INITIAL DECISION RELEASE NO. 144
UNITED STATES OF AMERICA
Fu-Sung Peter Wu, a registered representative associated with a broker-dealer registered with the Commission, allegedly defrauded his customers and others by making material misrepresentations and omitting to state material facts in connection with the secondary market trading of Netscape Communications Corporation stock. Specifically, the Division of Enforcement alleged that Mr. Wu misled his customers as to the price at which they could purchase Netscape common stock in aftermarket trading; failed to disclose risks associated with investing in the stock; made unauthorized transactions in customer accounts; and altered customer account documents.
This Initial Decision concludes that Mr. Wu willfully violated Sections 17(a)(2) and 17(a)(3) of the Securities Act in that he negligently made misrepresentations and omissions of material facts, and that he negligently engaged in transactions, practices, or courses of business which operated or would operate as a fraud or deceit upon purchasers of securities. This Decision further concludes, however, that Mr. Wu did not act with scienter, and therefore did not willfully violate Section 17(a)(1) of the Securities Act or Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Accordingly, this Decision orders Mr. Wu to cease and desist from committing or causing any violations or future violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act.
On June 11, 1996, the United States Securities and Exchange Commission ("Commission") issued an Order Instituting Public Administrative Proceedings and Notice of Hearing ("OIP") 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").
On June 17, 1996, the Chief Administrative Law Judge issued an order designating the presiding judge. A public hearing in this matter was held before me in Fort Worth, Texas, on October 22, 23, 24, and 25, 1996. At the hearing, I admitted into evidence two joint exhibits, thirty-one Division of Enforcement ("Division") exhibits, and thirteen Respondent exhibits. 1Eight witnesses testified in the Division's case, and two witnesses testified in the Respondent's case. 2 After the hearing, the parties each filed proposed findings of fact and conclusions of law, post-hearing briefs, and replies to the post-hearing briefs. 3
THE MOTION TO AMEND THE OIP IS GRANTED.
Following completion of the hearing, the Division filed a motion to amend the OIP to conform the pleadings to the proof adduced at the hearing. The original OIP alleged that Mr. Wu willfully violated the antifraud provisions of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder in that, among other things, he "made material misrepresentations to customers regarding the price at which they could purchase [Netscape] stock in the secondary market following Netscape's initial public offering on August 9, 1995." (OIP I.B.1.) The proposed amendment would include the allegation that Mr. Wu also made material omissions to customers regarding the price at which they could purchase Netscape stock. (Motion to Amend at 2.)
Commission Rule of Practice 200(d)(2) provides, in relevant part:
Upon motion by a party the hearing officer may, at any time prior to the filing of an initial decision . . . amend an order instituting proceedings to include new matters of fact or law that are within the scope of the original order instituting proceedings.
17 C.F.R. § 201.200(d)(2). The Comment to this Rule adds:
The Commission has stated that amendment of orders instituting proceeding should be freely granted, subject only to the consideration that other parties should not be surprised, nor their rights prejudiced. Carl L. Shipley, 45 S.E.C. 589, 595 (1974). Where amendments to an order instituting proceedings are intended to correct an error, to conform the order to the evidence or to take into account subsequent developments which should be considered in disposing of the proceeding, and the amendments are within the scope of the original order . . . a hearing officer . . . has authority to amend the order. See, e.g., Don A. Long, Admin. Proc. Rulings Release No. 233 (Mar. 31, 1980), 52 SEC Docket 497 (Aug. 18, 1992) (hearing officer's grant of motion to conform pleading to evidence adduced at hearing). Since, however, the Commission has not delegated its authority to authorize orders instituting proceedings, hearing officers do not have authority to initiate new charges or to expand the scope of matters set down for hearing beyond the framework of the original order instituting proceedings. See Securities Act Release No. 5309 (Sept. 27, 1972).
In support of its motion, the Division argues that the initial OIP charges Mr. Wu with violating statutory provisions that expressly prohibit omitting to state a material fact in order to make statements made not misleading. (Motion to Amend at 4 & n.2.) The Division further argues that the evidence introduced at the hearing shows that Mr. Wu failed to disclose material information concerning the opening market price of Netscape to his customers. (Motion to Amend at 2-5.) In addition, the Division contends that Mr. Wu will not be surprised or prejudiced by the amendment because he had ample notice prior to the hearing that the Division intended to introduce evidence of material omissions, and had several opportunities to answer the allegation during the hearing. (Motion to Amend at 4-5.)
Mr. Wu has not opposed the Division's motion. Moreover, in the Reply Brief he submitted after the motion had been filed, Mr. Wu states that "[t]he primary allegations of material misstatements or omissions of material fact revolve around the price of Netscape's stock." (Resp. Reply at 2.) (emphasis added.) Mr. Wu apparently acknowledges that the original OIP effectively charged him with failing to disclose price information. I am persuaded by the Division's arguments. I therefore GRANT the Division's motion and amend Paragraph I.B.1 of the OIP to read as follows: "1. made material misrepresentations and omissions to customers as to the price at which they could purchase Netscape Communications Corp. ("Netscape") stock in the secondary market following Netscape's initial public offering on August 9, 1995."
The general issue before me is whether Mr. Wu willfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder ("the antifraud provisions"). The Division alleges in the OIP that from approximately June 1995 through August 1995 ("the relevant period"), Mr. Wu: (i) made material misrepresentations and omissions to customers as to the price at which they could purchase Netscape Communications Corporation ("Netscape") stock in the secondary market following Netscape's initial public offering ("IPO") on August 9, 1995; (ii) failed to disclose the risks associated with Netscape stock when he solicited customer orders to purchase the stock; (iii) made unauthorized transactions in customer accounts; and (iv) altered customer account documents in connection with executing transactions in customer accounts, all in furtherance of a fraudulent scheme. (OIP I.B.1-4.)
If I conclude that any of the allegations in the OIP are true, I must then determine: (i) what, if any, remedial sanctions are appropriate in the public interest against Mr. Wu pursuant to Section 15(b) of the Exchange Act; (ii) whether, pursuant to Section 21B of the Exchange Act, a money penalty should be assessed against Mr. Wu; and (iii) whether Mr. Wu should be ordered to cease and desist from committing or causing a violation and any future violation of any or all of the antifraud provisions, pursuant to Section 8A of the Securities Act or Section 21C of the Exchange Act.
FINDINGS OF FACT
I based the findings and conclusions herein on the entire record and on the demeanor of the witnesses who testified at the hearing. I applied preponderance of the evidence as the applicable standard of proof. See Steadman v. SEC, 450 U.S. 91 (1981). I considered and rejected all arguments and proposed findings and conclusions that are inconsistent with this decision. I find that the following facts were established at the hearing and by the record.
In July 1995, Netscape, a maker of Internet-browsing software, announced that it would offer 3.5 million shares of its common stock in an IPO at $12 to $14 a share. (Div. Ex. 20 at 1.) Netscape was a hot issue;4 approximately two weeks before the offering, some analysts estimated the IPO was "at least 60 times oversubscribed, assuring a large opening-day premium." (Tr. 82, 406; Div. Ex. 22.) Investors who chose to purchase Netscape took on significant risks, particularly small investors who could not afford to lose their principal. (Div. Exs. 21, 22; see Div. Ex. 20 at 1, 6-14.) The prospectus issued by the fifteen-month-old company cited "risk factors," which included: competition from software giant Microsoft; "unproven acceptance of the company's products" in a market that was still undeveloped; the company's "limited operating history"; and "possible volatility" of the stock's price. (Div. Ex. 20 at 6-14; see Resp. Ex. 10.) Despite these considerations, many believed the company had a bright future and recognized that the IPO "offered [investors] the potential of a huge return." (Div. Exs. 21, 22; Resp. Ex. 10.)
Due to mounting demand for the stock, the underwriting price doubled to $28 per share two days prior to the opening of trading. (Tr. 83, 407.) The company also increased the number of shares offered from 3.5 million to 5 million. (Tr. 407; Resp. Ex. 10.) According to Securities Data, it was the only IPO in history to double in price before entering the market. (Resp. Ex. 10.) Investors had placed orders for 100 million shares by opening day. (Resp. Ex. 10.) In the days leading up to the offering, some speculated that the aftermarket price would open as high as $65. (Tr. 89-90, 193, 335-36.) On August 9, 1995, Netscape "stunned investors by opening at a heart-stopping $71 a share, a massive premium to its pricing of $28." (Resp. Ex. 1.) Thus, the opening price significantly exceeded the expectations of even the most seasoned investors and industry professionals. (Tr. 406-07; Resp. Ex. 1.) Within the first hour of trading, the price peaked for the day at $75, then plunged to $53.75 before closing at $58.25. (Tr. 93, 400.) In the months that followed, however, the stock price sustained a "phenomenal trajectory." (Resp. Ex. 11.) The price reached a high of $105.50 before Netscape announced a 2-for-1 stock split on November 15, 1995. (Resp. Ex. 11.)
Respondent Fu-Sung Peter Wu
Mr. Wu graduated from the University of Texas at Dallas in 1978 with a master's degree in international management. (Tr. 439, 491.) He became a registered representative in 1986, and he has been employed in the securities industry continuously since that time. (Tr. 439, 492.) He holds Series 7, 24, 28, and 63 licenses. (Tr. 439.) He worked at approximately four brokerage firms before opening his own firm, AAA Stockbrokers ("AAA") in February of 1994. (Tr. 492-93.) He has no history of violating the securities laws.
AAA is a broker-dealer located in Richardson, Texas, and registered with the Commission. (Resp. Answer 1.) During the period from March 1994 through November 1995, Mr. Wu was the sole registered representative and 50% owner of AAA. (Resp. Answer 1.) On September 19, 1995, AAA filed a Form BD-W with the Commission, withdrawing its registration. (Resp. Answer 1.) The withdrawal became effective on November 19, 1995. (Resp. Answer 1.) Mr. Wu is presently employed as an account executive in the Dallas, Texas, office of Dominick & Dominick, a broker-dealer registered with the Commission. (Tr. 506.)
Mr. Wu's Solicitation of Orders to Purchase Netscape Stock
Mr. Wu began recommending Netscape stock to customers and potential customers in June 1995. (Tr. 366.) He researched the company extensively, and obtained sixty copies of the preliminary prospectus. (Tr. 439-41, 509; Resp. Ex. 13; see, e.g., Div. Ex. 20.) He held two seminars at a local book store in July 1995, at which he distributed copies of the preliminary prospectus to seminar attendees. (Tr. 106, 509.) At the time, he believed Netscape would prove to be an extremely profitable investment, and that it was a rare opportunity for investors to double or even triple their money. (Tr. 107, 368, 378-80, 435-37.) He was so confident that he persuaded family members to order approximately 1,000 shares. (See Div. Ex. 23.) While he was soliciting orders, Mr. Wu also knew that Netscape was a highly speculative investment, particularly risky for small investors, because he had read the preliminary prospectus and certain news articles which warned of, among other things, potential volatility in the stock's price. (Tr. 363, 369; Div. Exs. 20-22.)
On August 4, 1995, he placed an advertisement in the Dallas Chinese News5 in which he quoted a share price of $14, and represented Netscape as a "must buy." (Tr. 371-73; Div. Exs. 16, 17.) The advertisement did not mention that it was a high risk, speculative investment, nor did it indicate that the opening price in the aftermarket would be higher than the $14 offering price stated in the prospectus. (Tr. 372-73; Div. Exs. 16, 17.) It stated, in essence, that investors could realize their financial goals by investing in Netscape. (Tr. 376-78; Div. Exs. 16, 17.)
Prior to the doubling of the underwriting price, Mr. Wu told prospective investors he estimated Netscape would begin trading at prices between $14 and $35 per share. (Tr. 105, 110, 147, 187-91, 226, 328, 370, 482.) After he learned that the underwriting price had doubled, he adjusted his projection according to a pre-established formula and began estimating a price of $55 per share. (Tr. 380, 384, 420.) Of course, Mr. Wu had no way of knowing what the actual price of the stock would be prior to the opening, and he concedes that the stock could have opened as high as $100 per share. (Tr. 365.) Shortly before trading began, Mr. Wu learned that Netscape would open in the $60's. (Tr. 89-90, 335-37, 423-24, 495.) He was surprised that the price was so high, but he did not call all of the customers who had placed orders for Netscape to confirm that they still wanted to execute the trades.6 (Tr. 424-27.) He believed, however, that those he was unable to contact would have purchased Netscape "no matter how high the opening price." (Tr. 501-02.)
The Purchase Orders Executed Through GVR Company
Steven F. Roy is the head trader for GVR Company's ("GVR") Nasdaq market-making operation, which is located in Chicago, Illinois. (Tr. 79-80.) The firm deals only with other National Association of Securities Dealers ("NASD") broker-dealers. (Tr. 80.) Mr. Roy's department makes markets in approximately 200 stocks as registered market-makers, and they execute and trade in other Nasdaq stocks for their broker-dealer customers. (Tr. 80.) GVR is not a clearing firm, however, because it does not hold securities for individual clients. (Tr. 81.)
In the summer of 1995, Mr. Roy personally handled trades that were requested by Mr. Wu. (Tr. 81.) GVR executed trades for AAA for the first time in June 1995. (Tr. 81.) Mr. Wu occasionally called to request faxed copies of news stories concerning stocks he traded in. (Tr. 84.) On August 4, GVR faxed Mr. Wu two Dow Jones News Service articles about Netscape, one entitled "Netscape Could Burn Small Investor," the other, "Some Say Flip Netscape's Offer." (Tr. 84-86; Div. Exs. 21, 22.) At 11:56 a.m. on August 8, the day before Netscape began trading in the secondary market, Mr. Wu placed a market order 7 with GVR for 21,290 shares of Netscape stock at the opening price. (Tr. 86-87; Jt. Ex. 1.) Due to the size of Mr. Wu's order and the particular stock involved, GVR chose to act as an agent (rather than a market maker) for the AAA order; the firm placed the order with a market maker. (Tr. 89.)
Trading in Netscape began on August 9, and Mr. Roy called Mr. Wu that morning before the opening because he had learned that the opening market price would be between $60 and $65 per share. (Tr. 89-90, 335-36.) Mr. Roy called to ask Mr. Wu to check with his customers to make sure that they still wanted to buy Netscape at its opening price, given the fact that the opening price was so high relative to the underwriting price. (Tr. 90, 335-36.) Mr. Wu told him to execute the purchase orders as planned. (Tr. 82, 89-91.) Mr. Wu did not seek to place a limit order, nor did he ask Mr. Roy to wait while he called his customers to confirm their orders. (Tr. 91.) Mr. Wu still believed that Netscape would rise promptly to a level well above the opening price, and that his customers shared his confidence. (Tr. 503.)
GVR executed Mr. Wu's market order at the opening price of $71 per share. (Tr. 92.) The firm called Mr. Wu, as usual, to tell him the price at which the shares had been purchased. (Tr. 92.) Mr. Wu called Mr. Roy at approximately 2:30 that afternoon. (Tr. 93-94; Div. Ex. 25 at 1.) At the time of the call, Netscape was trading in the high $50's. (Tr. 94.) Mr. Wu told Mr. Roy that a customer had "refused to take the order," and asked whether he could cancel the trade. (Div. Ex. 25 at 1.) Mr. Roy replied: "No, that's why I called you in the morning. That's why I wanted you to check with [the customers] and tell them that [Netscape is] gonna be opening . . . at ridiculous prices," and verify that they still want to buy the stock. (Div. Ex. 25 at 1-2.) Mr. Wu then informed Mr. Roy that he purchased approximately 6,000 shares too many. (Div. Ex. 25 at 2.) Mr. Roy reiterated that the trade could not be canceled, and told Mr. Wu that the situation was "very, very bad." (Div. Ex. 25 at 3.)
In executing the trade, GVR "acted" the shares to AAA, firming up the share quantity and price in the Nasdaq automated system, and then attributing the trade to AAA's clearing firm, Private Brokers Clearing Corporation ("PBC"). (Tr. 95-96.) When Mr. Roy checked the Nasdaq system following his telephone conversation with Mr. Wu, he saw that PBC had cleared only 16,000 of the 21,290 shares ordered by Mr. Wu. (Tr. 97.) Although he attempted to have PBC place the remaining shares in his account, Mr. Wu ultimately did not pay for the shares; thus GVR was forced to sell them the following morning for approximately $55 per share. (Tr. 98, 488.) As a result of the nonpayment, GVR lost about $90,000. (Tr. 98.) GVR subsequently filed an arbitration claim against AAA, GVR Co. v. AAA Stockbrokers, 1996 WL 520118 (N.A.S.D. 1996), and was awarded $91,581.54 in actual damages, which neither Mr. Wu nor AAA had paid as of the date of the hearing. (Tr. 99.)
Private Brokers Clearing Corporation
Robert A. Roberts is employed by PBC, a clearing firm located in Dallas, Texas. (Tr. 293-94.) In addition to executing trades on behalf of its introducing brokers and maintaining customer accounts, PBC also clears trades that introducing brokers execute with other "outside" brokers, such as GVR. (Tr. 294-95; see Tr. 96-97.) Because all of PBC's introducing brokers are members of NASD, the introducing brokers are allowed to execute trades through outside brokers, and then clear those trades through PBC. (Tr. 295-96.) In such situations, PBC requests that the introducing brokers inform PBC of the trade within twenty minutes of its execution. (Tr. 296.) PBC receives order tickets from the outside firms which it then compares against the information it has received from the introducing broker. (Tr. 296-97.)
PBC began clearing trades for AAA in July 1995. (Tr. 302.) During the relevant period, PBC maintained several customer accounts on behalf of AAA, including Mr. Wu's individual account and an account in the name of AAA. (Tr. 298, 315.) PBC supplies introducing brokers with a "new account approval form" that they may use to open accounts if they so choose. (Tr. 300; see, e.g., Div. Ex. 13.) New account approval forms are to be used for the introducing brokers' own records, and to provide PBC with basic information necessary for opening accounts. (Tr. 300; Div. Ex. 13.) If a customer fills out only a portion of a new account approval form, that is enough to open an account pending the receipt of additional information. (Tr. 300-01.) If the introducing broker fails to supply the necessary supplemental information, the account will be closed. (Tr. 301.) For each AAA customer account maintained at PBC, it was Mr. Wu's responsibility to obtain from the customer an executed "new account agreement." (Tr. 298; see, e.g., Div. Ex. 18.) In addition, in order for a AAA customer to execute trades on margin, Mr. Wu was required to obtain an executed "customer's agreement," more commonly known as a margin agreement, from the customer. (Tr. 299; see, e.g., Div. Ex. 19.) PBC allows trades to be executed on margin absent a signed customer's agreement, as long as the corresponding broker agrees to forward the customer agreement within a reasonable time. (Tr. 299-300.) If the introducing broker fails to get the customer agreement signed prior to margin trading, however, the introducing broker is responsible for the trade and for any margin deficits. (Tr. 300.)
If PBC does not receive funds for a trade executed in an account by the settlement date, it is required by Federal Reserve Board Regulation T to sell the stock. (Tr. 301.) If the stock is sold at a loss, PBC looks first to the customer for payment, then to the introducing broker. (Tr. 301-02.) Most of the time, PBC executed trades on AAA's behalf, though it occasionally cleared trades AAA placed with outside brokers. (Tr. 302-03.) Prior to August 9, AAA had sometimes failed to promptly notify PBC of trades it executed with outside brokers. (Tr. 303.) The clearance agreement between AAA and PBC gave PBC the right to impose additional charges on AAA for failing to notify PBC of outside trades. (Tr. 303.) Mr. Roberts had written a memo to Mr. Wu prior to August 9 advising him that AAA would have to pay these fines if it continued to neglect its obligation to report the outside trades promptly. (Tr. 303.)
During the first week of August 1995, Mr. Wu placed orders with PBC to purchase 3,155 shares of Netscape stock. (Tr. 304.) He placed one order on August 7, a second on August 8, and a third early on the morning of the 9th before trading opened. (Tr. 304.) Mr. Wu never attempted to place a limit order, and he did not identify whose accounts the stock was being purchased for. (Tr. 304-05.) He knew that PBC would execute orders prior to assigning an individual customer's account number to the trade if the introducing broker was in a hurry. (See Tr. 295.) PBC's trading desk contacted Mr. Wu shortly before the opening of Netscape trading, and advised him that trading would begin "[s]omewhere in the $70's." (Tr. 305, 335-36.) PBC had already placed the order with a Netscape market maker, and the order was executed at 10:30 a.m. (Tr. 305.) Mr. Roberts notified Mr. Wu of the exact price immediately after the trade was executed. (Tr. 306.)
Mr. Wu never notified PBC that he had placed a purchase order with GVR. (Tr. 306-07.) About an hour after PBC had filled Mr. Wu's order, PBC's trading desk alerted Mr. Roberts to the fact that Mr. Wu had purchased approximately 22,000 shares of Netscape through GVR, an outside broker. (Tr. 307.) At that time they still had not received any order tickets from Wu advising PBC as to which customers or accounts those shares should be allocated to. (Tr. 307.) Once it learned of the GVR trade, PBC's trading room called Mr. Wu and demanded a list showing the accounts and the corresponding number of shares; PBC agreed to fill out its order tickets using the list, instead of requiring Mr. Wu to fill out individual order tickets. (Tr. 308-09.) PBC received the first edition of the list from Mr. Wu at approximately 1:30 p.m. on the 9th. (Tr. 309; Div. Ex. 23.) By that time the stock had fallen to approximately $58. (Tr. 309.) Mr. Wu kept amending the list, adding names, and faxing updates to PBC over the course of the afternoon. (Tr. 309-10, 428-29; Div. Ex. 23.) PBC did not have the complete roster, which contained the names of approximately forty-one customers, until around 4 p.m. (Tr. 310; Div. Ex. 23.) PBC's trading room personnel noticed errors and omissions in the list, and they faxed Mr. Wu notes informing him that he was listing the same customers twice; failing to state whether the accounts were cash or margin; leaving off account numbers; and omitting to state the amount of the commissions he would receive, if any. (Tr. 310-14; Div. Ex. 23.) After all of the lists were in, Mr. Wu was still unable to account for approximately 5,150 shares he had ordered through GVR. (Tr. 315-17; Div. Ex. 23.) Thus, PBC refused to clear those shares, even though AAA's clearing deposit and the equity in the Wu and AAA accounts allowed Mr. Wu to purchase approximately $470,000 worth of stock -- more than enough to cover the cost of the unattributed shares. (Tr. 97, 317.)
In addition to the shares that were not attributed to any AAA customers, fifteen of the customers Mr. Wu listed as Netscape purchasers refused to pay for their shares. (Tr. 316.) PBC therefore had to sell out those accounts. (Tr. 315-17.) As sell-outs occurred and deficits of approximately $65,000 went unpaid, debits were created against the equity in the Wu and AAA accounts. (Tr. 317, 320.) Neither PBC nor any of the non-paying customers lost money as a result of the Netscape trades. (Tr. 320.) Although some customers who rejected the trades also refused to provide PBC information necessary for the firm to process Forms W-9 for those customers, and although all of the sell-outs resulted in net losses, PBC withheld taxes on the proceeds from the sell-outs and deposited them with the Internal Revenue Service ("IRS"). (Tr. 318.) The amount of withholding was also charged to the Wu and AAA accounts. (Tr. 319.) PBC then issued the Forms 1099 reflecting the amount of withholding to the individual AAA customers. (Tr. 319.) Mr. Wu was thus forced to pay approximately $39,000 in withholding, in addition to the $65,000 he lost as a result of the sell-outs. (Tr. 318-21.)
The Testifying Customers
Five former AAA customers testified against Mr. Wu: Maomian Fan; Yuan Chiao "Rose" Chang; Ezra Wang; Tong Sheu Li; and Kwok Fong "Betty" Siu, hereafter collectively "the testifying customers."
Mr. Fan has been employed by Southern Methodist University as a research assistant in the chemistry department for two and one-half years. (Tr. 104.) Yuanzhen Tong, Mr. Fan's wife, has worked as a waitress in a Chinese restaurant for two years. (Tr. 104-05.) Mr. Fan first learned about Netscape in July 1995 when he read an advertisement Mr. Wu placed in the Dallas Chinese News. (Tr. 105.) Annie Chia, a friend of Mr. Fan's and one of Mr. Wu's customers, referred Mr. Fan to Mr. Wu. (Tr. 128-29; Div. Ex. 13.) Mr. Fan subsequently attended a seminar conducted by Mr. Wu on July 30. (Tr. 105-06.) Neither Mr. Fan nor Ms. Tong had ever purchased stock prior to August 1995. (Tr. 106, 111.) The seminar took place after church. (Tr. 107.) After the meeting, Mr. Wu told them that the underwriting price of Netscape was approximately $14 per share, that Netscape was a good investment, and he gave them a new account approval form. (Tr. 107-08; Div. Ex. 12.)
Two days later, on August 1, Mr. Fan and Ms. Tong went to Mr. Wu's office with the partially completed new account application form and a check for $16,000, payable to PBC. (Tr. 108, 327; Div. Exs. 11-13.) Mr. Wu knew that they had never purchased stock before, and that they were borrowing money to buy the stock. (Tr. 106, 109, 113, 327.) At that time, Mr. Wu again discussed the price of Netscape, estimating that the purchase price would be between $28 and $30. (Tr. 109-10.)
Mr. Wu opened an account in Ms. Tong's name. (Tr. 111; Div. Exs. 12, 13.) Mr. Wu completed the "Special Instructions" section, which included an instruction to buy 500 shares of Netscape at the estimated price of $30 per share. (Tr. 111.) Mr. Wu explained to Ms. Tong that Netscape was a very risky investment, but she and Mr. Fan decided to invest the entire $16,000 anyway. (Tr. 330.) Ms. Tong was upset that she had missed an earlier opportunity to earn a large profit on the aftermarket trading of the UUnet Technologies IPO, and did not want to let a similar opportunity slip by, even though it meant risking nearly half of their annual household income in a single security. (Tr. 328-30, 368.)
Although the Netscape purchase was intended to be a cash transaction, Ms. Tong signed a margin agreement dated August 1, 1995, which authorized PBC to finance margin trading in her account. (Tr. 476; Resp. Ex. 12.) Mr. Wu sent the margin agreement along with Ms. Tong's check to PBC on August 1. (Tr. 477.) On August 9, Mr. Wu told Mr. Fan he had bought the 500 shares for Ms. Tong at $71. (Tr. 114.) Mr. Fan told Mr. Wu that the trade was unauthorized at that price, and told Mr. Wu to sell the shares immediately. (Tr. 114.) When Mr. Fan called again a half-hour later Mr. Wu told him it had not been sold because he was "very busy." (Tr. 114.) Mr. Fan promptly drove to Mr. Wu's office, and Mr. Wu again said that he was very busy, and that he had to draft a "customer list" by 3:00. (Tr. 114-15.) Mr. Fan remained in the AAA office for approximately three hours, helping Mr. Wu prepare the customer list for PBC. (Tr. 116-17; Div. Ex. 23.) Mr. Wu asked Mr. Fan to add up the total number of shares on the list. (Tr. 117, 133.) The list was several thousand shares short of the 21,290 mark, and Mr. Wu was scrambling to find customer names to absorb the surplus. (Tr. 117; Div. Ex. 23.) Mr. Fan did not try to reject the Tong trade on the grounds that it was unauthorized at any time while he was in the AAA office. (Tr. 445.) When Mr. Fan left the office that day, Ms. Tong's shares still had not been sold. (Tr. 133.)
About a week later, Mr. Fan and Ms. Tong got a letter from PBC informing Ms. Tong that she owed PBC $1,700 to cover her margin. (Tr. 117-18.) Because the couple did not send the money, PBC sold 110 shares of Netscape out of the account at a price of approximately $50.50 to cover the deficiency. (Tr. 118-19, 133.) Mr. Fan received a letter from Mr. Wu on or about August 24 informing him that the Netscape shares would have to be transferred to another broker or sold. (Tr. 119.) Mr. Fan instructed PBC to sell Ms. Tong's Netscape stock, although the price of the stock at the time of the sale was only approximately $56. (Tr. 119.) Mr. Fan and Ms. Tong received about $5,800 from their initial $16,000 investment. (Tr. 119.)
After Ms. Tong closed her account at PBC, she brought an arbitration claim against AAA and Mr. Wu. (Tr. 128.) As of the date of the hearing, no determination had been entered by the arbitration panel. (Tr. 128.) However, on October 31, 1996, the panel found in favor of Ms. Tong and awarded her over $10,000 in compensatory damages. Yuanzhen Tong v. AAA Stockbrokers, 1996 WL 704910 (N.A.S.D. 1996) (Whitaker et al., Arbs.).
Yuan Chiao "Rose" Chang
Mrs. Chang, a part-time waitress, lives in Richardson, Texas, with her husband and their two children. (Tr. 138-40.) She first met Mr. Wu approximately thirteen years ago, when he was working as a realtor. (Tr. 140-41.) Although she did not buy real estate from Mr. Wu, she did buy $2,000 worth of stock through him. (Tr. 141-42) Mrs. Chang realized a profit of $500 on the investment, which Mr. Wu had recommended. (Tr. 142.) In the ten-year gap between that purchase and the Netscape purchase, Mrs. Chang did not buy stock from Mr. Wu or anyone else. (Tr. 142.) Mrs. Chang attended two AAA investment seminars during the summer of 1995. (Tr. 142-45.) She also sent Mr. Wu her husband's Bear Stearns brokerage account statement, asked him to evaluate her husband's stock portfolio, and told him that her husband had lost $100,000 through trading in securities. (Tr. 167, 445-46; Resp. Ex. 5.) Mrs. Chang and Mr. Wu discussed Netscape at least twice. (Tr. 145-47.) Mrs. Chang then opened an account with AAA, and on August 8 she placed an order for 500 shares of Netscape. (Tr. 485; Div. Exs. 1, 2.)
On August 9, Mr. Wu instructed GVR to purchase 500 shares of Netscape for Mrs. Chang's account, for a total purchase price of approximately $35,000. (Tr. 155; Div. Ex. 23.) GVR executed the trade, but Mrs. Chang never opened a margin account with PBC, and she never paid for any of the stock. (Tr. 164.) Mr. Wu filed a lawsuit against Mrs. Chang seeking payment for the losses he incurred as a result of her refusal to buy the stock. (Tr. 164-65.)
Mr. Wang, a self-employed manager of rental properties, lives in Garland, Texas, with his wife and their two children. (Tr. 176-77.) Approximately ten years ago, he bought a house through Mr. Wu. (Tr. 177.) Although the Wu and Wang families socialized and attended the same church, none of Mr. Wang's six brokerage accounts were ever handled by Mr. Wu. (Tr. 178.) Mr. Wang first learned about the Netscape IPO from a magazine in June or July 1995. (Tr. 179.) Pursuant to conversations with Mr. Wu about the stock, Mr. Wu faxed him some brochures and news articles, including a story about Netscape published in The Washington Post on July 23, 1995. (Tr. 180-81; Div. Ex. 6.) Following Mr. Wang's attendance at an AAA seminar, Mr. Wu discussed Netscape in a telephone conversation with Mr. Wang on August 8. (Tr. 185-86, 188.) Mr. Wu asked Mr. Wang to look up the Prodigy Online quote for Netscape. (Tr. 187.) Mr. Wang complied, informing Mr. Wu that the price would be $28. (Tr. 187.) Mr. Wang's mother had just received $44,000 from a real estate transaction, and Mr. Wu spoke with her about purchasing 1500 shares of Netscape. (Tr. 189-90.) Mr. Wang gave Mr. Wu his Social Security Number. (Tr. 191.)
At around 11:30 a.m. the next day, after several conversations about the Netscape opening price, Mr. Wu called Mr. Wang and told him that he had purchased 1,500 shares of Netscape for Mr. Wang at $71, for a total purchase price of approximately $106,000. (Tr. 197-98; Div. Ex. 23.) Mr. Wang asked for Netscape's price at that time, and Mr. Wu informed him that it was trading at $73. (Tr. 199.) Mr. Wang instructed Mr. Wu to wait until the price reached $75 before selling. (Tr. 199, 206-07.) Mr. Wu did sell Mr. Wang's stock, but at $51 or $52. (Tr. 199-200.) From August 9 through August 11, Mr. Wu demanded that Mr. Wang pay for the trade. (Tr. 200-01.) However, Mr. Wang never remitted any funds for the purchase of the shares. (Tr. 201.) In addition, PBC withheld more than $23,000 for Mr. Wang's federal income tax as a result of the sale of the Netscape shares. (Tr. 211; Resp. Ex. 2.) Mr. Wang received and kept all of the $23,000 as part of his 1995 tax refund. (Tr. 210-11.) Mr. Wu filed a lawsuit against Mr. Wang seeking payment of the amount PBC charged against the Wu and AAA accounts. (Tr. 200, 205, 211-12.)
Tong Sheu Li
Mr. Li, a chemical engineer, lives in Richardson, Texas, with his wife and child. (Tr. 221.) He purchased stock for the first time on March 27, 1995, after opening a brokerage account with Mr. Wu. (Tr. 222; Div. Ex. 15.) Between late March 1995 and the end of that year, upon the recommendations of Mr. Wu, he engaged in a series of transactions in which Mr. Wu bought high-technology stocks and sold them shortly thereafter on Mr. Li's behalf. (Tr. 245-47, 263-64; Resp. Ex. 7.)
He first learned about the Netscape IPO by reading Mr. Wu's article in the Dallas Chinese News, and he discussed Netscape with Mr. Wu at church on August 6. (Tr. 222-23.) Mr. Wu recommended the stock and estimated that it would trade at $28 per share, and no higher than $32. (Tr. 223-24.) Mr. Li placed his order for 1,000 shares of Netscape on August 7th or 8th, when he had approximately $45,000 in securities in his AAA account. (Tr. 226, 249, 447.) Mr. Wu purchased 1,000 shares of Netscape for Mr. Li's account on August 9. (Tr. 227; Div. Ex. 14.) When Mr. Wu gave him the details of the trade, Mr. Li told Mr. Wu that the trade was unauthorized at the $71 price. (Tr. 227.)
On August 11, PBC sent Mr. Li a letter informing him he owed $35,000 to cover his margin deficit. (Tr. 228.) Mr. Li showed the letter to Mr. Wu, complaining that the trading was unauthorized. (Tr. 228.) On or about August 17, PBC sold 500 shares of Netscape along with other holdings out of Mr. Li's account to pay for the Netscape shares. (Tr. 229; Resp. Ex. 7.) Approximately one week later the remaining 500 Netscape shares were sold out of Mr. Li's account. (Tr. 451.) Neither Mr. Wu nor Mr. Li takes responsibility for directing these sales. (Tr. 229, 449, 451.) Mr. Li brought an arbitration claim against Wu, which was pending at the time of the hearing. (Tr. 229-30; Resp. Ex. 8.) On December 2, 1996, the NASD awarded Mr. Li approximately $26,000 in compensatory damages. Tong Shu Li v. AAA Stockbrokers, 1996 WL 77931 (N.A.S.D. 1996) (Kimball et al., Arbs.).
Kwok Fong "Betty" Siu
Mrs. Siu, a resident of Richardson, Texas, is a married student with two children. (Tr. 265-66.) Her husband is a part-time accountant at a noodle factory. (Tr. 266.) In the course of a July telephone conversation about a real estate purchase for her mother, Mrs. Siu and Mr. Wu discussed Netscape. (Tr. 267-68, 451.) Mr. Wu estimated it would trade at between $21 and $28 in August. (Tr. 268, 452.) She told him that she and her husband already had an account with another broker, referring to a joint account which held approximately $10,000 worth of a single security. (Tr. 268, 452.) Mr. Wu knew of the firm, and told her that she would save money on commissions if she traded through AAA. (Tr. 453.) Following the conversation, Mr. Wu faxed her several documents, including a new account approval form. (Tr. 270; Div. Ex. 4.) She filled out the form and faxed it back to Mr. Wu. (Tr. 270, 453.) Over the next several days, she and Mr. Wu spoke frequently about Netscape, and Mr. Wu faxed Mrs. Siu several newspaper articles about the company. (Tr. 275-76, 453; Div. Ex. 28.) Mrs. Siu placed an order for 500 shares of Netscape, which was executed on August 9. (Tr. 278-79, 453-54; see Div. Exs. 8, 23.)
Mrs. Siu sent Mr. Wu a letter dated August 11, 1995, denying that she authorized the purchase at $71 a share. (Tr. 279; Div. Ex. 7.) On August 17, Mrs. Siu's Netscape shares were sold at $50.75. (Tr. 280; Div. Ex. 9.) Mr. Wu's attorney sent Mrs. Siu a demand letter seeking payment of the $10,318 balance remaining after the sell-out. (Tr. 281; Div. Ex. 10.) On August 24, she received two letters from AAA, one of which informed her that AAA was going out of business and that her account would be transferred to PBC upon payment of any debit balance in her margin account. (Tr. 280; Div. Ex. 29.) AAA filed a lawsuit against Mrs. Siu, which was pending at the time of the hearing. (Tr. 292; Jt. Ex. 2.) The only losses Mrs. Siu has suffered as a result of her dealings with Mr. Wu and the Netscape purchase are the attorneys' fees she has had to pay to defend the suit. (Tr. 291.)
Respondent Wu's Investment Strategy
Mr. Wu knew that Netscape was going to open at a price as high as $55 a share two days before it opened. (Tr. 380, 384, 420.) On the morning of August 9, prior to the opening of aftermarket trading in Netscape stock, he learned from several sources that Netscape would open somewhere between $55 and $71. (Tr. 89-90, 335-37, 341, 384, 386-87, 423, 495.) He also knew that with one or two phone calls he could have canceled all of the Netscape orders he had placed. (Tr. 494.) Finally, he also knew that if his customers refused to pay for the shares cleared through PBC, he would be forced to pay for the shares out of his own accounts. (Tr. 433-34.) He suspected that some of his customers might not be able to pay for the shares he had ordered on their behalf. (Tr. 424-28.) Most importantly, he knew Netscape's price was subject to volatility, and that it was a risky investment for some of his customers. (Tr. 330, 362, 365, 413, 440; Div. Exs. 20-22.) In short, Mr. Wu recognized that he was jeopardizing his own financial well-being as well as that of his customers by placing a large market order for Netscape on a day trade.
The investment strategy Mr. Wu employed is not unusual. (Tr. 496-503; see Div. Ex. 22.) In fact, one of the articles cited by the Division as evidence of Mr. Wu's knowledge is entitled, "Some Say Flip Netscape's Offer." (Div. Ex. 22.) In the article, an analyst "recommend[s] flipping the stock, or selling on the first few trades after the opening." (Div. Ex. 22.) The analyst goes on to estimate that the price will rise at least $5 above the opening price, and he advises selling once the price has reached that point. (Div. Ex. 22.) I find that Mr. Wu and his customers, including the testifying customers, intended to do just that. Mr. Wu did not cancel the orders because he believed that he and his clients would profit from the Netscape investment regardless of the opening market price. (Tr. 501.) He refused to place limit orders because he feared that the orders would not be filled and that his customers would blame him for spoiling their chance to get in at the beginning of an "up trend" and to profit from the anticipated price increase. (Tr. 498-99.) He thought, incorrectly, that the stock would rise $10 a share on opening day, and he believed that his customers were "begging" him to get the shares for them. (Tr. 387, 499-500.) Many of his customers intended to sell their Netscape shares shortly after purchasing them for a gain of $5 or $10 a share; most of his customers did pay for the shares they ordered through AAA. (Tr. 387, 500-01.) Indeed, if the testifying customers had held their Netscape shares for a few months, they would have realized a handsome profit. (Resp. Ex. 11.) Those who did not pay for their shares -- including Mrs. Siu, Mrs. Chang, and Mr. Wang -- may have been free riding:8 they ordered Netscape anticipating a price increase prior to the settlement date, intending to liquidate the shares and use the proceeds from the sale to cover the cost of the purchase; when the price fell, however, they refused to pay for the shares and left Mr. Wu to pay their debts.
I find that Mr. Wu did act in his customers' best interests in several respects. For example, Mr. Wu did inform the testifying customers of the risks associated with purchasing Netscape, including potential price volatility, when he solicited orders to purchase the stock. He also obtained authority from the testifying customers to enter market orders for the number of shares of Netscape he ordered on their behalf. Although I find that Mr. Wu did not alter the account documents as alleged, he did fail to perform several significant acts. For example, Mr. Wu failed to inform the testifying customers that the market price of Netscape would be higher than he originally estimated, and he failed to clarify in the advertisement he placed in the Dallas Chinese News that the underwriting price he quoted was much lower than the price at which potential customers would be able to purchase Netscape. In addition, although he did not have enough customers to fill the purchase order he placed with GVR, he deceived GVR by failing to inform it of this fact. In order to ensure that his personal and corporate PBC accounts were charged for the unclaimed shares, Mr. Wu was obligated to explicitly allocate the shares to those accounts on the customer list he sent to PBC. He failed to do this, however.
CONCLUSIONS OF LAW
During the relevant period, Mr. Wu willfully violated Section 17(a)(2) of the Securities Act, in that he obtained money or property by means of untrue statements of material facts and by omitting to state material facts necessary in order to make statements made, in light of the circumstances under which they were made, not misleading, as described in the findings of fact. I further conclude that, during the relevant period, Mr. Wu engaged in transactions, practices, or courses of business which operated or would operate as a fraud or deceit upon purchasers of securities, in willful violation of Section 17(a)(3) of the Securities Act.
Mr. Wu misrepresented and omitted to state material facts related to the price at which investors could purchase Netscape common stock in the secondary market following the company's IPO on August 9, 1995. In the Dallas Chinese News advertisement(s), Mr. Wu omitted to state that the quoted underwriting price might be lower than the potential market price of Netscape. In conversations with the testifying customers, Mr. Wu failed to inform them that the price of the shares might be much higher than his "projections." When he learned that his projections were, in fact, well below the purchase price for their shares, he did not take steps to alert them to this fact. He concedes that he failed to inform his customers of this development, and he acknowledges that a lack of personnel at AAA contributed to his decision not to call each of his customers and verify that they wanted to proceed with the purchases. Mr. Wu argues that his conduct is excused by the fact that the opening price surprised even seasoned analysts. (Resp. Brief at 8.) The Division argues persuasively that, regardless of what others in the brokerage community knew, Mr. Wu was aware of the substantial price increase well in advance of the opening. (Div. Reply at 2.) I therefore conclude that Mr. Wu misrepresented to the testifying customers and others what the market price of Netscape would be; more accurately, he failed to inform them that he could not be sure what the price might be given the tremendous interest in the security, and subsequently failed to correct his initial price estimates.
Mr. Wu also misrepresented and omitted to state material facts concerning the purchasing power behind the order he placed with GVR. When Mr. Wu placed the market order with GVR, he negligently represented that he was entering the order on behalf of purchasers who could and would pay for the shares at the opening price. Mr. Wu should have known when he placed the orders that AAA did not represent investors who were both willing and able to buy all of the shares. He also should have known that his clearing arrangement with PBC would not automatically direct any unallocated shares into his personal and corporate accounts. Thus he failed to ensure that his accounts would be charged for the shares. It is obvious that GVR would have considered these facts to be significant in its decision to purchase the block of Netscape.
The material misrepresentations and omissions Mr. Wu made to the testifying customers with regard to the opening price of Netscape, as well as those he made to GVR in connection with the purchase order, violated Section 17(a)(2) of the Securities Act. Mr. Wu's dealings with his customers also constituted transactions, practices, or courses of business which operated or would operate as a fraud or deceit upon purchasers of securities in violation of Section 17(a)(3) of the Securities Act.
A careful evaluation of the record reveals, however, that the Division has not sustained its burden of proving the other violations charged in the OIP by a preponderance of the evidence. See Steadman v. SEC, 450 U.S. 91 (1981). Mr. Wu did not willfully violate Section 17(a)(1) of the Securities Act, nor did he violate Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. This conclusion is based upon my assessment of Mr. Wu's mental state when he solicited and placed the Netscape orders, as explained below.
Contentions of the Parties
The Division of Enforcement
The Division contends that during the relevant period, Mr. Wu willfully violated Sections 17(a)(1), 17(a)(2), and 17(a)(3) of the Securities Act in that, directly or indirectly, in the offer or sale of securities by use of the means or instruments of transportation or communication in interstate commerce or by use of the mails, he employed devices, schemes or artifices to defraud; obtained money or property by means of untrue statements of material facts or omissions to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or engaged in transactions, practices, or courses of business which would or did operate as a fraud or deceit upon other persons. (OIP I.B; Div. Pr. Findings at 23.) The Division further contends that during the relevant period Mr. Wu willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, in that, directly or indirectly, in connection with the purchase or sale of securities, by use of the means or instrumentalities of interstate commerce, or of the mails, or of the facilities of the national securities exchanges, he employed devices, schemes or artifices to defraud; made untrue statements of material facts or omitted to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or engaged in acts, practices, or courses of business which would or did operate as a fraud or deceit upon other persons. (OIP I.B; Div. Pr. Findings at 24.) Specifically, the Division alleges that Mr. Wu: (i) made material misrepresentations to customers and potential customers as to the price at which they could purchase Netscape common stock in the secondary market following Netscape's IPO on August 9, 1995; (ii) made a material omission to customers and potential customers in that he failed to disclose the risk associated with Netscape stock when he solicited purchases of the stock; (iii) made unauthorized transactions in customer accounts; and (iv) altered customer account documents in connection with executing transactions in Netscape stock on behalf of certain customers and potential customers. (OIP I.B.1-4; Div. Pr. Findings at 23-24.)
Respondent Fu-Sung Peter Wu
Mr. Wu categorically denies all of the Division's allegations. (Resp. Answer 2.) He contends that all of the testifying customers gave him authority to trade on their behalf, and argues that even if their testimony is credited, it indicates at most "a misunderstanding by [Mr.] Wu, certainly not a fraudulent scheme on his part." (Tr. 510; Resp. Brief at 7.) He cites as exculpatory evidence his own loss of more than $100,000 caused by the failure of certain customers to pay for the Netscape stock they had ordered. (Resp. Brief at 7-8.) While he acknowledges that he failed to disclose all of the price indications to his customers, he argues that the actual opening price "surprised the brokerage community as a whole." (Resp. Brief at 8.) Mr. Wu contends that all of his customers were aware that Netscape was a hot issue, and that they therefore knew the market price would be much higher than the underwriting price. (Tr. 508-09; Resp. Brief at 8.) As to the charge that he altered customer account documents to effect certain Netscape trades, Mr. Wu claims that any alterations he made were for his own purposes and had no impact on the trades. (Tr. 510; Resp. Brief at 8-9.) In sum, he contends that the testifying customers authorized the purchase of Netscape at the market price, and that they changed their minds when the value of the shares dropped during the day trade. (Tr. 501; Resp. Brief at 9.)
Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder
Section 17(a) of the Securities Act prohibits any person from committing fraud in the offer or sale of securities. Section 17(a)(1) makes it unlawful to directly or indirectly employ any device, scheme, or artifice to defraud; Section 17(a)(2) provides that no one shall obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made not misleading; Section 17(a)(3) proscribes any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon a purchaser of securities. Section 10(b) of the Exchange Act outlaws the direct or indirect employment of manipulative and deceptive devices in connection with the purchase or sale of securities. Rule 10b-5 makes it unlawful for any person, directly or indirectly, in connection with the purchase or sale of a security, to make an untrue statement of material fact; omit to state a material fact; use any device, scheme or artifice to defraud; or engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person.
Sections 17(a)(2) and Rule 10b-5 provide that only material misstatements and omissions are actionable. The materiality element is satisfied where there is a substantial likelihood that under all circumstances, a reasonable shareholder would consider the omitted or misstated information significant in making an investment decision. Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988) (citing TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). Sections 17(a) and 10(b) both contain jurisdictional means elements which require that the proscribed activity involve the use of the mails, instrumentalities of interstate commerce, or any facility of a national securities exchange. The jurisdictional requirements are broadly construed, and may be satisfied by any activity connected with a national securities exchange, by intrastate telephone calls, and by even the most peripheral mailings. SEC v. Softpoint, Inc., 958 F. Supp. 846, 865 (S.D.N.Y. 1997), aff'd, 159 F.3d 1348 (2d Cir. 1998).
The Division must establish that a respondent acted with scienter in order to prove a violation of Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Aaron v. SEC, 446 U.S. 680, 697, 701-02 (1980). The Supreme Court has defined scienter as "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). It is not necessary, however, to prove that the respondent acted intentionally; scienter may be established by showing that the respondent acted with severe recklessness. Hackbart v. Holmes, 675 F.2d 1114, 1117 (10th Cir. 1992). Recklessness is defined as "a highly unreasonable" omission or misrepresentation "involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care . . . which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it." Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990) (quoting Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)). Scienter is a question of fact, and the determination depends upon the circumstances of each particular case. SEC v. Hasho, 784 F. Supp. 1059, 1107 (S.D.N.Y. 1992) (citations omitted). Proof of scienter is not required to establish a violation of Sections 17(a)(2) or 17(a)(3) of the Securities Act. Aaron, 446 U.S. at 701-02; SEC v. Steadman, 967 F.2d 636, 643 n.5 (D.C. Cir. 1992). Negligent conduct is sufficient to meet the mental state requirement of those Sections. Aaron, 446 U.S. at 701-02; Meadows v. SEC, 119 F.3d 1219, 1226 n.15 (5th Cir. 1997).
Sections 15(b)(4) and 15(b)(6) of the Exchange Act provide that sanctions may be imposed on a broker or dealer or an associated person of a broker or dealer who has "willfully" violated the federal securities laws. Willfulness does not require intent to violate the law, nor does it require "deliberate or reckless disregard of a regulatory requirement." See Jacob Wonsover, 64 SEC Docket 694, 713 & n.36 (Mar. 1, 1999). It is sufficient if the respondent intends to commit the act which constitutes the violation. Arthur Lipper Corp. v. SEC, 547 F.2d 171, 180 (2d Cir. 1976); Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965); James E. Ryan, 47 S.E.C. 759, 761 n.9 (1982). Negligent conduct is sufficient to satisfy the willfulness requirement. C. James Padgett, 52 S.E.C. 1257, 1266 & n.34 (1997).
The Division has failed to prove by a preponderance of the evidence that Mr. Wu did not inform his customers of the speculative nature of the Netscape investment. The Commission has made it clear that:
[T]he initial purchasing of or trading in the after market of the securities of companies seeking public financing for the first time involves substantial risk of significant losses. Such risks are exacerbated when the security in question becomes a "hot issue" and is purchased in the trading market.
The Obligations of Underwriters, Brokers and Dealers in Distributing and Trading Securities, Particularly of New High Risk Ventures, Exchange Act Rel. 9671 (July 26, 1972). As detailed above, the Netscape prospectus explicitly warned prospective investors of the potential for price volatility. Mr. Wu was thus required by law to disclose the risks associated with trading in a speculative security such as Netscape, and to explain the particular dangers inherent in "IPO day trading" of a hot issue. See Hanly v. SEC, 415 F.2d 589, 595-97 (2d Cir. 1969). He was also required to inform his customers that he was placing market orders, and not limit orders, for the stock, and thereby exposing them to substantial financial risks given their limited economic resources. Id.; see also Laurie Jones Canady, Exchange Act Rel. No. 41250, 1999 WL 183600, at *8 & n.26 (Apr. 5, 1999) (antifraud provisions may be violated where defendant broker-dealer believed the securities traded were unsuitable in light of the nature of the investment objectives and needs of a client and that defendant nevertheless traded in those securities) (citations omitted).
I credit Mr. Wu's testimony that he understood these risks and conveyed his knowledge to each of the testifying customers, and I reject all testimony and evidence to the contrary. I further credit Mr. Wu's testimony that he informed each of the testifying customers that he intended to place market orders on their behalf, and that they understood the ramifications of those orders. He thus ascertained the facts which he was under an obligation to learn, and disclosed those facts to his customers. See Hanly, 415 F.2d at 597. I therefore conclude that Mr. Wu did not violate the antifraud provisions of the federal securities laws by neglecting to adequately apprise his customers of the risks they faced by placing market orders for Netscape.
The Division has also failed to prove by a preponderance of the evidence that Mr. Wu engaged in unauthorized trading in the accounts of his customers. Broker-dealers violate their duty to deal fairly with their customers when they execute unauthorized transactions on their behalf. First Anchorage Corp., 34 S.E.C. 299, 304 (1952). Unauthorized trades violate the antifraud provisions when they are the result of and accompanied by "deception, misrepresentation or non-disclosure." See Messer v. E.F. Hutton & Co., 847 F.2d 673, 678 (11th Cir. 1988); Hasho, 784 F. Supp. at 1110; Laurie Jones Canady, 1999 WL 183600, at *9 & n.30 (citations omitted). Based on the testimony of Mr. Wu and the testifying customers, as well as the documentary evidence in the record, I conclude that the trades Mr. Wu executed on behalf of the testifying customers were authorized.
Ms. Chang instructed Mr. Wu to purchase 500 shares of Netscape on her behalf at the market price. When the price dropped, she attempted to back out of the transaction, thinking she had not yet obligated herself to cover the cost of the stock. Mr. Wang either authorized Mr. Wu to purchase 1500 shares of Netscape at the market price or ratified the purchase by instructing Mr. Wu to sell as soon as the price reached $75.9 I am not persuaded by Mr. Wang's contention that this instruction was merely a general "recommendation" that Mr. Wu could follow if he so chose; rather, it was an express directive to hold and then sell his shares. Mrs. Siu placed a market order for 500 shares of Netscape and, like Mrs. Chang, reneged on her order when the price dropped and she was unable to finance the purchase with the proceeds of a sale. As for the cases of Mr. Fan and Mr. Li, both customers claim that, while they did place orders with Mr. Wu, they intended them to be limit orders. I find Mr. Wu's testimony more credible than that of Messrs. Fan and Li. I therefore conclude that Mr. Li and Mr. Fan gave Mr. Wu the authority to place market orders for 500 and 1000 shares of Netscape, respectively. I further conclude that Mr. Li authorized all sales out of his AAA account.
The Division has also failed to prove that Mr. Wu falsified the account documents as alleged. I do not credit the testimony of those who testified that Mr. Wu entered information on the account documents that was contrary to their representations. I instead credit Mr. Wu's testimony that he did not alter any account documents without the permission of his customers. Moreover, the Division has failed to prove that the alleged forgeries and alterations had any effect on the execution of trades in the accounts of the testifying customers. The Division cites the initial decision in Steven Erik Johnston, 51 SEC Docket 1879 (June 23, 1992), in support of its assertion that "placing . . . false information on a customer's account form, including false information concerning the customer's annual income, has been held to violate the antifraud provisions of the federal securities laws." This quotation, however, must be placed in the context of some nexus between the alteration and trading activity in the accounts. In Johnston, the registered representative "placed false and misleading information on the [customer account] forms so that they would pass in-house review and permit the opening of options accounts to allow" the representative to trade in those accounts. Id. at 1885. In the instant case, however, the Netscape trades in the accounts of the testifying customers would have been executed with or without the alleged alterations. Mr. Wu had no supervisor to impress or to deceive, and PBC allowed customers to purchase Netscape on margin without a signed agreement. Mr. Wu therefore had no motive to falsify either new account documents or customer agreements. Thus, the alleged alterations would not have had the same passport effect as the alterations in Johnston. In other words, the Division has not only failed to prove that Mr. Wu made the alterations, but also why he would have made them.
Although the OIP does not contain a specific allegation that Mr. Wu was engaged in a free riding scheme, the Division states in its Brief:
The Court can reasonably conclude that, had the stock price increased on the opening day as Wu expected, Wu would have placed substantially more, if not all [of the Netscape shares he had ordered] into his personal account. Wu's intention in this regard is supported by the fact that Wu waited until after the market opened, and after the price fell below the opening price, before he advised his clearing firm of the names of the customers on whose purported behalf he purchased the shares.
(Div. Brief at 11.) At the hearing, the Division introduced evidence in support of this allegation. (See Tr. 305-09; see also Div. Ex. 23.) Mr. Wu argues persuasively that the evidence does not establish such a scheme. (Resp. Reply at 3.) The Division has failed to show that Mr. Wu's tardiness in completing the customer list reveals a scheme to defraud. Based on the record, I conclude that Mr. Wu was simply negligent in following procedures, and he was overwhelmed by the exigencies of the unusual day. Mr. Wu understood that if he attempted to shift losses to his customers, many were likely to reject the trade, and that he would suffer the losses pursuant to the terms of the PBC clearing agreement. Mr. Wu did in fact pay over $100,000 in trading and tax losses. The existence of a "heads I win, tails you lose" scheme is further contradicted by the fact that Mr. Wu placed 1,000 shares in the accounts of family members, and by his failed attempt to pay GVR for the unallocated shares.
The Division has met its burden of proof with respect to the allegation that Mr. Wu unreasonably failed to inform his customers that Netscape would open at a price much higher than the figure he had quoted. In so doing, Mr. Wu obtained money or property by means of untrue statements of material facts and by omitting to state material facts necessary in order to make statements he had made not misleading. I conclude (from the fact that the customers Mr. Wu called wanted to reduce or cancel their orders) that the price information was material. Regardless of whether those customers he did not call would have proceeded with the purchases, a reasonable investor would have considered the price information significant in making an investment choice. I therefore conclude that Mr. Wu made material misrepresentations to investors concerning the price at which Netscape stock would trade in the secondary market.
The Division has also shown by a preponderance of the evidence that Mr. Wu employed misrepresentations and omissions to obtain money or property through GVR. Mr. Wu represented to GVR that he and his customers would pay for all of the Netscape shares GVR bought on their behalf, yet he should have known there was significant risk that some portion of the order would not be purchased. The materiality of this fact is obvious. GVR contacted Mr. Wu to confirm the market order because it anticipated just the sort of problems that arose due to volatility in the stock price, and due to Mr. Wu's confusion regarding who would pay for the trade. Mr. Wu erroneously and unreasonably believed his equity account and clearing deposit at PBC would immediately operate to cover any shortfalls in the order. A reasonable investor would have considered Mr. Wu's uncertainty as to actual customer demand, and his misunderstanding of the terms of the PBC clearing agreement, to be highly relevant to the decision of whether to buy Netscape. Mr. Wu therefore misled GVR by means of material misrepresentations and omissions.
The Division has also proved by a preponderance of the evidence that Mr. Wu engaged in a transaction, practice, or course of business which operated or would operate as a fraud or deceit upon purchasers of securities. The customers Mr. Wu failed to notify of the price increase were deceived as to the actual cost of the investment Mr. Wu made on their behalf. The deceptive effect of his failure to disclose the price information is evident in the responses of the customers he did contact prior to trading.
Mr. Wu argues persuasively that he did not act with sufficient scienter to support a conclusion that he violated Sections 17(a)(1) of the Securities Act or Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. (Resp. Pr. Findings at 1; Resp. Brief at 6-9.) Although Mr. Wu's conduct was unreasonable, it was not so egregious as to rise to the level of recklessness necessary to establish scienter for purposes of the antifraud provisions. Mr. Wu exercised very poor judgment in soliciting and entering the testifying customers' Netscape orders. Although his conduct was far short of perfect, I conclude that the losses from the Netscape trades were the product of Mr. Wu's incompetence, rather than the result of a failed scheme to defraud.
Mr. Wu failed to exercise reasonable care under the circumstances by misinforming his customers as to material pricing information. Mr. Wu also breached the duty he owed GVR to make certain that AAA's clearing arrangement would operate to absorb unclaimed shares, or to take whatever additional steps necessary to buy the shares himself. By not doing so, he unreasonably exposed GVR to a significant risk of harm. Although Mr. Wu did not act with scienter, he was negligent, and that is sufficient to establish liability under Sections 17(a)(2) and 17(a)(3) of the Securities Act. The violative conduct described above occurred in the offer or sale of securities. Finally, Mr. Wu used the mails, interstate and intrastate telephone calls, and other means or instruments of transportation or communication in interstate commerce to solicit and place orders for Netscape stock, thereby satisfying the jurisdictional means requirement of Section 17(a).
Based on the foregoing I conclude that Mr. Wu obtained money or property by means of untrue statements of material facts and by omitting to state material facts necessary in order to make statements made, in the light of the circumstances under which they were made, not misleading, in willful violation of Section 17(a)(2) of the Securities Act. I further conclude that Mr. Wu engaged in a transaction, practice, or course of business which operated or would operate as a fraud or deceit upon purchasers of securities, in willful violation of Section 17(a)(3) of the Securities Act.
THE PUBLIC INTEREST
I have concluded that the Division has established that Mr. Wu committed certain of the illegal acts described in the OIP. Hence, the remaining issue is the sanction that is appropriate. The governing standard in evaluating the propriety of administrative sanctions is whether the sanctions serve the public interest. The public interest analysis demands that several factors be considered, including: (i) the egregiousness of the respondent's actions; (ii) the isolated or recurrent nature of the infraction; (iii) the degree of scienter involved; (iv) the sincerity of the respondent's assurances against future violations; (v) the respondent's recognition of the wrongful nature of his conduct; and (vi) the likelihood that his occupation will present opportunities for future violations. Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979) (quoting SEC v. Blatt, 583 F.2d 1325, 1334 n.29 (5th Cir. 1978)), aff'd on other grounds, 450 U.S. 91 (1981). The severity of the sanctions depends on the facts of each case and the value of the sanction in preventing a recurrence of the violative conduct. Berko v. SEC, 316 F.2d 137, 141 (2d Cir. 1963); Leo Glassman, 46 S.E.C. 209, 211 (1975); Richard C. Spangler, 46 S.E.C. 238, 254 n.67 (1976). Sanctions should demonstrate to the particular respondent, the industry, and the public generally that egregious conduct will elicit a harsh response. Arthur Lipper Corp. v. SEC, 547 F.2d 171, 184 (2d Cir. 1976). The Division requests that I bar Mr. Wu from association with any broker or dealer for a period of four years; require him to pay a civil penalty of $50,000; and order him to cease and desist from committing or causing any violations or future violations of the antifraud provisions. (Div. Pr. Findings at 24-25; Div. Br. at 17-23.) Mr. Wu argues that the requested sanctions are excessive, and asks that none be imposed upon him. (Resp. Br. at 9.)
Sections 15(b) and 19(h) of the Exchange Act authorize the Commission to order a wide range of sanctions restricting the ability of brokers, dealers, and those associated with, or seeking to become associated with, brokers or dealers, to serve in the securities industry if the Commission determines that person has committed certain wrongful acts, subject to the public interest factors set forth above. Mr. Wu has no prior disciplinary history. He did not act with scienter, nor were the effects of his actions particularly egregious. The infraction consists of activity in one security over a period of only one day. Thus it is isolated. GVR, Ms. Tong, and Mr. Li have received arbitration awards, and two other testifying customers were in litigation with Mr. Wu at the time of the hearing. He faces the possibility of a judgment being enforced against him. As a result of his own ineptitude, he personally lost well over $100,000, as well as his entire business. At the hearing he was genuinely embarrassed and contrite. Although he continues to work as a securities broker, I conclude that he does not pose a danger to the investing public. Neither a suspension nor a bar is warranted under these circumstances.
Civil Money Penalty
Section 21(B)(a) of the Exchange Act provides, in relevant part, that the Commission may impose civil penalties in a proceeding under Section 15(b)(6), if it finds that the respondent has willfully violated any provision of the federal securities laws and that imposition of a penalty is in the public interest. Section 21(B)(b) sets out a three-tiered scheme for determining the severity of the penalty according to the egregiousness of the offense. For each violation, the maximum amount of penalty that may be assessed against a natural person is $5000 in the first tier, $50,000 in the second tier, and $100,000 in the third tier. In order to assess a second tier penalty, the violation must involve fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement. Assessment of a third tier penalty requires that the violation involve fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement; and that the violation directly or indirectly resulted in substantial losses or created a significant risk of substantial losses to other persons or resulted in substantial pecuniary gain to the person who committed the violation.
Section 21B(c) enumerates the factors that may be considered in determining whether a penalty is in the public interest, and what the amount of any penalty ought to be. Public interest findings must support the amount of the particular assessment, not merely the general decision to assess a penalty. See New Allied Dev. Corp., 52 S.E.C. 1119, 1130 & n.4 (1996) (citing First Sec. Transfer Sys., 60 SEC Docket 441, 447 n.15 (Sept. 1, 1995)). The factors listed in Section 21B(c) are: (i) whether the act or omission for which the penalty is assessed involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement; (ii) the harm to other person(s) resulting either directly or indirectly from such act or omission; (iii) the extent to which any person was unjustly enriched, taking into account any restitution made to persons injured by such behavior; (iv) whether the respondent previously has been found by the Commission, another regulatory agency or a self-regulatory organization to have violated federal or state securities laws or the rules of a self-regulatory organization or has been enjoined or convicted by a court of competent jurisdiction of violations of such laws or rules; (v) the need to deter respondent and others from committing such acts or omissions; and (vi) such other matters as justice may require.
In addition to the factors cited above militating against imposing a bar upon Mr. Wu, other considerations lead me to conclude that no monetary sanction should be assessed against him. Paramount among these added considerations is the fact that imposition of a penalty would serve no deterrent purpose. Certainly Mr. Wu was not unjustly enriched by his actions. The harsh lessons Mr. Wu learned from the Netscape ordeal and the disastrous consequences he has already faced will discourage him and others in the securities industry from practicing the "art" of day trading in this negligent fashion. Furthermore, although others were ultimately harmed by Mr. Wu's actions, he did not intend to injure anyone when he solicited or placed the Netscape orders. In short, imposition of a monetary penalty would be unnecessary and unjust under the circumstances.
Cease and Desist
Section 8A of the Securities Act and Section 21C of the Exchange Act authorize me to issue an order requiring Mr. Wu to cease and desist from committing or causing violations and future violations of provisions of the Securities Act or the Exchange Act. By the explicit language of the statutes, an order may issue absent a finding that a respondent is apt to commit violations in the future. Based upon my conclusion that Mr. Wu has violated Sections 17(a)(2) and 17(a)(3) of the Securities Act, I will order him to cease and desist from committing or causing such violations and any future violation of those provisions.
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on January 24, 1997.
Based on the findings and conclusions set forth above:
It is hereby ORDERED that, pursuant to Rule 200(d) of the Commission's Rules of Practice, 17 C.F.R. § 201.200(d), that Paragraph I.B.1 of the Order Instituting Public Administrative Proceedings and Notice of Hearing in this matter is hereby amended to read as follows: "1. made material misrepresentations and omissions to customers as to the price at which they could purchase Netscape Communications Corp. ("Netscape") stock in the secondary market following Netscape's initial public offering on August 9, 1995."
And it is further hereby ORDERED that, pursuant to Section 8A of the Securities Act, that Fu-Sung Peter Wu cease and desist from committing or causing violations or future violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this initial decision may be filed within 21 days after service of this decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within 21 days after service of the initial decision upon such party, unless the Commission, pursuant to Rule 360(b)(1), determine 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.
-- Joint exhibits are referred to by number as "(Jt. Ex. __)"; Division exhibits are referred to by number as "(Div. Ex. __)"; and Respondent exhibits are referred to by number as "(Resp. Ex. __)." -- Citations to the pages of the hearing transcript are designated "(Tr. __)." -- The Division's Proposed Findings of Fact and Conclusions of Law is referred to by page number as "(Div. Pr. Findings)"; the Division's Posthearing Brief is referred to by page number as "(Div. Brief)"; Respondent's Proposed Conclusions of Law and Findings of Fact is referred to by page number as "(Resp. Pr. Findings)"; Respondent's Post-Trial Brief is referred to by page number as "(Resp. Brief)"; the Division's Reply Brief is referred to by page number as "(Div. Reply)"; and Respondent's Reply Brief is referred to by page number as "(Resp. Reply)." -- A hot issue occurs "where the price of a new offering of securities rises to a substantial premium over the initial offering price immediately or very soon after the securities are first distributed to the public." The Obligations of Underwriters, Brokers and Dealers in Distributing and Trading Securities, Particularly of New High Risk Ventures, Exchange Act Rel. 9671 (July 26, 1972). -- Mr. Wu may have placed additional, substantially similar advertisements in previous editions of the Dallas Chinese News. (See Tr. 105.) -- Mr. Wu did call at least three of his customers -- Rose Montaniel, Robert Feng, and Sherry Tasi -- to see whether they wanted to modify their orders. (Tr. 337-42, 424-27.) Ms. Montaniel reduced the number of shares she had ordered, and Ms. Tasi and Mr. Feng instructed Mr. Wu to cancel their orders altogether. (Tr. 337-38, 427.) In addition, three other AAA customers who heard about the price increase from Ms. Montaniel decided to reduce their orders. (Tr. 425.) -- A market order is an "order to buy or sell a security at the best available price." John Downes & Jordan Elliot Goodman, Dictionary of Finance and Investment Terms, 325 (1995.) A limit order, by contrast, is an "order to buy or sell a security or commodity at a specific price or better. The broker will execute the trade only within the price restriction." Id. at 304. -- The illegal practice of free riding involves purchasing securities without sufficient capital and using the proceeds of the sale of the same stock to cover the purchase price. SEC v. Hansen, 726 F. Supp. 74, 76 n.8 (S.D.N.Y. 1989). Customers perpetrate free riding schemes by misrepresenting to their brokers that they have the ability to pay for trades, thereby inducing the brokers to take on the risk of the trading activity. SEC v. Margolin, 1992 WL 279735, at *2 (S.D.N.Y. 1992). -- Ratification is a theory of agency in which a principal adopts a previous action performed by an agent in the principal's name, but which prior action would not bind the principal absent the ratification because the act as originally done was without authority. Jaksich v. Thomson McKinnon Sec. Inc., 582 F. Supp. 485, 496 (S.D.N.Y. 1984) (footnote omitted).