Initial Decision of an SEC Administrative Law Judge
In the Matter of
In the Matter of
January 29, 2001
Leslie Kazon, Teresa M. Venezia, Anna Majewicz, and Janet Leiben for the Division of Enforcement, Securities and Exchange Commission
Lance M. Brofman for Respondents Fundamental Portfolio Advisors, Inc., Fundamental Service Corporation, and, pro se, Lance M. Brofman
Carol Fox Foelak, Administrative Law Judge
This Initial Decision finds that Respondents marketed shares of a government bond fund as a safe, stable investment but invested heavily in volatile inverse floaters that exposed the fund to significant losses when interest rates rose in 1994. Additionally, Respondents failed to disclose their soft dollar arrangements to the Board of Directors of the fund. The Decision concludes that Respondents thus violated the antifraud provisions of the securities laws.
The Decision orders Respondents to cease and desist from violations of the antifraud provisions, bars Lance M. Brofman from association with an investment adviser or broker-dealer, and revokes the investment adviser and broker-dealer registrations of Fundamental Portfolio Advisors, Inc. and Fundamental Service Corporation. The Decision also fines Brofman $250,000, and the two other Respondents $500,000 each.
A. Procedural Background
The Securities and Exchange Commission (Commission) initiated this proceeding by an Order Instituting Proceedings on September 30, 1997, pursuant to Section 8A of the Securities Act of 1933 (Securities Act); Sections 15(b), 19(h), and 21C of the Securities Exchange Act of 1934 (Exchange Act); Sections 9(b) and 9(f) of the Investment Company Act of 1940 (Investment Company Act); and Sections 203(e), 203(f), and 203(k) of the Investment Advisers Act of 1940 (Advisers Act). The Commission issued a Corrected Order Instituting Proceedings (OIP) on October 24, 1997.1
The undersigned held a hearing in New York City on September 1-4 and 8-9, 1998, as to the remaining Respondents. The Division of Enforcement (Division) called ten witnesses from whom testimony was taken, and Respondents, two. Over 100 exhibits were admitted into evidence.2
The findings and conclusions in this Initial Decision are based on the record. Preponderance of the evidence was applied as the standard of proof. See Steadman v. SEC, 450 U.S. 91 (1981). Pursuant to the Administrative Procedure Act,3 the following post hearing pleadings were considered: the Division's Post-Hearing Proposed Findings of Fact and Conclusions of Law and Post-Hearing Memorandum, filed January 15, 1999; Respondents' Proposed Findings of Fact and Conclusions of Law and Post-Hearing Memorandum, filed March 5, 1999; the Division's Reply to Respondents' Proposed Findings of Fact and Conclusions of Law and Post-Hearing Reply Memorandum, filed April 23, 1999. Additionally, correspondence from Brofman, dated April 30 and May 24, 1999, and from the Division, dated May 13, 1999, is accepted nunc pro tunc. All arguments and proposed findings and conclusions that are inconsistent with this decision were considered and rejected.
B. Allegations and Arguments of the Parties
The OIP alleges that Respondents Brofman, Fundamental Portfolio Advisors, Inc. (FPA), and Fundamental Service Corporation (FSC) violated the antifraud provisions of the federal securities laws because they marketed shares of a limited duration government bond fund as a safe, stable investment when it was not. Respondents allegedly exposed the fund to significant losses in net asset value (NAV) by investing a substantial portion of its portfolio in highly volatile inverse floating collateralized mortgage obligations (inverse floaters). When interest rates rose in 1994, the fund's NAV declined by over 30%. The OIP alleges that Respondents misrepresented the true volatility of the fund's NAV in its prospectus and in sales literature.
The OIP further alleges that Respondent FPA violated provisions of the Advisers Act by failing to disclose FPA's soft dollar practices to the Board of Directors and Trustees (Board) of the Fundamental Funds. The OIP alleges that Respondent Brofman aided and abetted and caused FPA's soft dollar violations.
Respondents contend that their risk management practices were consistent with the representations in the fund's prospectus and sales literature, and conformed to industry standards in 1993 and 1994. They argue that the decline in NAV in 1994 was the result of rapidly changing market conditions. They further contend that the Board was aware of the alleged soft dollar arrangement.
II. FINDINGS OF FACT
A. Respondents and Related Entities
The Fundamental U.S. Government Strategic Income Fund (the Fund) is a no-load, open-end management investment company created in early 1992. Jt. Ex. A at Stip. 1. It is registered with the Commission pursuant to Section 8(a) of the Investment Company Act. During the time at issue the Fund invested primarily in securities that were issued or guaranteed by the U.S. Government, its agencies or instrumentalities (government bonds) and had minimal credit risk. Div. Ex. 2 at 1, Div. Ex. 3 at 1.
Respondent FPA is an investment adviser registered with the Commission pursuant to Section 203(c) of the Advisers Act. Answer ¶ II.B.1. At all relevant times, FPA was the investment adviser to the Fund and four other funds constituting the Fundamental Family of Funds (Fundamental Funds). Answer ¶ II.B.1. FPA's fees for managing the Fund were approximately $366,000 in 1993 and $270,000 in 1994. Tr. 197-98. FPA was replaced as adviser to the Fundamental Funds on May 31, 1998, and at the time of the hearing was inactive. Tr. 215-17.
Respondent FSC is a broker-dealer affiliated with FPA and the Fundamental Funds. It has been registered with the Commission pursuant to Section 15(b)(1) of the Exchange Act since 1987. Answer ¶ II.B.4. At all relevant times, FSC distributed shares of the Fund and the other Fundamental Funds, directly or through other broker-dealers, and performed marketing activities for the Fundamental Funds, including preparation and distribution of advertising material and sales literature. Answer ¶ II.B.4. Since its inception, FSC's only activities have been the distribution and marketing of the funds managed by FPA. Tr. 217. FSC has been inactive since FPA was replaced as manager of the Fundamental Funds. Tr. 217.
Respondent Lance M. Brofman, at all relevant times, was associated with FPA and FSC and was FPA's and the Fund's chief portfolio strategist. Tr. 95, 98; Answer ¶ II.B.2. Brofman's compensation from FPA was approximately $295,000 in 1993 and $427,000 in 1994. Tr. 198. FPA's contract was renewed for 1997 with the condition that Brofman have nothing to do with the investment or trading of the Fundamental Funds. Tr. 754-55. At the time of the hearing Brofman was attempting to engage in a proxy fight with the aim of restoring his, FPA's, and FSC's relationship to the Fund. Tr. 216. During the period of the alleged violations, Brofman owned 48.5% of FPA and 9.9% of FSC. Tr. 97; Answer ¶ II.B.2. At the time of the hearing, Brofman owned 97% of FPA and 9.9% of FSC, and was the person controlling the affairs of those entities. Tr. 97.
Brofman has a Ph.D. in economics and finance and been working in the securities industry since 1974. Tr. 94-95. He has been managing mutual funds since 1981, when he founded the New York Muni Fund, one of the Fundamental Funds. Tr. 95. Each of the Fundamental Funds was managed mainly by Brofman from the time of its inception until he was removed. Tr. 95-97. Brofman had been president of, and chief portfolio strategist for, Investment Portfolio Management, Inc. (IPM), which managed the New York Muni Fund, the California Muni Fund, and other funds. Tr. 95-97. Around 1987, following a period of internal management, the funds previously managed by IPM came to be managed by FPA. Tr. 96-97.
Vincent Malanga was president of the Fund, vice-president of FSC, and owned 48.5% of FPA during the relevant period. He has a Ph.D. in economics, started his career as an economist at the Federal Reserve, and has been working in the securities industry since 1978. Tr. 1092; Jt. Ex. C at 3. He founded his own firm, LaSalle Economics, in 1983, and joined FPA in 1987. Tr. 1092.
B. Respondents' Disciplinary Records
Twice previously, Brofman settled fraud charges arising out of his management of mutual funds. Div. Ex. 35A (Investors Portfolio Management, Inc., and Lance M. Brofman, 30 SEC Docket 1010 (June 4, 1984)), Div. Ex. 36 (Lance M. Brofman, 36 SEC Docket 1249 (Oct. 2, 1986)). Additionally, the Commission concluded that, based on Brofman's activities as its portfolio manager, IPM violated the antifraud provisions and revoked IPM's investment adviser registration. Investors Portfolio Management, Inc., 50 S.E.C. 251 (1990).
In April 1994, FPA and FSC settled New York State charges that sales materials of the New York Muni Fund, which promised high returns with low risk, were misleading because they did not disclose aggressive portfolio strategies such as leverage and substantial investments in volatile inverse floating-rate municipal bonds. Div. Ex. 38 at 5-6. In settling the charges, FPA and FSC undertook to cease representing that the New York Muni Fund's primary objective was safety, disclose the higher risk of its high yield strategies, provide investors with a description of its "effective portfolio duration or sensitivity to interest rate risk" and use of leverage, and retain a Compliance Officer to review its compliance with the law and the requirements of the National Association of Securities Dealers, Inc. (NASD). Div. Ex. 38 at 9-12. The settlement was a result of an inquiry that began prior to January 19, 1994. Div. Ex. 76 at 7-9.
In February 1998, FSC, Malanga, and FSC's head of marketing, David P. Wieder, settled NASD charges related to the conduct at issue in this proceeding that they had overstated the Fund's safety and stability, omitted to state its risks and potential volatility, and misrepresented the nature of the portfolio. Jt. Ex. C. The sanctions included a $100,000 fine imposed jointly and severally on FSC and Malanga, a thirty-day suspension of Malanga, and a requirement that he requalify by examination for various registrations. Jt. Ex. C at 12-13.
C. The Fund
The Fund was Brofman's idea - to seek the highest yielding U.S. Government securities, avoiding any credit or currency risk, and to use hedging to limit interest rate risk, and thus obtain high current income with minimum risk. Tr. 99-102; Div. Ex. 24. Through hedging, the Fund's volatility in response to market interest rate changes was to be no greater than a portfolio consisting solely of U.S. Government securities with durations of less than three years. Tr. 106-07. As portfolio manager, Brofman selected the securities and calculated the duration. Tr. 98.
1. Earn High Yields with Maximum Safety
The Fund was marketed to conservative investors, and its sales material and prospectus emphasized safety and stability and de-emphasized risk. Tr. 270-71; Div. Exs. 1-3; Jt. Ex. A at Stips. 4-29 & Apps. 1-6, 8-13, 15-23. Brofman was familiar with the sales material and prospectus and their emphasis on safety. Tr. 102, 270-71.
The sales brochures distributed during the time at issue stressed the Fund's objective of achieving high yields without sacrificing safety or stability. They contained statements in large, boldface type such as Earn High Yields With Maximum Safety and frequent references to the safety of U.S. Government securities. Jt. Ex. A at Apps. 8, 10, 12-13, 17-18, 20-22. These brochures referred to risk vaguely - "Certain strategies employed by the Fund may result in an increased level of risk not present in other funds with similar objectives" - and in fine print.4 Jt. Ex. A at Stips. 11-16, 18, 20-22 & App. 8 at FN00042, App. 9 at FN01319, App. 10 at FE0000011, App. 11 at F00005, App. 12 at F00011, App. 13 at F00015, App. 15 at F00018, App. 17 at F00037, F00040, F00045, F00049, App. 18 at F00072, App. 19 at F00052.
The prospectus5 stated the Fund's objective as "high current income with minimum risk of principal and relative stability of net asset value."6 Div. Ex. 2 at 1, 2, 5, Div. Ex. 3 at 1, 2. Compared to other investment choices the Fund would "offer a higher yield than a money market and less fluctuation in net asset value than a longer-term bond fund." Div. Ex. 2 at 2, Div. Ex. 3 at 2. The prospectus stated that the Fund sought to achieve its objectives by investing in securities issued or guaranteed by the U.S. Government having high current yields, and by limiting the duration of the Fund's portfolio to three years or less through hedging, including investments in options and futures. Div. Ex. 2 at 1, 2, 5-9, Div. Ex. 3 at 1, 2, 5-9. The Fund would also use leverage to boost its current income, using bank loans or reverse repurchase agreements up to a third of the value of its total assets. Div. Ex. 2 at 10, Div. Ex. 3 at 12.
The prospectus and marketing materials highlighted the Fund's policy of maintaining a maximum three-year duration to reduce volatility caused by interest rate fluctuations. Div. Ex. 2 at 1, 2, 5, Div. Ex. 3 at 1, 2, 5; Jt. Ex. A at Stips. 11-13, 21 & App. 8 at FN00035, App. 9 at FN01320, App. 10 at FE0000012, App. 18 at F00073. The prospectus stated, "[t]he Fund intends to minimize the risk of principal and provide relative stability of net asset value by limiting the average weighted duration of its investment portfolio to three years or less." Div. Ex. 2 at 5, Div. Ex. 3 at 5. The three-year duration was advertised as an advantage that distinguished the Fund from funds that invested in portfolios having longer duration. The prospectus stated:
Since the value of debt securities owned by the Fund will fluctuate depending upon market factors and inversely with prevailing interest rate levels, the net asset value of the Fund will fluctuate. The Fund is not limited as to the maturities of the securities in which it may invest. Debt securities with longer maturities generally tend to produce higher yields and are subject to greater market fluctuation as a result of changes in interest rates than debt securities with shorter maturities. The potential for such fluctuation may be reduced, however, to the extent that the Fund engages in hedging techniques. The Fund's current operating policy is to maintain an average weighted portfolio of three years or less. Duration is expressed in years and is that point in time representing the half-life of the present value of all cash flows expected from a bond over its life (from coupon payments, sinking fund, if any, principal at maturity, etc.). Duration provides a yardstick to bond price volatility with respect to changes in rates. As maturity lengthens or as the coupon rate or yield-to-maturity is reduced, volatility increases. Duration captures all three factors and expresses them in a single number.
Div. Ex. 2 at 6, Div. Ex. 3 at 6.
The prospectus contained cautionary statements relating to the Fund's strategies and the risks associated with them. Div. Ex. 2 at 1-3, 7-10, Div. Ex. 3 at 1-3, 7-12. It stated that changes in interest rates could cause changes in the Fund's yield and share price and that leverage and hedging with futures and options would magnify the risks of investing in the Fund. Div. Ex. 2 at 2-3, 6-10, Div. Ex. 3 at 2-3, 6-12. The prospectus stated, "a sudden and extreme increase in prevailing interest rates would likely cause a decline in the Fund's net asset value." Div. Ex. 2 at 2, Div. Ex. 3 at 2. Overall, however, the offering materials emphasized safety and stability and de-emphasized risk.
Brofman and Malanga were billed in the Fund's marketing material as experts capable of implementing complex investment strategies. The material indicated that Brofman and Malanga were full-time in-house professional portfolio strategists able to make investment decisions more quickly and efficiently than outside advisors employed by other funds. Jt. Ex. A at Stips. 11, 13, 21, 29 & App. 8 at FN00035, FN00037, App. 10 at FE0000012, App. 18 at F00073, App. 24 at F13097.
2. Marketing the Fund
FSC marketed the Fund primarily by mailing materials directly to prospective investors. Jt. Ex. A at Stip. 2. The initial mailing was a mailer card describing the Fund with an attached reply card to be returned if the prospective investor sought further information. Jt. Ex. A at Stip. 3. If the reply card was returned, FSC sent an investment kit containing further sales literature describing the Fund and the Fund's performance, accompanied by an account application and the Fund's current prospectus. Jt. Ex. A at Stip. 3. Those who received the investment kit but did not purchase shares of the Fund were sent follow-up mailings of sales literature. Jt. Ex. A at Stip. 3.
Between April 1992 and August 1994, FSC sent out approximately 1.4 million mailer cards. Jt. Ex. A at Stips. 4, 9, 15, 16, 20. During that same period, FSC sent prospective investors over 100,000 investment kits and follow-up mailings. Jt. Ex. A at Stips. 4-8, 10-14, 19, 21. These mailings drew thousands of responses, and, through October 1993, induced investors to open at least 100 new Fund accounts totaling at least $878,000. Jt. Ex. A at Stips. 5, 10, 15, 17. FSC began using print advertising to market Fund shares in late 1992. Jt. Ex. A at Stips. 23. FSC placed advertisements concerning the Fund and the Fund's performance in several newspapers and magazines, including New York Newsday and Investment Advisor. Jt. Ex. A at Stips. 23-27. In the spring of 1992 and again in the spring of 1993, FSC sent the "Fundamental Outlook Newsletter" to all those who held shares in any of the funds managed by FPA. Jt. Ex. A at Stips. 28-29 & Apps. 23-24.
During the period April 30, 1993, through December 16, 1994, approximately 1,106 shareholders opened Fund accounts and purchased shares of the Fund. Jt. Ex. A at Stip. 74. During the six-month period ended December 31, 1993, the Fund took in approximately $24 million in new investments in the form of initial or additional investments or dividend reinvestments. Jt. Ex. A at Stips. 81-82. During the six-month period ended June 30, 1994, the Fund took in approximately $12 million in new investments in the form of initial or additional investments or dividend reinvestments. Jt. Ex. A at Stips. 87-88.
The representations contained in the prospectus and the sales literature characterizing the Fund as a high yield, stable investment induced investors to purchase shares in the Fund. Tr. 48-49, 51-54, 61. The limited duration figure was an important element of the investment decision because it explained how the Fund managers could minimize market risks and achieve relative stability of NAV. Tr. 49-50, 54-58; Div. Ex. 2 at 5, Div. Ex. 3 at 5. The credentials and abilities of the Fund's expert managers were likewise key considerations. Tr. 48-49. Investors who lost money as a result of the events at issue recovered a small percentage of their losses through a class action. Tr. 62-66.
D. CMOs and the 1994 Market Collapse
The securities in which the Fund invested had minimal credit risk. Their volatility derived from interest rate sensitivity and associated "prepayment risk." The Fund magnified these risks by using leverage and investing heavily in inverse floaters.7
1. Mortgage-Backed Securities; CMOs
Mortgage-backed securities are created by pooling a large number of residential mortgages, which are used as collateral for the issuance of the securities. Tr. 405; Div. Ex. 57, App. B at 1. The cash flows for these securities are comprised of coupon interest, regularly scheduled principal payments, and prepayments. Tr. 405-06, 878; Div. Ex. 56 at 8-9, Div. Ex. 57, App. B at 1-2. Prepayments are any payments made by the homeowner in excess of the scheduled monthly mortgage payment. Div. Ex. 57, App. B at 2. Because of prepayments, the cash flows from mortgage-backed securities are uncertain. Div. Ex. 57, App. B at 2. Thus, while an investor in a mortgage-backed security may know that eventually he will recover the principal, he does not know the timing of the principal payments, because of the uncertain rate of prepayments. Tr. 408-09, 899-900; Div. Ex. 56 at 8-9, Div. Ex. 57 at 2.
Prepayment risk is the uncertainty concerning the timing of principal payments. Tr. 449, 825; Div. Ex. 56 at 8-9, Div. Ex. 57, App. B at 2. When an investor purchases securities backed by a pool of mortgages, cash flow projections are made based upon the rate at which homeowners in the pool will prepay. Div. Ex. 56 at 9. When interest rates change, the rate of prepayments changes, which in turn changes the expected cash flows. Div. Ex. 56 at 9. Other factors such as seasonality (homes purchased so as to move in before school starts) and general business conditions (more or fewer job opportunities that involve moving) also affect prepayments. Tr. 410-11. Prepayment risk can result in a mortgage-backed security paying off principal significantly ahead of the scheduled payments (contraction risk) or paying off its principal significantly slower than expected at the time of purchase (extension risk). Div. Ex. 56 at 9. If the security contracts due to a drop in interest rates, the investor is forced to reinvest at a lower interest rate. Tr. 901; Div. Ex. 57, App. B at 2. If the life of the security is extended, the investor has a longer-lived security earning a below market interest rate. Div. Ex. 57, App. B at 2. The market price of mortgage-backed securities reflects prevailing market assumptions about the expected rate of prepayments. Tr. 409, 819-26, 927, 1028-32; Div. Ex. 56 at 8-10.
The simplest mortgage-backed security is a "pass-through," in which the cash flows from the underlying pool of mortgages are distributed to investors on a pro rata basis. Div. Ex. 57, App. B at 3. Collateralized mortgage obligations (CMOs) were developed to reduce the prepayment risk of mortgage-backed securities for some investors, while allowing other investors to take on varying kinds or degrees of prepayment risk in return for higher yields. Tr. 901-03; Div. Ex. 57, App. B at 3. CMOs are divided into bond classes called "tranches." Tr. 406; Div. Ex. 57, App. B at 3. Whereas with pass-throughs the investor receives pro rata distribution of cash flows, with CMOs each tranche is allotted principal and/or interest payments based upon a schedule. Tr. 406; Div. Ex. 57, App. B at 3.
CMO tranches are divided into classes with differing risks. Planned amortization class (PAC) tranches receive principal payments before any other tranche and thus have less prepayment risk than the underlying mortgage loans used to create the CMO. Tr. 902; Div. Ex. 57, App. B at 4. Although prepayment risk cannot be entirely eliminated, both extension and contraction risk are effectively reduced for PAC bonds. Tr. 902; Div. Ex. 57, App. B at 4. A "support tranche" absorbs the risk removed from the PAC tranche. Tr. 902-03; Div. Ex. 57, App. B at 4.
2. Inverse Floaters
Inverse floaters are bonds whose coupon interest rates are designed to reset periodically based on a multiple of a reference interest rate, such as the London Interbank Offer Rate (LIBOR), plus a contractual spread. Tr. 406-07; Div. Ex. 3 at 11, Div. Ex. 56 at 10; Jt. Ex. B at 484, 520. Inverse floaters are created by splitting a fixed-rate bond into two floating-rate components: a floating-rate bond and its counterpart, the inverse floater. Div. Ex. 57, App. B at 3-4; Jt. Ex. B at 485. While the coupon rates of standard floating-rate securities move in the same direction as the index rate, the coupon rates on inverse floaters vary inversely with the index rate. Div. Ex. 3 at 11, Div. Ex. 56 at 10.
Inverse floaters are leveraged securities. Tr. 897-98, 907-08; Div. Ex. 57, App. B at 7-9, Div. Ex. 59; Jt. Ex. B at 520-21. Buying an inverse floater is equivalent to buying the cash flows of a fixed-rate bond and financing the purchase by borrowing at a floating rate. Tr. 897-98, 907-08; Div. Ex. 57, App. B at 7-9; Jt. Ex. B at 521. Thus, a small increase in interest rates causes a dramatic decrease in the inverse floating rate. Tr. 896-98; Div. Ex. 57, App. B at 7-9. In addition to interest rate risk, for inverse floaters created from support tranches, prepayment risk is magnified. Tr. 907-08. Inverse floaters earn high returns if interest rates decline or remain constant, but lose substantial value if interest rates increase.
The May 2, 1994, Prospectus contained the following cautionary disclosure related to CMOs and inverse floaters:
Included in the U.S. Government securities the Fund may purchase are . . . [inverse floaters, which] are typically more volatile than fixed or floating rate tranches of CMOs [and] would be purchased by the Fund to attempt to protect against a reduction in the income earned on the Fund investments due to a decline in interest rates. The Fund would be adversely affected by the purchase of such CMOs in the event of an increase in interest rates since the coupon rate thereon will decrease as interest rates increase, and, like other mortgage-related securities, the value will decrease as interest rates increase.
Div. Ex. 3 at 9-11. The previous, April 30, 1993, prospectus had no such disclosure. Div. Ex. 2.
3. The Fund's Investment In Inverse Floaters
As of March 1993, the Fund's performance compared unfavorably with similar funds.8 Inverse floaters were among the highest yielding government bonds then, and Brofman decided to follow the example of a top-rated Piper Jaffrey fund and other successful government bond funds by investing heavily in them. Tr. 120, 360-63. He began purchasing inverse floaters for the Fund in May 1993. Tr. 115.
By October 1993, inverse floaters comprised approximately 28.7% of the Fund's net assets and 18.1% of its total assets; throughout 1994 inverse floaters represented approximately 30% of the Fund's net assets and approximately 20% of its total assets. Answer ¶ II.D.7. See also Jt. Ex. A at Stips. 34, 44-70 & Apps. 30-33.
The Fund's inverse floaters were very sensitive to changes in interest rates. They were support bonds with a high degree of prepayment risk. Tr. 124-26. Their coupon formulas contained multipliers ranging from 1.8 to 7 times the underlying interest rate change. Tr. 116-17; Div. Exs. 7 at S-3, 8 at S-3, 9 at S-8, 10 at S-7, 11 at S-8, 12 at S-3, 13 at S-3, 14 at S-3, 15 at S-3, 16 at S-3, 17 at S-9, 18 at S-8, 19 at S-3, 20 at S-3, 21 at S-3, 23 at S-8. The extent of the inverse floaters' sensitivity to changes in interest rates was difficult to measure and, hence, difficult to hedge. Tr. 177-79; Div. Ex. 56 at 10-11, 15.
The investment in inverse floaters was successful during 1993. At the end of the first quarter in which the Fund purchased inverse floaters, Lipper ranked the Fund first in its short-term government bond fund category. Tr. 272; Div. Ex. 79 at F21379.
4. The 1994 Collapse of the CMO Market
In February 1994, the Federal Reserve Board raised term interest rates. Resp. Ex. 16 at 9-10; Div. Ex. 56 at 24, 26. This set off a disastrous chain reaction in the CMO market. Resp. Ex. 16 at 10 & App. 3.
The jump in rates halted prepayments, which extended the average maturity of CMOs, especially bonds like the Fund's - inverse floaters created from support tranches. CMO holders flooded the market, trying to sell. CMO liquidity dried up, and the fear of illiquidity further reduced the number of purchasers. One investment fund filed for bankruptcy, forcing the liquidation of its large CMO portfolio. Later in 1994, Kidder Peabody, the most active CMO underwriter and market maker, collapsed, forcing the liquidation of the largest CMO portfolio on Wall Street. The market in CMOs virtually collapsed in 1994. Resp. Ex. 16 at 9-11.
5. The Fund's Losses
On June 30, 1993, the Fund had net assets totaling $58,711,022. Jt. Ex. A at Stip. 35. On June 30, 1994, the Fund's net assets had declined to $30,260,350. Jt. Ex. A at Stip. 64. The Fund's NAV, 2.00 on June 30, 1993, and 2.01 on December 31, 1993, declined to 1.54 on June 30, 1994, and 1.37 on December 30, 1994. Jt. Ex. A at Stip. 99. Thus, between December 31, 1993 and December 30, 1994, the Fund's NAV decreased approximately 32%. Jt. Ex. A at Stip. 99. As Respondents' expert, Steven P. Feinstein, stated, the decrease was not entirely due to the interest rate sensitivity of its holdings. Panic also contributed to the decline. Resp. Ex. 16 at 10-11, 31. Nonetheless, the losses suffered by the Fund were disproportionately severe compared to other government bond funds, both short- and long-term. Div. Ex. 56 at 28-29. Lipper ranked the Fund second to last in the short-term government bond fund category. Div. Ex. 81 at 46. The average annual percentage change for short-term funds was -1.65%, compared to the Fund's -25.56%. Div. Ex. 81 at 46-47. Morningstar, Inc., another service that ranks bond funds, placed the Fund last in total return among the 270 government bond funds it tracked in 1994. Div. Ex. 56 at 28-29 & App. 6. The average performance for all long-term government bond funds was -5.9%, and the Fund's -25.5% total return was twice as bad as the next worst long-term government bond fund's. Div. Ex. 56 at 28-29 & App. 6.
E. Brofman's Awareness of the Risks of Inverse Floaters
Brofman believed that the Fund's portfolio was within a three-year duration during the time at issue; he continues to maintain that his duration calculations were consistent with representations in the offering materials. Tr. 133-43, 179, 1127-81, 1205-07. Brofman obtained the durations of his investments from Bloomberg's ticket-writing screens and other Bloomberg screens that displayed "modified duration."9 Tr. 128-29, 134. His choice to use modified duration was passive; he wrote a ticket and modified duration came up automatically. Tr. 134, 1149-50, 1205-07. Brofman did not use Bloomberg's Help function, or consult other mutual fund portfolio managers concerning duration. Tr. 131-33, 143.
Modified duration is a weighted average times of cash flows, for example, of a U.S. Treasury security with coupon payments every six months and a final principal payment at maturity. Tr. 873-75. Modified duration is appropriate for such a security because, however interest rates may change, the cash flows will not change. Tr. 879-80. Modified duration does not take into account changes in cash flows when interest rates or prepayment rates change, and thus does not measure price volatility of inverse floaters. Tr. 781, 784, 930-31. "Effective duration" includes a model intended to take into account changes deriving from interest rate and prepayment rate changes. Tr. 390-93, 784, 879-81. Thus effective duration is a better measure of interest rate sensitivity and price volatility of inverse floaters. Tr. 427-28, 625-28, 880-82; Div. Ex. 57, App. A at 8. Effective duration was available in 1993 and 1994 on Bloomberg analytic screens that Brofman did not use until 1995, after the investigation that led to this proceeding commenced. Tr. 127, 204, 206, 782, 1149-50. In addition to describing modified and effective duration, the record contains much evidence that addresses whether the shortcomings of modified duration vis-à-vis inverse floaters were understood in 1993 and 1994 and whether effective duration was commonly used at that time. Tr. 389-493, 497-500, 625-28, 774-862, 871-1057, 1142-44; Div. Exs. 42-45, 56-59; Resp. Exs. 10, 12, 16, 19-20, 22.
Brofman knew his use of leverage magnified the interest rate sensitivity of the Fund. Tr. 195. Nonetheless, he calculated the Fund's duration on its total assets without taking into account the effect of borrowings, reasoning that the possible use of leverage was disclosed in the prospectus. Tr. 194-96. This meant that the duration figure in itself could not reflect the interest rate sensitivity and price volatility of the Fund's net assets.
Effective duration of the Fund's portfolio greatly exceeded three during the time at issue.10 Mark C. Abbott testified on behalf of the Division and was accepted as an expert in the calculation of duration. Tr. 377-88; Div. Ex. 42 at 2-4 (qualifications); Tr. 389-493, 497-500; Div. Exs. 42-45 (opinion). According to the method Abbott used, effective duration of the Fund's net assets was, as of June 30, 1993, 9.88; September 30, 1993, 6.71; December 31, 1993, 9.70; March 31, 1994, 7.24; and June 30, 1994, 8.15. Div. Ex. 42 at 4-33, Div. Exs. 43-45.
Srikanth Sankaran executed futures and options transactions for the Fund from approximately 1992 through 1995. Tr. 621. He also advised Brofman about hedging interest rate risk through investing in futures and options. Tr. 625, 630-32. Sankaran, who has extensive experience with mortgage-backed securities, informed Brofman that the Fund's stated objective - achieving high yields while maintaining stable NAV through the use of hedging - was unattainable. Tr. 624-27.
In 1993, when Sankaran learned that the Fund had invested in inverse floaters, he informed Brofman that inverse floaters were difficult to price and therefore difficult to hedge using futures and options. Tr. 220-23, 630-32, 636-39, 649. Sankaran sent Brofman excerpts from The Handbook of Mortgage-Backed Securities, which informed readers that inverse floaters could be very volatile - how volatile depends on the interest-rate sensitivity of the underlying fixed-rate tranche. Tr. 644-45; Jt. Ex. B; Resp. Ex. 12. He and Brofman discussed the essence of these difficulties, the effects of prepayments on cash flows. Tr. 636-38, 649. In January 1994, he urged Brofman to sell all the Fund's inverse floaters because they had become so unpredictable. Tr. 632-33. Brofman rejected the recommendation. Tr. 632. When the Fund's NAV dropped below $2 per share, Sankaran sent a written proposal to Brofman and the Fund in which he reiterated his position that the inverse floaters should be sold in order to stop the erosion of NAV. Tr. 188-91, 633-36; Div. Ex. 34. Brofman resisted on the grounds that the Fund had to maintain high yields in order to attract investors, notwithstanding the negative effects on the stability of the Fund's NAV. Tr. 188-91, 634-36.
Brofman received the offering circulars for the inverse floaters purchased by the Fund but did not read them although he was aware that the circulars contained risk disclosures. Tr. 122-23; Div. Exs. 7-23. Brofman knew the inverse floaters had substantial interest rate risk and prepayment risk. Tr. 124-26, 163-64. He knew that high profit potential is associated with high risk. Tr. 149. As of December 1993 Brofman knew that the durations he had calculated for the inverse floaters were a quarter or half of other securities in the Fund's portfolio, yet the yields of those other securities were one half or less than those of the inverse floaters. Tr. 147-48. When questioned about the fact that the yield on a particular inverse floater in the Fund's portfolio in December 1993 was twice that of thirty-year U.S. Treasury securities, he stated that he did not see this anomaly as troubling but as an opportunity. Tr. 155-60.
Brofman found that the inverse floaters were more volatile than would be suggested by the duration measurements he was obtaining from the Bloomberg screens. Tr. 177-79. For example, inverse floater 1552 UB, which he had purchased from and, on April 20, 1994, sold back to Goldman Sachs did not behave like a ten-year Treasury security although Goldman Sachs and his own calculations had predicted that it would. Tr. 167-69. He knew that leverage magnified the risks of the Fund. Tr. 191-92. He knew that the Fund's interest rate sensitivity was magnified by leverage. Tr. 193-94. He acknowledged that it was difficult, if not impossible, to hedge the Fund's inverse floaters. Tr. 177-79.
Brofman ignored material that he received in April 1994 from Alex Brown and from Mabon Securities that showed that the volatility of the Fund's inverse floaters was greater than he had assumed, that it was extremely difficult to hedge them, and that they would move not like the ten-year Treasury security, but rather their price changes for interest rate changes would be a multiple of the price change of the ten-year security. Tr. 170-84; Div. Exs. 27-30.
During the period June 30, 1993, through June 30, 1994, the Fund used leverage. Jt. Ex. A, Apps. 29-33. Brofman knew that the Fund's use of leverage increased its sensitivity to fluctuations in interest rates. Tr. 192-96.
F. Expert Testimony
Professor Frank J. Fabozzi testified as an expert witness for the Division and was accepted as an expert in fixed income securities, including mortgage-backed securities, and the management of bond funds and other fixed income portfolios. Tr. 864-70; Div. Ex. 56 at 2-5 (qualifications), Tr. 871-1057 (opinions); Div. Exs. 56-59, 61-63, 87.
According to Fabozzi, when the Fund moved away from easily hedged, option-free securities to extremely complex inverse floaters in May 1993, it took on significant prepayment risk and thereby became much more difficult to hedge. Tr. 889-90; Div. Ex. 56 at 5-11. He noted the risk that Fund management would be unable to quantify the sensitivity of those securities to changes in interest rates, and thus be unable to determine the proper hedge position. Div. Ex. 56 at 15. Fabozzi's technical explanation of this accorded with Brofman's own observation that the inverse floaters were difficult if not impossible to hedge. Tr. 177-79. It is found that, when interest rates rose in 1994, the Fund was hypersensitive to the change due mainly to the concentration of the portfolio in inverse floaters and a corresponding inability on the part of the Fund managers to effectively hedge away the interest rate risks the inverse floaters posed.
Evidence was also received from Respondents' expert witness, Professor Steven P. Feinstein. Resp. Ex. 16.11 He acknowledged that the interest rate sensitivity of the inverse floaters contributed to the 32% decline in the Fund's NAV but argued that unanticipated panic in the CMO market also contributed to the decline. Resp. Ex. 16 at 10, 31. This, however, was the type of eventuality the Fund was supposed to be able to guard against either by investing in stable securities, or by hedging against any volatile securities it purchased.
G. Soft Dollars
From 1990 through at least December 1995, FPA made soft dollar payments of $670,921 through Capital Institutional Services (CIS), a broker-dealer and processor of soft dollar arrangements, based on credits generated from transactions for funds FPA managed.12 Jt. Ex. A at Stip. 100; Div. Ex. 37. Capital Market Services, Inc. (CMS) received $115,000 of the payments, for oral research on interest rates. Tr. 716-17; Jt. Ex. A at Stip. 100; Div. Ex. 37 at F18106, Div. 51 at 8. CMS was owned by the wife of Don Newell, a business partner of Malanga. Tr. 579, 715; Div. Ex. 46 at 12-13. Respondents did not inform the Board of the CIS and CMS arrangements. Nor did they inform the Board that FPA had any soft dollar arrangements.
1. The Board was not Told of the Soft Dollar Arrangement with CIS or Payments to CMS.
Brofman was aware of FPA's soft dollar arrangement with CIS, which involved credits earned from syndicate designations on securities purchased for Fundamental Funds.13 Tr. 231-32. Brofman was aware of the soft dollar credits earned and used and knew that, from 1993 through 1995, CMS received some of the soft dollar payments. Tr. 232. Brofman understood the payments to be compensation for services provided by Sarankan. Tr. 232-33. Brofman knew that Sarankan and Newell were business associates sharing an office on LaSalle Street in Chicago and that Malanga and Newell were partners in several businesses. Tr. 218-221. There were frequent phone conversations among Newell, Sarankan, and Malanga; Brofman sometimes was in Malanga's office during the conversations. Tr. 221.
In the spring of 1996, Jules Buchwald, Fundamental's lawyer and an independent Board member, learned, as a result of Commission subpoenas, that FPA had soft dollar arrangements, and so informed Fundamental's Board of Directors. Tr. 576-77. At the May 2, 1996, Board meeting, Malanga then disclosed FPA's soft dollar arrangements with various companies including CIS and CMS.14 Tr. 577-79, 713; Div. Ex. 46 at 12, 16, 39-40, Div. Ex. 51. Neither Brofman nor anyone else from FPA had previously informed the Board, from at least 1993 onward, of the amount of soft dollar credits generated by the Fundamental Funds or a breakdown of the services FPA received for its soft dollar credits. Tr. 234-35. Nor did FPA or Brofman tell the Board that soft dollar payments were going to CMS or to an entity associated with Malanga's partner, Newell. Tr. 264.
2. The Board was not Told of any Soft Dollar Arrangement.
There is a conflict in the evidence as to whether Brofman or Malanga disclosed the existence of any soft dollar arrangement during the time at issue to Board members. Brofman and Malanga testified that soft dollars were alluded to when a Board member asked about attending a seminar and was told that soft dollars would pay for it; that an issue arose concerning an unpaid balance for services in the 1980s provided by Interstate Johnson Lane (Interstate), another soft dollar vendor; and that independent Board member Clark Bullock must have known of ongoing arrangements because of his friendship with Doug Ebbitt, who was associated with Interstate. Tr. 235-46, 1108-11.
Bullock and another former independent Board member, James Bowers, testified to the contrary.15 Tr. 710-31; Div. Ex. 46.16 Each understood that FPA had had soft dollar arrangements in the past, but believed that they had been discontinued because of abuses, and that there were none in the 1990s. Tr. 712; Div. Ex. 46 at 11. Both testified that the CIS-CMS soft dollar arrangement involving an affiliate of the manager was disclosed at the May 1996 Board meeting. Tr. 713-19; Div. Ex. 46 at 12-25. Bowers testified that at previous Board meetings Brofman and Malanga specifically denied that FPA had soft dollar arrangements. Tr. 712-14. Bullock testified that he and Ebbitt spoke twice a year, about mutual friends and the like, and that he did not learn from Ebbitt that Interstate's soft dollar arrangement had not been discontinued. Div. Ex. 46 at 29-33.
The conflict is resolved to find that neither Brofman nor anyone else from FPA advised the Board of the existence of soft dollar arrangements in the 1990s until the May 1996 meeting. This finding is consistent with the minutes of Board meetings, which considered FPA's management contract on October 19, 1994, January 25, 1995, and October 18, 1995. Tr. 569; Div. Exs. 47-49. This finding is also consistent with the explanation of Jules Buchwald, Fundamental's lawyer and an independent Board member, who took the minutes. Tr. 564-86. Buchwald noted that soft dollars were a special concern at the Commission at the time, and stated that he asked every mutual fund client about soft dollars.17 Tr. 569-70. Brofman was present at each meeting, and he or Malanga responded that there were no soft dollar arrangements and stated that they did only principal transactions. Tr. 569-70.
As was his usual practice, Buchwald drafted minutes while the meetings were fresh in his memory and forwarded the drafts to FPA for review and comment before he submitted the minutes to the Board for approval at the next meeting.18 Tr. 564-66, 571-76. Brofman received copies of the draft minutes. Tr. 237-38. Nonetheless, at the May 2, 1996, meeting, Malanga stated for the first time that the minutes of the three 1994 and 1995 meetings were inaccurate insofar as they indicated that Malanga and Brofman said there were no soft dollar arrangements. Tr. 584-85; Div. Ex. 51 at 9. He asked Buchwald to amend the minutes of the earlier meetings, and Buchwald refused. Tr. 585-86.
The finding that the Board was not told of any soft dollar arrangement is also consistent with contemporaneous correspondence: Brofman's June 25, 1996, reply to the Board's questions about FPA's soft dollar arrangements; and the May 23, 1996, letter from the independent Board members to Brofman and Malanga advising of the need for complete periodic disclosure about FPA's soft dollar practices and urging that the $115,000 paid to CMS be returned for the benefit of Fundamental Funds. Div. Exs. 37, 52. There would have been no need for this correspondence if Board members had been kept informed. Brofman's attempt to explain his statement about principal transactions as a representation only that there were no soft dollars derived from commissions that would qualify for the Exchange Act Section 28(e) safe harbor was evasive. Tr. 233-37, 1188-94. Finally, even assuming Board members knew that soft dollar credits were used during the 1990s, that is not inconsistent with their having been earned earlier.
III. CONCLUSIONS OF LAW
In this section it is concluded that FPA and FSC willfully violated the antifraud provisions in connection with sales of shares of the Fund, and Brofman willfully aided and abetted and caused those violations. FPA committed additional antifraud violations of the Advisers Act by failing to disclose its soft dollar practices to the Board of the Fundamental Funds, and Brofman willfully aided and abetted and caused those violations.
A. Antifraud Provisions
Section 17(a) of the Securities Act makes it unlawful "in the offer or sale of" securities, by jurisdictional means, to:
1) employ any device, scheme, or artifice to defraud,
2) obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary to make the statement made not misleading, or
3) engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder proscribe similar practices "in connection with" the purchase or sale of securities. Section 15(c) of the Exchange Act and Rules 10b-3 and 15c1-2 proscribe similar practices by brokers and dealers in connection with transactions in securities. Similar proscriptions are also contained in Sections 206(1) and (2) of the Advisers Act and 34(b) of the Investment Company Act.
Scienter is required to establish violations of Section 17(a)(1) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 206(1) of the Advisers Act; it is "a mental state embracing intent to deceive, manipulate, or defraud." Aaron v. SEC, 446 U.S. 680, 686 n.5, 695-97 (1980); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976); SEC v. Steadman, 967 F.2d 636, 641-42 (D.C. Cir. 1992).
Recklessness can satisfy the scienter requirement. See David Disner, 52 S.E.C. 1217, 1222 & n.20 (1997); see also SEC v. Steadman, 967 F.2d at 641-42; Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990). Reckless conduct is conduct which is "`highly unreasonable' and represents `an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.'" Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978) (quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977)).
The Advisers Act reflects the "congressional recognition `of the delicate fiduciary nature of an investment advisory relationship.'" SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-92 (1963). Consequently, investment advisers have "an affirmative duty of `utmost good faith, and full and fair disclosure of all material facts.'" Id. at 194.
Material misrepresentations and omissions violate Securities Act Section 17(a), Exchange Act Section 10(b) and Rule 10b-5 thereunder, Exchange Act Section 15(c) and Rule 15c1-2 thereunder, Investment Company Act Section 34(b), and Advisers Act Section 206(2). The standard of materiality is whether or not a reasonable investor or prospective investor would have considered the information important in deciding whether or not to invest. See SEC v. Steadman, 967 F.2d at 643; see also Basic Inc. v. Levinson, 485 U.S. 224, 231-32, 240 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
FPA and FSC are accountable for the actions of their responsible officers. See C.E. Carlson, Inc., 859 F.2d 1429, 1435 (10th Cir. 1988); A.J. White & Co., 556 F.2d 619, 624 (1st Cir. 1977). These included Brofman and Malanga. A corporation's scienter may be imputed from that of individuals controlling it. See SEC v. Blinder, Robinson & Co. 542 F. Supp. 468, 476 n.3 (D.C. Colo. 1982) (citing SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082, 1096-97 nn.16-18 (2d Cir. 1972)). Further, as an associated person of FSC and FPA, Brofman's conduct and scienter is attributed to FSC and FPA. See Sections 15(b)(4) of the Exchange Act and 203(e) of the Advisers Act.
1. Aiding and Abetting; Cause
For aiding and abetting liability under the federal securities laws, three elements must be established: (1) a primary or independent securities law violation that has been committed by some other party; (2) awareness or knowledge by the aider and abettor that his or her role was part of an overall activity that was improper; and (3) that the aider and abettor knowingly and substantially assisted the conduct that constitutes the violation. See Woods v. Barnett Bank, 765 F.2d 1004, 1009 (11th Cir. 1985); Investors Research Corp. v. SEC, 628 F.2d 168, 178 (D.C. Cir. 1980); IIT v. Cornfield, 619 F.2d 909, 922 (2d Cir. 1980); Woodward v. Metro Bank, 522 F.2d 84, 94-97 (5th Cir. 1975); SEC v. Coffey, 493 F.2d 1304, 1316 (6th Cir. 1974); Russo Sec., Inc., 65 SEC Docket 1990, 1998 & n.16 (Oct. 1, 1997); Donald T. Sheldon, 51 S.E.C. 59, 66 (1992), aff'd, 45 F.3d 1515 (11th Cir. 1995); William R. Carter, 47 S.E.C. 471, 502-03 (1981). A person cannot escape aiding and abetting liability by claiming he was ignorant of the securities laws. See Sharon M. Graham, 68 SEC Docket 2056, 2070 n.33 (Nov. 30, 1998), aff'd, 222 F.3d 994 (D.C. Cir. 2000). A respondent who aids and abets a violation also is a cause of the violation, within the meaning of Sections 8A of the Securities Act and 21C of the Exchange Act. See Sharon M. Graham, 68 SEC Docket at 2071 n.35.
The Division requests sanctions pursuant to Sections 8A of the Securities Act, 15(b)(6), 19(h), 21B, and 21C of the Exchange Act, 9(b), (d) and (f) of the Investment Company Act, and 203(d), (e), (f), and (k) of the Advisers Act. The Commission must find willful violations to impose sanctions under Sections 15(b), 19(h), and 21B of the Exchange Act, 9(b) and (d) of the Investment Company Act, and 203(e), (f), and (i) of the Advisers Act. It is well settled that a finding of willfulness does not require an intent to violate, but merely an intent to do the act which constitutes a violation. See Wonsover v. SEC, 205 F.3d 408, 413-15 (D.C. Cir. 2000); see also Steadman v. SEC, 603 F.2d 1126, 1135 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981); Arthur Lipper Corp. v. SEC, 547 F.2d 171, 180 (2d Cir. 1976); Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965).
B. Antifraud Violations
FPA and Brofman are charged with violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and FSC, with violations of Sections 10(b) and 15(c) of the Exchange Act and Rule 15c1-2 thereunder from May 1993 through March 1995, based on representations in the offering materials that the Fund was relatively safe and stable. (Brofman is charged, alternatively, either as a primary violator or with aiding and abetting FPA's violations.) Additionally, FPA is charged with, and Brofman, with aiding and abetting, antifraud violations of Section 34(b) of the Investment Company Act, from May 1994 through March 1995, based on representations in the 1994 prospectus incorporated in the Fund's registration statement.
The record demonstrates that the representations in sales materials that the Fund was a safe, stable investment misrepresented the portfolio strategy implemented by Brofman, whose actions are attributed as well to FPA and FSC. The strategy commenced in May 1993, when Brofman sought to boost the Fund's performance by investing heavily in high-risk inverse floaters, and continued during the period at issue.
The sales materials that FSC used to market the Fund emphasized high returns with maximum safety. The sales materials and prospectus used the concept of duration to explain how FPA would limit volatility and interest rate sensitivity to achieve these objectives. The 1993 and 1994 prospectuses stated that "[d]uration provides a yardstick to bond price volatility with respect to changes in [interest] rates." The prospectuses stated that the Fund would minimize the risk of principal and provide relative stability of NAV by limiting duration of its portfolio to three or less. There is much evidence in the record concerning the appropriate measure of duration in 1993 - 1994. Whatever standard was appropriate, it is clear that the measure Brofman used did not measure interest rate volatility of the Fund's portfolio and he knew that. The portfolio did not behave like a portfolio of bonds with a three-year maturity, but he did not investigate other ways to measure duration or change his investment strategy. His failure to include leverage in his duration calculations made the representation that volatility would be measured with a duration of three even more misleading.
Brofman started investing in inverse floaters shortly after the date of the 1993 prospectus, which contained no warning about the volatility of inverse floaters. Only after Brofman had committed the portfolio to inverse floaters did the 1994 prospectus disclose the risky nature of such investments. By the time of the May 1994 prospectus, which was incorporated in the Fund's registration statement filed with the Commission, the representation that the duration of the Fund's portfolio was three or less was misleading insofar as it purported to represent the Fund's interest rate sensitivity and stability of NAV.
The record contains much evidence that addresses whether the shortcomings of modified duration vis-à-vis inverse floaters were understood in 1993 and 1994 and whether effective duration was commonly used at that time.19 Brofman does not dispute that using effective duration and calculating the Fund's duration on the basis of net assets, rather than total assets, the Fund's duration substantially exceeded three. Nor does the Division dispute that using modified duration and ignoring leverage results in a duration closer to three in 1994. It is not necessary to establish precisely the Fund's actual duration to find that the 1994 prospectus's representation that its duration was three or less in order to find that the representation was materially misleading. The evidence in the record is more than sufficient to support the conclusion that the Fund's duration materially exceeded what was represented as the safe, stable figure of three. See Valicenti Advisory Servs., Inc., 68 SEC Docket 1805, 1808 (Nov. 18, 1998), aff'd, 198 F.3d 62 (2d Cir. 1999), cert denied, 120 S. Ct. 2745 (2000).
Brofman continues to maintain that his duration calculations were appropriate during the time at issue. Yet he was warned by Sankaran in 1993 that inverse floaters were difficult to price and very volatile. He knew that high profit is associated with high risk and that the inverse floaters that he purchased did not behave according to his calculations. As of December 1993 he knew that the durations he had calculated for the inverse floaters were a quarter or half of those of other securities in the Fund's portfolio, yet the yields of the other securities were a half or less than those of the inverse floaters. He did not see this anomaly as troubling. He knew that leverage magnified the interest rate sensitivity of the fund. He acknowledged that it was difficult if not impossible to hedge the inverse floaters. Brofman's claim that unusual market conditions were solely responsible for the decline in the Fund's NAV is undercut by the fact that other government bond funds experienced less volatility.
Brofman also points to selected language in the prospectus to support his contention that modified duration was appropriate for the inverse floaters20 and that duration was to be calculated without taking leverage into account.21 This in effect is an argument that "fine print" embedded in the prospectus enables him to escape responsibility, because it ignores language indicating that duration measures volatility and language throughout the prospectus and sales materials that emphasize safety and stability.
In sum, the Fund's sales materials and prospectus contained misrepresentations and misleading representations in light of the investments that Brofman made.
The standard of materiality is whether or not a reasonable investor would have considered the information important. SEC v. Steadman, 967 F.2d at 643; see also Basic Inc. v. Levinson, 485 U.S. at 231-32, 240; TSC Indus., Inc. v. Northway, Inc., 426 U.S. at 449. In this case, the misrepresented and misleading information was clearly material.
The record shows Brofman's scienter, which is attributed to FPA and FSC. Brofman's conduct was reckless - highly unreasonable and an extreme departure from the standards of ordinary care. The risks of investing in inverse floaters were either known to him or so obvious that he must have been aware of them. Despite his education and experience he decided that increased yields could be obtained from inverse floaters without increased risk. He ignored red flags. He knew that the inverse floaters were more volatile than his duration calculations predicted. Yet he passively accepted the low duration values that Bloomberg's ticket writing screens displayed.
The New York State investigation of the New York Muni Fund that resulted in an April 1994 settlement alerted Brofman to the need to disclose "effective portfolio duration or sensitivity or interest rate risk." It also alerted him that it was misleading to promise high returns with low risk and misleading not to disclose such aggressive portfolio strategies as the use of leverage and substantial investments in inverse floating-rate municipal bonds - like the strategies Brofman used for the Fund.
The record contains much evidence of Brofman's recklessness in ignoring the volatility of the inverse floaters. Although duration was a major selling point, he passively accepted the duration that appeared on Bloomberg's ticket writing function. The inconsistency between the inverse floaters' apparent low duration and their high yields did not cause him to look further into duration calculations. He knew that the inverse floaters were not behaving according to the duration calculations he accepted. He ignored the warnings of Sankaran that the inverse floaters were difficult to price and hedge, and ignored other material, including the offering circulars for the inverse floaters he purchased. He acknowledged that the investments were impossible to hedge. His failure to take leverage into account in his duration calculations adds to the recklessness.
In sum, it is concluded that the primary violations charged against FPA and FSC are proven. FPA violated Sections 17(a) of the Securities Act, 10(b) of the Exchange Act and Rule 10b-5 thereunder, and 34(b) of the Investment Company Act in connection with selling shares. FSC violated Sections 10(b) and 15(c) of the Exchange Act and Rules 10b-3 and 15c1-2. Brofman aided and abetted and caused those violations. The Fund was his idea - to obtain high income with minimum risk by investing in high yielding U.S. Government securities and using hedging to limit interest rate risk. He was aware of the representations in the prospectuses and sales materials concerning the safety and stability of the Fund while pursuing an investment strategy that emphasized risky investments. Thus, he knowingly and substantially assisted the conduct that constituted the primary violations and was aware that his role was part of an overall activity that was improper.
The acts that constituted the Respondents' violations were, as described above, clearly intentional. Their violations of the antifraud provisions were thus willful.
C. Soft Dollar Violations
Similar to the antifraud provisions of the Securities and Exchange Acts, Section 206(1) prohibits an investment adviser from, directly or indirectly, employing, "any device, scheme, or artifice to defraud any client or prospective client." Section 206(2) prohibits an investment adviser from, directly or indirectly, engaging "in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client."
As found in the Findings of Fact section above, from 1990 through 1995 FPA made soft dollar payments of $670,921 through CIS, and some of the payments went to CMS, owned by a business partner of Malanga. FPA did not tell the Fundamental Board of those arrangements or of any soft dollar arrangement during the 1990s until Brofman and Malanga were confronted at the May 1996 Board meeting by Fundamental's lawyer, who had learned of the existence of the arrangements from the Commission. The record shows that Brofman and Malanga affirmatively denied the existence of such arrangements when questioned at three Board meetings in 1994 and 1995. These misrepresentations and omissions misled the Board.
The use of soft dollars is material because of the actual and potential conflicts of interest that result from an adviser's allocating brokerage on behalf of a client's account in return for some benefit. See Kingsley, Jennison, McNulty & Morse, Inc., 51 S.E.C. 904, 909 (1993); Interpretive Release Concerning the Scope of Section 28(e) of the Securities Exchange Act of 1934, 51 Fed. Reg. 16004, 16008 (Apr. 30, 1986), 35 SEC Docket 905, 909 (1986 Release). Consequently, the failure to disclose such material facts regarding both actual and potential conflicts of interest constitutes fraud or deceit within the meaning of the Advisers Act. See Capital Gains Research, 375 U.S. at 200.
Brofman argues that the arrangements in this case were not soft dollars because they involved syndicate designations, not brokerage commissions. This argument is without merit. Whether research is paid for through brokerage commissions or selling concessions, it has been purchased with soft dollars. See NASD, Order Approving Proposed Rule Change, 21 SEC Docket 930, 935 n.23 (Dec. 12, 1980).
Brofman also argues that the arrangements were not soft dollars because they fell outside the "safe harbor" provided by Section 28(e) of the Exchange Act for soft dollars.22 As Brofman recognizes, the safe harbor shelters only soft dollars derived from agency transactions, while the soft dollars at issue derived from principal transactions. This argument is also without merit. Section 28(e) does not define the entire universe of soft dollar transactions; it provides a safe harbor for some soft dollars. See 1986 Release, 51 Fed. Reg. at 16008, 35 SEC Docket at 909.
In the alternative, assuming for the sake of argument that the arrangements were not "soft dollars" as a matter of law, failing to disclose their existence to the Board was a material omission. The fact that there was a conflict of interest in the transactions that benefited CMS underscores the materiality of the omission.
The record shows Brofman's scienter, which is attributed to FPA. The fact that he and Malanga affirmatively denied the existence of soft dollar arrangements to the Board until they were confronted in May 1996 shows the intent to deceive and defraud. In the alternative, Brofman was reckless in denying the existence of soft dollars and failing to disclose the arrangements with CIS, or any other soft dollar vendor, and the payments to CMS.
It is concluded that FPA violated Sections 206(1) and (2) of the Advisers Act by failing to disclose to the Board the existence of FPA's soft dollar arrangements with CIS or of any soft dollar arrangements during the time at issue. It is also concluded that Brofman aided and abetted and caused the violations. He was present at the Board meetings and participated with Malanga in denying that there were any soft dollar arrangements. By virtue of his education and experience he was aware that this was improper. Thus, he knowingly and substantially assisted the conduct that constituted the primary violations and was aware that his role was part of an overall activity that was improper.
The acts and omissions that constituted Respondents' violations were, as described above, clearly intentional. Their violations were thus willful.
The Division requests a cease and desist order; civil monetary penalties of $250,000 against Brofman, $1.5 million against FPA, and $1 million against FSC; a bar of Brofman from association with a broker-dealer, investment adviser, or investment company, and revocation of registrations of FSC and FPA as a broker-dealer and investment adviser, respectively. The Respondents urge that this proceeding be dismissed and argue that FSC and FPA are insolvent and unable to pay any money penalty.
For the reasons discussed below, these sanctions will be ordered: a cease and desist order against all three Respondents; money penalties of $250,000 against Brofman and $500,000 each against FPA and FSC; and bar and revocation of registration of Respondents.
A. Sanction Considerations
When the Commission determines administrative sanctions, it considers:
the egregiousness of the defendant's actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant's assurances against future violations, the defendant's recognition of the wrongful nature of his conduct, and the likelihood that the defendant's occupation will present opportunities for future violations.
Steadman v. SEC, 603 F.2d at 1140 (quoting SEC v. Blatt, 583 F.2d 1325, 1334 n.29 (5th Cir. 1978), aff'd on other grounds, 450 U.S. 91 (1981)).
The Commission determines sanctions pursuant to a public interest standard.23 Thus, in addition to issues related to the violator, it "weigh[s] the effect of [its] action or inaction on the welfare of investors as a class and on standards of conduct in the securities business generally." Arthur Lipper Corp., 46 S.E.C. at 100; Richard C. Spangler, Inc., 46 S.E.C. 238, 254 n.67 (1976). The amount of a sanction depends on the facts of each case and the value of the sanction in preventing a recurrence. See Berko v. SEC, 316 F.2d 137, 141 (2d Cir. 1963); Leo Glassman, 46 S.E.C. 209, 211-12 (1975).
1. Cease and Desist
Sections 8A of the Securities Act, 21C of the Exchange Act, 9(f) of the Investment Company Act, and 203(k) of the Advisers Act authorize the Commission to issue a cease and desist order against a person who "is violating, has violated, or is about to violate" any provision of the Acts or rules thereunder. Whether there is a reasonable likelihood of such violations in the future must be considered. See KPMG Peat Marwick LLP, 2001 SEC LEXIS 98, at *98-*101, *116 (Jan. 19, 2001). The Commission considers the Steadman factors quoted above in determining whether a cease and desist order is appropriate. As concluded above, all Respondents willfully violated antifraud provisions of the Securities, Exchange, Investment Company, and Advisers Acts. Further, the record shows a reasonable likelihood of such violations in the future.
All Respondents' violations were part of a pattern and were also flagrant and deliberate, involving a high degree of scienter. All Respondents have disciplinary histories for fraud and misrepresentation concerning mutual funds. Brofman's dates back to 1984. He has twice previously settled fraud charges, and, based on Brofman's activities as its portfolio manager, the Commission revoked the investment adviser registration of IPM, the forerunner of FPA. In April 1994, while the violations that are the subject of this proceeding were ongoing, FPA and FSC settled New York State charges concerning another Fundamental Fund that were similar to those at issue here: sales materials that promised high returns with low risk were misleading because they did not disclose aggressive portfolio strategies such as leverage and substantial investments in volatile inverse floating-rate securities. Yet they continued similar violations with reference to the Fund. It should also be noted that Brofman owns FPA and controls the affairs of FPA and FSC. Further, although the Fundamental Board eliminated Brofman and FPA from management of the Fund and FSC became inactive as a result, Brofman was attempting to resume the relationship at the time of the hearing. Thus, Respondents' business will present opportunities to violate the law in the future. A cease and desist order against all three is appropriate. Accordingly, Brofman and FPA will be ordered to cease and desist from committing or causing any violations or future violations of Sections 17(a) of the Securities Act, 10(b) of the Exchange Act and Rule 10b-5 thereunder, 34(b) of the Investment Company Act, and 206(1) and (2) of the Advisers Act, and FSC will be ordered to cease and desist from committing or causing any violations or future violations of Sections 17(a) of the Securities Act, 10(b) and 15(c) of the Exchange Act and Rules 10b-3, 10b-5, and 15c1-2 thereunder.
2. Civil Money Penalty
Sections 21B of the Exchange Act, 9(d) of the Investment Company Act, and 203(i) of the Advisers Act authorize the Commission to impose civil money penalties for willful violations of the Securities, Exchange, Investment Company, or Advisers Acts or rules thereunder.24 In considering whether a penalty is in the public interest, the Commission may consider six factors: (1) fraud; (2) harm to others; (3) unjust enrichment; (4) previous violations; (5) deterrence; and (6) such other matters as justice may require. See Sections 21B(c) of the Exchange Act, 9(d)(3) of the Investment Company Act, and 203(i)(3) of the Advisers Act; New Allied Dev. Corp., 52 S.E.C. 1119, 1130 n.33 (1996); First Sec. Transfer Sys., Inc., 52 S.E.C. 392, 395-96 (1995); see also Jay Houston Meadows, 61 SEC Docket 2444, 2456-58 (May 1, 1996), aff'd, 119 F.3d 1219 (5th Cir. 1997); Consolidated Inv. Servs., Inc., 52 S.E.C. 582, 590-91 (1996).
There are no mitigating factors, and there are several aggravating factors. Respondents violated the antifraud provisions, so their violative actions "involved fraud [and] reckless disregard of a regulatory requirement" within the meaning of Sections 21B(c)(1) of the Exchange Act, 9(d)(3)(A) of the Investment Company Act, and 203(i)(3)(A) of the Advisers Act. Harm to others occurred by virtue of the Fund's losses. Brofman, FPA, and FSC have several previous fraud violations related to mutual funds. Concerning deterrence, settlements with the Commission, New York State, and the NASD did not deter the instant violations, indicating that substantial penalties are needed for deterrence.
Penalties are in the public interest in this case. Penalties in addition to cease and desist orders, bar, and revocation are necessary for the purpose of deterrence. See Sections 21B(c)(5) of the Exchange Act, 9(d)(3)(E) of the Investment Company Act, and 203(i)(3)(E) of the Advisers Act; H. Rep. 101-616 (1990). Second and third tier penalties, as the Division argues, are appropriate because the violative acts involved reckless disregard of a regulatory requirement and directly or indirectly resulted in substantial losses or created a significant risk or substantial losses to other persons. See Sections 21B(b)(2) and (3) of the Exchange Act, 9(d)(2)(B) and (C) of the Investment Company Act, and 203(i)(2)(B) and (C) of the Advisers Act.
The maximum second tier penalty for "each act or omission" is $50,000 for a natural person and $250,000 for any other person for the violations in this proceeding.25 The maximum third tier penalty for each act or omission is $100,000 for a natural person and $500,000 for any other person. Sections 21B of the Exchange Act, 9(d) of the Investment Company Act, and 203(i) of the Advisers Act, like most civil penalty statutes, leave the precise unit of violation undefined. See Colin S. Diver, The Assessment and Mitigation of Civil Money Penalties by Federal Administrative Agencies, 79 Colum. L. Rev. 1435, 1440-41 (1979). The Division requests that Respondents be ordered to pay third tier penalties for two units of violation: violative activities connected with the 1993 prospectus and with the 1994 prospectus and that Brofman and FPA each pay a second tier penalty for the soft dollar violations. Accordingly, the Division requests a total of $250,00 in penalties for Brofman, $1.5 million for FPA, and $1 million for FSC. In response Brofman argues that there were no violations and that FSC and FPA are insolvent and unable to pay penalties.
The penalty amounts are consistent with Commission precedent, and the Division's reasoning is accepted.26 However, the amounts imposed on FPA and FSC will be reduced to $500,000 each. This value takes into account the need for deterrence as well as record evidence bearing on FPA's and FSC's present ability to pay.27 See Sections 21B(c)(5) and (d) of the Exchange Act, 9(d)(3)(E) and (4) of the Investment Company Act, and 203(i)(3)(E) and (4) of the Advisers Act.
3. Bar and Revocation
As the Division requests, and based on the factors enunciated in Steadman v. SEC, 603 F.2d at 1140, Brofman will be barred from association with a broker-dealer, investment company, or investment adviser and the investment adviser and broker-dealer registrations of FPA and FSC will be revoked. These remedies are authorized by Sections 15(b) and 19(h) of the Exchange Act, 9(b) of the Investment Company Act, and 203(e) and (f) of the Advisers Act. Combined with other sanctions ordered, bar and revocation are in the public interest and an appropriate deterrent. The violations involved scienter. Respondents' business presents them with the opportunity to commit violations of the securities laws in the future. Their disciplinary history and Brofman's evasive explanations concerning why he ignored the volatility of the inverse floaters and why FPA did not disclose its soft dollar arrangements to the Fundamental Board indicate a lack of recognition of the wrongful nature of their conduct. In short, it is necessary for the public interest and the protection of investors that Respondents not be in the securities industry.
V. RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. ¶ 201.351(b), it is certified that the record includes the items set forth as of the record index issued by the Secretary of the Commission on January 11, 2001.
Based on the findings and conclusions set forth above:
IT IS ORDERED that, pursuant to Sections 8A of the Securities Act, 21C of the Exchange Act, 9(f) of the Investment Company Act, and 203(k) of the Advisers Act:
Lance M. Brofman CEASE AND DESIST from committing or causing any violations or future violations of Sections 17(a) of the Securities Act, 10(b) of the Exchange Act and Rule 10b-5 thereunder, 34(b) of the Investment Company Act, and 206(1) and (2) of the Advisers Act;
Fundamental Portfolio Advisors, Inc., CEASE AND DESIST from committing or causing any violations or future violations of Sections 17(a) of the Securities Act, 10(b) of the Exchange Act and Rule 10b-5 thereunder, 34(b) of the Investment Company Act, and 206(1) and (2) of the Advisers Act;
Fundamental Service Corporation CEASE AND DESIST from committing or causing any violations or future violations of Sections 17(a) of the Securities Act, 10(b) and 15(c) of the Exchange Act and Rules 10b-3, 10b-5, and 15c1-2 thereunder.
IT IS FURTHER ORDERED that, pursuant to Sections 21B of the Exchange Act, 9(d) of the Investment Company Act, and 203(i) of the Advisers Act:
Lance M. Brofman PAY A CIVIL MONETARY PENALTY of $250,000;
Fundamental Portfolio Advisors, Inc., PAY A CIVIL MONETARY PENALTY of $500,000;
Fundamental Service Corporation PAY A CIVIL MONETARY PENALTY of $500,000;
IT IS FURTHER ORDERED that, pursuant to Sections 15(b) and 19(h) of the Exchange Act, 9(b) of the Investment Company Act, and 203(e) and (f) of the Advisers Act:
Lance M. Brofman IS BARRED from association with any broker, dealer, investment adviser, or investment company;
The REGISTRATION of Fundamental Portfolio Advisors, Inc., as an investment adviser IS REVOKED; and
The REGISTRATION of Fundamental Service Corporation as a broker or dealer IS REVOKED.
Payment of the penalty shall be made on the first day following the day this initial decision becomes final by certified check, U.S. Postal money order, bank cashier's check or bank money order payable to the Securities and Exchange Commission. The check and a cover letter identifying the Respondent and Administrative Proceeding No. 3-9461, should be delivered by hand or courier to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, Virginia 22312. A copy of the cover letter should be sent to the Commission's Division of Enforcement at the above address.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. ¶ 201.360. Pursuant to that rule, a petition for review of this initial decision may be filed within twenty-one days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision upon him, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the initial decision shall not become final as to that party.
Carol Fox Foelak
Administrative Law Judge
|1||The OIP also included Respondent Vincent J. Malanga, who settled his portion of the proceeding for specified sanctions and undertakings. See Fundamental Portfolio Advisors, Inc., 67 SEC Docket 1486 (July 7, 1998).|
|2||Citations to exhibits offered jointly, by the Division, and by Respondents and to the hearing transcript will be noted as "Jt. Ex. __," "Div. Ex. __," "Resp. Ex. __," and "Tr. __," respectively.|
|3||See 5 U.S.C. ¶ 557(c); 17 C.F.R. 201.340.|
|4||A June 1994 letter sent to prospects who had responded to previous mailings, but had not purchased shares, contained the warning in standard size print. Jt. Ex. A at Stip. 19 & App. 16 at F00027.|
|5||The Fund's prospectuses for the time at issue were dated April 30, 1993, and May 2, 1994, and were filed with the Commission as part of registration statements. Tr. 98; Div. Exs. 2, 3.|
|6||Rule 22c-1, 17 C.F.R. ¶ 270.22c-1, provides that the price of a mutual fund share must be based upon the current "net asset value" of the share. NAV is generally calculated "after the close of the exchanges each day by taking the closing market value of all securities owned plus all other assets such as cash, subtracting all liabilities, then dividing the result (total net assets) by the total number of shares outstanding." Barron's Dictionary of Finance and Investment Terms 362 (4th ed. 1995).|
|7||Inverse floaters are found in several sectors of the bond market, including agency debentures, corporate bonds, and municipal bonds, but the largest issuance has been in collateralized mortgage obligations, as in the instant case. Div. Ex. 57, App. B at 1.|
|8|| For the year ended March 31, 1993, Lipper Analytical Services, Inc. (Lipper) ranked the Fund 33rd of fifty short-term government bond funds in terms of total return, and for the month ended March 31, 1993, last of sixty-six such funds. Div. Ex. 77 at F21220. Brofman monitored the Fund's Lipper rankings, which were reported to the Board. Tr. 196-97; Div. Exs. 73 at F15011, 74 at F15004-05, 75 at F15025, 76 at F15042-43.
A mutual fund's total return is the change in the value of the investment during a specified period, including capital gains and losses and all dividends, whether received or reinvested, divided by the value of the investment at the beginning of a specified period. See Securities Act Rule 482, 17 C.F.R. ¶ 230.482. A mutual fund's yield is computed by dividing a fund's net investment income per share during the base period (thirty-day or one month) by the maximum offering price on the last day of the base period. Thus, total return reflects changes in NAV, whereas yield does not. Generally, yield and total return are inversely related because, as interest rates rise, a bond fund's yield typically will rise, while the value of the fund's securities, and the fund's NAV, will decline. See Advertising by Investment Companies, Adoption of Rules, 53 Fed. Reg. 3868, 3870-72 (Feb. 10, 1988), 40 SEC Docket 207, 209-11.
|9||Modified duration was also called spread duration on the Bloomberg system. Tr. 797-98.|
|10||Brofman does not dispute that calculating effective duration on net assets would have produced a duration value greater than three. See Brofman's Post-Hearing Memorandum at 26-28. Nor does the Division dispute that calculating modified duration on total assets without regard for leverage would have produced a duration value of three or less. See the Division's Post-Hearing Reply Memorandum at 31 n.36.|
|11||Professor Feinstein was not made available for cross-examination, thus lessening the weight of the opinions expressed in Resp. Ex. 16. Tr. 697-99, 758-59.|
|12|| Under a soft dollar arrangement, an investment adviser obtains products or services other than execution of securities transactions from or through a broker-dealer in exchange for the adviser's directing its clients' transactions to the broker-dealer.
|13||For fixed price offerings, an underwriting syndicate buys a specific amount of securities at a specific price from an issuer and then resells those securities to the public at a higher fixed price. The spread includes the "selling concession" paid to broker-dealers involved in the distribution for the securities they sold. An institutional investor may buy directly from the managing underwriter and direct that the selling concession be given to another syndicate member in exchange for research or services provided to the institutional investor. Tr. 587-88. See NASD, Order Approving Proposed Rule Change, 21 SEC Docket 930, 934-35 & n.23 (Dec. 12, 1980). The arrangement in the instant case involved such syndicate designations. The question of whether, as a matter of law, syndicate designations are soft dollars will be discussed below in the Conclusions of Law.|
|14||At the meeting Malanga claimed that he had only recently learned of CMS's ownership, as a result of a Commission investigation. Tr. 579; Div. Ex. 46 at 39-40, Div. Ex. 51 at 8. He did not repeat this claim in his testimony at the hearing. Tr. 1091-1124. Accordingly, any claim that FPA or Malanga was unaware of CMS's ownership is rejected. Additionally, such a claim is not credible in light of Malanga's relationship with Newell and FPA's intentional direction of soft dollar payments to CMS.|
|15||The testimony of Carole Laible does not support Brofman's contention that the Board was informed about FPA's soft dollar arrangements before May 1996. Laible, a CPA, was Financial Compliance Officer at FPA from April 1994 to November 1997. Tr. 1070-72. Laible submitted reports about soft dollars to the Board but did not recall the time period when she did so. Tr. 1081-83.|
|16||Div. Ex. 46 is Bullock's testimony. Tr. 560. Bullock's deposition was taken and received as evidence in lieu of live testimony because of his inability to attend the hearing, pursuant to the unpublished July 14, 1998, Order on Motion to Take Deposition and Rules 233 and 235, 17 C.F.R. ¶¶ 201.233, .235.|
|17||Buchwald explained the reasons for his concern. First, when an advisory contract or its renewal is pending approval by a mutual fund's board of directors, the Investment Company Act requires a management company to disclose all relevant information needed to allow the board make an informed decision. Tr. 567-68. The independent board members must consider soft dollar arrangements to negotiate an arms' length fee; any soft dollar products or services received by the management company may have been those for which it would otherwise have had to pay. Tr. 567-68. Finally, disclosure is necessary to expose any potential conflict of interest; soft dollar products and services received by a management company must be used for the benefit of the fund, not the advisor. Tr. 568.|
|18||Over time Buchwald has received and incorporated comments or corrections from Wieder, Laible, Malanga, and Brofman on drafts of minutes. Tr. 566-67.|
|19||Brofman cites footnote 16 in County of Orange, 61 SEC Docket 395, 403-04 n.16 (Jan. 24, 1996) as support for the proposition that the Commission has endorsed modified duration as a measure of an investment's sensitivity to interest rate changes. Reliance on the passing reference to modified duration in footnote 16 is misplaced. The Orange County case was a settlement. It goes without saying, and the Commission has stressed many times, that settlements are not precedent. See Richard J. Puccio, 63 SEC Docket 158, 163 (Oct. 22, 1996) (citing David A. Gingras, 50 S.E.C. 1286, 1294 (1992), and cases cited therein); Robert F. Lynch, 46 S.E.C. 5, 10 n.17 (1975) (citing Samuel H. Sloan, 45 S.E.C. 734, 739 n.24 (1975); Haight & Co., 44 S.E.C. 481, 512-13 (1971), aff'd without opinion, (D.C. Cir. June 30, 1971); Security Planners Assocs., Inc., 44 S.E.C. 738, 743-44 (1971)); see also Michigan Dep't of Natural Resources v. FERC, 96 F.3d 1482, 1490 (D.C. Cir. 1996) and cases cited therein (settlements are not precedent). Indeed, like every Commission settlement order, the Orange County case contains a disclaimer to this effect. County of Orange, 61 SEC Docket at 396 n.1. Additionally, there is no indication in the settlement order that the inverse floater investments at issue were mortgage backed securities or otherwise subject to prepayment risk.|
|20||For example, Brofman points to the language describing duration in terms of weighted times of cash flows in the prospectus language quoted supra in the Findings of Fact section (at II.C.1. - Earn High Yields with Maximum Safety): "Duration is expressed in years . . . representing the half-life of the present value of all cash flows expected from a bond over its life. . . . Duration provides a yardstick to bond price volatility with respect to changes in rates. As maturity lengthens or as the coupon rate or yield-to-maturity is reduced, volatility increases. Duration captures all three factors and expresses them in a single number."|
|21||Brofman argues that all references to duration specify portfolio duration, overlooking the context, such as in prospectus language quoted supra in the Findings of Fact section (at II.C.1. - Earn High Yields with Maximum Safety) that the Fund would "minimize the risk of principal and provide relative stability of [NAV] by limiting the average weighted duration of its investment portfolio to three years or less."|
|22|| Section 28(e) provides:
No person [who exercises] investment discretion with respect to an account shall be deemed to have acted unlawfully . . . solely by reason of his having caused the account to pay [more than the lowest available] commission for effecting a securities transaction . . . if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided . . . viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion.
|23||See, e.g., Exchange Act Sections 15(b)(6)(A) and 21B(a), (c), and (d).|
|24||The cited provisions of the civil penalties provisions in the Exchange, Investment Company and Advisers Acts are identical.|
|25||The Commission increased the amounts for violations occurring after December 9, 1996. Adjustment to Civil Monetary Penalty Amounts, 61 Fed. Reg. 57773 (Nov. 8, 1996), 63 SEC Docket 431.|
|26||See, e.g., J. Stephen Stout, 73 SEC Docket 1411 (Oct. 4, 2000) ($300,000 penalty, bar, and cease and desist order. Individual violated antifraud provisions in trading with retail customers and caused substantial losses.); Al Rizek, 70 SEC Docket 927 (Aug. 11, 1999), aff'd sub nom. Rizek v. SEC, 215 F.3d 157 (1st Cir. 2000) ($100,000 penalty, disgorgement, bar, and cease and desist order. Individual violated antifraud provisions by churning.); L.C. Wegard, 67 SEC Docket 814 (May 29, 1998), aff'd, 189 F.3d 461 (2d Cir. 1999) (table decision) (Broker-dealer - $1 million penalty, registration revoked, disgorgement, cease and desist order; sole owner - $175,000 penalty, one year broker-dealer suspension, penny stock bar, cease and desist order. Market manipulation.); New Allied Dev. Corp., 52 S.E.C. 1119 (1996) ($1 million penalty for individual with history of securities violations and deceit, $150,000 for individual with less knowledge and involvement, also penny stock bars, disgorgement and cease and desist orders. Respondents violated antifraud provisions.)|
|27||The evidence includes Resp. Ex. 25, which includes financial statements and tax returns for FPA and FSC, which have been inactive since FPA was terminated. Brofman directs the affairs of FSC and FPA, is essentially sole owner of FPA, and has attempted to restore their relationship with the Fundamental Family of Funds.|
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