SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 38742 \ June 17, 1997 Admin. Proc. File No. 3-8370 ________________________________________________ : In the Matter of : : DONALD A. ROCHE : 6822 22nd Avenue North #137 : St. Petersburg, Florida 33710 : ________________________________________________: OPINION OF THE COMMISSION BROKER-DEALER PROCEEDINGS Grounds for Remedial Action Fraud in Offer and Sale of Securities Former salesman of former registered broker-dealer made fraudulent price predictions, made a materially misleading statement concerning the existence of a stop/loss order, and churned the accounts of customers. Held, it is in the public interest to: bar salesman from association with any broker or dealer; order salesman to cease and desist from committing or causing any violation or future violation of Section 17(a) of the Securities Act of 1933 or Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder; and order salesman to disgorge $102,182, plus prejudgment interest. APPEARANCES: Donald A. Roche, pro se. Maureen Maguire Bailey and Stephen J. Korotash, for the Division of Enforcement. Appeal filed: August 14, 1995 Last brief received: No separate briefs filed on appeal. I. Donald A. Roche, formerly a registered representative and manager of the Clearwater, Florida branch office of The Stuart-James Co., Inc. ("Stuart-James"), a former registered broker-dealer, appeals from the decision of an administrative law judge. The law judge found that Roche used various fraudulent sales tactics, made unauthorized trades, and churned customer accounts in violation of Section 17(a) of the Securities ======END OF PAGE 1====== Act of 1933 ("Securities Act") and Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5 thereunder. The law judge barred Roche from association with any broker or dealer; ordered Roche to cease and desist from committing or causing any violation of, and from committing or causing any future violation of, Section 17(a) of the Securities Act or Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; and ordered him to disgorge $102,182, plus prejudgment interest. Our findings are based on an independent review of the record. <(1)> II. During the period from approximately June 1989, to March 1990, Roche made price predictions in conjunction with recommendations of a number of speculative securities. CM Communications, Inc. CM Communications, Inc. ("CM") was a risky enterprise engaged in the distribution of cellular phone equipment and accessories. In early 1990, Roche recommended CM stock to at least three of his customers. In January, Roche recommended that his client Steven Johnson purchase CM stock. Roche told Johnson that CM would increase in price to "the neighborhood of $20 to $25 a share" within thirty to sixty days. On January 22, 1990, Johnson purchased 700 shares of CM for $7.35 a share. CM later fell to under $1.00 per share. Similarly, Roche recommended CM to his client Robert Maegerle. Roche indicated that CM "potentially could recapture [] losses" in Maegerle's account. In late March or early April of 1990, Roche faxed materials to Maegerle stating that CM had an expected price "in excess of" $13 per share over the next six to nine months and $26 per share over the next fifteen to eighteen months. Maegerle purchased 1000 shares of CM for $8.25 per share. Maegerle later sold his CM holdings for $1.1875 per share. <(1)> On July 24, 1995, new Rules of Practice governing Commission administrative proceedings became effective. Because this proceeding was docketed prior to that date, it has been conducted under the former Rules of Practice. See 60 Fed. Reg. 32,738 (1995). Our review of this proceeding has been complicated by the parties' failure to brief fully the case on appeal. Roche filed a petition for review, but neither Roche nor the Division of Enforcement ("Division") filed a brief on appeal. ======END OF PAGE 2====== Roche also touted CM to his customer Kenneth Gregory. In March 1990, Roche solicited Gregory to purchase CM stock. Roche predicted to Gregory that CM would increase to $15 per share "fast." Gregory then purchased 350 shares on March 26, 1990 for $7.875 per share. Europa Cruises Corp. Stuart-James underwrote the initial public offering of the securities of Europa Cruises Corp. ("Europa") in 1989. The prospectus described the offering as "speculative," entailing substantial risk of loss. In June 1989, Roche solicited his customer Fred Scheidker to purchase Europa stock. Roche represented to Scheidker that Europa, which sold for $1.00 per share, would double to $2.00 per share "pretty fast." On June 29, 1989, Scheidker purchased 1500 shares of Europa at $1.00 per share. Scheidker sold Europa the next month for a $215 profit. The Meadow Group, Inc. In 1989, Roche also had recommended the stock of The Meadow Group, Inc. ("Meadow"). Meadow was formed the previous year as a blind pool company engaged in the acquisition of operating companies. In November 1989, Roche recommended that his customer Theodore Boe purchase stock in Meadow. By this time, Boe had suffered losses in his account, and Roche had told Boe that his goal "was to get [Boe] back even by Christmas." Roche represented to Boe that Meadow would "recoup losses" in Boe's account of $11,000. On November 16, 1989, Boe purchased 20,000 shares of Meadow at $.28 per share, and on November 29, 1989, he purchased an additional 10,000 shares at $.27 per share. Boe sold 30,000 shares of Meadow in May, 1990, for $.0325 per share. * * * We long have held that predictions of specific and substantial increases in the price of a speculative security within a relatively short period of time are fraudulent. <(2)> We also have held that predictions of specific and substantial increases in the price of any security that are made without a reasonable basis are fraudulent. <(3)> <(2)> Irving Friedman, 43 S.E.C. 314, 320 (1967); Alfred Miller, 43 S.E.C. 233, 235 (1966)(such predictions "are a `hallmark' of fraud"). <(3)> Lester Kuznetz, 48 S.E.C. 551, 553 (1986). In her initial decision in this case, the law judge also addressed the adequacy of Roche's basis for recommending the purchase of all the above securities. In this regard, she cited Hanly v. SEC, 415 F.2d 589 (2d Cir. 1969). Hanly dealt with the necessity that every salesman have a reasonable basis for recommending a security. While this is a related concept, the (continued...) ======END OF PAGE 3====== Roche committed fraud when he made price predictions to his customers. CM was a very risky investment, yet Roche made explicit predictions of rapid price increases to Johnson, Maegerle, and Gregory. Similarly, Roche predicted to Scheidker that Europa, a speculative stock, rapidly would double in price. Roche told Boe that investing in Meadow, a highly speculative investment, would rapidly recoup $11,000 in losses in Boe's account. Given the speculative nature of the securities, there could be no reasonable basis for these predictions, and they were fraudulent. Even if the securities were less speculative, the record does not indicate that Roche had a basis to support such predictions. Roche acted recklessly, at a minimum, when he made such predictions. <(4)> We therefore conclude that Roche wilfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by making price predictions which lacked a reasonable basis. III. As discussed above, Roche recommended in March 1990 that his customer Kenneth Gregory purchase CM stock, which at the time was quoted on Nasdaq. Gregory was hesitant, as he was "getting down to hardly anything in the account." The stock was trading at $7.875 per share at the time. Roche volunteered to put a "stop/loss order" to sell the stock at $7 per share on Gregory's purchase if he agreed to the transaction. Gregory agreed, because he felt that, if the share price declined, he could get out of the stock before he "lost it all." Gregory purchased 350 shares. Roche did not place any formal stop/loss order on the securities but rather made a "mental stop" to sell Gregory's securities at $7 per share. Not long thereafter, CM began to drop in price. Roche was not in the office when Gregory telephoned regarding the decline. Gregory instead spoke to Roche's sales assistant and told the assistant that Roche had placed a "stop/loss order" on CM. After two or three telephone calls to the assistant, the assistant told Gregory that stop/loss orders could not <(3)>(...continued) charges in this case alleged only that Roche made fraudulent specific price predictions and did not address the broader basis for his recommendations. At the hearing, the Division sought only to prove, as alleged, that there was no basis for Roche's price predictions. <(4)> The law judge also found that Roche made a fraudulent price prediction to another customer, Paresh Doshi. The evidence concerning the prediction is more equivocal than those discussed above. Given the number and severity of Roche's violations, we need not reach this allegation. ======END OF PAGE 4====== be placed on issues quoted on Nasdaq. <(5)> Gregory lost most of his investment in CM. Roche's statement that he would place a stop/loss order on the stock was materially misleading in that Roche intentionally gave Gregory the impression that his investment in CM would be protected automatically from a sharp decrease in price, whether or not Roche was in the office. Roche's conduct induced Gregory to make an investment which he was otherwise reluctant to make. We therefore find that Roche wilfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. IV. The law judge also found that Roche churned the accounts of three of his customers: Kenneth Gregory, Robert Novak, and Fred Scheidker. None of the three customers had speculation as an account objective or had an expectation of rapid turnover. Gregory explained to Roche that his investment represented his savings and that he did not want to risk his savings. Novak was not willing to risk the loss of his entire investment and would have been satisfied with a 10% return. His employer did not have a retirement plan, and Novak intended his investing to provide for retirement. Scheidker hoped for "appreciation" in investing with Stuart- James. He rolled over an Individual Retirement Account from another broker and used the funds to invest at Stuart-James. Roche made all the investments in Gregory's account, frequently telling Gregory about the transactions after the fact. Gregory believed what Roche told him, and when Gregory sold an investment, he usually rolled the money over into another investment pursuant to Roche's direction. Similarly, the ideas for the investments in Novak's account originated with Roche. Novak accepted Roche's investment decisions, only turning down investments when he did not have the necessary money. On those occasions when Novak had no money available, Roche suggested selling specific stocks to finance the recommended purchases. Roche recommended all of the transactions in Scheidker's account. Roche also controlled the trading in Scheidker's account, sometimes making purchases and then calling Scheidker, who would visit the office and bring money to pay for the transactions. During the period April 1988, through April 1990, Gregory's account had an average monthly equity value of $7,221. On an annualized basis, the account turnover rate was 3.3, <(6)> and the average holding period <(5)> There is no legal impediment to placing such orders on Nasdaq securities. It is undisputed, however, that Roche did not arrange for such an order with his firm. <(6)> The turnover rate represents the number of times in one year that a portfolio of securities is exchanged for (continued...) ======END OF PAGE 5====== was 103 days. The account had a cost- equity maintenance factor of 107.8%, meaning that, due to the transaction costs related to trading, the account would need to appreciate that amount to break even. <(7)> Gregory suffered nearly $10,000 in net losses, approximately 78% of the funds he invested during the time period. The trading in Gregory's account generated $15,571 in total commissions. During the period March 1988, through May 1990, Novak's account had an average monthly equity value of $12,335. On an annualized basis, the account turnover rate was 4.6, and the average holding period was 123 days. The account had a cost-equity maintenance factor of 138.8%. Novak suffered nearly $39,000 in net losses, approximately 75% of the funds he invested during the time period. The trading in Novak's account generated $37,107 in total commissions. During the period April 1988, through June 1990, Scheidker's account had an average monthly equity value of $16,398. On an annualized basis, the account turnover rate was 7.2, and the average holding period was 92 days. The account had a cost-equity maintenance factor of 258.8%. Scheidker suffered nearly $54,000 in net losses, approximately 95% of the funds he invested during the time period. The trading in Scheidker's account generated $49,504 in total commissions. * * * Churning "occurs when a securities broker enters into transactions and manages a client's account for the purpose of generating commissions and in disregard of his client's interests." <(8)> Churning has been found where: (1) trading in an account was excessive in light of the investment objectives; (2) the broker exercised control over the account; and (3) the <(6)>(...continued) another portfolio of securities. The Division's expert calculated the turnover rate by dividing the total purchases by the average account equity and annualizing the number. <(7)> While the Division's expert used the term "break-even cost factor," he noted that the calculation is also referred to as a "commission to equity ratio" and a "cost-equity maintenance factor." The expert noted that the phrases refer to identical calculations. <(8)> Miley v. Oppenheimer & Co., 637 F.2d 318, 324 (5th Cir. 1981); Mihara v. Dean Witter & Co., 619 F.2d 814, 820- 21 (9th Cir. 1980). ======END OF PAGE 6====== broker acted with the intent to defraud or with reckless disregard for the interests of the client. <(9)> Churning, "in essence, involves a conflict of interest in which a broker or dealer seeks to maximize his or her remuneration in disregard of the interests of the customer." <(10)> This motivation creates the element of scienter necessary for a violation of the antifraud provisions of the securities laws. <(11)> Scienter, in turn, is what separates "churning" from "excessive trading." In the proceedings below, the term "churning" was used interchangeably with "excessive trading." As we have noted in a previous case, the violation's normal designation in a fraud context is "churning." <(12)> "Excessive trading," without more, is a type of violation of broad "suitability" rules promulgated by self-regulatory organizations, which are not antifraud provisions. <(13)> We find that Roche churned the accounts of Gregory, Novak, and Scheidker. The frequent turnover in the accounts conflicted with the customers' expressed investment objectives. This is illustrated clearly by, for example, the transaction costs associated with the level of trading in the accounts. Those costs made it extremely unlikely that any of the customers would be able to break even, much less earn any profit. Under the circumstances presented in this case, Roche abused his control over the trading in the accounts of Gregory, Novak, and Scheidker to make numerous trades that placed his compensation ahead of the customers' best interests. <(14)> The fact that Roche's clients were sustaining large losses while he was generating substantial commission income for himself was readily <(9)> See, e.g., Miley, 637 F.2d at 324; Mihara, 619 F.2d at 821. See also Albert V. O'Neal, 51 S.E.C. 1128, 1130 (1994). <(10)> Loss & Seligman, Securities Regulation, 3877 (1991). <(11)> See, e.g., Mihara, 619 F.2d at 820. <(12)> O'Neal, 51 S.E.C. at 1130 n.8. <(13)> See, e.g., Paul Kettler, 51 S.E.C. 30, 32 (1992); John Reynolds, 50 S.E.C. 805, 806 (1992). <(14)> De facto control of an account may be established where the client habitually follows the advice of the broker. E.g., Mihara, 619 F.2d at 821. The evidence strongly shows Roche exercised de facto control of trading in all three accounts, as the customers routinely followed his recommendations. Roche also frequently made unauthorized trades in Scheidker's account. ======END OF PAGE 7====== apparent. At the least, Roche acted in reckless disregard of his customers' interests and account objectives, and in favor of his own interests. Accordingly, we find that Roche wilfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, by churning the accounts as alleged. V. A. The law judge found that Roche made additional material misrepresentations and omissions of fact to his customers Johnson and Gregory. <(15)> The Amended More Definite Statement alleged that Roche made a material misrepresentation or omitted material information to Johnson involving one particular stock. It omitted detail as to what Roche said or failed to say to Gregory. The testimony of Johnson and Gregory provides few additional details. Johnson testified that, when Roche took over his account, Roche stated that many of Roche's clients had made 25-40% returns and that Roche felt that, if given the opportunity, he could do the same for Johnson. Johnson also testified that Roche generally indicated that companies he was recommending were on the verge of making discoveries or major changes "that were not particularly public knowledge." Gregory's testimony was of similar brevity and generality. Gregory testified that Roche once told him to ignore the language relating to risk factors in an unidentified prospectus. <(15)> The law judge made similar findings with respect to other customers. The Division's Amended More Definite Statement, however, alleged that Roche made material misrepresentations and omissions to only Johnson and Gregory. The Division's post-hearing brief addressed only the allegations in its Amended More Definite Statement. Fairness requires that we set aside those findings against Roche that were not charged or litigated. ======END OF PAGE 8====== While we have not hesitated to hold, upon a proper showing, that similar statements violate the antifraud provisions if they are false when made, there is nothing in this record that establishes that these statements were actually fraudulent. There is no evidence at all concerning Roche's success rate with clients other than those discussed here. Because the companies to which Johnson's testimony refers are not identified, it is not possible to determine if Roche's statements about them are false. Because the prospectus discussed by Gregory is not identified, it is not possible to determine the materiality of any language in that document relating to risk. We therefore reverse the law judge's findings that Roche made material misrepresentations and omitted material facts, apart from those previously discussed relating to price predictions and the stop/loss order, in regard to Johnson and Gregory. B. The law judge also found that Roche violated the antifraud provisions by making unauthorized trades in the accounts of Paresh Doshi and Scheidker. <(16)> In general, unauthorized trading violates the antifraud provisions when accompanied by deceptive conduct. <(17)> This requirement is satisfied by the respondent's omission to inform the customer of the materially significant fact of the trade before it is made. We therefore affirm the law judge's findings that Roche violated the antifraud provisions by making unauthorized trades in these two accounts. VI. Roche argued in his Petition for Review that this proceeding is barred by the "applicable statute of limitations," without specifying any statutory provision. The only possibly applicable statute of limitations is the five-year limit contained in 28 U.S.C. Section 2462 on administrative proceedings seeking to enforce a "penalty." <(18)> <(16)> The law judge made similar findings with respect to two other accounts. The Division's allegations pertained only to the accounts of Doshi and Scheidker. As discussed, supra, fairness compels us to set aside findings of violations that were not charged. <(17)> See Messer v. E.F. Hutton & Co., 847 F.2d 673, 678 (11th Cir. 1987); Brophy v. Redivo, 725 F.2d 1218, 1220-21 (9th Cir. 1984); SEC v. Hasho, 784 F.Supp 1059, 1110 (S.D.N.Y. 1992)(unauthorized trades are actionable under Rule 10b-5 "when accompanied with deception, misrepresentation, or non-disclosure"). <(18)> See Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996). ======END OF PAGE 9====== A portion of the trading covered by the churning claims occurred more than five years before the order instituting proceedings. "Churning is a unified offense [and] a finding of churning, by the very nature of the offense, can only be based on a hindsight analysis of the entire history of a broker's management of an account and of his pattern of trading that portfolio." <(19)> Thus, the offense was not complete until the end of the review period, which here occurred within five years of the order instituting proceedings. Moreover, even if we were not to consider the churning violations in assessing the sanctions, we think the sanctions are justified by the other violations that Roche committed. We have found that Roche committed serious antifraud violations. He repeatedly made fraudulent price predictions to customers, made a materially misleading statement in order to make a sale to a reluctant customer, and churned three customers' accounts in complete disregard of the customers' best interests. Roche's conduct was not isolated, but extended over a period of time. His actions demonstrate a pattern of sales abuse that we cannot tolerate from anyone involved in the securities industry. Under these circumstances, the public interest warrants an order that Roche be barred from association with any broker or dealer and that he cease and desist from violating the charged antifraud provisions of the securities laws. The law judge also ordered that Roche disgorge $102,182, plus prejudgment interest, representing commissions earned on the accounts that Roche churned. Disgorgement is not a penalty within the meaning of Section 2462. <(20)> We agree that Roche should disgorge the ill-gotten gains from his churning. The testimony of the Division of Enforcement's expert witness, which Roche did not dispute, indicated that the trading in Gregory's account generated $15,571 in total commissions, that the trading in Novak's account generated $37,107 in total commissions, and that the trading in Scheidker's account generated $49,504 in total commissions. <(21)> While termed total "commissions," these figures appear to include markups and markdowns, traditional commissions, and other transaction costs associated with the trading. The record does not indicate what percentage of the total commissions Roche received. This figure, however, under the circumstances, represents a reasonable approximation of profits directly related to the churning. Prejudgment interest also is appropriate. <(19)> Miley, 637 F.2d at 327 (discussing nature of violation in the context of assessing damages). <(20)> Johnson, 87 F.3d at 488. <(21)> See SEC v. First City Financial Corp., Ltd., 890 F.2d 1215, 1231 (D.C. Cir. 1989). ======END OF PAGE 10====== An appropriate order will issue. <(22)> By the Commission (Chairman LEVITT and Commissioners WALLMAN, JOHNSON, and HUNT). Jonathan G. Katz Secretary <(22)> All of the contentions advanced by the parties have been considered. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed herein. ======END OF PAGE 11====== UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. Admin. Proc. File No. 3-8370 ________________________________________________ : In the Matter of : : DONALD A. ROCHE : 6822 22nd Avenue North #137 : St. Petersburg, Florida 33710 : ________________________________________________: ORDER IMPOSING REMEDIAL SANCTIONS On the basis of the Commission's opinion issued this day, it is ORDERED that Donald A. Roche be, and he hereby is, barred from association with any broker or dealer; and it is ORDERED that Donald A. Roche cease and desist from committing or causing any violation of or future violation of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder; and it is further ORDERED that Donald A. Roche disgorge ill-gotten gains, plus prejudgment interest thereon, as set forth below: <(1)> Roche shall disgorge a total of $102,182.00, representing profits earned from his churning of customer accounts, which we deem to have occurred as of May 8, 1990. Roche also shall pay prejudgment interest in the amount of $80,513.08, calculated in accordance with Commission Rule 600(b) and due from June 1, 1990 through June 17, 1997. Interest shall continue to accrue on all funds owed until they are paid. By the Commission. Jonathan G. Katz Secretary <(1)> Although the Commission's new Rules of Practice were not applicable to this proceeding, we see no reason not to issue this disgorgement order according to the format prescribed by Commission Rule 600.