him no worse off financially than if he had not violated the law. A penalty in addition to disgorgement is necessary for the purpose of deterrence. See Exchange Act Section 21B(c)(5); H. Rep. 101-616 (1990). A third tier penalty is appropriate because the violative acts involved deceit and resulted in substantial pecuniary gain to the Respondent. See Section 21B(b)(3).
The maximum third tier penalty for a natural person for "each act or omission" is $100,000 for the violations in this proceeding. 66 The statute, like most civil penalty statutes, leaves the precise unit of violation undefined. See Colin S. Diver, The Assessment and Mitigation of Civil Money Penalties by Federal Administrative Agencies, 79 Colum. L. Rev. 1435, 1440-41 (1979). In the instant case the unit could be each forward recon, which would result in an astronomical maximum penalty. Alternatively, the Respondents entire course of action could be considered as one violation, which would result in a maximum penalty of $100,000. The Division has requested a penalty approximating the bonuses Mr. Jett was awarded as a result of the forward recon scheme, that is, $11.4 million. A penalty of this size is excessive because there was no violation of the antifraud provisions and because of the mitigating factors. I conclude that two courses of action form the basis for two violations and for penalties: his forward recons through 1992, which resulted in a $2.1 million bonus, and his 1993 and 1994 forward recons, which were bolder and far more profitable to him. Accordingly, a third-tier penalty of $200,000 is appropriate.
Based on the findings and conclusions set forth above:
IT IS ORDERED that, pursuant to Section 21C of the Exchange Act, 15 U.S.C. § 78u-3, Orlando Joseph Jett cease and desist from committing or causing any violations or future violations of Exchange Act Section 17(a), 15 U.S.C. § 78q(a), and Rules 17a-3 and 17a-5 thereunder, 17 C.F.R. §§ 240.17a-3, .17a-5.
IT IS FURTHER ORDERED that, pursuant to Sections 15(b) and 19(h) of the Exchange Act, 15 U.S.C. §§ 78o(b) and 78s(h), Orlando Joseph Jett be, and hereby is, barred from association with any broker or dealer.
IT IS FURTHER ORDERED that, pursuant to Section 21C of the Exchange Act, 15 U.S.C. § 78u-3, Orlando Joseph Jett disgorge $8.21 million plus prejudgment interest at the rate established under Section 6621(a)(2) of the Internal Revenue Code, 26 U.S.C. § 6621(a)(2), compounded quarterly, pursuant to Rule 600 of the Commissions Rules of Practice, 17 C.F.R. § 201.600. Pursuant to Rule 600(a), prejudgment interest is due on $6.67 million from January 1, 1994, and on $1.54 million from January 1, 1993, through the last day of the month preceding which payment is made.
IT IS FURTHER ORDERED that, pursuant to Section 21B of the Exchange Act, 15 U.S.C. § 78u-2, Orlando Joseph Jett pay a civil penalty in the amount of $200,000.
Payment shall be made on the first day after this decision becomes final. Such payment shall be: (i) made by United States postal money order, certified check, bank cashier's check or bank money order; (ii) made payable to the Securities and Exchange Commission; (iii) delivered by hand or courier to the Office of the Secretary, Securities and Exchange Commission, 450 Fifth St., N.W., Washington, D.C. 20549; and (iv) submitted under cover letter which identifies Orlando Joseph Jett as the Respondent in these proceedings, and the file number of these proceedings. The Division shall submit a plan of disgorgement no later than sixty (60) days after Respondent Jett has paid any or all of the disgorgement amount and interest.
This order shall become effective in accordance with and subject to the provisions of Rule 360, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this initial decision may be filed within twenty-one (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 twenty-one (21) days after service of the initial decision upon him, 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
-- The OIP was amended by Order of February 2, 1996, to correct errors in internal references.
-- Additionally, the OIP alleged that Melvin Mullin failed reasonably to supervise Respondent Jett. Respondent Mullin's portion of these proceedings was settled. Orlando Joseph Jett and Melvin Mullin , Order Making Findings and Imposing Remedial Sanctions Against Melvin Mullin, 61 SEC Docket 2852 (May 20, 1996).
-- Citations to exhibits offered by the Division and the Respondent and to the transcript of the hearing will be noted as "Div. Ex. __," "Resp. Ex. __," and "Tr. __," respectively.
-- The Respondent argues that the Due Process Clause of the U.S. Constitution requires the Division to prove its case by clear and convincing evidence. As stated in my Order Ruling on Motion for Summary Disposition, 61 SEC Docket 2949, 2951 (May 17, 1996), preponderance of the evidence is the standard of proof in Commission administrative proceedings. See Steadman v. SEC , 450 U.S. 91 (1981). See also Seaton v. SEC , 670 F.2d 309, 311 (D.C. Cir. 1982).
-- See 5 U.S.C. § 557(c).
-- FOCUS is an acronym for Financial and Operational Combined Uniform Single (Report). Pursuant to Rule 17a-5, Kidder filed its FOCUS Reports with the New York Stock Exchange, which transmitted them to the Commission. See, e.g. , Div. Ex. 23H.
-- Window dressing has been defined as "accounting gimmickry designed to make a financial statement show a more favorable condition than actually exists -- for example by omitting certain expenses, by concealing liabilities, by delaying write-offs, by anticipating sales, or by such other actions, which may or may not be fraudulent." John Downes & Jordon Elliot Goodman, Barron's Dictionary of Finance and Investment Terms 657-58 (4th ed. 1995). See also Resp. Ex. 130 at 1.
-- In December 1994, PaineWebber Group, Inc. issued $670 million in securities in exchange for key assets of Kidder. PaineWebber Closes Kidder, Peabody Purchase Ahead of Schedule , Business Wire (Dec. 16, 1994). In upholding the dismissal of a class action against GE that resulted from the matters at issue in this proceeding, the court of appeals noted: "GE had acquired 80 percent of Kidder for $620 million in 1986. Shortly thereafter, an insider trading scandal was exposed at Kidder, resulting in a $26 million fine paid to the (Commission) and the implementation of a compliance system at Kidder to detect fraudulent trading. Kidder's business declined, with losses of $53 million posted in 1989, and $54 million in 1990. In 1990, GE acquired the remaining 20 percent of Kidder in a $550 million bailout transaction. Following this transaction, Kidder began turning a profit, and did so throughout 1991, 1992 and 1993." Chill v. General Electric Company , 101 F.3d 263, 265 (2d Cir. 1996). The 1987 sanction against Kidder is reported at SEC v. Kidder, Peabody & Co. , 1987 U.S. Dist. LEXIS 15884 (S.D.N.Y. 1987); Kidder was enjoined from antifraud and other violations and ordered to disgorge $13.7 million and pay a civil penalty of $11.7 million.
-- Market making is making bids and offers to customers, both institutional and retail. Tr. 827. In proprietary trading for the firm's own account, trade is initiated by the trader rather than in response to a customer order. Tr. 827.
-- The courses he took included Finance, Capital Markets, Corporate Financial Management, Management of Financial Service Organizations, and New Financial Instruments in the Capital Markets. Div. Ex. 55 at Bates 000041.
-- Mr. Cerullo submitted an Offer of Settlement, which the Commission accepted, in anticipation of the institution of administrative proceedings against him in this matter. Edward A. Cerullo , Order Instituting Public Administrative Proceedings, Making Findings, and Imposing Remedial Sanctions, 61 SEC Docket 82 (Jan. 9, 1996).
-- GE's 10-Q for the first quarter of 1994 stated that the write-off was $210 million ($350 million before tax), and that $139 million of the write-off related to periods prior to 1994. Div. Ex. 50 at B01, B03. The Division's estimate of false profits was $338 million. Tr. 1972-74, 2262, 2412-16 ; Div. Ex. 121 .
-- "Notes" are Treasury securities with original maturities of between two and ten years and are issued as coupon securities; "bills" are those with original maturities of one year or less and are issued as zero coupon securities. Div. Ex. 119 at A1. See also Downes & Goodman, supra , at 617.
-- STRIPS is an acronym of Separate Trading of Registered Interest and Principal of Securities. TINTs (Treasury Interest Securities) are the coupon payments, and TPRN or corpus refers to the principal piece. Tr. 783-84, 1881; Div. Ex. 119 at A3-A4.
-- See, e.g. , Div. Ex. 1F; Tr. 385-90.
-- Every stock or registered bond is identified by a CUSIP number, using the Committee of Uniform Securities Identification Procedures. Tr. 393; Downes & Goodman, supra , at 122-23.
-- See, e.g. , Div. Ex. 1D; Tr. 775-77, 1831.
-- See, e.g. , Div. Ex. 1E; Tr. 375-79.
-- See, e.g. , Div. Ex. 1B; Tr. 391-98.
-- Profits from the Respondent's activities that are at issue in this proceeding were recorded in the quarterly FOCUS Reports from March 1992 through March 1994. Tr. 165-66.
-- The Fixed Income or Government Daily P&L/Inventory Report included a "Net Interest" value. Tr. 988-91, 1977; Resp. Ex. 120. Likewise the PPR-2 Report included a "carry" value. See, e.g. , Div. Ex. 1F. The net interest or net cost of carry figure includes income in minus the cost of financing. Tr. 989-90. All settled positions, long or short, had a net interest value. Tr. 990, 1976-77. For a long position in a bond, it would include the coupon interest earned on the bond less the cost of financing -- repo interest or carry; on a short position it would include the coupon interest Kidder paid on the bond to the purchaser and the reverse repo interest earned from lending cash and borrowing the security involved. Tr. 1976-77.
-- The Division's calculations of what it characterized as false profits included even next-day settlement STRIPS and recons as forward trades. Tr. 1972-74, 2262, 2313-14, 2412-16. This method reduced the Division's false profit figure from $350 million to $338 million.
-- A reason for corporate or greater settlement would be to accommodate a customer or to have time to gather STRIPS. Tr. 877-78, 891, 2483.
-- As Mr. Jett observed, "(when traders) lost money (they) would seek to make an adjustment. When they made money, no adjustment was ever requested." Tr. 545. See also Tr. 3060.
-- From November 1993 to March 1994 the quantity of STRIPS required to settle open recons exceeded the available supply. Div. Tr. 2117-20; Div. Ex. 153 at 30, D.
-- For example, Mr. Jett attributed profits, in part, to an arbitrage strategy when questioned by Barry Finer, the FI Division Risk Manager, in 1993, Tr. 694-96, and by Claudia Sonz, a Kidder accountant, in December 1993. Tr. 561-62, 2431; Div. Exs. 90, 90A.
-- The Red Book concept had been used at Kidder prior to Mr. Jett's arrival. Tr. 2484-85.
-- Mike Benatar and Kevin McLaughlin also participated in some conversations. Tr. 1475-76, 1493-94, 1496, 2909.
-- Resp. Exs. 702A, 702B, 704, 705, 706, 707, and 707A are notes taken by Davis, Polk staff of interviews of Mr. Bernstein in April, May, and June 1994 concerning these and other conversations. The notes were the impressions of the notetaker, were not verbatim transcripts of the interviews, and were not affirmed by Mr. Bernstein. Tr. 2533-86, 2643-45. The undersigned gave no evidentiary weight to the notes, which were used during cross examination to attempt to refresh recollection.
-- Mr. Jett also stated that he showed Mr. Bernstein the daily report of his inventory (FI 12), which indicated that his positions were flat, to show that he owned or was purchasing STRIPS. Tr. 2905. Such an apparently flat trade date position could, however, be achieved by a long dated recon matched with a shorter dated STRIP.
-- Dummy CUSIPs had been used at Kidder to track a security that for some reason did not have its own CUSIP number. Tr. 1601-02.
-- Mr. Jett stated that Mr. Cerullo told him the Fed had called in May; Mr. Cerullo stated it was during 1993. Tr. 1030-32, 2942. The record shows a June 14, 1993, implementation date for a correction in reporting STRIPS and recons on Schedule B of the Fed's Form 2004 (to move them from the "Primary Broker" category to "All Other"). Resp. Ex. 22 at Bates CA0023840; Resp. Ex. 29 at CA035902; Resp. Ex. 39 at CA0023544. An internal Fed memo references a June 24, 1993, meeting with Kidder and revisions to past Schedule B reports to change stripping from "Customer" to "All Other." Resp. Ex. 6 at Bates 000000093. Mr. Cerullo set up a committee to deal with the Fed reporting problem in July 1993. Tr. 1031, 2942; Resp. Ex. 7 at Bates KJ04990; Resp. Ex. 30.
-- The actions to be taken included correct reporting of settled and unsettled positions on Form 2004 Schedule A to remove unsettled positions. Resp. Ex. 39 at CA0023564; Resp. Ex. 43.
-- The 30% figure was an understatement. See Div. Ex. 152; Div. Ex. 153 at J.
-- Confirmations were not sent to the Fed until the day before settlement; the exchanges were not compared trades. Tr. 1218, 2957.
-- The Respondent claims that the strategy gained the attention of the Fed in September 1993 such that it questioned the high numbers of STRIPS and recons reported on Kidder's Fed Form 2004. Tr. 2950-53; Resp. Ex. 48. As evidence of this he points to a handwritten notation on the Form 2004 dated September 22, "as per Joseph Jett Massive Strip + Reconstitution Activity - Several times normal activity." Tr. 2951-53; Resp. Ex. 48. According to his account a Fed official called him to query the numbers reported, which he verified. Tr. 2943, 2952. There is no evidence that such a query, which is otherwise unsubstantiated in the record, was brought to the attention of Kidder managers, such as Mr. Cerullo.
-- It was the Respondent's explanation of this action at an April 14, 1994, meeting, that caused Mr. Cerullo to understand that the Respondent "knew what he was doing and why he was doing it" and to become "flabbergasted, devastated . . . nauseous." Tr. 933-34; Div. Ex. 100 at 8.
-- Municipal defeasances occur when a municipality has a payment schedule spread over time and invests in a manner that matches the payments; the municipality might purchase STRIPS whose maturities matched the dates of the payments. Tr. 975. During 1993 it was possible to make high profits from a small number of unsophisticated municipalities which purchased STRIPS for defeasance by selling them STRIPS at today's yield for forward settlement (typically one to four weeks forward). Tr. 2933; Div. Ex. 119 at F8-F9.
-- See, e.g. , Race Study to Criticize Wall Street , Wall St. J., Jan. 23, 1998, at C1; Congeniality and Unease as Wall St. Addresses Race , N.Y. Times, Jan. 17, 1998, at D1; Addressing Racial Issues on Wall St. , N.Y. Times, Jan. 14, 1998, at D4; Smith Barney Diversity Plan Represents a Major Leap for Women on Wall Street , Wall St. J., Nov. 11, 1997, at B2; Commission Chairman Arthur Levitt, Remarks at the Trinity Church Tercentenary (Mar. 18, 1997).
-- See 18 U.S.C. § 3500, commonly known as the Jencks Act.
-- See also Tr. 1297.
-- In November 1994 the Washington Post described Kidder as "the scandal-ridden brokerage house that has been an albatross for parent company General Electric." Daniel Gross, Barbarians Adjust Their Gait; Shrinking Profits Take the Swagger Out of Wall Street's Walk Wash. Post, Nov. 13, 1994, at C2. By late 1994 to early 1995 the bulk of Kidder's assets were sold to PaineWebber, and losses for 1994 were attributed to the "bond trading scandal" related to the Respondent, reduced underwriting, the slump in the mortgage-backed market, operating results, and the costs of transferring ownership to PaineWebber. G.E. Sees Kidder Loss of Up to $900 Million , N.Y. Times, Nov. 4, 1994, at D15. The discovery of the Respondent's scheme led not only to the firing of the Respondent, but also of top managers at Kidder. Sylvia Nasar, More Kidder Resignations Are Expected in Jett Case , N.Y. Times, Oct. 7, 1994, at D1. Jack Welch, the Chairman of GE, was reported as shrugging off the sale of Kidder, given its small size in comparison with the assets of GE as a whole. Tony Jackson & Andrew Gowers, Big Enough to Make Mistakes , Financial Times, Dec. 21, 1995, at 13.
-- Section 17(a)(3) proscribes "any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser." It does not apply in this case because the allegations focus on the culpability of the Respondent rather than on the effect of particular conduct on members of the investing public. Aaron v. SEC , 446 U.S. 680, 696-97 (1980).
-- Scienter is not required to establish a Section 17(a)(2) violation; a finding of negligence is adequate. Jay Houston Meadows , 61 SEC Docket 2444, 2453 n.16 (May 1, 1996), aff'd , 119 F.3d 1219 (5th Cir. 1997); SEC v. Steadman , 967 F.2d 636, 643 & n.5 (D.C. Cir. 1992) (citing Aaron , 446 U.S. at 701-02; Newcome v. Esrey , 862 F.2d 1099, 1102 n.7 (4th Cir. 1988)).
-- The "in the offer or sale of securities" standard of Securities Act Section 17(a) is at least as high as the "in connection with the purchase or sale of any security" standard of Exchange Act Section 10(b) and Rule 10b-5. Chemical Bank v. Arthur Anderson & Co. , 726 F.2d 930, 944-45 (2d Cir. 1984), cert. denied , 469 U.S. 884 (1984). "In" and "in connection with" are sometimes used interchangeably. U.S. v. Naftalin , 441 U.S. 768, 773 n.4 (1979).
-- In Naftalin , the customer's fraudulent short sale scheme was to place sell orders with broker-dealers and not deliver the securities when the price moved against him. In Perlow , the customers placed buy orders with broker-dealers with the fraudulent intent of paying only if the price moved in their favor by the settlement date.
-- The Division also quoted, in addition to the "touching" language, from Bankers Life in a May 7, 1996, prehearing pleading: "Section 10(b) must be read flexibly, not technically and restrictively." Bankers Life , 404 U.S. at 12. The Supreme Court, however, has not continued to use such expansive language in more recent decisions concerning the scope of conduct proscribed by the antifraud provisions. The Court has emphasized the statutory language rather than expanding it by reference to the broad congressional purposes behind it. See Central Bank of Denver v. First Interstate Bank of Denver , 511 U.S. 164, 169, 173-74 (1994); Santa Fe Indus., Inc. v. Green , 430 U.S. 462, 470-73 (1977); Hochfelder , 425 U.S. at 197-99. But see United States v. O'Hagan , 117 S. Ct. 2199, 2206-14 (1997).
-- Prior to the Chemical Bank case, after Superintendent v. Bankers Life , "the 'in connection with' requirement was not generally viewed as posing a significant obstacle in establishing a securities fraud case." Barbara Black, The Second Circuit's Approach to the "In Connection with" Requirement of Rule 10b-5 , 53 Brooklyn L. Rev. 539, 539-40 (1987). See also Daniel A. McLaughlin, The "In Connection With" Requirement of Rule 10b-5 as an Expectation Standard , 26 Sec. Reg. L.J. 3, 5, 11-14 (1998).
-- Courts have examined other situations where purchases and sales in the context of the antifraud provisions did not exist. See, e.g. , International Controls Corp. v. Vesco , 490 F.2d 1334, 1342-44 (2d Cir.), cert. denied , 417 U.S. 932 (1974) (transfer of ownership of subsidiary to another subsidiary not a sale since complete control retained over transferee); Penn Central Securities Litigation , 494 F.2d 528, 532-39 (3rd Cir. 1974) (formation of holding company not a sale when little change in shareholders' rights); Abrahamson v. Fleschner , 568 F.2d 862, 868 (2d Cir. 1977), cert. denied , 436 U.S. 913 (1978) (internal corporate management decision, without significant change in the nature of the investment or in the investment risks so as to amount to a new investment, not a sale); Gelles v. TDA Industries, Inc. , 44 F.3d 102, 104-06 (2d Cir. 1994); Troyer v. Karcagi , 488 F. Supp. 1200, 1204-05 (S.D.N.Y. 1980) (transfer of accounts and custody of stock from one broker to another not a sale); Sacks v. Reynolds Securities, Inc. , 593 F.2d 1234, 1239-41 (D.C. Cir. 1978). In Sacks the court observed, "lower federal court interpretations of purchase and sale, although encompassing many transactions that bear little overt resemblance to conventional cash sales, require some surrendering of control, change in ownership, or change in the fundamental nature of an investment before a transfer will be deemed within the ambit of Rule 10b-5." 593 F.2d at 1240 (footnotes omitted).
-- The Respondent argues that the losses were derived from futures trading, which is not within the Commission's jurisdiction, and that his trading in treasury securities by itself was profitable. The futures trading was required by Kidder's policy to hedge risk arising from trading in securities. There is a closer nexus between the Respondent's securities and futures trading than between such trading and forward recons.
-- The only recent reported Commission cases that specifically rule on blotter and order ticket violations are settlements. Even these rulings would not support a conclusion that Rules 17a-3(a)(1) and 17a-(3)(a)(7) were violated. In contrast to the instant case, in which blotters and order tickets revealed the Respondent's activities accurately, the blotter and order ticket irregularities in these cases were for the purpose of concealing wrongdoing. Howard A. Rubin , 45 SEC Docket 1530, 1531 (Mar. 20, 1990) (absence of entry for transaction); PaineWebber Incorporated , 61 SEC Docket 179, 205-06 (Jan. 17, 1996); Goldman, Sachs & Co. , 55 SEC Docket 3208, 3214-16 (Feb. 3, 1994) (failure to record side agreements, such as parking agreements); Cantor Fitzgerald & Co. , 56 SEC Docket 812, 816-17 (Mar. 17, 1994); Howe Barnes Investments, Inc. , 62 SEC Docket 2627, 2633 (Sept. 23, 1996) (inaccurate or no time stamp and unclear customer, security or buy/sell information); Lehman Brothers Inc. , 59 SEC Docket 3135, 3140 (Aug. 15, 1995) (failure to record customer names accurately); James W. Adams , 63 SEC Docket 964, 965 (Dec. 2, 1996); Carroll McEntee & McGinley Securities, Inc. , 54 SEC Docket 2407, 2410-11 (Sept. 2, 1993); First Fidelity Securities Group , 61 SEC Docket 68, 79 (Jan. 9, 1996) (inaccurate prices - failing to reveal kick-backs or hidden fees); Refco Securities, Inc. , 62 SEC Docket 1330, 1332-33 (Aug. 6, 1996); Gruntal & Co. , 61 SEC Docket 1994, 2005-06 (Apr. 9, 1996) (blotters that did not reflect theft of customer securities and funds); M. Rimson & Co., Inc. , 63 SEC Docket 2707, 2716-17 (Feb. 21, 1997) (tickets naming registered representatives who were not involved in the transactions).
-- Kidder has not been charged as the primary violator. However, as the Commission has stated, even in a criminal context it is not necessary to indict, try or convict a principal wrongdoer in order to convict an aider and abettor. Swartwood, Hesse, Inc. , 50 S.E.C. 1301, 1304 n.8 (1992) (citing United States v. Mann , 811 F.2d 495, 497 (9th Cir. 1987)).
-- See, e.g. , Exchange Act Sections 15(b)(6)(A) and 21B(a), (c), and (d).
-- While far more administrative proceedings are settled than litigated, it goes without saying that settled cases are questionable precedent, particularly on the issue of sanctions, since parties to a settlement may be motivated by pragmatic considerations. See Richard J. Puccio , 63 SEC Docket 158, 163 (Oct. 22, 1996) (citing David A. Gingras , 50 S.E.C. 1286, 1294 (1992), and cases cited therein); Robert F. Lynch , 46 S.E.C. 5, 10 n.17 (1975) (citing Samuel H. Sloan , 45 S.E.C. 734, 739 n.24 (1975); Haight & Co. , 44 S.E.C. 481, 512-13 (1971), aff'd without opinion , (D.C. Cir. 1971), cert. denied , 404 U.S. 1058 (1972); Security Planners Associates, Inc. , 44 S.E.C. 738, 743-44 (1971)).
-- The Commission's authority to impose the bar sanction is long-standing. The cease and desist, disgorgement, and civil money penalty sanctions, authorized in Securities Act Section 8A and Exchange Act Sections 21B and 21C, were added to the securities laws by the Remedies Act. The Congressional intent in authorizing the Commission to impose these sanctions was to give it increased flexibility in its choice of remedies. See H. Rep. 101-616 (1990); Sen. Rep. 101-337 (1990).
-- The precedential Commission opinions on appeal from Administrative Law Judges' Initial Decisions that concerned violators in the securities business are: Terry T. Steen , Exchange Act Rel. No. 40055, 1998 SEC LEXIS 1033 (June 2, 1998); L.C. Wegard & Co. , Exchange Act Rel. No. 40046, 1998 SEC LEXIS 1130 (May 29, 1998); Victor Teicher , Exchange Act Rel. No. 40010, 1998 SEC LEXIS 980 (May 20, 1998); William F. Lincoln , 66 SEC Docket 1433 (Feb. 9, 1998); John Francis D'Acquisto , 66 SEC Docket 1094 (Jan. 21, 1998); Meyer Blinder , 65 SEC Docket 1970 (Oct. 1, 1997); Samuel O. Forson , 65 SEC Docket 24 (July 21, 1997); Donald A. Roche , 64 SEC Docket 2042 (June 17, 1997); Russell G. Koch , 64 SEC Docket 1616 (May 20, 1997), appeal pending , No. 97-70834 (9th Cir.); Benjamin G. Sprecher , 64 SEC Docket 720 (Apr. 8, 1997); Demitrios Julius Shiva , 64 SEC Docket 157 (Mar. 12, 1997); Martin B. Sloate , 64 SEC Docket 117 (Mar. 7, 1997); David Disner , 63 SEC Docket 2246 (Feb. 4, 1997); New Allied Development Corp. , 63 SEC Docket 807 (Nov. 26, 1996); Richard J. Puccio , 63 SEC Docket 158 (Oct. 22, 1996); Robert I. Moses , 62 SEC Docket 3046 (Oct. 8, 1996); Jay Houston Meadows , 61 SEC Docket 2444 (May 1, 1996), aff'd , 119 F.3d 1219 (5th Cir. 1997); Timothy Mobley , 61 SEC Docket 42 (Jan. 5, 1996); Consolidated Investment Services, Inc. , 61 SEC Docket 20 (Jan. 5, 1996); Ivan D. Jones, Jr. , 60 SEC Docket 1377 (Oct. 10, 1995), aff'd , 115 F.3d 1173 (4th Cir. 1997), cert. denied , 118 S. Ct. 1512 (1998); First Securities Transfer Systems, Inc. , 60 SEC Docket 441 (Sept. 1, 1995); Martin Herer Engelman , 59 SEC Docket 1038 (May 18, 1995), aff'd , 87 F.3d 1319 (9th Cir. 1996); Ahmed Mohamed Soliman , 59 SEC Docket 356 (Apr. 17, 1995); David M. Haber , 59 SEC Docket 59 (Apr. 5, 1995); Albert Vincent O'Neal , 51 S.E.C. 1128 (1994).
-- In Ivan D. Jones, Jr. , a respondent was sanctioned solely for aiding and abetting books and records violations. Required books and records were not being kept or were in a shambles. The Commission imposed a limited suspension and a cease and desist order. The NASD had also censured him, required him to requalify as a principal and fined him $5,000.
-- In Ahmed Mohamed Soliman , the Commission imposed a bar and revocation of registration, based on a respondent's misdemeanor conviction for submitting false and fraudulent documents (to support deductions related to his rental property) to the Internal Revenue Service and on his failure to keep required books and records. He had argued that there was no precedent for a bar based on books and records violations, that his conviction for submitting false documents was not related to the securities industry, and that no member of the investing public was harmed. The Commission, however, stated that the conviction showed a lack of honesty and that the respondent failed to recognize the wrongfulness of his conduct. Thus the sanctions were appropriate because opportunities for dishonesty recur constantly in the securities industry. 59 SEC Docket at 361-63.
-- In First Securities Transfer Systems, Inc. , the Commission imposed a bar, revocation, and penalties totaling $75,000. A transfer agent's owner, who had an extensive disciplinary history, had willfully caused it to file with the Commission a form which falsely omitted to disclose his relationship with it. The Commission noted, as aggravating factors, his disciplinary history and the failure of past sanctions to halt his violations and, as mitigating factors, the lack of harm to others or of unjust enrichment. 60 SEC Docket at 446-48.
-- 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. See Precious Metals Associates, Inc. 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. As noted in the House Report on the legislation, other federal agencies, for example, the Commodity Futures Trading Commission (CFTC), Federal Trade Commission (FTC), National Labor Relations Board (NLRB), and each of the federal bank regulatory agencies, are 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 at 647-48; United States v. W.T. Grant Co. , 345 U.S. 629, 633 (1953).
-- The Division also requested a cease and desist order concerning the antifraud provisions, Securities Act Section 17(a) and Exchange Act 10(b) and Rule 10b-5 thereunder. Mr. Jett, however, did not violate the antifraud provisions, so there is no basis for such an order.
-- Six litigated cases that arose after the effective date of the Remedies Act included such a proviso. Martin B. Sloate , 64 SEC Docket 117 (Mar. 7, 1997); David Disner , 63 SEC Docket 2246 (Feb. 4, 1997); Richard J. Puccio , 63 SEC Docket 158 (Oct. 22, 1996); Jay Houston Meadows , 61 SEC Docket 2444 (May 1, 1996); Consolidated Investment Services, Inc. , 61 SEC Docket 20 (Jan. 5, 1996); Albert Vincent O'Neal , 51 S.E.C. 1128 (1994). Additionally, the Commission ordered the lesser sanction of a suspension in Ivan D. Jones, Jr. , 60 SEC Docket 1377 (Oct. 10, 1995) and in Terry T. Steen , 1998 SEC LEXIS 1033 (June 2, 1998).
-- See, e.g. , David Disner , 63 SEC Docket at 2257; Jay Houston Meadows , 61 SEC Docket at 2456-58; Consolidated Investment Services, Inc. , 61 SEC Docket at 32-34. Compare Martin B. Sloate , 64 SEC Docket at 120-21 with Jay Houston Meadows , 61 SEC Docket at 2456-58, and Richard J. Puccio , 63 SEC Docket at 162.
-- Mr. Cerullo also was awarded multimillion dollar bonuses based in part on the Respondent's profits. When he left Kidder his severance payment was reduced to offset the compensation he received that was based on Mr. Jett's activity so that he did not profit from it.
-- There have been a number of settled cases in which disgorgement and/or penalty amounts were provided. Even these have little in the way of clues as to why disgorgement and/or penalties were selected or a particular penalty amount was assessed. An exhaustive review of these issues is contained in Arthur B. Laby & W. Hardy Callcott, Patterns of SEC Enforcement Under the 1990 Remedies Act: Civil Money Penalties , 58 Alb. L. Rev. 5 (1994). The authors conclude that "it is hard to find any pattern in the amounts assessed as civil money penalties, either in court or administratively; this seems to be . . . negotiated on a case-by-case basis, often taking into account penalties in similar cases." Id. at 53. A review of cases and settlements since 1994 provides no further guidance.
-- The Commission increased the amounts for violations occurring after December 9, 1996. Adjustment to Civil Monetary Penalty Amounts , 61 Fed. Reg. 57773 (Nov. 8, 1996).
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