Initial Decision of an SEC Administrative Law Judge
In the Matter of
In the Matter of
Richard Hoffman and
January 27, 2000
William A. Rees and William S. Dixon for the Division of Enforcement, Securities and Exchange Commission.
Alexander D. Bono and Timothy D. Katsiff of Blank Rome Comisky & McCauley LLP for Respondent Richard Hoffman.
Peter J. Anderson, Kristen Jones Indermark, and Todd Ratner of Sutherland, Asbill & Brennan LLP for Respondent Kirk Montgomery.
Carol Fox Foelak, Administrative Law Judge
This Initial Decision dismisses charges brought against Richard Hoffman and Kirk Montgomery. Hoffman was charged with violating the antifraud provisions of the securities laws in connection with the sale of mutual funds, and Montgomery was charged with failing to supervise him so as to prevent violations. The charges against Hoffman included improper switching, omitting to fully inform customers concerning sales charges, and making unsuitable recommendations. The Decision finds that about 400 of Hoffman's customers held a fund in the Kemper family during the time at issue; most continue to hold it. A few customers who had held a Kemper fund for periods ranging from one year and four months to several years became dissatisfied, sold it, and purchased a "hot" Templeton fund after conferring with Hoffman about their portfolios. Hoffman fully informed the customers about their options and about the costs and risks of changing to the Templeton fund. Sales practice charges concerning two other customers were also unproved. The Decision concludes that Hoffman did not violate the antifraud provisions and dismisses the proceeding as to him.
Montgomery was the Chief Compliance Officer at the broker-dealer with which Hoffman was associated. He was charged with failing reasonably to supervise Hoffman with a view to preventing violations of the antifraud provisions. Since Hoffman did not violate the antifraud provisions, the failure to supervise charge fails. Additionally, assuming for the sake of argument that Hoffman did violate the antifraud provisions, the Decision concludes that Montgomery was not Hoffman's supervisor; in the alternative, Montgomery's supervision was reasonable under the attendant circumstances. Thus the Decision dismisses the proceeding as to him.
The Securities and Exchange Commission (Commission) initiated this proceeding by an Order Instituting Proceedings (OIP) on December 9, 1998, against (1) Richard Hoffman, 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); and (2) Kirk Montgomery, pursuant to Sections 15(b) and 19(h) of the Exchange Act. The undersigned held seven days of hearings in Allentown, Pa., May 17-25, 1999, and four days of hearings in Atlanta, Ga., June 7-10, 1999. The record compiled in the hearing in Allentown mostly concerned Respondent Hoffman; in Atlanta, Respondent Montgomery. In Allentown, the Division of Enforcement (Division) called twelve witnesses from whom testimony was taken, including Respondent Hoffman, and he called six witnesses. In Atlanta, the Division called six witnesses, including Respondent Montgomery, and he called three witnesses. The record includes 194 exhibits in evidence.1
The findings and conclusions in this Initial Decision are based on the record. Preponderance of the evidence was applied as the standard of proof. Pursuant to the Administrative Procedure Act,2 the Proposed Findings of Fact and Conclusions of Law filed by each party on August 16 and responsive pleadings filed by each party on September 1 were considered. All arguments and proposed findings and conclusions that are inconsistent with this decision were considered and rejected.
The OIP alleges that Hoffman violated the antifraud provisions between July 1, 1993 and December 31, 1994, through improper mutual fund sales practices. It alleges that Hoffman induced customers to engage in short-term trading of mutual funds, omitted to inform them of sales charges, recommended funds whose objectives were inconsistent with the customers' objectives, and engaged in breakpoint violations. In its posthearing filings the Division alleges that Hoffman violated the antifraud provisions during 1994 by mutual fund switching, unsuitable recommendations, omitting to disclose material facts, and a breakpoint violation. Hoffman argues that there were no material misrepresentations or omissions, no mutual fund switching, no unsuitable recommendations, and a complete lack of scienter. The OIP also alleges that Montgomery failed reasonably to supervise Hoffman so as to prevent violations by Hoffman. Montgomery argues that Hoffman committed no violations and that, further, Montgomery was not Hoffman's supervisor, and lacked the responsibility, ability, or authority to affect Hoffman's conduct; in the alternative, Montgomery's conduct was reasonable under the attendant circumstances.
As to Hoffman, the Division seeks a bar from association with a broker-dealer,3 a $50,000 civil penalty, disgorgement, and a cease and desist order. As to Montgomery, the Division seeks a three-month suspension from association with a broker-dealer, with a six-month suspension from serving in a supervisory capacity, and a $10,000 civil penalty. The Respondents contend that the proceeding should be dismissed.
Respondents were associated with FSC Securities Corporation (FSC), a broker-dealer that operates through registered representatives and small branch offices that are independent contractors. Hoffman was a one-person Office of Supervisory Jurisdiction (OSJ).4 Montgomery was FSC's Chief Compliance Officer at its home office. The facts pertaining to Hoffman and the transactions that form the basis for the allegation that he violated the antifraud provisions will be addressed first. Facts pertaining to the failure to supervise charge against Montgomery will be addressed next. These facts include his role at FSC and his role in implementing changes in FSC's procedures in response to a 1991 deficiency letter from the Commission.
During the time at issue Hoffman was associated with FSC, as a one-person OSJ in Palm, Pennsylvania. A "Managing Field Associate" of FSC, such as Hoffman, pays the expenses of his own business, such as salaries, rent, and equipment, while obtaining back office and marketing services through FSC and being subject to its compliance procedures. Tr. 1198-99. Consistent with this he receives 80% to 90% of commissions paid on the products he sells. Tr. 294-95. Hoffman was one of FSC's top producers. Tr. 385; M. Ex. 78 at 1.
Hoffman joined FSC in 1987 and commenced selling mutual funds full-time after a period of selling mutual funds part-time while holding other full-time jobs. He grew up on a dairy farm in a Pennsylvania Dutch community and was accustomed to working long hours since childhood, before and after school. Tr. 356, 360. As an adult, he found that a "9 to 5" office job was part-time work, and he began selling mutual funds on the side. Tr. 355-56, 359. Eventually he decided to sell mutual funds full-time and evaluated several broker-dealers before settling on FSC in 1987. Tr. 355-58, 576. He was influenced by the fact that FSC does not sell proprietary funds. Tr. 358, 576.
Hoffman has resided in the same community for his whole life. Tr. 348, 352. Church is a big part of his life; he and his wife have always gone to Sunday school and church. Tr. 351. Additionally, he has been active in church affairs, starting as Sunday school manager. Tr. 348-50. Next he was elected treasurer for an eight-year term and then vice-moderator (like vice-president) for an eight year term. Tr. 348-50. He has also been, for a number of years, a member of the finance committee, which oversees the investments of the church's endowment, presently about $1 million. Tr. 349-50. He was asked to serve as moderator but did not have time to fulfill the duties of moderator because it is almost a full-time job. Tr. 350.
The transcript discloses Hoffman's cautious means of expressing himself indirect phraseology and passive sentence structure. However, it does not completely convey his demeanor. Tr. 895, 901-02. He was subdued, unassuming, and soft-spoken. He spoke slowly and was careful to convey completely accurate information. For example, there were cautious, hesitant pauses between words even when providing routine information such as the address of his office or the ages of his children. His demeanor was consistent with his testimony that he methodically followed a routine in meetings with customers and with customer testimony that he had a low-key approach and did not pressure them in their investment decisions. He is the antithesis of a fast-talking, overbearing, aggressive salesman. In keeping with his appearance and attire, Hoffman's personal financial policy is thrift and aversion to debt. Tr. 383-84. He and his wife bought their house soon after their marriage and have lived in it for thirty-six years. Tr. 347-48. The mortgage was paid off in two or three years. Tr. 383-84. His car has 355,000 miles on it. Tr. 384. In 1994, at the time of the events in question, his net worth was $3 to $4 million, and he was under no financial pressure. Tr. 384.
Hoffman's business consists of selling mutual funds and, to a small extent, insurance products. Tr. 570. Hoffman has a Series 24 license (securities principal), which authorizes him to supervise the activities of others as well as himself and to be the principal of an OSJ. Tr. 373-75, 579. In 1994 the business consisted of Hoffman as the sole registered representative, assisted part-time by his wife and daughter, who performed administrative and clerical duties. Tr. 378-79, 604. In 1994 he had about 2800 accounts. Tr. 380; M. Ex. 78 at 2. He had, and has, no discretionary accounts and no margin accounts. Tr. 292, 428, 570-71; M. Ex. 78 at 2.
Hoffman's practice is to call on customers in their homes or places of business when they request a meeting, or, periodically at his own initiative; this helps him to "know your customer" in addition to the information he records on new account forms, which the customer signs, and which he updates periodically. Tr. 121, 146, 149, 209, 283-84, 301-08, 458-59, 508-09, 517-18, 528-29, 530-31, 533-37, 539, 548-49, 559-63, 585-93, 604-05; H. Exs. 38-41, 52-53, 62, 65-66, 81-83, 87, 92-95, 102-04, 107, 111, 115; M. Ex. 78 at 2.
Hoffman always followed a routine when conferring with his customers. Tr. 388-96. This included a handwritten summary or "recap" of their holdings. Tr. 50, 77, 101-02, 215, 237, 242, 270-72, 291-92, 387-89, 458-59; H. Exs. 42-43, 84, 96, 108, 114. If the customer's funds were doing well and there was no adverse information concerning them, the calls were short, such that Hoffman could see two or three customers a night. Tr. 49, 149, 157, 209-10, 215, 389. If Hoffman or the customer saw a need for more discussion, his routine included discussing these alternatives: first, no change; second, if the customer wanted to leave a fund, a change to a fund within the same family at minimal cost; and third, a selection of funds in a different family. Tr. 46, 54, 88, 211, 252, 291-92, 309-10, 395-97, 412, 434-35, 512-13, 564, 893-94. Hoffman keeps six crates of prospectuses in his car. Tr. 320. He always furnished prospectuses and reviewed them with customers. Tr. 51-52, 54, 121-22, 127, 146, 150, 178, 192, 462. When appropriate, Hoffman explained the difference between Class A and Class B shares and the benefits and drawbacks of each such that the customer understood it at the time.5 Tr. 465-66, 489-90, 363-70. His explanation was easy to comprehend, as he demonstrated at trial. Tr. 366-70; H. Ex. 120. His routine includes discussing breakpoints when applicable and pointing out the section in a fund's prospectus that sets forth the breakpoints. Tr. 307, 313-14, 364, 415-16, 523, 540, 563.
Hoffman's policy is to give customers information so they can make their own decisions. Tr. 54, 129, 146, 155, 179, 210-11, 216-17, 221, 292, 460. This low-pressure approach is consistent with his demeanor at the hearing.
When Hoffman joined FSC in 1987, he signed a Representative's Declaration to confirm to FSC that he had complied in the past and intended to comply in the future with the securities laws, the rules of the NASD, and the rules of FSC. Tr. 577-79; M. Ex. 19. The Declaration included a statement that he had not improperly switched a customer from one mutual fund to another and had fairly disclosed breakpoints to customers. Tr. 578-79; M. Ex. 19 at Q. 12. A document entitled "Managing Field Associate Agreement," signed by Hoffman, and dated July 20, 1990, specified a number of topics pertaining to Hoffman's being an OSJ. Tr. 579-83; M. Ex. 22. In the section entitled "Compliance," Hoffman agreed to familiarize himself with all applicable statutes, rules, and policies; to complete at least three hours of compliance training a year; to read FSC's Operations and Compliance Manuals and to comply with its policies as established from time to time; and to establish and maintain records required by statutes and rules. Tr. 581-83; Div. Ex. 108; M. Ex. 21, M. Ex. 22 at 3. FSC's compliance manual for OSJs that was in effect in 1994 contained procedures intended to prevent, inter alia, unsuitable transactions, switching, and breakpoint violations. Tr. 596-600; Div. Ex. 109 at 168-71; M. Ex. 20 at SEC 1248-51. Hoffman understood that it was his responsibility as OSJ principal to review each transaction in a client's account to prevent these violations; in 1994 as a one-person OSJ, it was his responsibility to review his own business. Tr. 596-600.
In 1994 Hoffman did not use mutual fund switch letters or obtain prospectus receipts from clients.6 Tr. 296, 594-95. He felt that it was not necessary given his close relationship with his clients. Tr. 297, 594. During 1994 FSC suggested, but did not require, switch letters and prospectus receipts. Tr. 594-95; Div. Ex. 108 at 39-40; M. Ex. 21 at SEC 1616-17. Hoffman now uses switch letters, currently required by FSC, and prospectus receipts. Tr. 296, 594-95.
FSC required Hoffman to enter on his blotter all customer transactions, including redemptions. Tr. 378-79, 608-09, 611-13; M. Ex. 47. As of January 1993, FSC required OSJs to submit daily blotters. Tr. 609; M. Ex. 43. Hoffman understood it was his responsibility to make sure all transactions were posted and to review and approve the blotter before it was sent to the home office; his daughter Cindy made the blotter entries. Tr. 378-79, 610-11. Cindy was not posting redemptions. Tr. 616-18; M. Ex. 89. Hoffman did not understand and did not communicate to Cindy the need to post redemptions that took place through his office; a second reason for the incomplete blotters was their difficulty in learning to input transactions into FSC's electronic system, Field CAESAR, when FSC made that system available and encouraged its use for daily blotter transmissions as of January 1993. Tr. 716-23, 785. He did not contact FSC's Compliance Department with any questions about what should be posted. Tr. 610-11, 613.
A representative of FSC came to Hoffman's office once a year to audit his business. Tr. 622-25. Hoffman was completely cooperative during the audits; all customer files were accessible to the auditor. Tr. 622-25, 1593-5. The audits included a questionnaire. M. Exs. 35, 61, 80. In 1992 Hoffman gave incorrect answers to questions asking whether all transactions were posted to the blotter and whether he had switched a client from one mutual fund to another when a sales load was charged. Tr. 630, 632; M. Ex. 35 at SEC 1032, 1035. In 1993 he had become aware that some liquidations had not been posted and divulged this in his answer. Tr. 636; M. Ex. 61 at SEC 955. In September 1994 he gave an incorrect "no" answer to the question asking whether he had switched a client from one mutual fund to another when a sales load was charged.7 Tr. 643; M. Ex. 80 at SEC 1000. Language on the first page of the questionnaires warned of the importance of truthful responses and allowed thirty days for receipt by the home office. M. Exs. 35, 61, 80. Nonetheless, Hoffman filled them out hurriedly at the end of the day of the audits for the auditor to take with him; he did not intend to mislead FSC.8 Tr. 632-33, 635, 643-44, 732-33, 736-37, 1557-58. Hoffman's disavowal of an intent to mislead is consistent with the testimony of Richard Young, who conducted the audits in 1993 and 1994. Young found Hoffman very cooperative and his records orderly and well-kept; he did not feel that Hoffman was trying to cover up information or deceive him. Tr. 1581, 1593-95.
The Division argues that the credibility of Hoffman's testimony is diminished by his incorrect answers on the questionnaires. This argument is rejected. Hoffman's explanation that the incorrect answers were unintentional is accepted as consistent with other record evidence and his demeanor. Additionally, Hoffman's customer files contained a record of changes in customer holdings. These files were open to the auditor, Young, who did not rely on the questionnaire in selecting files to examine.
During the time at issue about 400 of Hoffman's 2800 accounts held Kemper funds; most of the 400 still do. Tr. 1079-81; H. Ex. 123. A few customers sold their Kemper funds and bought Templeton Developing Markets Trust (Templeton) or another fund with a different objective from their Kemper fund.9 Compare Div. Ex. 148 at 38; H. Ex. 4 at 8-9 with Div. Exs. 145, 146 at 5. The Templeton fund was "red hot" during the time at issue; many other investors were purchasing it, such that it grew from August 1991 through December 1993 from zero to $1.392 billion in assets. Tr. 966-68, 978-82, 1099-1100; Div. Ex. 89; H. Ex. 23 at 141, H. Ex. 25 at 144. Hoffman included this fund among those he recommended in part because of his confidence in its management. Tr. 313-20. Concerning Kemper, Hoffman advised customers that it had legal troubles, was losing key personnel, and was "in play." There is much varying evidence in the record concerning the performance of various Kemper funds during various time periods and concerning whether or not lawsuits and loss of personnel would affect performance. However, it is undisputed that Kemper's assets under management declined during the time at issue while the mutual fund market generally was receiving a net inflow of funds. Tr. 1100-01; H. Ex. 23 at 9-10, 30, 33-41; H. Ex. 24 at 6-7; H. Ex. 25 at 9, 33, 38.
No customer witness, or any other customer, has registered any complaint concerning Hoffman, whether by a letter to Hoffman, to FSC, or to the NASD. Tr. 530. Most of the customer witnesses continue to deal with Hoffman and testified that they were fully informed concerned their investment decisions.10 Several of the Division's customer witnesses expressed negative opinions concerning the government's decision to bring charges against Hoffman. Tr. 60-61, 159, 474, 484, 498-99. Hoffman's customer witnesses also expressed such opinions. Tr. 896-97, 918-19.
Customers who liquidated a Kemper fund and purchased Templeton or another fund will be discussed in this section. The transactions of Clarence Leister and Frances Koester will be discussed separately.
Sandra Kleckner. Tr. 37-61, 433-40, 657-59, 789-91; Div. Exs. 1-18; H. Exs. 65-70. Kleckner testified on behalf of the Division. Fifty-two years old in 1994, and a high school graduate, she is a spare parts manager for a boiler firm. In 1994 she earned about $22,000. Her investment objective, indicated as "growth" on her new account form, was saving for retirement. She owned her home, free of mortgage, and, through Hoffman, had a variable annuity valued at $22,000 and several mutual funds valued at $51,000.11 In April 1994 she liquidated a Kemper fund (KIP Growth Initial Portfolio), which she had held for one year and eight months, for about $20,000 and purchased Templeton, which she still holds. She was dissatisfied with how the Kemper fund was doing. She understood that there was a cost to the change, but believed she would make it up. Hoffman always fully explained things such as cost and risk and pointed out relevant portions of prospectuses. She understood that Hoffman would receive a commission on her purchase because that is how he makes his living. She resents the proceeding against Hoffman.
Aleta Detwiler. Tr. 66-93, 307-08, 440-48, 528-30, 768-69, 789-91; Div. Exs. 79-80 H. Exs. 52-55. Detwiler testified on behalf of the Division. Forty-five years old in 1994, she is a dentist. She started dealing with Hoffman about 1985. Their first meeting was at her house, but thereafter she fitted him between patients at her office, and the meetings were rushed, lasting twenty minutes rather than one hour, which Hoffman would have preferred. In 1994 her income was about $100,000. She had about $100,000 equity in real estate investments, about $50,000 in liquid assets, and about $70,000 equity in her home. Her investment objective, indicated as "growth" on her new account form, was saving for retirement. In April 1994 she liquidated a Kemper fund (KIP Total Return Initial Portfolio), which she had held for one year and four months, for about $35,000 and purchased Templeton. Her reason for making the change was the potential for better returns. She sold Templeton at a profit shortly before the hearing. She stopped dealing with Hoffman as a result of a misunderstanding about a premium increase in a life insurance policy he had sold her.
Robert Lingo. Tr. 115-135, 539-48, 659-60, 769-70, 789-91; Div. Exs. 43-49; H. Exs. 102-106. Lingo testified on behalf of the Division. Forty-nine years old in 1994, he has a masters degree in technical education and works as an instructor and supervisor at a firm that manufactures process control instrumentation and systems. In 1994 his income was about $50,000, he had about $12,000 in liquid assets, and his investment objective was growth. In 1994 he liquidated a Kemper fund in his IRA (KIP Total Return Initial Portfolio), which he had held for two years, for about $9,000 and purchased Templeton. His reason for the change was the potential for better performance. He sold Templeton a few months before the hearing to help pay for the purchase and renovation of his house. He has been investing with Hoffman for about twelve years. He trusts Hoffman and is pleased with his services. He meets with him every year or so for about an hour. He always understood that Hoffman received a commission. He plans to resume investing through Hoffman after he finishes paying for his house.
William F. Schumaker. Tr. 135-161, 559-66, 660-61, 702-04, 767, 789-91; Div. Exs. 27-34; H. Exs. 115-117. Schumaker testified on behalf of the Division. Forty years old in 1994, he is a maintenance mechanic at a firm that distributes aftermarket car parts and is a high school graduate. His income was around $30,000 or $32,000. He had about $80,000 in liquid assets distributed among his IRA, his 401(k) plan, and an education fund. His investment objective for his IRA was growth. In March 1994 he liquidated a Kemper fund in his IRA (KIP Total Return Portfolio), which he had held for one year and seven months, for about $33,000 and purchased Templeton, which he still holds. His reason for the change was the potential for better performance. He trusts Hoffman, is pleased with his services, and also deals with him in connection with his mother's affairs. He is offended by the proceeding against Hoffman.
Brian Hanes. Tr. 168-86, 517-28, 590-91, 770, 789-91; Div. Exs. 72-74; H. Exs. 62-64. Hanes testified on behalf of the Division. Forty-one years old in 1994, he is a manufacturers representative and has a college education. In 1994 the joint income of Hanes and his wife, a teacher, was about $135,000. Hanes invested about $29,000 in Kemper funds with Hoffman in 1991, including about $3500 in Kemper Growth Fund A in May 1991. In April 1994 he liquidated Kemper Growth Fund A for about $4000 and invested the proceeds in Templeton. The reason for the change was dissatisfaction with Kemper. His wife arranged periodic meetings with Hoffman. His investment objective for his account with Hoffman was growth. Most of his money, then and now, was invested through a major wire house with an objective of having a mix of conservative and aggressive investments. He subsequently left Hoffman because he found him insufficiently attentive.
Catherine Koestel. Tr. 188-202, 298-300, 325-26, 530-33, 767, 789-91; Div. Exs. 25-26; H. Exs. 81-86. Koestel testified on behalf of the Division. Seventy years old in 1994, she is a retired library technician who had been employed by the Merck pharmaceutical firm. She trusts Hoffman and feels he has great integrity. Her investment goal, indicated as "growth" on her new account forms, is "not having to depend on our children." In 1994 she and her husband had about $112,000 invested in four mutual funds through Hoffman. In March 1994 she liquidated a Kemper fund in her IRA (KIP High Yield Initial Portfolio), which she had held over two years, for about $46,775 and purchased Delaware Group Delaware Fund A, a balanced fund, which she still has. She had become dissatisfied with the Kemper fund and asked Hoffman to recommend an investment that he would recommend for his mother.
Terry L. Conrad. Tr. 204-27, 507-16, 585-89, 770-71, 789-91; Div. Exs. 75-78; H. Exs. 38-45 Conrad testified on behalf of the Division. Forty-two years old in 1994, he is an electrician. He graduated from high school and has taken some college courses. He has been dealing with Hoffman for many years. Other family members have investments with Hoffman. Also, he owns his own company, and its pension plan is invested through Hoffman. He is satisfied with Hoffman and trusts him. In 1994 Conrad's income was $25,000 to $30,000. He had about $65,000 invested in mutual funds through Hoffman. His investment objective was growth. In April 1994 Conrad liquidated a Kemper fund (KIP Growth Initial Portfolio), which he had held for two years and six months, for about $29,000 and purchased Templeton, which he still holds. His reason for the change was the potential for better growth.
Barbara Schmoyer. Tr. 232-62, 308-10, 337-42, 389-95, 432, 665-70, 767-68, 789-91; Div. Exs. 50-52; H. Exs. 111-14. Schmoyer testified on behalf of the Division. Fifty-two years old in 1994, she is a college graduate who helps run a retail home center, a family business. She must provide for and care for her husband, who has been disabled for many years. To meet with Hoffman she took time out from business during the workday, and the meetings were more rushed than Hoffman preferred. In 1994 she had about $207,500 in investments through Hoffman. Her investment objective was growth. In February 1994 she liquidated a Kemper fund (KIP Growth Initial Portfolio), which she had held for two years, for about $27,000 and purchased Templeton. She made the change because Templeton was more aggressive, and there was potential for higher returns. She had first invested in Templeton in 1992. Hoffman's testimony that Schmoyer was very determined and decisive in making the change from Kemper to Templeton was consistent with the demeanor she displayed at the hearing and with the constricted amount of time she allotted to their meetings. The employee pension plan of the family business invests through Hoffman, and Schmoyer has recommended Hoffman to several family members. She was satisfied with Hoffman in 1994, but at the time of the hearing she was considering leaving him.
Dennis Nice. Tr. 262-80, 304, 548-59, 771, 789-91; Div. Exs. 55-69; H. Exs. 107-10. Nice testified on behalf of the Division. Sixty-nine in 1994, he is a high school graduate and is still working as a carpenter. In 1994 Nice earned $25,000 to $30,000 from his job. When he and his wife commenced investing with Hoffman in 1992, their new account form indicated an investment objective of income. In 1994 the Nices had about $370,000 invested through Hoffman. The Nices first invested in KIP Total Return Initial Portfolio in 1987. In April 1994 they liquidated KIP Total Return Initial Portfolio in their IRAs, which the IRAs had held for two years and one month, for a total of $65,000 and purchased Templeton, which they still hold. They took advantage of a breakpoint in the purchase. The Nices are well-satisfied with Hoffman's services.
Marjorie Landis. Tr. 455-85. Landis, fifty-eight years old in 1994, testified on behalf of Hoffman. She has been the elected tax collector of Franconia township since 1990, following thirty years of experience in banking. She is a high school graduate. She met Hoffman through a fellow tax collector in 1992 and commenced investing with him. She bought a Kemper fund through him in 1992 and sold it and bought Templeton in 1994. The reason for the change was dissatisfaction with the performance of the Kemper fund. She subsequently sold Templeton. She is well-satisfied with Hoffman and has referred her son and daughter to him. She expressed a negative view of the proceeding against Hoffman.
Raymond Lorish. Tr. 486-506. Lorish testified on behalf of Hoffman. Fifty-three in 1994, he owns a lawnmower repair shop and is a high school graduate. He knows Hoffman because he is on a cemetery board that invests through Hoffman and was satisfied with his services. Thus, when Lorish had some money to invest he asked Hoffman to meet with him. He calls Hoffman to meet with him about once a year. Hoffman explains everything carefully and does not pressure his wife and him. He bought a Kemper fund in March 1992 and sold it to buy an MFS fund in June 1994. He and his wife had originally chosen different funds for their investments, and his was not doing as well as hers. Lorish called Hoffman to ask about alternatives. The alternatives Hoffman presented were patience, a change within the same family, or a change to a different family which would incur transaction costs. Among the alternatives Hoffman presented was Templeton, which Lorish declined because of its foreign investments. He is well-satisfied with Hoffman.
Richard and Bonnie Cerven. Tr. 883-904, 906-926. Mr. and Mrs. Cerven testified on behalf of Hoffman. They own a research toxicology laboratory. Richard Cerven, forty-nine in 1994, has a post-graduate degree in science. His wife, Bonnie Cerven, completed two years of college. She has worked with her husband for many years at the laboratory and presently is director of regulatory compliance. Her previous employment included work as a paralegal for a private attorney, a district attorney, and a judge. The Cervens first met Hoffman when he made a presentation to the previous owner of the laboratory about a retirement plan for the company. They liked him because he is low-key, not fast-talking like some others in the industry. Around 1990 or 1991, the Cervens had some money to invest and contacted Hoffman. They bought Kemper Total Return and other Kemper funds. In 1994 they sold Kemper Total Return and bought Templeton, which they sold recently. The reason for the change was the hope for better returns. They deliberated over the purchase of Templeton. They discussed it with Mr. Cerven's father, who suggested that it would not be appropriate to invest all their money in Templeton, but that they might risk part of it. They understood the speculative nature of the fund. The Cervens were and are happy with Hoffman. Mrs. Cerven commented negatively about the proceeding against Hoffman, stating her belief that no customer had complained about him and that he does not have a "crystal ball."
Not all of the customer witnesses recalled the specific information that Hoffman conveyed to them, but several recalled that they understood it at the time. To the extent that any customer testimony suggests that Hoffman did not characterize risk or transaction costs correctly in connection with any fund, Hoffman's testimony that he followed a routine is accepted. Such a methodical approach is consistent with his demeanor as observed by the undersigned. His recollection that he consistently followed a routine is more reliable than an individual customer recollection as to the specific information he conveyed during a meeting five years earlier. Further, while the witnesses' recollection of information Hoffman provided varied, no customer testified that he did not provide prospectuses.
The customers were aware that they incurred costs when the bought or sold mutual funds; they were aware that Hoffman made a living from commissions from selling mutual funds. Tr. 59, 103, 130, 154, 276, 466. In conflict with Hoffman's testimony, Detwiler and Schmoyer, however, testified that they were unaware of the costs of their transactions. Tr. 73, 239, 248. Neither customer complained at the time she paid the costs, when the transactions were executed. Hoffman's testimony is consistent with the routine he followed in meeting with customers, and is accepted. Additionally, Hoffman had made a presentation concerning mutual funds to all employees at Schmoyer's business, including Schmoyer, and had explained sales charges. Tr. 236, 339. Further, prior to the questioned transactions, Schmoyer had bought Templeton and experienced the sales charge.
Mary Calhoun testified on behalf of the Division as an expert in industry standards and practices with regard to mutual funds, including suitability, switching, and breakpoints. Tr. 801-17 (qualifications); Tr. 817-82, 933-1051, 1056-60 (opinions); Div. Ex. 82. She examined only accounts selected by the Division. Tr. 818. Her opinion was based on examining account statements, FSC commission reports, some of the prospectuses for the funds purchased and sold in the accounts, information from Morningstar and Value Line, and new account forms for customers Kleckner, Koester, Leister, Lingo, and Schumaker. Tr. 822-23, 1016-18; Div. Ex. 82 at 2. She also relied on the direct testimony, but affirmatively disregarded the testimony on cross-examination, of Hoffman and the customers who testified. Tr. 822-23, 1016-18, 1035-39. She also examined five to ten other, unidentified, Hoffman customer accounts selected by the Division. Tr. 872, 1010-11, 1014-16. She did not examine all of Hoffman's accounts. She opined that an improper switch had occurred in two of the Kemper customer accounts, Detwiler and Schmoyer, based on the assumption that neither was informed of the costs. Tr. 829-32. However, as set forth above, Detwiler and Schmoyer were informed of the costs at the time of the transactions.
She also opined that in five other accounts, the Conrad, Koestel, Lingo, Nice, and Schumaker accounts, there were transactions that were not improper switches, but showed a pattern indicating Hoffman caused the customers to believe that it was normal and appropriate to change mutual funds every year or two, rather than to hold them for a longer term. Thus, if a mutual fund was held for a year or two and not doing well, the investor would think it appropriate to liquidate his holding in that fund and move to a "hot" fund that was doing exceptionally well in the short term; the increased performance would make up for any costs involved. Tr. 836-44. In Calhoun's opinion, short-term trading is anything less than five years. Tr. 839. In forming her opinion that Hoffman recommended improper switches, Calhoun specifically disregarded testimony by Hoffman and customers that Hoffman presented customers with three alternatives: first, no change; second, move to another fund within the same family; and third, if the customer rejected the first and second alternatives, to suggest a variety of options into which the customer could move.12 Tr. 1032-36. However, as set forth above, Hoffman did present customers with these alternatives.
Henry Ferguson (H. Ferguson) testified on behalf of Hoffman as an expert in the area of mutual fund switching and trade practices. Tr. 1062-75 (qualifications); Tr. 1075-179 (opinions). His experience includes being retained by a major Wall Street firm to perform an internal review of its sales force in the areas of suitability, excessive trading, and mutual fund switching. Tr. 1066. In connection with the opinions he offered in this case, he familiarized himself with market conditions and the market environment for mutual funds between 1992 and 1994; he reviewed performance and other issues regarding the Kemper family of funds, and market conditions and other factors regarding Templeton; and he reviewed and became familiar with junk bonds during the relevant period. Tr. 1077-78. He reviewed Hoffman's accounts to ascertain that, during the relevant period, approximately 400 accounts held a Kemper security, and that most still held it through 1998. Tr. 1079-81, 1157-59; H. Ex. 123. Thus, those who left Kemper during the time at issue were a very small proportion of the accounts which held Kemper.
In opining that there were no improper switches, H. Ferguson listed a number of factors, absent in Hoffman's case, that might indicate improper switches. These were: short-term holding periods measured in days, weeks, or months; client investment objectives dissimilar to mutual fund objectives; trading in funds with different objectives on a short-term basis; excessive trading; use of margin; no legitimate reason for the switch; unauthorized transactions; switching as a significant part of a registered representative's production;13 continual contact with clients urging them to make quick decisions; registered representative strongly recommending only one alternative; no explanation of costs of transactions; fraudulent documents given to clients distorting facts; complaints filed against registered representative. Tr. 1082-99, 1138, 1141-53; H. Ex. 118 at 4. Concerning holding periods that might indicate an improper switch, H. Ferguson testified that major broker-dealers with which he is familiar use holding periods of six months to a year in monitoring account activity to determine whether or not there has been an improper switch. Tr. 1171.
In opining on holding periods and other factors, H. Ferguson commented on the precedent of Russell L. Irish, 42 S.E.C. 735 (1965), aff'd, 367 F.2d 637 (9th Cir. 1966). Tr. 1155-56, 1171-72. Sales loads at that time were much higher than today. Tr. 1156. The sales loads in the Irish case were as high as 8 3/4% of the offering price. 42 S.E.C. at 739. In Thomas Arthur Stewart, 20 S.E.C. 196, 201-02 (1942), the Commission referred to sales loads of 8% to 19½%. The maximum sales loads in the funds purchased in 1994 by the customers in this case, Templeton and Delaware Fund A, were 5 3/4% of the offering price. Div. Ex. 145 at 10, Div. Ex. 146 at 3.
Hoffman acknowledges that the Leister cross-switch transactions described below were improper. Tr. 417-25. The only issue is whether Hoffman made a mistake, as he claims, or whether he intended to defraud Leister, as the Division argues.
Clarence Leister. Tr. 95-110, 416-25, 592-93, 758-64, 770, 789-91; Div. Exs. 22-23; H. Exs. 92-101, 121-22. Leister testified on behalf of the Division. Seventy-one years old in 1994, he is a retired bricklayer with an eighth grade education; he invested money he did not need and hoped to leave to his children; his objectives were income and some growth. Tr. 95-97, 534-37; H. Exs. 92-95. Also, he made withdrawals for special expenses, such as a trip to Europe and a tractor. In 1994 he had several mutual funds valued at about $145,000. Leister has been Hoffman's neighbor and friend for thirty-six years. Tr. 100, 348, 417.
Hoffman usually prepares methodically for meetings with customers, including a "recap" of their holdings. However, he stopped at the Leisters' home one day, not really expecting to find them in, and began discussing their holdings without having their files with him. He suggested that they would benefit from moving out of their tax-exempt fund since Leister was fully retired, and retrieved some prospectuses from his car. Delaware Group Delaware Fund A was chosen. Later, having discovered that the Leisters had another Delaware fund, Hoffman suggested that they not have all their money in one family of funds. The result of his suggestions was that they sold $48,952 of Delaware Group Decatur Series II and bought $48,952 of American Capital Equity Income Fund at about the same time in April and May 1994 that they sold $39,886 of American Capital High Yield Tax Exempt Fund A and bought $39,886 of Delaware Group Delaware Fund A. As Division expert Calhoun noted, these transactions constituted a switch that is improper on its face; the cross-transactions could have been done as exchanges at minimal cost.14 Tr. 827-29.
When Hoffman realized his error, he determined to repay Leister. Tr. 760-61. By then Hoffman had been notified that he was the target of an investigation, and he was advised by counsel to refrain from repaying Leister at that time. The night after Leister testified, Hoffman gave him a check for the total commission he had received on the transactions plus 6% interest, compounded.
Hoffman has learned a hard lesson. He determined never to transact any business without all the customer's files together in front of them. Tr. 421. Hoffman states that the cross-switch was an inadvertent mistake, and Leister himself believes Hoffman's error was unintentional. Tr. 103, 108-09. Hoffman's explanation is credible. The contrary explanation, that he intentionally misled Leister, is unsupported by any evidence outside the fact of the transactions. Further, it would be counterproductive to swindle a friend and neighbor in a small community; word would spread quickly and the wrongdoer's business would be ruined. Tr. 760.
Frances Koester. Tr. 297-98, 327-38, 697-99, 765-67, 789-91; Div. Exs. 20-21, 144, 147, 154; H. Exs. 87-91, 119. Age ninety-two in 1994, Koester lives in a retirement home. Physically frail, she is mentally alert. When she found she was not getting sufficient income from a Certificate of Deposit with the Mellon Bank to pay for her monthly expenses without invading principal, she commenced investing in mutual funds through Hoffman on the recommendation of her son-in-law Richard Benfield. Her investment objective was income. In 1994 Delaware Group U.S. Government Fund A, which she had held for two years, declined. In April 1994, after she and Benfield met with Hoffman, she moved to American Capital High Yield Investment A, a junk bond fund, which she still holds. Her reason for the change was her desire for income. At the meeting they discussed alternatives, including the option of placing Koester in Delaware Group's junk bond fund, the Delchester Fund; the cost of changing to the American Capital Fund; and risk factors. Hoffman believed that the increased income she could expect from the junk bond fund would offset any decline in asset value that the fund might experience.
As Division expert Calhoun noted, Koester could have had a cost-free exchange into the Delchester Fund; thus, Calhoun opined, it was an improper switch. Tr. 832-36. However, this would have placed all of Koester's money in the Delchester Fund, which she had also purchased through Hoffman in 1992. Hoffman's view was that it was preferable not to "put all your eggs in one basket." Calhoun, however, opined that any additional risk from concentrating all Koester's investment in one fund was preferable to paying an additional sales charge to purchase a second fund. Hoffman's expert H. Ferguson opined that it was not an improper switch. Tr. 1131-32. He considered that Koester benefited from the diversification of having her money in two junk bond funds rather than one; there is a difference in how portfolio managers and portfolios will respond during different time periods in the interest rate market. Tr. 1128. Calhoun's opinion of an improper switch is inconsistent with the facts that Koester decided on the change after a discussion of its costs and risks in comparison with alternatives.
Calhoun also opined on suitability, which she described as having three factors: the investor's financial situation, his understanding of the risk of the investment, and his investment objectives; if the investor can afford the risk of the investment, understands the risk, and is willing to take the risk, the investment is suitable. Tr. 856. Calhoun opined that junk bond funds offer an above-average risk for an investor seeking fixed income. Tr. 850-51. She stated that the risk is much less than in buying individual junk bonds, and that junk bond funds might have a place, along with other investments, in the portfolio of an investor with a conservative profile. Tr. 850-51, 946. She expanded on the risk by noting that, while junk bonds in general have performed well for a long time, there were substantial disruptions in the junk bond market and depreciation in junk bond funds in 1989 and 1990, and that such depreciation will recur some time again. Tr. 851-52. She did not, however, know how many, if any, defaults there were in any of the investments of the junk bond portfolios of the Delaware Delchester Funds, from 1985 through 1994, and the American Capital High Yield Fund, from 1980 through 1994, or how many, if any, bankruptcies there were of the companies that issued those junk bonds. Tr. 948-49.
Calhoun opined that concentrating Koester's portfolio entirely in junk bond funds was unsuitable because of her financial situation. Because of her age and financial circumstances, including her expressed objective of income, the most important consideration was to conserve principal, Calhoun opined. Tr. 856-57. H. Ferguson opined, taking into account the past record of the Delchester and American Capital junk bond funds, in comparison with the past record of U.S. government bond funds, as well as Koester's desire for income and her son-in-law's participation in their meeting, that Hoffman had a reasonable basis for his recommendation. Tr. 1121-1131. He noted that a U.S. government bond fund can experience volatility, and that junk bond funds are managed to reduce risk. Tr. 1123, 1128-29.
Templeton's prospectus described the fund's objective as "seeks long-term capital appreciation by investing in securities of issuers of countries having developing markets. Investment in such securities involves certain considerations which are not normally involved in investment in securities of U.S. companies, and investment in the Fund may be considered speculative. . . . See "Risk factors" on page 7."15 Div. Ex. 145 (bold in original). Calhoun opined that the Templeton Developing Markets Trust is a speculative, high-risk investment among mutual funds, albeit not among the highest risk investments. Tr. 847-50. She acknowledged that at the time Hoffman's customers purchased Templeton, it was "red hot;" many other investors were purchasing it, such that it grew from August 1991 through December 1993 from zero to $1.392 billion. Tr. 967-68, 978; Div. Ex. 89.
As noted above, Calhoun described suitability as having three factors: the investor's financial situation, his understanding of the risk of the investment, and his investment objectives. Tr. 856. She opined that the Detwiler, Kleckner, Nice, Schumaker, and Lingo purchases of Templeton were unsuitable because they lacked understanding of the risk of the investment.16 Tr. 854-60. This opinion is inconsistent with the facts set forth above that all of those customers were informed at the time of the transactions of the costs and risks of the transactions. Calhoun also opined that the investment was inconsistent with their objectives. However, as noted by H. Ferguson, who opined that the transactions were suitable, their objectives included "growth." Tr. 1104-15, 1132-36.
Additionally, Calhoun opined that Templeton was not suitable for Kleckner's and Detwiler's financial situations. Concerning Kleckner's financial situation, however, the record does not contain a complete inventory of her assets. Calhoun also points to Kleckner's answer to the question "how much of that money would you have been comfortable losing in the course of a year?" "I wouldn't want to lose any of it." Tr. 44-45. An answer such as Kleckner's almost can be expected and cannot be relied on by itself in assessing an individual's financial situation. Similarly, Calhoun's opinion that Detwiler's purchase of the Templeton fund was unsuitable because of her financial situation was based on her testimony that she did not want and could not afford to lose any of the money she had invested. Calhoun did not consider Detwiler's February 24, 1994, new account form, which indicated an objective of "growth." Tr. 854-55, 1016-17; H. Ex. 53. Again Detwiler's reflexive answer to the question of how much she wanted to lose cannot be relied on to assess her financial situation. Additionally, Detwiler had substantial assets and had the potential for high earnings for years to come.
In sum, Calhoun's opinions on suitability are based on assumptions that are inconsistent with the facts of the customers' financial circumstances, their investment objectives, and their understanding of the risk involved.
There is dispute between Calhoun and H. Ferguson as to whether Templeton was "a speculative high-risk investment among mutual funds" or an "aggressive growth" fund.17 Tr. 847-50, 1118-21. Nonetheless, Calhoun's characterization was more extreme than that disclosed in Templeton's prospectus, on which Hoffman was entitled to rely.
The Division attempts to impeach Hoffman's testimony that he advised customers of problems at Kemper by pointing to his December 5, 1996, testimony taken in the investigation of FSC, in which he never mentioned such problems. Tr. 658-61, 704-12. His testimony at the hearing was not actually inconsistent with his investigative testimony, but the omission appears questionable. However, when the circumstances of the investigative testimony are compared with those of this proceeding, the previous omission is explained and does not impeach the credibility of his testimony at the hearing. In December 1996 Hoffman was contacted by FSC and told to bring specified files, which filled two briefcases, to Atlanta, where he would be questioned by Commission staff. The files included those of witnesses in this proceeding and many more. Tr. 741-43, 746-47. FSC made, and paid for, the travel arrangements; Hoffman went to Atlanta the day before the testimony and met with FSC's lawyers. Tr. 742-44. They reviewed the files very cursorily, with emphasis on the accuracy of information on the new- account forms and whether the customers had signed them. Tr. 746-47. Thus, Hoffman's knowledge of the customer files was very shallow at the time of the investigative testimony. Tr. 749. FSC's lawyers also showed him an instructional tape; the tape's message was to say as little as possible and not to volunteer information to avoid getting into unanticipated trouble. Tr. 745-46. Accordingly, at the investigative testimony Hoffman intended to give truthful answers that were brief and to the point; he did not intend to mislead. Tr. 748-51. Subsequently, in August 1997, Hoffman was informed that he was a target and should hire his own lawyer. Tr. 751-53. He retained a lawyer recommended by FSC.18 Tr. 753. In preparation for the hearing Hoffman reviewed the files in depth. Tr. 748-49. Hoffman testified that methodical preparation, rather than cursory review, is more consistent with his way of doing business. Tr. 749. This is consistent with his demeanor observed at hearing.
FSC is a broker-dealer headquartered in Atlanta. It operates through small branch offices that are independent contractors. M. Ex. 22 at 2. During the time at issue it had over 600 registered representatives in approximately 485 branch offices, including approximately 155 OSJs, many of which were one-person offices. Tr. 1201, 1457; M. Ex. 64 at 2. This form of organization contrasts with that of a broker-dealer such as Merrill Lynch that has numerous large branches and employees and is self-clearing. Tr. 1516-17, 1741. FSC conducts primarily a retail business in mutual funds, variable annuities, and listed and over-the-counter (OTC) securities. Tr. 1723; M. Ex. 64 at 1. It conducts a large mutual fund wire order business; general securities transactions are cleared through Pershing, a division of Donaldson Lufkin & Jenrette, on a fully- disclosed basis. M. Ex. 64 at 1-2.
During the time at issue FSC's senior management included E. James Wisner, president, and four senior vice-presidents, including Thomas Hutchins, Chief Operating Officer, who reported to Wisner. Tr. 1240-41, 1722; M. Ex. 58. Wisner was the principal shareholder of FSC's parent, Financial Services Corporation; Hutchins had an approximately 10% interest. Tr. 1235-36. Respondent Montgomery, who reported to Hutchins, was not senior management. Tr. 1195-96, 1241; 1478; M. Exs. 32, 58, 77.
On August 23, 1991, Commission staff sent FSC a five-page letter listing a number of problems uncovered during an examination. Tr. 1202-08, 1459-60, 1480, 1501, 1742-43; M. Ex. 23.19 Wisner was shocked by the deficiency letter; he had understood that the NASD, which examined FSC periodically, was generally satisfied with FSC's compliance system; he now saw that FSC would have to make a major change in the way it conducted its mutual fund business. Tr. 1513-15. Wisner then met with Commission staff to gain a greater understanding of the staff's views and prepare to remedy any problems; he was accompanied by Hutchins; Montgomery, newly appointed Chief Compliance Officer; LaVerne Zellman, Director of Compliance; and Michael Brown, the controller. Tr. 1209-10, 1379, 1453, 1480. Wisner considered the situation to be extremely serious, and immediately started a very intense work project to respond to the Commission's concerns. Tr. 1502, 1513-15, 1518, 1520-21.
Supervision by FSC of one-person OSJs was not discussed at the meeting, and FSC did not understand this to be among the Commission's concerns until a follow-up investigation in 1994. Tr. 1204-05, 1251-52, 1261-62, 1538. There was no rule forbidding one-person OSJs and neither the NASD nor the Commission had issued any specific guidance on supervising them. Tr. 1440-41.
Montgomery coordinated the efforts of a task force that included himself, Zellman, and others, to respond to the Commission's concerns. Tr. 1211-12, 1379, 1460, 1522-28. Hutchins reported to Wisner on progress and on matters needing Wisner's decision. Tr. 1505-06, 1522-28; M. Ex. 24 at LZ 773-75. Montgomery's action plan listed a number of initiatives to correct problems at FSC. Tr. 1378, 1522; M. Ex. 24. Some of these changes were implemented. Tr. 1382-90; M. Exs. 9, 41-43, 45, 47, 50, 82, 88. For example, a costly change required offices to submit daily blotters to FSC. Tr. 1220-21, 1258-59, 1284-85, 1483, 1523-25; M. Exs. 42-43, M. Ex. 45 at 3, M. Exs. 47, 51, 52, 65, M. Ex. 94 at SEC 1656-57, M. Ex. 100, M. Ex. 157 at 2. Other changes Montgomery recommended were not implemented; for example, FSC did not require switch letters until after the events at issue in this proceeding. Tr. 296, 1274, 1296, 1394, 1494, 1582; M. Ex. 102.
An October 29, 1991, letter from Wisner to the Commission described FSC's plans, which included a number of automated exception reports, trade blotters to be submitted electronically to the home office, and an increase in the number of transactions required to be submitted by wire order. M. Ex. 25. A follow-up examination by Commission staff started September 28, 1993, and continued through the fall and winter. Tr. 1260-62; M. Exs. 64, 78. Eventually Commission staff prepared an internal report alleging violations by FSC. Tr. 1262; M. Exs. 64, 78. On December 9, 1998, the Commission released a consent order requiring FSC to pay a civil money penalty and retain and implement the recommendations of a consultant which would review its supervisory, compliance, and other policies and procedures.20
Montgomery, who has MBA and law degrees, began working at FSC in 1985. Tr. 1451. The position of Chief Compliance Officer was added to his other duties in August 1991 after FSC received the Commission's deficiency letter. Tr. 1242, 1374, 1453. Montgomery held that position until he left FSC four years later, frustrated that he was not able to accomplish more in the compliance area, and joined Prudential Insurance Company. Tr. 1374, 1453, 1476. FSC expected him to spend 20% of his time on supervision of FSC's compliance and registration functions; the remainder of his time was to be spent on business, legal, and administrative matters. Tr. 1264, 1270, 1489-91; M. Ex. 72. His position was middle management, subordinate to senior management. Tr. 1236-41, 1722, 1575-76; M. Exs. 32, 58, 77. As such, he could make recommendations to senior management but had no authority to implement changes in policies and procedures; to hire additional compliance staff; or to fire, discipline, or refuse to hire registered representatives who had compliance problems; nor could he reverse a trade if he discovered an improper switch or unsuitable trade. Tr. 1245-50, 1266-70, 1274, 1287-88, 1294, 1296-97, 1375, 1389-90, 1393-97, 1401-11, 1426-37, 1491-97, 1582-83, 1766-69; M. Exs. 2, 68, 84, 176.
Montgomery was not the direct, line supervisor of any OSJ principal, including Hoffman. Tr. 1376, 1454, 1477-78, 1573-75; M. Exs. 32, 58, 77. Nor did he systematically review the daily sales activity of Hoffman or any other one-person OSJ for evidence of sales practice abuses such as mutual fund switching or unsuitable transactions. Tr. 1454. The Division concedes that he was not required to do so.21 Supervision of OSJs was diffused among various areas in the home office, including the trading desk and the compliance department. Tr. 1218-24, 1234, 1419-21, 1454-56, 1468-69, 1587, 1735-36; M. Ex. 25. The responsibility of the compliance department was general oversight, rather than direct supervision. Tr. 1225, 1453, 1489. The head of the compliance department, LaVerne Zellman, reported to Montgomery; she was expected to spend all of her time on compliance and was responsible for the day-to-day operation of the compliance department. Tr. 1264, 1325, 1374, 1377; M. Exs. 3, 28, 32, 56, 58, 73, 77. Montgomery always supported her efforts to improve oversight of OSJ principals. Tr. 1437-38.
Expert testimony concerning whether Montgomery was Hoffman's supervisor was received from Elizabeth Ferguson (E. Ferguson), on behalf of the Division, and from Robert Lowry, on behalf of Montgomery. E. Ferguson interpreted language in FSC manuals and opined that Montgomery was Hoffman's supervisor, in effect, because no one else was. Tr. 1622, 1641, 154-58, 1667-72; Div. Exs. 107-09, 117, 140; M. Exs. 20-21, 93-94. She also opined that there was otherwise no effective system of supervision of mutual fund transactions by producing OSJs during the time at issue.22 Tr. 1623. Lowry opined that Montgomery was not Hoffman's supervisor, and that as compliance officer, he did not have the responsibility, authority, or ability to effect Hoffman's conduct so as to be held accountable as a supervisor. Tr. 1871-73.
The opinion that Montgomery was Hoffman's direct supervisor is rejected as contrary to the evidence. The testimony of all FSC witnesses, including Montgomery's supervisor Hutchins and Compliance Director Zellman, was consistent. Supervision was by a combination of areas of the firm, and Montgomery was not Hoffman's direct supervisor. Tr. 1223-25, 1234, 1308 (Hutchins); Tr. 1335-37, 1376 (Zellman); Tr. 1454-56, 1477-78 (Montgomery); Tr. 1570-71, 1573-75 (Young). Respondent Hoffman did not recognize Montgomery (or anyone in particular) as his direct supervisor; when he was questioned about this, he displayed difficulty in understanding what was being asked. Tr. 614-16, 645-49.
Division Expert E. Ferguson's theory that Montgomery was Hoffman's supervisor is based on the assumptions that (1) no one else was; and (2) a broker-dealer is required to have an effective system of supervision. Her theory is rejected on the basis of the record evidence. Every FSC witness appeared puzzled on being asked who was Hoffman's supervisor and every one eventually responded, in essence, that it was everyone at headquarters, that supervision was diffused among compliance and various trading desks. In the context of this evidence, E. Ferguson's interpretation of language in the manual is not only strained, but incorrect. Additionally, E. Ferguson's theory fails to take into account the possibility that there was no one person at FSC who was Hoffman's supervisor or the possibility that FSC did not have an effective system of supervision.
The question of whether Montgomery, as an FSC employee who had compliance responsibilities, can be held accountable as a supervisor is a question of law that will be addressed below in the Conclusions of Law section of this Decision.
As previously noted, Montgomery's action plan included daily transmission of blotters, requiring more transactions to be submitted by wire order, and a number of automated exception reports. Montgomery also tried to improve the compliance function by asking for increased staffing, mandatory switch letters, and happiness letters sent directly to clients without going through the OSJ. Tr. 1274, 1396-97, 1491, 1582-83; M. Exs. 68, 84, 176. Although the number of registered representatives increased, his requests for more staff were denied. Tr. 1266-70, 1396-97, 1409-11, 1490-91, 1582, M. Exs. 68, 84, 176. A total of twelve employees in the compliance and registration groups increased only by one or two while Montgomery was Chief Compliance Officer. Tr. 1490-91. Both experts opined that Montgomery's initiatives improved, or would have improved, FSC's compliance system. Tr. 1628, 1690-91, 1870.
The Division concedes that Montgomery was not required to employ an automated mutual fund switching exception report.23 Nonetheless, much evidence was introduced concerning FSC's efforts to develop a switching report.24 The evidence focused in particular on the truth or falsity of a statement in the November 5, 1992, letter from Montgomery to Commission staff that "[w]e are currently operational on the following exception reports: . . . . d.) `Switching' exception report."25 M. Ex. 41 at 3; see also, Tr. 1213-14, 1216-17, 1254-61, 1275, 1279, 1317, 1381, 1401-03, 1459-64, 1483-85, 1492-94 1528-34, 1572, 1639, 1651, 1682-89, 1749-66, 1783-1807, 1874-75; M. Exs. 25, 27, 26, 41, 48, 49, 70, 71, 161, 157, 161, 163.
This evidence establishes the following, essentially undisputed, facts. Soon after the August 1991 deficiency letter and meeting with Commission staff, FSC commenced a project of numerous administrative improvements. This included development of an automated exception report to highlight questionable mutual fund switches. No firm like FSC had such an automated report. No one at FSC foresaw the length of time it would take to develop a usable report. After Montgomery and others brainstormed the parameters, the project was assigned to computer programmer Elias Sbaity on October 3. Sbaity finished his project in November. However, various problems developed, sequentially, in implementing the report. Various solutions were tried. At the time Sbaity left FSC in 1995, the report was still not usable. A switching report was finally in use in 1996 or 1997. The switching report that Sbaity was developing would not have detected the switches like those at issue, between funds with different objectives. The November 1992 letter was intended to inform the Commission of FSC's significant progress in improving its compliance system in response to the issues raised by the Commission's deficiency letter. Among the items listed in the six-page letter was a list of ten exception reports stated to be operational. The list included the switching report, which, in fact, was not operational.
Under the circumstances, the inaccurate statement was an oversight or misunderstanding by Montgomery and not an intentional misrepresentation. Neither he, nor anyone else at FSC, intended the letter to be inaccurate or to deceive the Commission. Any such deception would have been counterproductive since the Commission was expected to return for a follow-up examination.
The evidence about the switching report shows the persistence of FSC and Montgomery in attempting to develop a usable switching report and to improve FSC's compliance system. Otherwise, it is irrelevant to any issue in this proceeding. The Division has argued variously that failure to have or use such a report indicates a failure to supervise or lack of credibility of Montgomery. Concerning credibility, the record is clear that the statements in all three letters were made in good faith. There is no evidence in the record that is inconsistent with this. No one at FSC foresaw how long it would take to develop a usable switching report. Further, the OIP charges Montgomery with failure reasonably to supervise Hoffman with a view to preventing violations by Hoffman. He is not charged with fraud, with aiding and abetting violations of the antifraud provisions, or with filing any kind of inaccurate or false reports with the Commission.
Concerning the relationship of an exception report to failure to supervise, the Division is understood, by its February 1, 1999, Response to Respondents' Motions for More Definite Statement, to have dropped failure to use a switching report as an element of Montgomery's alleged failure to supervise Hoffman. Additionally, as described above, there is an abundance of evidence in the record concerning the difficulties FSC experienced in attempting to develop a usable switching report and establishing that no other broker-dealer like FSC had such a report.
Annual audits were part of FSC's compliance system. Tr. 1336. Zellman was responsible for annual audits of OSJs, like Hoffman. Tr. 1330. During the time at issue there were four FSC employees whose full time was devoted to such audits, and there were about 175 OSJs. Tr. 1330. From time to time Zellman and Montgomery would be apprised of problems concerning registered representatives discovered by audits or by principals on the trading desks. Tr. 1417-19, 1494-96. No problems or red flags concerning Hoffman were brought to Montgomery's or Zellman's attention. Tr. 1414, 1495. Moreover, had the Compliance Department called any of Hoffman's customers in 1994, the customer would have said that he or she was happy with Hoffman and the service he rendered. Tr. 199-200, 202, 226, 261, 278-79, 483-84, 904, 925.
Richard Young performed audits of Hoffman's business in 1993 and 1994. Tr. 1547-70; M. Exs. 59-63, 79-81. Expert testimony concerning the audits was received from E. Ferguson, on behalf of the Division, and from Robert Lowry, on behalf of Montgomery. E. Ferguson opined that the audits of Hoffman's business by FSC were insufficient. Tr. 1631-39. However, she also opined that it was not unreasonable for Montgomery to have delegated responsibility for development and implementation of the audit program to Zellman. Tr. 1672. She also conceded that the execution of the audit, rather than the audit program may have been flawed. Tr. 1676.
Both experts agreed that an audit program should not specify a minimum number of accounts to be reviewed. Tr. 1637, 1852-53. Lowry noted that each auditor had to do three or four cases a month and opined that was not unreasonable.26 Tr. 1847-48. He opined that the audit program was reasonable and that the Hoffman audits did not indicate any red flags. He also noted that Montgomery asked for, and did not receive, more staff. Tr. 1848, 1851-54, 1863. He opined that the amount of time spent at Hoffman's place of business, one day, was not unreasonable, noting that Commission staff conducting an examination of an office with forty or fifty registered representatives doing multiple lines of business might spend four or five days at that office. Tr. 1849-50. In sum, while E. Ferguson disagrees with Lowry's opinion that the audits were sufficient, she acknowledged that it was reasonable for Montgomery to delegate responsibility for audits to Zellman and that more effective supervision and audits required more resources, which FSC denied to Montgomery.
E. Ferguson discussed several methods Montgomery could have used to improve supervision, including employing non-producing regional OSJs to supervise the personal production of OSJs and to require that more trades be executed through Pershing; however, she stressed that these steps would cost more than the resources he had available. Tr. 1639-41, 1652-53. Lowry opined Montgomery did everything within his power to effect a reasonable supervisory system. Tr. 1863-64, 1867-69, 1874-77. Again, while E. Ferguson was critical of the supervisory system, she acknowledged that more effective supervision required more resources, which FSC denied to Montgomery.
In this section, it is concluded that Hoffman did not violate the antifraud provisions. Accordingly, the failure to supervise charge against Montgomery fails as well. In the alternative, assuming arguendo that Hoffman did violate the antifraud provisions, Montgomery was not his supervisor or, alternatively, Montgomery's supervision was reasonable under the attendant circumstances, and the failure to supervise charge against him fails.
The OIP charged Hoffman 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.
Section 17(a) 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,
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, or
3) engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder proscribe similar practices "in connection with" the purchase or sale of securities.
Material misrepresentations and omissions violate Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. 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. See SEC v. Steadman, 967 F.2d 636, 643 (D.C. Cir. 1992); see also Basic Inc. v. Levinson, 485 U.S. 224, 231-32, 240 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
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." Aaron v. SEC, 446 U.S. 680, 686 & n.5, 695-97 (1980); see also Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976).27
Recklessness can satisfy the scienter requirement. David Disner, 52 S.E.C. 1217, 1222 & n.20 (1997); see also SEC v. Steadman, 967 F.2d at 641-42; Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990). 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. 1978) (quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977)).
Mutual fund sales practices such as short-term holding periods, mutual fund switches, and breakpoint violations violate the antifraud provisions. Russell L. Irish, 42 S.E.C. at 740-42. Such practices are also subject to NASD discipline as unsuitable recommendations in violation of NASD Conduct Rule 2310.28 Kenneth C. Krull, 68 SEC Docket 2324 (Dec. 10, 1998); Terry Wayne White, 50 S.E.C. 211 (1990); Winston H. Kinderdick, 46 S.E.C. 636 (1976); Charles E. Marland & Co., Inc., 45 S.E.C. 632 (1974).29
The term "unsuitable recommendations" derives from NASD Conduct Rule 2310:
in recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
Unsuitable recommendations may be part of a course of fraudulent conduct that violates the antifraud provisions but are not violative taken by themselves. Mauriber v. Shearson/American Express, Inc., 567 F. Supp. 1231, 1237 (S.D.N.Y. 1983); Clark v. John Lamula Investors, Inc., 583 F.2d 594, 600 (2d Cir. 1978). Unsuitable recommendations may include actual misrepresentations and omissions so as to violate the antifraud provisions. Joseph J. Barbato, 69 SEC Docket 178 (Feb. 10, 1999) (recommendations made in disregard of investors' professed investment objectives coupled with misrepresentations and omissions concerning the securities, unwarranted price predictions, and investors' new account cards falsely changed to show increased tolerance for risk); Martin Herer Engelman, et al., 52 S.E.C. 271 (May 18, 1995), aff'd sub nom. Isen v. SEC, 87 F.3d 1319 (9th Cir. 1996) (recommendations made in disregard of investment objectives coupled with false representations that the securities met those objectives). Thus, to the extent that Hoffman made any unsuitable recommendations, the evidence must be examined for any material misrepresentations or omissions, as well as scienter, to conclude that he violated the antifraud provisions.
There are no improper switches. The facts show that a few customers who held Kemper mutual funds for periods ranging from one year and four months to more than two years liquidated them and purchased funds with different objectives that were consistent with their investment objectives. In all cases the customers were fully informed as to the costs and risks and were not pressured to make the change. Even the Division's expert witness on sales practices, Mary Calhoun, opined that there were improper switches in only two accounts, the Detwiler and Schmoyer accounts. However, her opinion even as to those two was based on assumptions that are contrary to fact. She assumed incorrectly that the customers had not been informed of the costs of the transactions.
The Commission has never held that switching mutual funds after holding periods like those in this case is short-term trading or improper switching. In the Irish case the holding periods were less than one year in 37% of the transactions and from one to two years in 29%. Also, 31% of the registrant's commissions derived from switches. In the Krull case the average holding period was eleven months. In the White case the average holding period was seventy days, with the shortest being seven days, and the longest, 130 days. The average holding period was not stated in the Kinderdick case, but the Commission noted examples of multiple switches within a year. Additionally, the case included a single switch after a three-year holding period, for which the registered representative offered a truly incredible reason: that the customer desired to have her stepson's name eliminated from ownership of the investment. The holding period was not stated in the Marland case.30
In addition to her opinion that there were two improper switches, Calhoun opined that there were transactions in five other accounts that were not improper switches, but indicated that Hoffman caused his customers to think it appropriate to change mutual funds every year or two rather than to hold them for a longer term. There is no precedent for establishing a violation of the antifraud provisions through a series of trades that are not improper switches. Likewise, there is no basis in law or industry practice for Calhoun's opinion that short-term trading is anything less than five years; the opinion is rejected. Indeed it is common knowledge that mutual fund investors are turning over their holdings more rapidly than in the past and changing funds according to past performance or future expectations. See, e.g., Tornado Upends Fund Rankings, Wall St. J., July 6, 1999, Mutual Funds Quarter Review at R1 (reporting influx and outflow of money in various funds); Trade Out, or Truck On?, Wash. Post, Oct. 10, 1999, Third Quarter Mutual Fund Report at H1 (quoting a major fund spokesman as saying that three years is now considered a long holding period and reporting various funds' steps to discourage short-term trading of a few months or less).
Calhoun's description of suitability follows NASD Conduct Rule 2310. As noted above, she described suitability as having three factors: the investor's financial situation, his understanding of the risk of the investment, and his investment objectives. As described above, Calhoun opined that the purchase of Templeton was unsuitable for five customers because they lacked understanding of the risk of the investment and, as to two of them, because it was inconsistent with their financial situations. As discussed above, Calhoun's opinion was based on assumptions that are inconsistent with the facts specifically, the facts of the customers' financial circumstances, investment objectives, and understanding of the risks involved. Thus, Calhoun's opinion is rejected. Additionally, the record shows no material misrepresentations or omissions by Hoffman concerning the purchase of Templeton; to the contrary, Hoffman made every effort to educate the customers about the risks, costs, and other factors concerning the Templeton fund.
Hoffman has acknowledged inappropriate trading in the Leister account and repaid Leister; under the circumstances, it was an inadvertent mistake.31 The Leister transactions were an improper cross-switch because they could have been accomplished without cost to Leister, as Hoffman readily acknowledges. Hoffman made the mistake because, unlike his usual practice, he fell into a discussion of the Leisters' holdings without having their files at hand. The question arises, however, whether Hoffman's actions were negligent such that they violated Section 17(a)(2) or (3) of the Securities Act. To show negligence, it must be shown that Hoffman failed to exercise a reasonable standard of care or competence of a registered representative. The record, however, is devoid of evidence concerning the standard of care that would apply. Nor is there any case precedent, and the Division has pointed to none, that provides guidance concerning the standard. Under the circumstances, it is concluded that Hoffman's mistake did not rise to the level of a violation of Section 17(a)(2) or (3). Even assuming there were a violation, under the standards of Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), Hoffman's remorse, self-imposed disgorgement, and determination never again to do business with a customer without full records at hand are a sufficient sanction and provide assurance against future violations.
In 1994 Koester, aged ninety-two, was invested in two Delaware Group funds, the Delchester junk bond fund and the U.S. Government Bond fund. The U.S. Government Bond fund declined, and Koester sought a change. Her reason was the desire for income to maintain her residence in a retirement home. After she and her son-in-law met with Hoffman, she liquidated the U.S. Government Bond fund and purchased a junk bond fund in another family. Calhoun opined that concentrating all Koester's assets in junk bond funds was unsuitable because of her financial situation and that the transaction was an improper switch because Koester could have switched into the Delchester fund at no cost. Hoffman's rationale for recommending a second junk bond fund under the circumstances was that the increased income Koester could expect would offset any decline in asset value that the fund might experience, and that it was preferable not to "put all your eggs in one basket." There is no evidence that Hoffman made any material misrepresentations or omissions in connection with his recommendation to Koester and her son-in-law. There was no improper switch because Koester decided on the change after discussion of its costs and risks in comparison with alternatives. While there is room for a difference of opinion as to whether this was the best investment for her, Hoffman's recommendations were not unreasonable and, under the circumstances, not unsuitable and were accepted at the time and after the fact by Koester and her family. Therefore, there was no improper switch and no fraudulent unsuitable recommendation.
The facts show that there were no material misrepresentations or omissions by Hoffman. The costs and risks of various courses of action were disclosed by him and he never pressured customers to engage in a transaction or to choose one course of action over another. However, assuming arguendo, that there were material misrepresentations or omissions, the record shows a complete lack of scienter by Hoffman; he had no intent to deceive or defraud. Nor could scienter be imputed through reckless conduct. Hoffman was unusually thorough in his efforts to "know your customer" and in his efforts to explain investments to them. The fact that he made a living, as his customers were aware, through earning commissions on the sale of mutual funds does not make such sales securities fraud. There is nothing sinister about his responding to his customers' requests for meetings or for initiating periodic follow-ups with customers to review their holdings. The record shows that he provided full information to his customers and did not particularly recommend one course of action over another. The customers were thus free to make their own decisions without pressure. The customers were and are happy with Hoffman's low-key style of doing business.
The Commission has held that
determining if a particular person is a "supervisor" depends on whether, under the facts and circumstances of a particular case, that person has a requisite degree of responsibility, ability, or authority to affect the conduct of the employee whose behavior is at issue. [citations omitted.]
Patricia Ann Bellows, 67 SEC Docket 2910, 2912 (Sept. 8, 1998).32
The Commission distinguishes between persons who are clearly direct, line supervisors, for example, a branch manager, and employees of brokerage firms, who, like Montgomery, have legal or compliance responsibilities. A branch manager is presumed to be a supervisor for the purpose of a failure to supervise charge, while a compliance officer must be shown to have the responsibility, ability, and authority to affect the conduct of an employee who has violated the securities laws in order to be considered his supervisor. Compare James J. Pasztor, 1999 SEC LEXIS 2193, *19-*21 & nn.27-28 (Oct. 14, 1999) with Patricia Ann Bellows, 67 SEC Docket 2910, 2912 (Sept. 8, 1998); John H. Gutfreund, 51 S.E.C. 93, 113 (Dec. 3, 1992).
The evidence in this case shows that Montgomery was not Hoffman's direct, line supervisor. In any event, Montgomery lacked the responsibility, ability, or authority to affect the conduct of Hoffman. He had no responsibility, ability, or authority to discipline Hoffman or any other individual registered representative or OSJ; he could bring problems or potential problems to the attention of senior management, but, at times, his recommendations to discipline, fire, or not to hire were ignored. Nor did Montgomery have the responsibility, ability, or authority to implement general procedural changes that would detect questionable sales practices by Hoffman or any other registered representative or OSJ. Again, he could make recommendations to senior management, who would, at times, reject them. Examples of such rejections that are relevant to this case are his recommendation to require mutual fund switching letters and his several attempts to increase the compliance staff. In short, he was not Hoffman's supervisor within the meaning of Section 15(b) of the Exchange Act.
In the alternative, assuming for the sake of argument, that Montgomery was Hoffman's supervisor, his supervision was reasonable under the attendant circumstances. See Louis J. Trujillo, 49 S.E.C. 1106, 1110 (Mar. 16, 1989). There were no red flags concerning Hoffman's sales practices that came to Montgomery's attention. Montgomery could not, without the approval of senior management, change procedures or hire more compliance staff. He continuously urged that FSC require mandatory switch letters and continuously asked for more compliance staff. His requests were not granted. If his requests had been granted, the assumed improper switches might not have occurred or might have been detected. Likewise, Montgomery was powerless to speed up FSC's development and implementation of the mutual fund switching report.
No violation alleged in the OIP was proved. Respondent Richard Hoffman did not violate Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Respondent Kirk Montgomery did not fail reasonably to supervise Hoffman with a view to preventing violations by him within the meaning of Section 15(b)(4)(E) of the Exchange Act. Accordingly, the proceeding will be dismissed.
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), it is certified that the record includes the items set forth in the record index issued by the Secretary of the Commission on January 21, 2000.
It is ordered that this administrative proceeding IS DISMISSED as to Respondent Richard Hoffman.
It is further ordered that this administrative proceeding IS DISMISSED as to Respondent Kirk Montgomery.
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 the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within 21 days after service of the initial decision upon 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
1 Citations to exhibits offered by the Division, Hoffman, and Montgomery, and to the transcript of the hearing will be noted as "Div. Ex. __," "H. Ex. __," "M. Ex. __," and "Tr. __," respectively.
2 See 5 U.S.C. § 557(c).
3 The Division also requested a "collateral bar," but that remedy is no longer available. See Victor Teicher v. SEC, 177 F.3d 1016 (D.C. Cir. 1999).
4 As defined in National Association of Securities Dealers (NASD) Conduct Rule 3010. The NASD is a self-regulatory organization, operating under Commission supervision, of firms in the over-the-counter market. One of its basic purposes is to establish and enforce fair and equitable rules of securities trading.
5 Class B shares have a deferred sales charge paid on liquidation of the investment. The charge is a percentage of the amount invested (not on appreciation or reinvested dividends) and declines on a sliding scale with the number of years that the fund is held. Tr. 821-22. Class A shares have a sales charge paid on purchase of the investment. Additionally, a higher annual fee is assessed against Class B shares than Class A shares of the same fund. The OIP alleged that Hoffman omitted to inform "switched" customers of this. However, the evidence in the record concerns only customers' purchases of Class A shares.
6 FSC's Registered Representative Compliance Manuals define mutual fund switching as "moving a client from one mutual fund to another with the same or similar investment objectives." A switch letter is a statement from the client acknowledging costs that may be incurred. M. Ex. 21 at 39, M. Ex. 94 at SEC 1695. M. Ex. 21 is the same as Div. Ex. 108.
7 Hoffman, however, called FSC's home office to report that customers were leaving Kemper. Tr. 649, 741, 1440.
8 In the future Hoffman will ponder his answers to the questionnaire carefully. Tr. 740.
9 Five of the customers discussed below Detwiler, Schmoyer, Conrad, Lingo, and Schumaker liquidated a Delaware Group mutual fund in 1991 or 1992 when they bought their Kemper funds. Schumaker and Lingo bought their Delaware funds in 1988 and held them for three years and nine months and three years and four months, respectively. Divs. Exs. 27, 43. There is no evidence in the record as to how long Detwiler, Schmoyer, and Conrad held the Delaware funds.
10 Two no longer deal with Hoffman for reasons that are unrelated to the issues in this case.
11 Kleckner declined to identify or quantify her additional assets. Tr. 41.
12 Calhoun disregarded the testimony because it was elicited on cross-examination. Tr. 1035-36.
13 The total commissions from all the questioned transactions in this case were an insignificant portion of Hoffman's commissions. Div. Ex. 86; H. Ex. 1.
14 Additionally, the $48,952 portion of the improper transactions considered by itself appears to show a breakpoint violation. Leister, however, did not have the extra cash to reach the $50,000 breakpoint. Tr. 105.
15 In addition to the customers who moved to Templeton, one customer moved from a Kemper junk bond fund to a Delaware Group balanced fund.
16 Calhoun also stated that Kleckner's failure to comment unfavorably on Templeton's performance showed that she could not have understood the risk. Tr. 855. However, Kleckner's omitting to criticize Templeton must be seen in the light of her strong support of Hoffman and strong disapproval of this proceeding against Hoffman. Tr. 42, 60-61.
17 The customers consistently testified that Hoffman offered more than one suggested investment; there is no evidence in the record concerning the investment objectives of the other funds that Hoffman suggested to each customer.
18 Subsequently Hoffman determined that he should discharge counsel recommended by FSC and obtained new counsel to represent him at the hearing. Tr. 771-73.
19 M. Ex. 23, the August 23, 1991, letter is also referred to in the transcript as Div. Ex. 110.
20 FSC Sec. Corp., Order Instituting Public Proceedings Pursuant to Sections 15(b) and 19(h) of the Securities Exchange Act of 1934, Making Findings and Imposing Sanctions, 68 SEC Docket 2318 (Dec. 9, 1998).
21 The OIP alleged, at para. III.H., "As part of his failure reasonably to supervise Hoffman, Montgomery: . . . 1. Failed to ever conduct a review of all of Hoffman's accounts for evidence of sales practice abuses or to ensure that anyone else regularly conduct such a review." However, the Division's February 1, 1999, Response to Respondents' Motions for a More Definite Statement (M. Ex. 191 at 2) states, "the Division is not alleging and is not aware, at this time, of any law requiring Montgomery to review or ensure the regular review of Hoffman's customer accounts . . . ." NASD Conduct Rule 3010 does not require a principal to review the day to day transactions of a one-person OSJ or for one person to be designated his supervisor. Tr. 1422, 1440-41, 1496-97, 1651, 1662, 1876.
22 E. Ferguson also opined that trading desk principals would be too busy to review trades for compliance and did not consider it their job. Tr. 1624, 1628-29. However, she conceded that she had no first hand knowledge of this and could not recall where she had obtained the facts that formed the basis for this opinion. Tr. 1699-1702.
23 The OIP alleged, at para. III.H., "As part of his failure reasonably to supervise Hoffman, Montgomery: . . . 2. Failed to employ the automated mutual fund switching exception report which he represented was `operational' to monitor for mutual fund switching [which] contributed to the . . . failure to detect the switching in which Hoffman was engaging in 1993 and 1994." However, the Division's February 1, 1999, Response to Respondents' Motions for a More Definite Statement (M. Ex. 191 at 2) states, "the Division is not alleging and is not aware, at this time, of any law requiring Montgomery to . . . employ an automated mutual fund `switching' exception report." E. Ferguson, the Division's expert witness in the area of securities industry standards and practices regarding supervision of registered representatives and producing OSJs, agreed that there was no such requirement. Tr. 1608.
24 The Commission has ruled that administrative law judges should be inclusive in making evidentiary determinations in its proceedings: "if in doubt, let it in." See City of Anaheim, Order Vacating Grant of Motion to Exclude Evidence, 1999 SEC LEXIS 2421, *4-*6 & nn. 4-8 (Nov. 16, 1999).
25 Also, an April 7, 1994, letter from Montgomery to the NASD described the switching report as "To be run." Tr. 1463-64; M. Ex. 71 at SEC 1293. In contrast, other reports are described as "It is run daily." The alleged misrepresentation is that "to be run" is a misrepresentation because the exception report was still under development at the time of the letter and many problems had been encountered. This interpretation of a representation that the report was expected to be run at some time in the future is extremely strained; it simply is not a misrepresentation. Likewise, an October 29, 1991, letter from James Wisner to the Commission described a switching exception report as "to be operational within 90 days." M. Ex. 25 at 4. M. Ex. 41 is also referred to in the transcript as Div. Ex. 112; M. Ex. 71, as Div. Ex. 113; and M. Ex. 25 as Div. Ex. 111.
26 E. Ferguson's calculation that each auditor had to do an unreasonable 14.7 audits per month was an arithmetic error. Tr. 1631-32, 1847-48.
27 Scienter is not required to establish a violation of Section 17(a)(2) or (3); 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 at 643 & n.5 (citing Aaron, 446 U.S. at 701-02); Newcome v. Esrey, 862 F.2d 1099, 1102 n.7 (4th Cir. 1988)).
28 Formerly Article III, Section 2 of the NASD Rules of Fair Practice.
29 In its Opinions in review of NASD disciplinary proceedings, the Commission has approved the NASD's theory that a pattern of similar switching transactions justifies a presumption of unsuitable recommendations that the person responsible must rebut. Krull, 68 SEC Docket at 2327-28; White, 50 S.E.C. at 212-13; Kinderdick, 46 S.E.C. at 639; Marland, 45 S.E.C. at 635-36. Neither the Commission nor any court has endorsed such a shift in the burden of proof in ruling on alleged violations of the antifraud provisions.
30 Marland contained a statement that the sixty-one violative switches appeared on a list of eighty-nine transactions, and that the average holding period of the eighty-nine was twenty-nine months. Marland, 45 S.E.C. at 634 n.6. It is assumed that the average holding period of the twenty-eight non-violative transactions exceeded that of the violative transactions.
31 Also, there is no pattern of breakpoint violations. Leister's explanation that he did not have the additional $1000 cash to reach a breakpoint shows there was no violation in his account, while the transactions in the Nice account took advantage of the breakpoint.
32 The settlement and Report of Investigation Pursuant to Section 21(a) of the Exchange Act reported at John H. Gutfreund, 51 S.E.C. 93, 113 (Dec. 3, 1992) in which the "responsibility, ability, or authority" test was articulated has been referenced many times by the Commission in litigated cases both in administrative proceedings and in review of NASD disciplinary proceedings for violation of the broader NASD Conduct Rule 3010 (formerly Art. III, Rule 27). See administrative proceedings James J. Pasztor, 1999 SEC LEXIS 2193, *19-*21 & nn.27-28 (Oct. 14, 1999), Bellows, supra, C. James Padgett et al., 52 S.E.C. 1257, 1266 n.32 (March 20, 1997); review of NASD disciplinary proceedings Steven P. Sanders et al., 68 SEC Docket 982, 997 & n.30 (Oct. 26, 1998), Michael H. Hume, 52 S.E.C. 243, 248 n.14 (Apr. 17, 1995), Rita H. Malm et al., 52 S.E.C. 64, 70 n.22 (Nov. 23, 1994), Conrad C. Lysiak, 51 S.E.C. 841, 844 & n.13 (Nov. 24, 1993), Douglas Conrad Black, 51 S.E.C. 791, 795 n.13 (Nov. 12, 1993).
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