Initial Decision of an SEC Administrative Law Judge
In the Matter of
|In the Matter of||:|
|: INITIAL DECISION|
|BYRON G. BORGARDT and||: JUNE 1, 2000|
|ERIC M. BANHAZL||:|
Gregory C. Glynn and Andrew G. Petillon for the Division of Enforcement, Securities and Exchange Commission.
Joel H. Goldberg, Susan K. Leach, and Kevin J. O'Brien for Respondent Banhazl.
Irving M. Einhorn for Respondent Borgardt.
James T. Kelly, Administrative Law Judge
The Securities and Exchange Commission (Commission) instituted this proceeding on September 28, 1998, pursuant to Section 8A of the Securities Act of 1933 (Securities Act) and Section 9(f) of the Investment Company Act of 1940 (Investment Company Act). The Order Instituting Proceedings (OIP) charged Respondents with causing violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act, and with violating Section 34(b) of the Investment Company Act. At issue was the omission of two allegedly material facts from six registration statements filed with the Commission by Target Income Fund (Target or Fund), a now-defunct registered investment company, between 1992 and 1996. As relief, the OIP sought a cease and desist order.
The OIP specifically alleged that two material facts were omitted from the relevant Fund registration statements: (1) the Fund's "relationship with, and complete dependence on," a finance company, Concord Growth Corporation (Concord), in that Concord "was the Fund's only source of investments, and the Fund's only servicer for the loans in which the Fund invested"; and (2) "the material conflict of interest resulting from the fact that a Fund director [Reid Rutherford] was simultaneously chairman of the board, chief executive officer, and a 20 percent owner of [Concord]."
In their amended answers, Respondents maintained that the omitted information was not material. They also argued that they were not liable because they exercised due care and reasonably relied on the advice of counsel at all times. For these reasons and others, they urged that the proceeding be dismissed.
The matter was initially assigned to Administrative Law Judge Carol Fox Foelak; it was reassigned to my docket on April 12, 1999.
On May 26, 1999, pursuant to Rule 200(d)(2), I granted the motion of the Division of Enforcement (Division) to amend the OIP. The amended OIP identifies two more allegedly material omissions from the same six registration statements. The third charge has three parts: (a) it alleges that Respondent Byron Borgardt had a separate business relationship with Concord, arising from his position as an officer and manager of investments of James Hardie Industries (USA) Inc., and it contends that this fact was not disclosed; (b) it alleges the existence of a conflict of interest on the part of Mr. Borgardt because he "simultaneously served as a Fund director, the Fund's portfolio manager and President of [the Fund's] Adviser while also serving as an officer and manager of [Hardie, a company] which functioned in competition with the Fund"; and (c) it alleges that these omissions reflected the extent of Concord's relationship with the Fund. The fourth allegation recited that Concord received average annual yields of 27.7 percent to 32.1 percent on its loans while the Fund received average annual yields of only 10.74 percent to 11.32 percent. That fact is said to be material because "the significantly higher returns paid to [Concord] revealed a greater investment risk on the underlying loans than was apparent from the return paid to the Fund by [Concord]" and because "the disparate rates of return also reflected on the nature of the undisclosed relationship of [Concord] to the Fund." As with the original OIP, the only sanction sought in the amended OIP is a cease and desist order.
I held a public hearing in Los Angeles, California, on June 21-25, 1999. The parties filed their proposed findings of fact, conclusions of law, and briefs on September 8, 1999. They also filed reply briefs on September 27, 1999. At Respondents' request, I heard oral argument by telephone on November 10, 1999.1
In addition to the present proceeding, the Commission simultaneously brought and settled two companion cases.
Concord Growth Corp., 68 SEC Docket 516 (Sept. 28, 1998). The Commission alleged that Concord, acting as principal, sold loan participations to the Fund while "an affiliate of an affiliate" of the Fund, without seeking or receiving prior Commission approval for such affiliate transactions. Without admitting or denying the charges, Concord consented to an order finding that it willfully violated Sections 17(a)(1) and 17(a)(2) of the Investment Company Act. The Commission entered a cease and desist order and imposed a $10,000 civil penalty.
Reid Rutherford, 68 SEC Docket 288 (Sept. 28, 1998). Without admitting or denying the charges, Mr. Rutherford consented to an order finding that he willfully aided, abetted, and caused Concord's violations of Sections 17(a)(1) and 17(a)(2) of the Investment Company Act, caused the Fund's violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act, and violated Section 34(b) of the Investment Company Act. The Commission entered a cease and desist order and imposed a $5,000 civil penalty.
In their brief, Respondents renew their objections to the amended OIP and to any consideration of Division Exhibits 43-23 and 44-24.
Amended OIP. Respondent Borgardt's affiliation with Hardie and Concord's method of setting rates of return on the loans that were the Fund's sole investments received only a brief mention in Paragraphs III.A and III.E of the OIP. They entered the case as potential grounds for liability on February 1, 1999, when the Division offered the report of its expert witness, Professor David L. Ratner. One month later, on March 5, 1999, Respondent Banhazl's expert witness, Professor John C. Coffee, submitted his own report. Professor Coffee specifically noted that these two issues, as discussed in the Ratner report, had not been identified as potential grounds of liability in the OIP. He nonetheless addressed both matters on their merits. On April 9, 1999, more than two months after they had received the Ratner report, Respondents moved to exclude portions of the testimony of Professor Ratner, as well as any other Division witnesses, on these two issues. Cf. City of Anaheim, 71 SEC Docket 191 (Nov. 16, 1999) (involving a similar motion in a contemporaneous case originating from the same regional office). The instant case was reassigned to my docket on April 12, 1999, with that motion pending.
After considering the parties' pleadings, I issued an Order on May 6, 1999. I agreed with Respondents that they could not reasonably have known from reading the OIP that the alleged Borgardt conflict of interest and the alleged rate differential could form a basis for liability. I also agreed with the Division that such evidence was relevant, and could be used by the Division to rebut an anticipated defense of reliance on the advice of counsel. However, I ruled that, if the Division wished to use such evidence as part of its case-in-chief, it must seek to amend the OIP.
The Division drafted amending language and filed its motion to amend the OIP on May 13, 1999. Respondents vigorously opposed it. By Order dated May 26, 1999, I rejected Respondents' more histrionic claims that the Division's motion was "startling," "unprecedented," "revolutionary," and "radical," as well as their assertion that they had been "blindsided" at the "eleventh hour." I found no prejudice to Respondents, based on the fact that Professor Coffee had (months earlier) responded with aplomb to the new allegations. I also noted that Respondents had steadfastly refused to explain why they had waited over two months after receiving the Ratner report to complain about it. I determined that the Division's proposed amendments were "within the scope" of the original OIP, and I granted the motion to amend under Rule 200(d)(2). On June 14, 1999, I denied Respondents' motion for reconsideration. The amended OIP was the operative document at the hearing (Resp. Ex. 7-46).
My reasons for granting the Division's motion to amend the OIP are explained in my Orders of May 6, 1999, May 26, 1999, and June 14, 1999; those explanations are incorporated by reference here.
The only new development on this subject is the testimony of Professor Ratner, whose report precipitated the Respondents' belated Motion to Exclude Certain Witness Testimony and the Division's subsequent Motion to Amend the OIP.
Professor Ratner acknowledged that his February 1, 1999, report had "extrapolated" beyond the four corners of the original charging document, and was based in part on an "interpretation" of the OIP, gleaned from his discussions with Division counsel (Tr. 508-15). Professor Ratner testified: "I must confess that I found the [OIP] a bit difficult to follow as to what were allegations and what were not" (Tr. 514).2 As to the third count of the amended OIP (Resp. Ex. 7-46), which was drafted by the Division to conform the original charging document to the February 1, 1999, report, Professor Ratner expressed a similar view: "This revised [OIP] is not as precisely worded as it might have been" (Tr. 585).
Despite the Division's missteps, I do not believe that Respondents have been unfairly surprised or their rights prejudiced.
Division-Jeffers correspondence. At the hearing, the Division sought the admission into evidence of two exhibits-May 1996 letters from Division counsel to attorney Michael D. Jeffers, asking questions about the Fund, and Mr. Jeffers' letter response to the Division in June 1996 (Div. Exs. 43-23 and 44-24). Beyond establishing the authenticity of the documents and the fact that Mr. Jeffers wrote his response with due care (Tr. 233, 235), the Division never asked Mr. Jeffers a single question about the contents of his letter. Indeed, it never intended to question Mr. Jeffers about the contents (Tr. 240). Respondents objected to the admission of these documents (Tr. 232-40). I ruled that the exhibits would be accepted into evidence, subject to a motion to strike in the posthearing pleadings (Tr. 282-83).
Respondents argue that Mr. Jeffers' letter is not covered by the business record exception to the hearsay rule. See Fed. R. Evid. 803(6). They also contend that the letter is inadmissible for the non-hearsay purpose of attempting to impeach Mr. Jeffers' hearing testimony. They note that Mr. Jeffers' letter is not a sworn statement and that the Division never "confronted" Mr. Jeffers with it. See Fed. R. Evid. 801(d)(1)(A). In its posthearing submissions, the Division relies heavily on Mr. Jeffers' letter to prove its case.3
Respondents have reluctantly acknowledged that the Federal Rules of Evidence do not apply to administrative adjudications (Barkley Tr. 34-35). See Gimbel v. CFTC, 872 F.2d 196, 199 (7th Cir. 1989); Calhoun v. Bailar, 626 F.2d 145, 148 (9th Cir. 1980). The Commission has cautioned its Administrative Law Judges to be inclusive in making evidentiary determinations. See City of Anaheim, 71 SEC Docket at 193 nn. 5-7 ("if in doubt, let it in"); Alessandrini & Co., 45 S.E.C. 399, 408 (1973); Charles P. Lawrence, 43 S.E.C. 607, 612-13 (1967). The Division initiated the correspondence in question at the request of counsel for Respondent Banhazl. Along with its letter, the Division provided Mr. Jeffers with SEC Form 1662, Supplemental Information for Persons Requested to Supply Information Voluntarily or Directed to Supply Information Pursuant to a Commission Subpoena.4 That form advised Mr. Jeffers of the many routine uses that could be made of his response, including its use in an administrative enforcement proceeding.5 Now that the substance of Mr. Jeffers' response has turned out to be inconvenient for Respondents, their effort to seek cover behind a narrow reading of the Federal Rules of Evidence rings hollow. Mr. Jeffers was not only a witness for the Division; he was on Respondents' amended witness list as well. At Respondents' request, I signed a subpoena requiring his testimony. If Respondents wanted to question Mr. Jeffers about discrepancies between his June 1996 letter and his hearing testimony, they were free to do so. Having elected to remain silent as a matter of trial tactics, they cannot be heard to complain now. The letters are unquestionably relevant and trustworthy; under Rule 320, I affirm my earlier determination to admit them into evidence.
FINDINGS OF FACT
I base the findings and conclusions herein on the entire record and on the demeanor of the witnesses who testified at the hearing. I applied "preponderance of the evidence" as the applicable standard of proof. Steadman v. SEC, 450 U.S. 91, 97-104 (1981). I have considered and rejected all arguments and proposed findings and conclusions that are inconsistent with this decision.
Target Income Fund
The Fund was a continuously offered, non-diversified, closed-end investment company located in Glendora, California. It was incorporated on December 27, 1991, under the laws of the State of Maryland. It filed for registration on January 21, 1992, and registration became effective on October 8, 1992. The Fund's portfolio consisted primarily of participation interests in short-term debt obligations of small and medium-sized businesses, all of which were originated and serviced by Concord, a firm specializing in such loans. The Fund's shares were not redeemable, except through quarterly tender offers, and there was no secondary market for the Fund's shares. Target's net assets never exceeded $12 million. It withdrew from registration on July 24, 1997 (Div. Ex. 10-43 at 3). At all relevant times, the Fund used the same telephone number as Robert H. Wadsworth & Associates, Inc. (Wadsworth & Associates), a company that is in the business of putting mutual funds in business (Div. Exs. 1-40, 57, and 61-D50; see Tr. 195, 808).
Respondents And Affiliated Entities
Byron Borgardt was president and a director of the Fund, and also president and a director of the Fund's investment adviser, Foothill Advisers, Inc. (Adviser), from April 28, 1992, to May 3, 1994 (Tr. 798).
The Fund's articles of incorporation described the duties of the Fund president in typically broad fashion. As president, Mr. Borgardt was the chief executive officer. Subject to the supervision of the board of directors, he had general charge of the business, affairs, and property of the Fund, and exercised general supervision over its officers, employees, and agents (Div. Ex. 1-40). The articles of incorporation also stated that the Fund's business and affairs were managed under the direction of the Fund's board of directors, and that all the Fund's powers were exercised by or under authority of its board of directors (id.).
In contrast to the expansive wording of the articles of incorporation, Mr. Borgardt emphasized how narrowly he viewed his roles. Respondent initially intended to be no more than a consultant to the Fund. He assumed his duties as president and director reluctantly, and only after other candidates for these positions had been eliminated from consideration (Tr. 695, 753-54). Mr. Borgardt's expertise was in analyzing financial statements and evaluating credit risk (Tr. 693). He reviewed and selected loan investments for the Fund (Tr. 753-56), but relied on Wadsworth & Associates for administrative and compliance matters (Tr. 692-93).
Mr. Borgardt graduated from North Park College with a degree in accounting in 1971, and earned an M.B.A. from National University, San Diego, in 1978 (Tr. 683). Prior to his association with the Fund, Mr. Borgardt had never been involved in the management of a mutual fund (Tr. 692, 749). He has no disciplinary history in the securities industry (Tr. 749-50).
At all relevant times, Mr. Borgardt was also chief financial officer of James Hardie Industries (USA), Inc., the American subsidiary of an Australian public company, James Hardie Industries, Ltd., which manufactures building materials. Through Hardie's investment vehicle, James Hardie Credit Corporation, Mr. Borgardt selected loan participations offered by Concord from the late 1980s to 1997 (Tr. 683-88, 712-13).6 On many occasions, Hardie, Concord, and the Fund co-participated in the same loans (Tr. 25, 801; Div. Ex. 47-2).
From 1990 through 1997, Mr. Borgardt also served as a part-time consultant for Finance 500, Inc. (Finance 500), the registered broker-dealer that became the Fund's underwriter and distributor (Tr. 74, 82-83, 690). Hardie was Mr. Borgardt's primary employer and Finance 500 was his secondary employer.
Eric Banhazl was vice president, secretary, and treasurer of the Fund and the Adviser from April 28, 1992, to November 1, 1995 (in the case of the Adviser) and April 1, 1997 (in the case of the Fund). From May 3, 1994, to November 1, 1995, Mr. Banhazl also served as interim president of the Fund and the Adviser. He was part owner of the Adviser as well. Mr. Banhazl graduated from the University of Massachusetts, Amherst, in 1979, with a degree in accounting and finance; he later earned an M.B.A. from Tulane University (Tr. 805-06).
Mr. Banhazl has been involved in mutual fund consulting and administration since 1985 (Tr. 862). He served as director of compliance, administration, and operations for a proprietary mutual fund at L.F. Rothschild (Tr. 806). Since 1990, he has been senior vice president and executive vice president of Wadsworth & Associates (Tr. 806-07; Div. Ex. 57). Mr. Banhazl is also part owner of Investment Company Administration Corporation (ICAC), which provided several mutual funds, including Target, with administrative services. These services included preparing various federal and state regulatory filings, reports, and returns; paying Fund expenses; and organizing board meetings (Tr. 821-23; Div. Ex. 1-40). Mr. Borgardt, for one, considers Mr. Banhazl to be sophisticated in organizing and setting up mutual funds (Tr. 825). Wadsworth & Associates and ICAC were Mr. Banhazl's primary employers.
Apart from the present case, Mr. Banhazl has never been the subject of disciplinary action by any administrative or regulatory body (Tr. 867-68).
Concord Growth Corporation
Concord was incorporated in California on February 22, 1985 (Div. Ex. 45-8). Its main office was located in Palo Alto, California. As a commercial finance company, Concord provided accounts receivable financing and servicing to small and medium-sized companies (Tr. 314-15, 387-92). EXXE Data Corporation (EXXE Data) was incorporated in California on June 29, 1993, and absorbed Concord through an exchange of stock (Tr. 311). Both Concord and EXXE Data were privately held firms (Tr. 313). Reid Rutherford was Concord's chairman of the board, chief executive officer, and 20 percent stockholder (Tr. 463; Barkley Tr. 41). At various times, Matthew Carpenter was Concord's chief financial officer, chief operating officer, secretary, and president (Tr. 312-13, 463).
Concord's client base consisted of manufacturing and distribution companies located in the western United States, primarily California (Div. Ex. 45-8 at 8). In most cases, the companies that used Concord's services were too small, too new, or too undercapitalized to obtain bank loans (Tr. 315-16, 387). Concord provided ongoing credit evaluations of its clients and their customers. In addition, it obtained collateral on all financed accounts (Tr. 389-92).
Concord was aggressive in searching for ways to diversify its capital base (Tr. 382-83, 387-91, 403). It began servicing business credit participations in January 1990, and received service revenue on the participants' portion of the credit for acting as the lead participant and managing the shared credit participations (Div. Ex. 45-8 at 10). Concord also used Robert Lance Hicks as a fund-raiser for private placements (Tr. 67, 321, 327, 382). Through Mr. Borgardt, Hardie was a longstanding participant in such Concord programs (Tr. 325-27). In 1995, Concord entered a strategic relationship with ContiTrade Services Corporation to provide a $50 million warehouse credit line that would form a new asset base for making secured loans to small businesses (Tr. 403). Target became one of many vehicles that Concord used to expand its loan business (Tr. 383).
Formation Of The Fund
At all relevant times, Robert Lance Hicks was president and sole owner of Finance 500, a registered broker-dealer, and Finance 500 Advisory Services, Inc., a registered investment adviser. Both firms are located in Irvine, California. In 1991, Mr. Hicks attended a meeting of the Orange County Society of Investment Managers. The speaker was Eric Banhazl of Wadsworth & Associates, who talked about how to organize a mutual fund (Tr. 61-65, 195-96, 808-09). Mr. Hicks met briefly with Mr. Banhazl after the seminar.
Mr. Hicks was interested in starting a mutual fund that would invest in asset-based loans to small businesses. Finance 500 had been making private placements of such loans on behalf of Concord for six to seven years, and Mr. Hicks liked the idea of expanding his marketing effort through a mutual fund that could advertise to the general public (Tr. 67-69, 322, 382). Shortly after the seminar, Mr. Hicks spoke to Mr. Rutherford and Mr. Carpenter of Concord and determined that they were interested (Tr. 69-70). Mr. Hicks then met with Mr. Banhazl of Wadsworth & Associates and Mr. Carpenter of Concord at the Orange County Airport to discuss the potential for such a mutual fund (Tr. 323, 811-12).
Two organizational meetings were held in late 1991 (Tr. 70-71, 196). The first took place in the Newport Beach office of attorney Michael D. Jeffers (Tr. 196-98) and the second was at the Palo Alto headquarters of Concord (Tr. 199, 814-15). Messrs. Banhazl, Carpenter, Hicks, and Jeffers participated in both meetings; Mr. Robert Wadsworth and Mr. Rutherford participated in only the second. Later discussions were conducted by telephone (Tr. 287).
Four individuals were selected for the Fund's board of directors (Barkley Tr. 109-10; Tr. 70-73, 689-91, 754, 830). These were Reid Rutherford, the chairman and chief executive of Concord; Lawson C. Adams, a certified public accountant and executive at Lockheed Corporation, who knew Mr. Rutherford through church activities; R. Gillem Lucas, managing director of a consulting firm, who had been a classmate of Mr. Rutherford at business school; and Respondent Borgardt, who was sponsored by Mr. Hicks. Mr. Borgardt was the only director identified in the Fund's registration statements as being an "interested person" within the meaning of Section 2(a)(19) of the Investment Company Act (Div. Exs. 2-41 at 16 and 6-13 at B12).
The Fund's board of directors held its organizational meeting on April 28, 1992 (Div. Ex. 16-D5 at 5-7). Among other things, the board selected Foothill Advisers to be the Fund's investment adviser and ICAC to be its administrator. The Fund's launch was slow: as of June 30, 1992, its net assets were limited to $103,569 in short-term cash investments (Div. Ex. 3-42 at 28). It did not begin to invest in loan participations until some time after December 1, 1992 (Div. Ex. 19-D8 at 2).
Michael D. Jeffers
Michael D. Jeffers is an attorney admitted to practice law in the States of Washington, New York, and California. After earning undergraduate and law degrees at the University of Washington, and a master's degree in taxation at New York University, he eventually developed a mutual fund practice in New York City (Tr. 190-92). Mr. Jeffers has been involved in the creation of ten to fifteen mutual funds (Tr. 193).
In 1988, Mr. Jeffers relocated from New York to California. At the times relevant to this case, he was affiliated with four different California law firms. In the late 1980s, he was with Buchalter, Nemer, Fields & Younger, a firm that represented Concord (Tr. 191, 227). Thereafter, until 1992, he was with Riordan & McKinzie, of Los Angeles and Costa Mesa. From 1992 to 1994, he was with Phillips, Haglund, Haddan & Jeffers, of Newport Beach; and next, he was with Jeffers, Wilson & Shaff (later, Jeffers, Wilson, Shaff & Falk) of Irvine (Tr. 191; Div. Exs. 19-D8 and 44-24).
Mr. Jeffers knew Mr. Wadsworth from New York City; he had asked Mr. Wadsworth to steer him some legal business in southern California (Tr. 285-86, 817, 868-69). The Target assignment represented the first time that Wadsworth & Associates had retained Mr. Jeffers or recommended him to one of its clients (Tr. 195, 325, 868-69).
Mr. Jeffers' involvement with the Fund started in the summer or fall of 1991 (Tr. 195). He had not been engaged at the time of the two organizational meetings described above (Tr. 199-200, 286, 428), but he "was certainly trying to be" (Tr. 209). Mr. Jeffers was eventually retained by Wadsworth & Associates, although he was unsure if this occurred in late 1991, or the winter or spring of 1992 (Tr. 200, 283-84). He was assigned to review and fine-tune the initial registration statement that Wadsworth & Associates' in-house attorney, Steven Paggioli, had drafted for the Fund (Tr. 242-43; Div. Ex. 57). Mr. Jeffers also participated in vetting candidates for Fund president and its board of directors. He vetoed one or two such candidates because of potential conflicts of interest (Tr. 107-10, 159, 695, 754).
At the organizational meeting on April 28, 1992, the board selected Phillips, Haglund, Haddan & Jeffers to be counsel to the Fund (Div. Ex. 16-D5 at 10). Mr. Jeffers' principal duties were to draft periodic revisions to the Fund's registration statement and to attend quarterly board meetings. After March 3, 1993, he also kept the minutes. Mr. Jeffers drafted the co-participation agreement form used by the Fund, Hardie, and Concord (Tr. 213, 216, 287, 290, 332-33, 761, 871; Div. Ex. 47-2).
From the commencement of operations on November 24, 1992, through the end of its first fiscal year on October 31, 1993, the Fund spent $35,204 on legal fees (Div. Ex. 7-14 at B16). From November 1, 1993, through October 31, 1994, the Fund spent $48,280 on legal fees (Div. Ex. 8-15 at 31). From November 1, 1994, through April 30, 1995, the Fund spent $24,797 on legal fees (id. at 38). The record does not show what specific legal services were performed to generate these payments. Mr. Banhazl received periodic bills from Mr. Jeffers, but they were not very detailed (Tr. 803-04, 899-900).
Apart from the post-effective amendments to the registration statement and the co-participation agreement form he drafted, Mr. Jeffers rendered verbal advice, not written advice (Tr. 803-04, 899-900). Some of the "advice" at issue in this proceeding is not even verbal; rather, its substance was implied or inferred by board members from Mr. Jeffers' silence (Tr. 40, 42-43, 112-13, 831-32, 872-73).
Concord's Role In The Fund
Concord was the sole source of loan participations purchased by the Fund from December 1992 to March 1997. Wadsworth & Associates' billing statement from August 7, 1991, identifies the prospective fund as the "CGC Accounts Receivable Fund" (Tr. 380; Div. Ex. 14-38). Mr. Jeffers' handwritten notes from November 11, 1991, refer to it as the "Concord Fund" (Tr. 204; Div. Ex. 42-22). Mr. Jeffers went even further at the hearing; he testified that Concord had engaged Wadsworth & Associates to advise and assist it in setting up the Fund (Tr. 200). Concord hosted several of the Fund's board meetings. Concord also afforded the Fund an extraordinary level of access to its internal deliberations. Mr. Borgardt participated in Concord's credit review meetings "on numerous occasions" (Tr. 763-64). At least twice, he cast a "no" vote as if he were part of the committee. This led Concord to reject the loan applications under consideration (Tr. 788).
Mr. Hicks' marketing plan projected that the Fund would have net assets of $50 million to $100 million within three years (Tr. 87, 114-15, 132, 437, 691).7 Upon hearing this estimate, Mr. Carpenter immediately informed Mr. Hicks and the Fund's board that Concord had the capacity to provide the Fund with no more than $15 million to $20 million in loan participations, and that the Fund would have to obtain the rest of its anticipated asset growth from other sources (Tr. 114-15, 437).
The Fund never had the financial staying power to last until it built a marketable track record. The causes of its demise were present from the outset: no one critically examined Mr. Hicks' wildly inflated marketing projections, no one paid heed to Mr. Carpenter's admonition, and all efforts to obtain loans from other originators failed, for the reasons described below. From start to finish, the Fund was caught in a never-ending cycle of self-deception: (a) as soon as the Fund grows, it will no longer be dependent on Concord; (b) the Fund will grow once the marketing effort is successful; (c) the marketing effort must be curtailed because the Fund cannot yet afford it; (d) because the Fund cannot yet afford to do more marketing, it must continue to rely on Concord for just a little while longer; (e) return to step (a) and repeat.
Concord was the Fund's only loan originator. Several individuals connected with the Fund participated in an ongoing attempt to find additional suitable sources of loans for the Fund, most notably Mr. Rutherford and Mr. Carpenter. Mr. Hicks, Mr. Jeffers, Mr. Borgardt, and Mr. Banhazl also contributed (Tr. 19-20, 39, 115, 276, 398, 742, 859-60). After October 1995, Jonathan LaVine, the Fund's new president, made genuine efforts to find originators other than Concord (Tr. 261-62, 265).
These efforts proved unsuccessful for several reasons. Some loan providers rejected the Fund because its diversification requirement made its prospective participation levels too small (Tr. 115, 743, 775).8 Other providers had access to cheaper capital than the Fund offered (Tr. 116-17, 399). The Fund rejected some loan providers because they were not acceptable in terms of rate or risk (Tr. 118-19, 743, 774). Those involved with the Fund considered Concord "the benchmark" of its industry, a company that was "very impressive," had "state of the art" loan tracking systems, and was "vastly" superior to the competition (Tr. 20, 105, 767, 871-72). Even when selecting from among the loan participations offered to it by Concord, the Fund was quite picky. It rejected at least 20 to 25 percent of them because of perceived investment risks (Tr. 399-400, 765-66, 784). On some occasions, the Fund sat on up to $2 million in cash, rather than investing in the market (Tr. 879; Div. Exs. 23-D12 and 25-D14). Finally, Mr. Hicks explained that the Commission's investigation made him "nervous" and he "sort of stopped" his marketing efforts after mid-1994 (Tr. 133).
Concord was the Fund's only loan servicer. Concord also screened and serviced all of the loans it provided to the Fund. Its screening and servicing costs were not charged to the Fund, but were included in the interest rate that Concord charged the borrower. The yield that the Fund received on its Concord participations was the difference between Concord's gross loan return and what Concord deducted for its fixed costs, cost of funds, bad debt reserve, screening, servicing, and profit (Tr. 387-96, 401, 405, 421-22, 424-25).
Concord's screening and servicing costs were usually considerable because of the nature of its business. It incurred substantial expenses in finding prospective borrowers, determining their credit worthiness, negotiating loan agreements, setting up its in-house system of financial controls, and tracking accounts receivables (Tr. 314, 387-96, 401, 405, 421-22). Concord's charges to the borrower for these services could run as high as 30 percent per year (Tr. 121, 140-43).
On September 27, 1993, Concord drafted, and Target signed, an agreement whereby Concord became the "master servicer" for all loans in which the Fund invested (Tr. 328-29; Div. Ex. 46-1). Mr. Borgardt explained that those involved with the Fund's management considered themselves no more than investors, and that the Fund lacked the facilities to monitor and collect loans (Tr. 741-42). Other prospective loan originators were unwilling to use Concord as a master servicer, and it never actually functioned in that role (Tr. 280-81, 744).
Concord fronted the Fund's organizational expenses, as well as a portion of its fiscal year 1993 and fiscal year 1994 operating expenses. It is undisputed that the organizational expenses were the obligation of Mr. Hicks as underwriter (Tr. 75, 79, 143, 438). However, by 1991, Mr. Hicks had established a track record of operating thinly capitalized ventures. For example, Finance 500 had been in existence since the early 1980s (Tr. 61), but because of "affordability issues," it never had either a full-time due diligence officer or a full-time compliance officer (Tr. 74). To fill that void, Mr. Hicks had hired Mr. Borgardt to moonlight on a part-time basis (Tr. 73-74, 690). Mr. Hicks also had asked Concord to underwrite expenses he had incurred in connection with private placements of Concord's notes (Tr. 136, 379, 438). Thus, when Wadsworth & Associates presented Mr. Hicks with its bill for $73,813 in consulting services and organizational expenses for the Fund, Mr. Hicks immediately informed all concerned that he did not have the ability to pay (Tr. 76; Div. Ex. 40-36). He talked to several possible sources, but was unable to get a loan (Tr. 75, 135-36). Ultimately, Mr. Hicks again approached Concord, which acquiesced in his request for money (Tr. 143).
In 1991 and 1992, Concord wrote several checks to Wadsworth & Associates on behalf of the Fund (Div. Ex. 14-38). It did so with the understanding that it would be reimbursed. Within a year and a half, Concord was repaid in full (Tr. 857-58, 882-83).
Concord also covered operating expenses of at least $46,075 and $21,950 that the Fund incurred during fiscal years 1993 and 1994, respectively (Tr. 170; Div. Exs. 14-38 and 41-37). These sums exceeded the Fund's 2.5 percent expense cap (Tr. 32-33, 78, 348-49).9 Concord advanced the money to Finance 500, which then paid the Fund (Div. Ex. 41-37). Although Concord expected reimbursement for these operating expense payments, it ultimately recovered only about half of its advances (Tr. 883-84).
Mr. Carpenter expressed frustration that Concord was subsidizing the Fund so that the Fund could meet its investment objectives (Tr. 350, 436, 461). On September 30, 1993, Concord proposed, and Target accepted, a 1 percent rate reduction on its participations. This was, at least in part, a quid pro quo for Concord's continuing to honor the Fund's request for advancing the payment of its operating expenses (Tr. 344-46, 348-49, 856; Div. Ex. 13-5).10
Concord bought back the Fund's troubled loans. Over the life of the Fund, Concord bought back the Fund's interest in two troubled loans, worth approximately $100,000 and $25,000 (Tr. 400-01). Concord prided itself on its monitoring systems, and was generally successful in minimizing credit losses (Tr. 396-97, 788). In two instances, however, Concord determined that defaults were the result of fraud by the borrowers when Concord underwrote the loans, and Concord accepted the responsibility for failing to catch the frauds (Tr. 354-55, 397, 730-31, 788). Although Concord was not contractually obligated to buy back the Fund's loan participations (Tr. 252, 355), Mr. Carpenter testified that Concord did so because it was "the right thing to do" (Tr. 354). Concord had followed the same practice earlier, when defaults had occurred on co-participations with Hardie (Tr. 731, 789). Mr. Jeffers and Mr. Borgardt offered an additional (less altruistic and more practical) explanation for Concord's buy-back practice: in the event of a bankruptcy liquidation of the defaulting borrower, it was easier for Concord to assume the Fund's interest in the loan than to deal with the complication of working out the Fund's fractional security interest (Tr. 252, 788-89).
Miscellaneous issues. There is no evidence that Mr. Rutherford, Mr. Carpenter, or anyone else at Concord ever coerced or pressured Mr. Borgardt, Mr. Banhazl, or anyone else at the Fund or Adviser regarding a loan participation or yield rate offered by Concord (Tr. 120, 427, 787-88, 882). There is no evidence that Concord ever opposed disclosure of its role in the Fund (Tr. 247-48, 356-57, 457).
Jeffers' Advice Regarding Disclosure Of Concord's Role In The Fund
In late 1991 or early 1992, in connection with the filing of the Fund's first registration statement, Mr. Jeffers considered whether or not the registration statement should disclose that Concord would be the only originator and servicer of loans for the Fund. He concluded that such disclosure was neither necessary nor appropriate, for several reasons. First, Mr. Jeffers relied on the expectation of those involved that Concord would be one of many sources of loans for the Fund and that the Fund itself would be a direct lender. Second, Mr. Jeffers expressed his concern that investors might get the misleading impression that Concord guaranteed the Fund's loans or stood behind the Fund in the event of a default. Third, Mr. Jeffers knew that Concord was not legally obligated to provide any loans to the Fund (Tr. 242-45, 705-08, 724-25).11
The record contains conflicting evidence about the legal advice given regarding the continued non-disclosure of Concord's role after the initial registration statement. Mr. Adams did not recall any discussions at board meetings about the need to disclose Concord's role (Tr. 15). Neither did Mr. Carpenter (Tr. 356-57, 364-65). The third time he was asked, Mr. Carpenter acknowledged having a "vague recollection" that the subject came up "initially" (Tr. 457). Mr. Banhazl did not recall any specific questions by the board or any specific advice by Mr. Jeffers on this topic (Tr. 831-36, 872-76). He nonetheless believed that Mr. Jeffers' silence "implied" that it was proper for the Fund to continue to omit disclosure of Concord's role in its post-effective amendments (Tr. 832, 872-73).
Mr. Jeffers gave conflicting accounts about his own advice. During its investigation, the Division asked Mr. Jeffers about any discussions he may have had regarding disclosure of Concord's role as sole loan originator and servicer, as well as Concord's payment of the Fund's organizational costs and annual expenses (Div. Ex. 43-23 at 2-3, items 5(2) through 5(5)). Mr. Jeffers responded that he did not recall any discussions about disclosing these matters (Div. Ex. 44-24 at 3-4).
By the time of the hearing, however, Mr. Jeffers' recollection had improved considerably.12 He testified that he frequently considered the need to revise the Fund's registration statements to disclose Concord's role, both at board meetings and when drafting post-effective amendments (Tr. 264-69, 296-97). He stated that the board members knew his position on the subject, and that this was an area where his expertise was probably a determining factor (Tr. 266, 297). Mr. Borgardt also testified that the continued non-disclosure of Concord's role was raised at several board meetings, and that Mr. Jeffers addressed it at least four times (Tr. 725-28).
Faced with the rather glaring inconsistencies in Mr. Jeffers' accounts, I have given more weight to his 1996 letter than to his 1999 hearing testimony. In 1996, he was closer in time to the events in question. In 1996, Respondents had not yet fashioned their litigation strategy. I find the collective testimony of Messrs. Adams, Carpenter, and Banhazl on this subject to be more reliable than that of Mr. Borgardt, an obviously interested party. I find that Mr. Jeffers did not give specific legal advice on this subject to the Fund's board between late 1992 and mid-1996, and that his silence could not reasonably be considered as "legal advice." In reaching this determination, I have given no weight to Professor Ratner's evaluation of Mr. Jeffers' credibility (Tr. 673-75). See United States v. Scop, 841 F.2d 135, 142 (2d Cir. 1988).
The Fund's Co-Participations With Hardie And Mr. Borgardt's Conflict Of Interest
Hardie's participations in Concord loans were in the range of $100,000 to $1 million; at Hardie's insistence, they were split with Concord on a 50-50 basis (Tr. 460, 688, 733). Because of inefficiencies, Hardie was typically not interested in loan participation investments of less than $100,000 (Tr. 407, 460, 733-34). As described in note 8 above, the Fund's diversification requirements limited its participation in any given loan to 5 percent of its net assets. During the period that Mr. Borgardt was arranging co-participations for both the Fund and Hardie in Concord loans, he had the Fund participate to the maximum extent permitted by its diversification requirement, with Hardie and Concord splitting the remainder (Tr. 370-71, 732-33, 776-80; Div. Ex. 51-35). There is no evidence that Mr. Borgardt offered a participation opportunity to Hardie that he did not also offer to the Fund (Tr. 408, 780). Hardie did participate in some Concord loans when the Fund did not, but that was because the Fund had opted out (Tr. 409; Resp. Ex. 3-28).
The Fund's yields on Concord participations were unequal, but roughly comparable, to Hardie's yields on Concord participations over the life of the Fund (Tr. 410-16; Div. Ex. 47-2 at 13; Resp. Ex. 3-28; see supra note 10). There is no evidence that Concord's cost of servicing each co-participant's interest in a given loan varied. At the same time, there is no requirement that a lender in Concord's position adhere to a rigid cost-based formula when negotiating yields with its co-participants. According to Respondents, the differences in yields reflect the fact that the Fund and Hardie sometimes had different yield formulas, negotiated at different times, and under different circumstances (Tr. 333-35, 412-15, 782-86, 803). The Division has not presented any evidence that the yield differences here were statistically or economically significant.
Mr. Jeffers was unquestionably aware of the fact that the Fund and Hardie were jointly participating in the same Concord loans-he attended virtually all the Fund's board meetings and drafted the co-participation agreement form. Mr. Borgardt testified that he asked Mr. Jeffers whether he had a conflict of interest before he assumed his roles with the Fund (Tr. 697, 700, 757-58). However, he never specifically told Mr. Jeffers that he would be simultaneously selecting loan participations for the Fund and for Hardie (Tr. 697-700). Nor did Mr. Borgardt specifically ask Mr. Jeffers if his dual roles needed to be disclosed in the Fund's registration statements (Tr. 757). Messrs. Hicks, Carpenter, and Banhazl stated that others, probably Mr. Lucas, asked Mr. Jeffers at an early board meeting if Mr. Borgardt's affiliation with Hardie should bar him from serving on the Fund's board (Tr. 165-67, 430, 433-34, 836, 838-39). Messrs. Hicks and Banhazl also testified that Mr. Lucas asked the separate question about whether Mr. Borgardt's dual affiliations with the Fund and Hardie needed to be disclosed in the registration statement (Tr. 167, 836). The witnesses quote Mr. Jeffers as replying that it was acceptable for Mr. Borgardt to serve on the board, and that disclosure was not required.
I do not credit the testimony of Messrs. Borgardt, Hicks, Carpenter, and Banhazl on these issues. The witnesses tended to blur the question of whether Mr. Borgardt had a disqualifying conflict from the separate question of whether the conflict should have been disclosed in the registration statement. Mr. Hicks' testimony about disclosure items must be balanced against his view that certain negative statements in the Fund's prospectus were alarming prospective investors and impeding his sales efforts (Tr. 30-31, 88-91, 133-34; Div. Ex. 19-D8 at 3). The testimony of these four witnesses conflicts with the credible testimony of Mr. Adams, who never heard the words "conflict of interest" uttered at a board meeting before May 3, 1994 (Barkley Tr. 117). It is also inconsistent with testimony that Mr. Jeffers had previously rejected nominees for the Fund's board and presidency because of conflicts similar to those posed by Mr. Borgardt (Tr. 107-10, 159, 695, 754). Respondents have offered no explanation for why Mr. Jeffers might have expressed contradictory views on such conflicts, or how they could reasonably have relied on his legal advice if he had done so.
The weight of the credible evidence also demonstrates that Respondents never received legal advice from Mr. Jeffers, giving his imprimatur to the non-disclosure of Mr. Borgardt's simultaneous loan selections for Hardie and the Fund. Certainly, there is no evidence that Mr. Jeffers ever delivered an unqualified written opinion on this subject, or even a verbal opinion in which he expressed a high level of confidence. Mr. Hicks quoted Mr. Jeffers as stating that he "didn't think" Mr. Borgardt's dual affiliation was "problematic," but that he needed to check. According to Mr. Hicks: "Mr. Jeffers' frequent answer was `I'll have to research it and get back to you'" (Tr. 172). Mr. Hicks also noted that Mr. Jeffers was "hard to get in touch with," and that they often communicated through another attorney (Tr. 137). Verbal advice filtered through a third party who did not testify is too tenuous to be probative here.
Nor was Mr. Jeffers conscious that he had given legal advice on this subject. In early 1994, Mr. Jeffers told another attorney in his law firm that he had previously been unaware of what Mr. Borgardt was doing (Tr. 218). When the issue finally came to a head on May 3, 1994, Mr. Borgardt confronted Mr. Jeffers. He paraphrased Mr. Jeffers' response as "I didn't know" or "I didn't focus on it" (Tr. 762, 799-800). Mr. Jeffers later told the Commission's investigative staff the same thing (Div. Ex. 44-24).
Events Of Early 1994
A newly hired attorney at Mr. Jeffers' law firm, Barry D. Falk, attended the January 13, 1994, Fund board meeting in Mr. Jeffers' absence (Tr. 34, 217-18; Div. Ex. 23-D12). Mr. Falk had just come from the staff of the Commission.
After the meeting, Mr. Falk discussed with Mr. Jeffers what he thought were potential legal problems under Section 17 of the Investment Company Act, arising from Mr. Rutherford's presence on the Fund board and from Mr. Borgardt's co-participations in the same Concord loans on behalf of both the Fund and Hardie. Mr. Jeffers told Mr. Falk he was unaware of the latter circumstance (Tr. 218). The two lawyers then researched the issues (Tr. 218-22). Mr. Jeffers concluded that Mr. Rutherford's presence on the Fund board raised at least the possibility of a Section 17 violation, and that Mr. Borgardt's co-participations on behalf of the Fund and Hardie in the same loans were prohibited transactions.
Mr. Jeffers presented his conclusions at the Fund's next board meeting, held on May 3, 1994 (Tr. 223-24, 359-60, 843). He recommended that Mr. Borgardt resign from his positions with the Fund and the Adviser, unless he was willing to resign from his positions with Hardie. Mr. Jeffers recommended that Mr. Rutherford resign from the board as well. Both men did so that same day (Tr. 360-61, 709-11, 762, 800; Div. Ex. 24-D3). Mr. Borgardt's affiliation with the Fund ceased at this time; Mr. Rutherford's continued, as described below.
Mr. Jeffers testified that the board was "surprised" by his presentation on May 3, 1994 (Tr. 220-23, 226, 301-02). Others offered more colorful descriptions. Mr. Carpenter characterized Mr. Rutherford's reaction as one of "shock that we would be this far down the road and that would come up" (Tr. 361). Mr. Borgardt described himself as "very upset" at this "bombshell" and found it "unbelievable" (Tr. 710, 762, 800). Mr. Borgardt challenged Mr. Jeffers for his prior silence. He paraphrased Mr. Jeffers as responding that he might have been aware of the situation before, but had not focused on it (compare Tr. 762, 800 with Tr. 218, 220, 224-25, 227). Mr. Adams testified that he had never heard the words "conflict of interest" at a board meeting before that day (Barkley Tr. 117). Mr. Banhazl later discussed these developments with his colleagues at Wadsworth & Associates, but he never considered getting new counsel for the Fund (Tr. 894-95).
May 1994 To July 1997
Following the meeting of May 3, 1994, the Fund experienced considerable difficulty with staffing and marketing issues.
In addition to his roles as the Fund's vice president, secretary, and treasurer, Mr. Banhazl took over as the Fund's and Adviser's interim president (Tr. 845-46, 878). He expected to serve only a few months. From May 1994 through June 1995, the Fund's board functioned with only two directors (Messrs. Lucas and Adams), even though its bylaws required a minimum of three directors (Div. Ex. 1-40 at 55). It took more than a year until Jonathan LaVine came aboard as the new president of the Fund and chairman of its board of directors (Tr. 847; Div. Ex. 30-D19).13
A routine Commission examination of the Fund commenced on May 23, 1994. An examiner from the Los Angeles regional office spent at least twenty hours over several weeks with Mr. Banhazl, learning the details of the Fund's operation and management (Barkley Tr. 77-80). Some time later, the examination developed into an investigation, and the investigation led to the OIP.
Although Mr. Rutherford had resigned as a director on May 3, 1994, he continued to attend the Fund's board meetings by invitation. The minutes of the October 1994 meeting make clear that he was no mere guest observer: "Mr. Rutherford led the Board in a discussion of potential candidates for President of the Fund and the Adviser. He was asked to continue his discussions with the individuals under consideration and to report again at the next meeting" (Tr. 362; Div. Ex. 27-D16).14
Mr. Hicks stopped marketing the Fund, as a result of the Division's investigation, and pending revision of the prospectus (Tr. 133; Div. Exs. 27-D16 and 28-D17). He explained to the board that major broker-dealers would not sell the Fund's shares unless the Fund was listed on the National Securities Clearing Corporation's FUNDSERV system and unless the Fund had registered for sale in all fifty states. The cost of nationwide Blue Sky registration was estimated at $20,000 to $30,000 (Div. Exs. 28-D17 and 29-D18).
As found above, Mr. Hicks had originally envisioned the Fund's net assets would be $50 to $100 million within three years. In June 1995, he lowered that ambitious goal to a more modest figure of $25 million (Div. Ex. 30-D19). The Fund did not join the FUNDSERV network until July 1996 (Div. Ex. 34-D23). Because of "economic considerations," it sought Blue Sky registration in only twenty-five states (Div. Ex. 35-D24).
Mr. Banhazl described the Fund as "fairly stagnant" during this period (Tr. 878). Its net assets were $10.5 million on October 31, 1994, and $11.0 million on April 30, 1995 (Div. Ex. 8-15). There were sixty-eight shareholders on October 31, 1994, and seventy-five shareholders on October 31, 1995 (Div. Exs. 9-16 and 39-D51). Most of these shareholders had a prior business relationship with Concord, or had purchased private placement securities issued by Concord and sold by Finance 500 (Tr. 83-85, 88). Mr. Banhazl was nowhere near as active as Mr. Borgardt had been in selecting investments for the Fund. He reviewed Concord's written reports and spoke infrequently to Mr. Carpenter (Tr. 879-80).
By May 1996, the Commission's examination/investigation of Target had been underway for two years. On May 9 and May 15, 1996, an attorney for the Division wrote to Mr. Jeffers, seeking voluntary responses to questions about the Fund's relationship to Concord and Hardie (Div. Ex. 43-23). The Division did so at the request of Kevin J. O'Brien, an attorney for Mr. Banhazl.
On June 26, 1996, Mr. Jeffers responded to the Division's inquiry with a detailed six-page letter (Div. Ex. 44-24). Among other things, Mr. Jeffers stated that: (1) both Mr. Borgardt and Mr. Banhazl had been involved in the review or discussion of the Fund's initial registration statement and pre-effective amendments and (2) post-effective amendments to the Fund's registration statements had also been circulated to members of the board of directors, as well as to Mr. Banhazl, prior to filing with the Commission. After receiving comments, Mr. Jeffers' practice was to circulate a final draft for review and approval by all concerned.
Mr. Jeffers next wrote that he had analyzed issues raised by Section 17 of the Investment Company Act in late 1991, during the early organizational stages of the Fund. At the time of this analysis, Mr. Rutherford had not been elected as a Fund director.15 Mr. Jeffers stated that he did not perform any subsequent Section 17 analysis--and thus did not consider the propriety and legality of Mr. Rutherford's serving as a director of the Fund while at the same time serving as a director and officer of Concord--until early 1994.
Mr. Jeffers further wrote that the propriety and legality of Mr. Borgardt's loan selections for Hardie and the Fund first came to his attention in early 1994, when he learned that Hardie was participating in the same loans at the same time as was the Fund. Mr. Jeffers did not recall any discussions regarding disclosure of Concord's role as sole loan originator of substantially all loans in which the Fund invested, or of Concord's repurchase of defaulted loans. Finally, Mr. Jeffers informed the Division that Target participated in loans at a negotiated rate, and was not subject to the costs and expenses of originating, servicing, and administering the loans in which it invested. He explained that such costs, expenses, and administrative functions were borne exclusively by the loan originator, to date, Concord.
On July 30, 1996, about one month after Mr. Jeffers' letter to the Division, the Fund filed another post-effective amendment to its registration statement (Div. Ex. 39-D51). For the first time, this registration statement disclosed information concerning Concord as the source of all loan originations to the Fund. It stated in pertinent part (id. at 4-5):
Dependence on [Concord] for Loan Originations and Master Servicing. As of June 30, 1996, all of the Loan participations held by the Fund have been originated as small business loans through Concord, . . . a commercial finance services firm located in Palo Alto, California . . . While the Fund is attempting to expand its base of loan originators, it is still dependent on [Concord] for the origination of Loans for the Fund portfolio and would have difficulty finding new Loans meeting its current investment criteria if [Concord] discontinued doing business with the Fund.
Respondents suggest that only by mid-1996 had it become clear to the board that the Fund would be unable to attract additional loan originators, and that amendment of the registration statement had become appropriate. I reject this interpretation of the record. The minutes of board meetings from 1995 and early 1996 show that the board was keeping a watchful eye on the Commission's investigation. The amendment disclosing Concord's role came right on the heels of the Division's exchange of correspondence with Mr. Jeffers. As soon as the Fund's board and officers felt the heat, they saw the light. Mr. Jeffers disavowed any such link (Tr. 303), but I reject his testimony as incredible.
In January 1997, Bay View Capital Corporation (Bay View), a publicly-traded bank holding company with assets of $5 billion, agreed to acquire EXXE Data and Concord. The takeover of Concord by Bay View became effective on March 17, 1997, and was the end of the Fund (Tr. 278-79). As Mr. Carpenter explained, Bay View "had plenty of cheap capital" and it wanted all of Concord's product (Tr. 461-62).16 The Fund's board was unable to find another firm willing to replace Concord as a master servicer. No other potential loan originators offered participations at yields and a level of credit-worthiness to meet the Fund's criteria. Accordingly, Concord and the Fund negotiated a repurchase by Concord of all outstanding loan participations and Fund investments (Div. Exs. 36-D25 and 37-D26). Mr. Rutherford took the lead in suggesting to the Fund's board how this should be accomplished. The Fund wound down by repurchasing all of the outstanding shares of its investors. The shareholders were paid in full, but only after Concord, Wadsworth & Associates, and others involved with the Fund had agreed to "take a hit" on the fees and expenses owed them (Tr. 279, 883-84; Div. Ex. 37-D26 at 2). The Fund then withdrew from Commission registration in July 1997 (Div. Ex. 10-43 at 3).
The Six Registration Statements
The Fund's original registration statement was filed with the Commission on January 21, 1992 (Div. Ex. 1-40). After three pre-effective amendments (Div. Exs. 2-41, 3-42, and 4-11), registration became effective on October 8, 1992. The Fund filed post-effective amendments that became effective on October 26, 1993, November 16, 1993, and April 22, 1994 (Div. Exs. 5-12, 6-13, 7-14, and 10-43). Mr. Borgardt and Mr. Banhazl did not sign the original registration statement (Div. Ex. 1-40), but they did sign all three pre-effective amendments and all three post-effective amendments.
None of these registration statements disclosed Concord's role as sole loan originator and servicer for the Fund. The statements did disclose that Mr. Rutherford was a director of the Fund, as well as chairman and chief executive officer of Concord. However, they did not mention that Mr. Rutherford was also a 20 percent owner of Concord. The registration statements also did not disclose Mr. Borgardt's prior dealings with Concord on behalf of Hardie, Hardie's co-participation with the Fund in Concord loans, Mr. Borgardt's selection of co-participations for both Hardie and the Fund, or the fact that Concord's gross lending rates substantially exceeded the net yields it offered the Fund. The registration statements did disclose the risk of the underlying loan investments, including the fact that the Fund might act as co-lender with other firms; that administrative services would be provided by a lending agent; and that a borrower would typically pay a lending agent an administrative and servicing fee.
After the resignations of Mr. Borgardt and Mr. Rutherford on May 3, 1994, the Fund filed two additional post-effective amendments to its registration statement. These became effective on November 1, 1995, and March 11, 1996 (Div. Exs. 8-15, 9-16, and 10-43). Mr. Banhazl signed both statements. Neither statement disclosed Concord's role as the sole loan originator or servicer nor the fact that Concord's gross lending rates substantially exceeded the net yields it offered the Fund.
Mr. Adams and Mr. Carpenter were generally credible witnesses. Mr. Mackin was also generally credible, but much of his testimony was not probative. As to the other fact witnesses, I have accepted some parts of their testimony and rejected other parts. My reasons are stated throughout this decision. Mr. Hicks was an impatient witness. He often blurted out his answers before the attorneys had completed their questions (Tr. 62-63). After cautioning, he continued to do this (Tr. 68, 105, 127, 131, 142). In a sense, Mr. Hicks' refusal to pause for thoughtful reflection serves as a metaphor for the way the Fund operated.
I was fortunate to have expert input from two distinguished law professors, and this decision has drawn heavily from both their presentations. On cross-examination, Professor Ratner modified several of the statements he had made in his written report. He explained that the Division had engaged him to testify only in January 1999, and that he had not had as much time as he would have liked to prepare his report before its due date (Tr. 520; see also Tr. 915-16). The Division knew on November 5, 1998, the date of Judge Foelak's prehearing conference and order, that its expert report would be due on February 1, 1999. That it took the Division two months after that prehearing conference to engage an expert is disturbing.
CONCLUSIONS OF LAW
The amended OIP alleges that Respondents caused violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act by causing the Fund to offer and sell its securities using registration statements that omitted material information. No scienter requirement exists for violations of Sections 17(a)(2) or 17(a)(3) of the Securities Act; negligence alone is sufficient. Aaron v. SEC, 446 U.S. 680, 701-02 (1980); Newcome v. Esrey, 862 F.2d 1099, 1102 (4th Cir. 1988) (en banc); Pagel, Inc. v. SEC, 803 F.2d 942, 946 (8th Cir. 1986).
The amended OIP also alleges that Respondents violated Section 34(b) of the Investment Company Act in that they caused the Fund to omit to state facts necessary in order to prevent statements made in the Fund's prospectuses, which were incorporated in the Fund's registration statements filed with the Commission, in light of circumstances under which they were made, from being materially misleading. Omissions are not required to be willful to be in violation of Section 34(b) of the Investment Company Act. SEC v. Advance Growth Capital Corp., 470 F.2d 40, 52 (7th Cir. 1972).
A fact is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision and if disclosure of the omitted fact would have significantly altered the total mix of information made available. Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
The question of whether a fact is material is an objective one. Resolution of the issue of materiality is a mixed question of fact and law, and the trier of fact is uniquely competent to make the materiality determination, requiring as it does "delicate assessments of inferences a `reasonable [investor]' would draw from a given set of facts and the significance of those inferences to him." TSC Indus., 426 U.S. at 450.
The function of the materiality requirement is to weed out claims based on trivial or tangential omissions. An analysis of materiality should include an evaluation of both the meaning of the information that allegedly should have been disclosed and the "total mix of information made available" to the reasonable investor.
I agree with Professor Ratner's analysis of the Fund's original registration statement. See supra note 11. The Fund did not start purchasing loan participations until December 1992, at the earliest. Thus, the Fund's exclusive relationship with Concord had not yet become firmly established when the original registration statement took effect. By the same reasoning, the potential conflicts of interest of Mr. Rutherford and Mr. Borgardt had not yet ripened. Until the Fund actually had a loan portfolio, the "rate differential" between Concord's gross lending rates and the Fund's net yields did not exist either. The charges in the amended OIP, insofar as they relate to the Fund's original registration statement, have not been sustained.
Concord's role in the Fund became material after December 1992 (Paragraph III.H of the amended OIP). The first allegation in the amended OIP is that, in registration statements filed after October 8, 1992, the Fund failed to disclose that Concord was the Fund's only source of investments, and the only servicer for the loans in which the Fund invested. The omitted information is alleged to be material because it reflected the extent of Concord's relationship with the Fund, and the Fund's complete reliance on Concord as the source of its investments.
Diversification is an important risk-reducing device, as the Fund's initial business plan recognized. The Fund originally intended to purchase loans in individually negotiated transactions with commercial banks, thrifts, insurance companies, finance companies, and other financial institutions. In fact, however, from December 1992 to March 1997, the Fund relied on a single source, Concord, to originate and service the loans that would generate returns to Fund investors. Concord also advanced the Fund's organizational costs, paid part of its operating expenses, and bought back its troubled loans. The Fund's fortunes stood or fell with Concord's fortunes.
Respondents argue that the Fund was not totally dependent on Concord for loans because it could have purchased loans of marginally lower yields or higher risk than Concord's, consistent with its investment criteria. The record does not support this argument, because the Fund regularly rejected other loan providers as unacceptable in terms of rate or risk. Mr. Adams viewed Concord as the "benchmark" of its industry (Tr. 20). Mr. Hicks considered it "vastly" superior to the competition (Tr. 105). Mr. Borgardt considered Concord's systems "very impressive" (Tr. 767). Mr. Banhazl testified that it was "very difficult" for the Fund to find a firm that had the capability, the capital, and the business history of Concord (Tr. 872).
Professor Coffee opined that it is the margin between the product a company buys and the next best package of products it could buy that determines whether the role of the supplier is a material fact that has to be disclosed (Tr. 964). If a fast food restaurant were to sign an exclusive dealing relationship with Pepsi Cola, it may well be that the type of soft drink served in the fast food restaurant is important, and it may well be that the restaurant got the best terms available from Pepsi Cola. However, the relationship with Pepsi Cola would not be material because, if Pepsi Cola were to disappear as a supplier, the restaurant could sign up with Coca Cola on only slightly inferior terms.
In an effort to build up a track record of strong returns, the Fund was extremely selective in picking its investments. To those associated with the Fund, including Respondents, there simply was no acceptable second choice to Concord. If Concord ceased to supply the Fund with loan participations (as eventually happened), the Fund would be out of business. Because there was no Coca Cola to Concord's Pepsi Cola, Concord's role was material to prospective reasonable investors.
Respondents also suggest that a practical measure of materiality is investor reaction to the facts once they are disclosed. Pointing to the July 1996 amendment of the Fund's registration statement, which disclosed that Concord was the sole source of the Fund's loan participations, Respondents assert that there was no upsurge in redemptions or other adverse reaction by investors. Postulating that the market essentially yawned at the news about Concord, Respondents contend that the newly disclosed information was immaterial. This claim also misreads the record. First, it is a theory that lacks evidentiary support. The hearing simply did not establish whether there was or was not an "upsurge" in redemptions after July 1996. In any event, most of the seventy-five investors who had purchased the Fund's shares were existing customers of Mr. Hicks, had a prior business relationship with Concord, or had previously bought Concord's private placement notes. These individuals knew about Concord's role in the Fund because Mr. Hicks had told them. That does not make the information about Concord immaterial, nor does it excuse the Fund from failing to provide it in the registration statement. As soon as Mr. Hicks tried to market the Fund's shares, seven or eight broker-dealers in his selling network "grilled" him on Concord's role with the Fund (Tr. 86-87).
Finally, Respondents contend that the Fund was not totally at the mercy of Concord because it always had an obvious exit strategy; it could sell off its loans and close down, at a low cost and with no financial loss to investors. The registration statement, of course, made no such pledge. It explained that a secondary market in the Fund's shares was unlikely to develop, and that the Fund's board would make periodic tender offers for the Fund's shares at net asset value. It listed several factors that might result in the return to investors of considerably less than their net asset value in such a tender offer. A fact is not immaterial to the reasonable investor just because the investor subsequently gains an opportunity to cease being an investor and to obtain a refund of his investment. In this case, the Fund's shareholders were made whole only because the Fund's vendors agreed to write off some of the fees and expenses owed to them (Tr. 279, 883-84; Div. Ex. 37-D26 at 2). As Mr. Jeffers explained, everyone concerned with the Fund "took a hit." There is no evidence that the 1997 liquidation was accomplished at a low cost.
Once the Fund began buying loan participations from a single source in December 1992, with no other alternative loan provider meeting its investment criteria, Concord's role in the Fund became material. It should have been disclosed in the post-effective amendments to the registration statement.
Mr. Rutherford's potential conflict of interest was material; his ownership of 20 percent of Concord's stock was not material (Paragraph III.H of the amended OIP). The relevant amendments to the Fund's registration statement adequately disclose that Mr. Rutherford was the chairman and chief executive officer of Concord. Standing alone, however, that fact has no meaning. The registration statements do not disclose Concord's role in the Fund, which is the material information the Division contends is necessary to make what is disclosed about Mr. Rutherford meaningful to a reasonable investor (Tr. 568-69; Div. Ex. 54-48 at 4).
Respondents argue that, since the omission of information about Concord's role is already the subject of the first allegation in the amended OIP, this second allegation is duplicative and adds nothing. That is not entirely true, because the Fund's reliance on Concord presents different issues from the connections the Fund's directors had to Concord from 1992 to 1994.
Section 1(b)(2) of the Investment Company Act declares that the national public interest and the interest of investors are adversely affected when investment companies are organized, operated, managed, or their portfolio securities are selected in the interest of directors and their affiliated persons, rather than in the interest of the companies' securities holders. The policy and purpose of the Investment Company Act is to mitigate and, so far as is feasible, to eliminate such conditions. Cf. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-200 (1963); Alabama Farm Bureau Mut. Cas. Co. v. American Fidelity Life Insur. Co., 606 F.2d 602, 608-09 n.3 (5th Cir. 1979); Galfand v. Chestnutt Corp., 545 F.2d 807, 811-12 (2d Cir. 1976). Mr. Rutherford's affiliation with Concord (and Mr. Borgardt's affiliation with Hardie) provided a significant potential for abuse. Prospective reasonable investors should have been permitted the opportunity to evaluate overlapping motivations in deciding if these directors were serving two masters, or only one.
Had Concord's role been explained, the total mix of information available to the prospective investor about Mr. Rutherford would have changed significantly. The reasonable investor could then have better evaluated the dual affiliations of Mr. Rutherford, who was described in the registration statement only as a disinterested Fund director, but who in fact controlled the firm from which the Fund purchased all its loan participations.
The relevant amendments to the registration statement do not mention that Mr. Rutherford was a 20 percent owner of Concord. That fact, by itself, is not material. Disclosure of the fact that Mr. Rutherford was the chairman and chief executive officer of Concord already informs a potential investor that Mr. Rutherford controls Concord. Thus, the additional information about his stock ownership adds nothing that would require disclosure (Tr. 934).
Mr. Borgardt's separate relationship with Concord through Hardie, and his simultaneous selection of loan participations for Hardie and the Fund were material (Paragraphs III.I and III.J of the amended OIP). The relevant circumstances are straightforward: Mr. Borgardt had two employers, Hardie and the Fund, both of which counted on him to manage their loan portfolios; Hardie had a separate and preexisting relationship with Concord; through Mr. Borgardt, both Hardie and the Fund co-participated in several of the same Concord loans; and, in early 1994, once the Fund's counsel focused his attention on this situation and evaluated it, Mr. Borgardt resigned from his positions with the Fund and the Adviser. I conclude that Mr. Borgardt's selection of co-participations for Hardie and the Fund created a potential conflict of interest and was material.
Respondents argue that Mr. Borgardt applied the same investment criteria to both Hardie's and the Fund's investments and, at times, subordinated Hardie's interests to those of the Fund. This suggestion is irrelevant. As explained above, it is the potential for the conflict that is significant to a reasonable investor. I give little weight to the speculative claim that the Fund actually benefited from Hardie's presence in the same loans (Tr. 933, 972). While co-participations may well have enabled the Fund to participate in larger, less risky, loans than it could have obtained without co-participations, that is no reason to treat as immaterial the fact that Mr. Borgardt was arranging both his employers' co-participations in the same loans.
Respondents also argue that the Fund's small size and its diversification requirement, see supra note 8, left it unable to take a very large chunk out of the kinds of loans that Concord was offering. By this reasoning, competition between the Fund and Hardie was "phantom," because Hardie was not interested in participations under $100,000, while the Fund held few participations that large. Respondents cannot have it both ways: having argued that the use of a single loan provider was immaterial because the Fund was optimistic about its ability to reach "critical mass," outgrow its reliance on Concord, and take bigger participations from multiple originators, they cannot simultaneously argue that the Fund was so small that it could not effectively compete with Hardie for loan participations from that single source.
Concord's gross lending rates, and their relation to the Fund's net yields, were not material. According to Paragraph III.J of the amended OIP, the rate differential was material because the significantly higher returns borrowers paid to Concord "revealed a greater risk of investment risk on the underlying loans than was apparent from the return [Concord] paid to the Fund" and "reflected on the nature of the undisclosed relationship" of Concord to the Fund. The evidence did not support these charges.
First, the evidence established that it is the norm in the loan participation marketplace for loan originators to charge for their services by taking a portion of the loan interest rate and passing on a lesser yield-even a significantly lesser yield-to all loan participants (Tr. 120-21, 140-42, 935-39; Resp. Ex. 5 at 11-13). Concord's practice with respect to the Fund did not differ from the norm, and was not shown to have anything to do with the "undisclosed relationship." Second, the evidence showed that the extent to which Concord's gross lending rates exceeded the yields received by the Fund was a function of the screening and servicing costs incurred by Concord in providing safe loans that met the Fund's investment criteria (Tr. 401, 424-25). Thus, the "differential" between Concord's gross lending rates and the Fund's net yields was not indicative of an unusual or excessive investment risk to the Fund. Third, indirect disclosure of risks through a discussion of the "differential" was unnecessary because the Fund's registration statements already contained adequate direct disclosure regarding the risks pertaining to the loans in which the Fund was investing. Professor Coffee opined that the registration statements adequately disclosed the Fund's investment risk on the underlying Concord loans (Tr. 937), and Professor Ratner did not take issue with that conclusion (Tr. 611-12).
In light of the Fund's direct disclosure of risk on the underlying loans in all its registration statements, the amended OIP's insistence that the Fund also should have disclosed the risk inferentially, by quoting Concord's gross lending rates, is rejected.
The Fund's Prospectuses. Section 34(b) of the Investment Company Act is broadly written to prohibit material omissions in "any registration statement, application, report, account, record, or other document" filed or transmitted under its provisions. In contrast to the statutory text, Paragraph III.L of the amended OIP focuses quite narrowly on the omission of material information necessary to prevent statements in the Fund's prospectus, a specific part of the registration statement, from being materially misleading.
The parties tried the case by addressing materiality; they did not address the separate question of where or how omitted material information should have been disclosed. This is part of the Division's burden. As made clear in two recent rulemaking proceedings, however, material information about mutual fund directors might be disclosed in any one of several places, including the prospectus, the Statement of Additional Information, the proxy statement, or the annual report to shareholders. The charge here is that such information belonged in the prospectus, and nowhere else, and that Respondents should have known this in 1992-1994.
I have concluded above that information about Concord's role in the Fund was material and should have been included in the Fund's post-effective registration statements. In light of the wording of Sections 2(a)(10), 5, and 10(a)(1) of the Securities Act, I also conclude that the information about Concord's role belonged in the Fund's prospectuses. However, any claim that the material information disclosing the two directors' potential conflicts of interest also belonged in the Fund's prospectuses must address the reasoning in two recent Commission rulemaking proceedings. See Section 10(a)(4) of the Securities Act and Registration Form Used By Open-End Management Investment Companies, 66 SEC Docket 2200, 2215 (Mar. 23, 1998) (final rules) (rejecting a proposal that more information about fund directors be included in the prospectus); Role Of Independent Directors Of Investment Companies, 70 SEC Docket 2528, 2542-43 (Oct. 14, 1999) (proposed rules) (proposing to supplement information currently available in mutual fund Statements of Additional Information and in proxy statements with disclosure in the annual report to shareholders).
The parties disagree about whether to apply federal common law or state law in determining the applicable standard of care under Sections 17(a)(2) and 17(a)(3) of the Securities Act. Because the Securities Act imposes a high standard of conduct on specific persons, including directors and officers, associated with a registered public offering of securities, the Division contends that the analysis should begin with Section 11 of the Securities Act. That provision makes the signers of a registration statement, directors, officers, and certain other persons, civilly liable to purchasers of a registered security for misstatements or omissions of material facts in an effective registration statement.17 Professor Ratner opined that the standard of care provision in Section 11(c) should be borrowed to resolve negligence issues arising under Sections 17(a)(2) and 17(a)(3), and that state law due care standards are not relevant (Tr. 649-52, 659).
Respondents argue that the Division's analogy between Section 11 and Section 17(a) is flawed in several respects (Tr. 940-42). First, unlike Section 11, which provides an express private right of action, there is no implied private right of action under Section 17(a). See Newcome v. Esrey, 862 F.2d at 1104-07; In re Washington Pub. Power Supply Sys., 823 F.2d 1349, 1358 (9th Cir. 1987) (en banc). Second, unlike Section 11, which contains an explicit statutory definition of the applicable standard of care, Section 17 is silent as to enforcement mechanisms and the standard of care. Third, unlike Section 11, which requires a defendant to prove an affirmative defense of non-negligence, the burden in Section 17(a)(2) and 17(a)(3) proceedings is on the Division to prove negligence.
Respondents also point to a line of Supreme Court cases holding that a court should endeavor to fill in the interstices of a federal regulatory scheme with uniform federal rules only when the scheme in question evidences a distinct need for nationwide legal standards, or when express provisions in analogous statutory schemes embody congressional policy choices readily applicable to the matter at hand. Otherwise, the Supreme Court has indicated that federal courts should incorporate state law as the federal rule of decision, unless application of the particular state law in question would frustrate specific objectives of the federal program. See Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 98 (1991); Burks v. Lasker, 441 U.S. 471, 477-80 (1979). In this instance, Respondents argue that the Commission should look to the laws of Maryland, the Fund's state of incorporation, to determine the applicable standard of care.18 They contend that one cannot logically be negligent under federal law while meeting the due care obligations imposed by state law.
At first glance, the Maryland provision seems innocuous enough-it looks like simple negligence with a statutory gloss. And, in fact, that is how Respondents pitched their argument (Tr. 942, 978; Resp. Br. 22-23). Upon closer examination, however, the Maryland provision codifies the business judgment rule, see Independent Distrib., Inc. v. Katz, 637 A.2d 886, 895 (Md. 1994), which many courts have interpreted as requiring a showing that directors were grossly negligent. Cf. FDIC v. Jackson, 133 F.3d 694, 699-700 (9th Cir. 1998) (interpreting Arizona business judgment rule); FDIC v. Mintz, 816 F. Supp. 1541, 1546 (S.D. Fla. 1993) (interpreting Florida business judgment rule); Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985); Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). I decline to apply a gross negligence standard here because doing so would clash with the holding of Aaron and frustrate the specific objectives of the Securities Act. Moreover, Katz makes clear that the Maryland business judgment rule is only relevant to a director's duty of care, not his duty of loyalty. It provides no help for non-directors, like Mr. Banhazl, or directors whose dual affiliations present issues of loyalty, like Mr. Borgardt.
I have borrowed the standard of care enunciated in Section 11(c) of the Securities Act for purposes of this proceeding, with the understanding that the burden is on the Division to establish negligence, and not on Respondents to establish non-negligence. That standard is consistent with the Restatement (Second) of Torts § 283, at 12 (1965) (the standard of conduct to which an actor must conform to avoid being negligent is that of a reasonable man under like circumstances).
The record contains ample evidence that Respondents did not conduct themselves with the care that a prudent man would use in the management of his own property. On a purely business level, the negligence is apparent from the way the Fund's board and management never closely examined the promises of the distributor, Lance Hicks. Mr. Hicks had a history of operating thinly capitalized ventures, lacked the resources to pay Wadsworth & Associates its $73,000 consulting fee, was unable to secure conventional financing to cover that obligation, spoke out against "negativistic" prospectus disclosure that was impeding his sales efforts, never formed a reliable distribution network, and ultimately delivered only $12 million in Fund assets after promising $50 million to $100 million. In Texas terminology, Mr. Hicks was "all hat, no cattle." Yet there is no evidence that Mr. Borgardt, the Fund's president and a director, ever pressed Mr. Hicks about any of these matters. Mr. Hicks was Mr. Borgardt's part-time employer ($3,000 a month at Finance 500) and golfing partner (Tr. 72, 74, 689-90). Under the circumstances, it may have been unrealistic to expect too much curiosity from Mr. Borgardt on these topics. The reticence of the other board members and Mr. Banhazl is more difficult to understand.
Negligence took root in a corporate culture that valued directorial silence and compartmentalization of responsibilities. Board members who spoke up or asked questions were considered a nuisance. Mr. Adams learned this at the board's meeting of April 28, 1992, when he pointed out the need to make a minor editorial change in the bylaws. For his troubles, he received a gratuitous and snide "compliment" in the minutes (Tr. 50; Div. Ex. 16-D5 at 2). Mr. Hicks testified that board member Gillem Lucas brought up a question about disclosing Mr. Borgardt's conflict of interest, but then added with the back of his hand: "[Mr. Lucas] made a big deal out of it and, if you knew Gillem Lucas, you'd know what I mean" (Tr. 166). The mindset of the Fund's organizers was apparent from the start. They assumed that all the pesky little regulatory details of operating a mutual fund-including the duty to disclose material facts in the registration statement-could be subcontracted out to Wadsworth & Associates and/or Mr. Jeffers, and that they were free to do nothing more than pick the Fund's investments (Tr. 325, 692-93, 741-42). As Mr. Hicks explained: "we need like, you know, total reliance on somebody who's going to hold our hand here" (Tr. 139). But see Advance Growth Capital, 470 F.2d at 52 ("Officers and directors of investment companies should not be allowed to avoid their statutory duties so easily. To hold otherwise would make it impossible to enforce the disclosure provisions of the Act").
Against this background, Mr. Borgardt's testimony appears to be based on the premise that he lacked free will-he really only wanted to be a consultant who picked loans for the Fund, but was dragged into being president and director at the last moment, and against his better judgment. Mr. Borgardt never shared such misgivings with the other members of the Fund's board, or told the board in clear terms that he was unwilling and unable to perform the full range of duties required of the president and a director by the Fund's articles of incorporation. The same is true of Mr. Borgardt's dealings with Mr. Jeffers. He never told Mr. Jeffers that he would be selecting co-participations for Hardie and the Fund. Rather, he assumed that others had already done this for him. Even when walking away from the Fund on May 3, 1994, Mr. Borgardt left half the task undone. To avoid liability in a Section 11(a) shareholder suit, he also should have notified the Commission and the investing public that he was disavowing the prior registration statements he had signed. See Section 11(b)(2) of the Securities Act.
Based on the breadth and depth of his prior experience in the mutual fund industry, Mr. Banhazl brought a much higher degree of competence to the Fund than Mr. Borgardt. Nevertheless, Mr. Banhazl did not review any of the Fund's registration statements for disclosure compliance, on the grounds that disclosure was the job of Fund counsel (Tr. 864-65). The material omissions at issue in this proceeding are not esoteric. They are basic to the way the Fund conducted its business. It took Mr. Falk, a newcomer in January 1994, only a few hours at a board meeting to recognize that things were amiss and to sound the alarm bell to Mr. Jeffers.
I conclude that the Division has satisfied its burden of demonstrating that Respondents were negligent. However, if the applicable standard of care is gross negligence, then the Division has not made that more demanding showing.
Reliance On Counsel As A Defense To Liability19
In prior cases arising under the federal securities laws, the courts have developed a four-part test for evaluating the reliance on counsel defense. Its essential elements are that a person: (1) made a complete disclosure to counsel of the intended action; (2) requested counsel's advice as to the legality of the intended action; (3) received counsel's advice that the conduct was legal; and (4) relied in good faith on that advice. See Markowski v. SEC, 34 F.3d 99, 104-05 (2d Cir. 1994); C.E. Carlson, Inc. v. SEC, 859 F.2d 1429, 1436 (10th Cir. 1988); SEC v. Goldfield Deep Mines Co., 758 F.2d 459, 467 (9th Cir. 1985); SEC v. Savoy Indus., Inc., 665 F.2d 1310, 1314 n.28 (D.C. Cir. 1981).
Respondents describe this test as "quite severe and quite parsimonious" (Tr. 946). They attribute this to the fact that the cited cases involved scienter, and the claims of reliance on professional advice were treated skeptically. They urge the Commission not to "trivialize the defense" or to make it "cumbersome, limited, and unworkable" by applying the test strictly at the other end of the spectrum, where the underlying violations do not involve scienter (Tr. 946-47).
The argument comes too late to be considered here. The Commission has repeatedly held that the reliance on counsel defense "usually" is not available where intent is not an element of the violation. McLaughlin Piven Vogel Sec., Inc., 52 S.E.C. 1164, 1168 n.14 (1996); David M. Haber, 52 S.E.C. 201, 206 (1995); John Thomas Gabriel, 51 S.E.C. 1285, 1292 n.31 (1994), aff'd, 60 F.3d 812 (2d Cir. 1995) (Table Case). If Respondents believe the Commission has been insufficiently hospitable to the defense in non-scienter cases, they must ask the Commission to reconsider its precedent.
The Commission has departed from its usual practice and entertained a reliance on counsel defense in one recent proceeding where the underlying violation did not involve scienter. William H. Gerhauser, Sr., 68 SEC Docket 1289, 1298-1300 (Nov. 4, 1998) (considering, but rejecting, the defense where the underlying misconduct was operating a securities business in violation of the net capital rule). Assuming that this proceeding, like Gerhauser, is one of the "unusual" non-scienter cases where the Commission might consider the defense to be available, I address it. On this record, the defense fails.
First, for the reasons explained above, the weight of the credible evidence does not show that Mr. Jeffers gave any legal advice to the Fund's board about the immateriality of the facts omitted from disclosure. I conclude that this is so with respect to the continued non-disclosure of Concord's role between December 1992 and July 1996, and with respect to the non-disclosure of Mr. Rutherford's and Mr. Borgardt's conflicts of interest between December 1992 and May 1994. I further conclude that Mr. Jeffers' physical presence at board meetings, coupled with his silence, does not constitute legal advice.
Second, even if Mr. Jeffers gave legal advice to the Fund's board on the immateriality of Concord's role and Mr. Rutherford's conflict of interest, it was not shown to be the sort of "wholly disinterested advice" on which Respondents could reasonably rely. Arthur Lipper & Co. v. SEC, 547 F.2d 171, 182 (2d Cir. 1976); cf. Carlson, 859 F.2d at 1436 (counsel must be independent); Sorrell v. SEC, 679 F.2d 1323, 1327 (9th Cir. 1982) (same). Mr. Jeffers and Mr. Carpenter both paid lip service to the notion that Mr. Jeffers was never Concord's attorney (Tr. 226, 249, 357). The weight of the evidence is otherwise. Concord, Mr. Rutherford, and Mr. Carpenter were relying on Mr. Jeffers for advice and analysis on issues arising under the Investment Company Act, and Mr. Jeffers knew it (Tr. 198, 227). Concord had several law firms available to it, but elected not to use them in its dealings with the Fund (Tr. 329-30, 357-58). Instead, Concord turned to Mr. Jeffers, who had previously worked for one of the law firms it retained (Tr. 191, 227). Mr. Jeffers was serving two masters, and it is not clear how he could render objective disclosure advice to the Fund's directors for the benefit of the Fund's shareholders on topics of potential conflict between the Fund and Concord. Of course, the applicable codes of legal ethics permit a lawyer to represent clients with conflicting interests after full disclosure and client consent. The record is silent on these matters. In these circumstances, Mr. Jeffers' advice to the Fund was not shown to be "wholly disinterested."
Third, Respondents have failed to demonstrate that they relied in good faith on Mr. Jeffers' legal advice. As an illustration, Mr. Jeffers explained that he kept Concord's name out of the Fund's registration statement largely to avoid creating the misleading impression that Concord was guaranteeing the loans in which the Fund participated, or would buy back participation interests in the event of borrower default. This was inaccurate, and Mr. Borgardt knew it. Concord had an established practice of buying back troubled loan participations from Hardie. Mr. Borgardt insisted that Concord follow the same practice when dealing with the Fund, and Concord did so twice. Both Mr. Jeffers and Mr. Borgardt knew that another reason for Concord's buy-back practice was to save Concord additional paperwork. It was easier for Concord to assume the Fund's interest in a defaulted loan than to deal with the complication of working out the Fund's fractional security interest.
Likewise, Mr. Banhazl did not meet the good faith test as to the last two post-effective amendments. By May 3, 1994, it had become clear to all that Mr. Jeffers had given incorrect advice about Mr. Rutherford's and Mr. Borgardt's ability to serve on the Fund's board. Mr. Banhazl had considerable experience in mutual fund management, and he should have been skeptical of Mr. Jeffers' legal advice from that point forward. Mr. Banhazl was responsible for the Fund's loan portfolio selections after May 3, 1994, but he just went through the motions. He relied heavily on Concord's written evaluations and spoke to Mr. Carpenter infrequently. Foothill Advisers was inactive at this point. Until the arrival of Mr. LaVine and Target Capital Advisers, Concord was functioning as the Fund's de facto investment adviser. Mr. Banhazl also knew, in 1994 and 1995, that the Fund's assets were not growing and that Mr. Hicks' marketing efforts were dead in the water. He knew or should have known that the Fund's ability to reach the "critical mass" of $50 to $100 million would remain well beyond reach, and that continued reliance on Concord as the sole source of the Fund's loan participations was highly likely. Mr. Banhazl's suggestion that he lacked such knowledge in 1994 and 1995, and only gained it in July 1996, strains belief.
Respondents argue that the Commission must look to Maryland law to determine the availability of any defense to the charges in the amended OIP, because the relevant federal statutes do not articulate any defenses. The statute Respondents invoke, Article 2-405.1(b) of the Maryland Corporations and Associations Code, provides an express reliance on experts defense that is more generous to directors of Maryland corporations than the federal cases cited above. However, even the Maryland statute does Respondents no good. Article 2-405.1(b)(2) provides that "a director is not acting in good faith if he has any knowledge concerning the matter in question which would cause [his] reliance [on an attorney] to be unwarranted." Mr. Banhazl was never a Fund director and he has not shown that the Maryland statute even applies to him. Mr. Borgardt was a director, but one who appears on two sides of a transaction, as he did, cannot claim the protections of the business judgment rule. Mr. Borgardt's conflict of interest involved his state law duty of loyalty, not his state law duty of care. In any event, based on my determination above that both Respondents lacked good faith under the federal standard, I also conclude that Respondents have failed to satisfy the "any knowledge" requirement of the good faith test under Maryland law.
CEASE AND DESIST ORDER
The Division seeks a cease and desist order against both Respondents for causing violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act and for violating Section 34(b) of the Investment Company Act.20 Mr. Borgardt and Mr. Banhazl contend that no sanction is appropriate. Sanctions are not intended to punish a respondent, but to protect the public from future harm. Leo Glassman, 46 S.E.C. 209, 211-12 (1975).
Under Sections 8A(a) of the Securities Act and Section 9(f)(1) of the Investment Company Act, the Commission may impose a cease and desist order upon any person who "is violating, has violated, or is about to violate" any provision of the respective statutes. The same is true as to any other person who "is, was, or would be a cause of the violation, due to an act or omission the person knew or should have known would contribute to such violation."
Having determined that Respondents caused the Fund's violations by signing inaccurate registration statements, the question is whether Respondents "knew or should have known" that their actions would contribute to the violations. The Division does not allege that Respondents acted with knowledge, and the evidence does not establish such knowledge. Accordingly, I find that Respondents did not know that they contributed to the violations.
The Commission has not yet ruled on the meaning of the phrase "should have known" in the context of a cease and desist order. Based on the discussion above, I find it appropriate to use a negligence standard to determine whether Respondents "should have known" that their actions would contribute to the Fund's violations. Cf. Edward D. Jones & Co., 66 SEC Docket 3086, 3093-95 (Apr. 15, 1998), final, 67 SEC Docket 726 (May 28, 1998).
The Commission stated in Joseph J. Barbato, 69 SEC Docket 178, 200 n.31 (Feb. 10, 1999) that, when addressing cease and desist orders, it is guided by the public interest factors cited in Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd, 450 U.S. 91 (1980). That analysis requires that several issues be considered, including: (1) the egregiousness of the respondents' actions; (2) the isolated or recurrent nature of the infraction; (3) the degree of scienter involved; (4) the sincerity of the respondents' assurances against future violations; (5) the respondents' recognition of the wrongful nature of their conduct; and (6) the likelihood that their occupations will present opportunities for future violations. No one factor is controlling.
The third and sixth Steadman factors warrant mention here. If this were an injunctive action in federal district court, the Division could not prevail simply by showing negligent misconduct, with no likelihood of repetition. In Aaron, the Supreme Court addressed this precise issue in relation to injunctions to halt negligent violations of Sections 17(a)(2) and 17(a)(3):
This is not to say, however, that scienter has no bearing at all on whether a district court should enjoin a person violating or about to violate § 17(a)(2) or § 17(a)(3). In cases where the Commission is seeking to enjoin a person . . . the Commission must establish a sufficient evidentiary predicate to show that such future violation may occur. . . . An important factor in this regard is the degree of intentional wrongdoing evident in a defendant's past conduct. . . . Moreover, as the Commission recognizes, a district court may consider scienter or lack of it as one of the aggravating or mitigating factors to be taken into account in exercising its equitable discretion in deciding whether or not to grant injunctive relief.
446 U.S. at 701 (citations omitted). In addition, Chief Justice Burger emphasized in his concurrence:
It bears mention that this dispute, though pressed vigorously by both sides, may be much ado about nothing. This is so because of the requirement in injunctive proceedings of a showing that "there is a reasonable likelihood that the wrong will be repeated." . . . To make such a showing, it will almost always be necessary for the Commission to demonstrate that the defendant's past sins have been the result of more than negligence. Because the Commission must show some likelihood of a future violation, defendants whose past actions have been in good faith are not likely to be enjoined . . . An injunction is a drastic remedy, not a mild prophylactic, and should not be obtained against one acting in good faith.
Id. at 703 (citations omitted); see SEC v. Pros Int'l, Inc., 994 F.2d 767, 769 (10th Cir. 1993) (a knowing violation of Section 17(a)(1) will justify an injunction more readily than a negligent violation of Sections 17(a)(2) or 17(a)(3); but if there is a sufficient showing that the violation is likely to recur, an injunction may be justified even for a negligent violation of Sections 17(a)(2) or 17(a)(3)); SEC v. Steadman, 967 F.2d 636, 647-48 (D.C. Cir. 1992) (affirming findings of negligent violations of Sections 17(a)(2) and 17(a)(3), but vacating injunction); SEC v. Haswell, 654 F.2d 698, 700 (10th Cir. 1981) (assuming that the defendant violated Sections 17(a)(2) and 17(a)(3), which would not require a showing of scienter, the absence of scienter alone supports the denial of an injunction).
The Division assumes that things are different when it seeks a cease and desist order in the administrative forum-that it need only jump over lower hurdles. But no statutory analysis has been offered to support that assumption. There is a dispute as to whether the Commission may only impose a cease and desist order where the respondent is reasonably likely to commit similar securities violations in the future, or whether no additional showing beyond the underlying violation itself is necessary. Compare Fu-Sung Peter Wu, 70 SEC Docket 513 (July 22, 1999) (initial decision finding negligent violations of Sections 17(a)(2) and 17(a)(3) and entering cease and desist order), appeal pending, with Warren G. Trepp, 70 SEC Docket 2037 (Sept. 24, 1999). Neither the Commission nor the appellate courts have yet resolved the dispute.
Respondents' violations were not egregious. They involved simple negligence, not gross negligence and not scienter. Respondents have no prior or subsequent disciplinary history, but the violations were not isolated. They were ongoing (one and one-half years in Mr. Borgardt's case and three and one-half years in Mr. Banhazl's case). The violations were repeated in each post-effective amendment to the Fund's registration statement. They were not corrected quickly, even though everyone associated with the Fund knew of the Commission's investigation. Respondents make no promises of altering their behavior in the future, insist they have done nothing wrong, and show no remorse. Finally, Respondents remain in a position to repeat their violations. Mr. Banhazl has been active in the securities industry from 1985 to the present, and remains heavily involved in the establishment of new mutual funds. Mr. Borgardt left the securities industry on May 3, 1994, and had been out for four years when the OIP was issued. That fact, while relevant, is not controlling. SEC v. Bonastia, 614 F.2d 908, 913 (3d Cir. 1980). Mr. Borgardt has now returned to the securities industry as an officer of a company about to go public (Posthearing Tr. 12).
By reason of negligence, there was falsity in several registration statements signed by two Respondents who may reasonably be expected to sign future registration statements involving other securities. A cease and desist order will provide substantial assurance that these negligent Respondents will take more pains the next time to avoid all falsity. Assuming, without deciding, that the Division must show a reasonable likelihood of future violations, that showing has been made here as to both Respondents. In these circumstances, a cease and desist order is appropriate.
Pursuant to Rule 351(b) of the Commission's Rules of Practice, I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on December 6, 1999.
Based on the findings and conclusions set forth above, I order Byron G. Borgardt and Eric M. Banhazl to cease and desist from causing any violations or future violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933 and from committing any violations or future violations of Section 34(b) of the Investment Company Act of 1940.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice. Pursuant to that Rule, a petition for review of this initial decision may be filed within twenty-one days after service of the initial decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision on that party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to that party. If a party timely files a petition for review, or the Commission acts to review on its own motion, the initial decision shall not become final as to that party.
James T. Kelly
Administrative Law Judge
1 Citations to the exhibits offered by the Division and by Respondents will be noted as "Div. Ex. ___," and "Resp. Ex. ___," respectively. Citations to the posthearing pleadings will be noted as "Div. Prop. Find. ___," "Div. Br. ___," "Div. Reply Br. ___," "Resp. Prop. Find. ___," "Resp. Br. ___," and "Resp. Reply Br. ___," respectively. Citations to the posthearing oral argument will be cited as "Posthearing Tr. ___." Pursuant to my Order of August 17, 1999, and for the reasons stated therein, the official transcript of the morning session of June 21, 1999 (which contains the testimony of Thomas Mackin and the beginning of the testimony of Lawson Adams) is that provided by Respondents from Barkley Court Reporters & Transcripts ("Barkley Tr. ___"). The official transcript for the remainder of the hearing is that provided by Diversified Reporting Services, Inc. ("Tr. ___").
2 A disproportionate number of administrative proceedings are instituted at the end of the fiscal year. See Audit Report No. 253, Administrative Proceedings, Nov. 7, 1997, issued by the Commission's Office of the Inspector General. The difficulties encountered by Professor Ratner with the original OIP are attributable to problems in one such document.
3 Div. Prop. Find. at 22-23; Div. Br. at 24; Div. Reply Br. at 14; Posthearing Tr. 24-27.
4 SEC Form 1662 was referenced in and enclosed with the Division's letter of May 9, 1996, but it was not attached to the copy of the letter offered as Div. Ex. 43-23. Official notice of the contents of SEC Form 1662 is permissible under Rule 323.
5 Cf. United States v. Teyibo, 877 F. Supp. 846, 855 (S.D.N.Y. 1995) (holding that SEC Form 1662 gave a defendant sufficient notice that any information he provided to the Commission could be used against him in subsequent criminal proceedings); In re Leslie Fay Cos. Sec. Litig., 152 F.R.D. 42, 45-46 (S.D.N.Y. 1993) (requiring production of a report to plaintiff in civil litigation where the Commission's staff had rejected a request for confidential treatment and the report's preparer knew the report could be used for any of the routine uses listed in SEC Form 1662).
6 As the distinction between the three Hardie entities is not important, all three will be referred to in this decision as "Hardie."
7 Two witnesses referred to the $50 million to $100 million level as "critical mass" (Tr. 87, 346, 348, 379; see also Tr. 972-73). Funds of smaller size are unlikely to be found in the mutual fund tables of the newspapers. Funds without a three-year track record are unlikely to be followed by rating services.
8 The effect of the diversification requirement was to limit the Fund's participation interest in any given loan to 5 percent or less of the Fund's net assets (Tr. 569-71, 732, 863-64, 889-90; Div. Ex. 51-35).
9 Obviously, a 2.5 percent expense cap on a $12 million fund is much more restrictive than a 2.5 percent expense cap on a $100 million fund. As explained in note 7 above, it was the failure of Target's marketing effort to reach "critical mass" that led the Fund to continue borrowing from Concord.
10 In part, Concord's rate reduction proposal also responded to changes in competitive market conditions (i.e., falling interest rates). Concord asked other loan participants, including Hardie, to accept rate reductions, although not necessarily similar rate reductions (Tr. 415, 440-41, 787).
11 The Division acknowledges that Mr. Jeffers gave advice not to disclose Concord's role in the Fund's original registration statement, but contends that he did not give similar advice with respect to the post-effective amendments (see Paragraph III.H of the original and amended OIPs; Div. Prehearing Br. at 13). Professor Ratner's view is somewhat different: in his opinion, there was no material omission in the original registration statement because the Fund had not yet started purchasing loan participations and its exclusive relationship with Concord had not yet become firmly established (Div. Ex. 54-48 at 4). See also the Commission's Order accepting Reid Rutherford's settlement offer (Resp. Ex. 8-3 at III.F and III.G).
12 Mr. Jeffers' memory began to improve shortly before the OIP was issued. See Resp. Ex. 9-42, letter from Kevin J. O'Brien, counsel for Respondent Banhazl, to the Division, dated May 8, 1998, which made the following proffer: "Mr. Jeffers . . . is in a position to clarify his [investigative] testimony regarding his legal advice to the Fund. Mr. Jeffers would testify that, at board meetings subsequent to the beginning of the Fund's operations, he reiterated his view that the role of Concord in the Fund did not have to be disclosed. Although Mr. Jeffers does not recall the specific dates when these communications were made, he is certain that he had them and can recall with some precision the circumstances under which they took place."
That proffer is inconsistent with another letter from Mr. O'Brien only four months earlier. See Div. Ex. 56-27 at 2, letter from Kevin J. O'Brien to Division counsel, dated January 9, 1998 (emphasis added): "[A]s to the alleged violations of the Fund's disclosure obligations, Mr. Jeffers testified [during the investigation] that (1) early in the life of the Fund, he did address the question of whether the relationship of [Concord] to the Fund should be more fully disclosed in the prospectus and he concluded, for several reasons, that such additional disclosure was not legally necessary or appropriate; (2) he discussed his firm legal conclusion with Mr. Banhazl and Mr. Carpenter, among others; [and] (3) Mr. Jeffers does not recall this subject arising again until the prospectus was amended regarding [Concord] in 1996."
13 Mr. LaVine also established a new advisory firm, Target Capital Advisors, Inc., to replace Foothill Advisers (Div. Ex. 30-D19).
14 Respondents suggest that there is nothing unusual about mutual fund directors asking a non-director, in this case Mr. Rutherford, to attend board meetings and make presentations about topics of interest to the directors (Tr. 877, 896-98). I reject this view of the evidence. I agree with Professor Ratner that the practice raises questions about whether the Fund's board was fulfilling its duty by inviting a non-director to lead the deliberations (Tr. 526-28, 570-71). The board's continuing deference to Mr. Rutherford is probative of the Fund's reliance on Concord.
15 Mr. Jeffers prepared two pages of handwritten notes dealing with the proposed fund's compliance with Section 17 of the Investment Company Act (Tr. 204-09; Div. Ex. 42-22). The notes bear the date "11-11-91" under the heading "Concord Fund." At that time, the Fund had not even been incorporated, and its board of directors had not yet been selected. Mr. Jeffers was unclear about who asked him to prepare the notes, when he reported the results of his analysis, and whether he did so at a meeting or in a series of telephone calls (Tr. 291-92).
16 At about the same time, Concord ceased its loan participations with Hardie (Tr. 712-13) and its private placements through Finance 500 (Tr. 322).
17 Section 11 places a relatively minimal burden on a purchaser seeking to utilize its remedies. To establish a prima facie case, the purchaser need only show a material misstatement or omission in the registration statement, and that he lost money. Liability against the issuer of a security is virtually absolute, but other persons, including directors and officers, are accorded an affirmative defense of due diligence. Under Section 11(b)(3), they may avoid liability in some circumstances by proving that they made a reasonable investigation of, had reasonable grounds to believe in, and did believe in, the accuracy of the non-expertised portions of the registration statement or, with respect to any parts presented on an expert's authority, that they had no reasonable grounds to believe and did not believe that there was a material misstatement or omission. Under Section 11(c), the standard of reasonableness to be applied in the Section 11(b)(3) analysis is "that required of a prudent man in the management of his own property."
18 Maryland Corporations and Associations Code, Article 2-405.1 provides: "Standard of care required of directors. (a) In general. A director shall perform his duties as a director . . . . (1) In good faith; (2) In a manner he reasonably believes to be in the best interests of the corporation; and (3) With the care that an ordinarily prudent person in a like position would use under similar circumstances."
19 Reliance on advice of counsel may also be considered as a mitigating factor when imposing sanctions in the public interest. Joseph G. Chiulli, 71 SEC Docket 1544, 1554 n.26 (Jan. 28, 2000); Kidder, Peabody & Co., 43 S.E.C. 911, 914 n.1 (1968); Gearhart & Otis, Inc., 42 S.E.C. 1, 6 n.9 (1964).
20 Paragraph IV.B of the amended OIP erroneously refers to violations specified in Paragraph III.J of the amended OIP. The correct reference should be to Paragraph III.L of the amended OIP. Respondents have not complained about the discrepancy.
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