SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 39517 / January 6, 1998 Admin. Proc. File No. 3-8543 _____________________________________________ : In the Matter of : : D.E. WINE INVESTMENTS, INC. : Houston, Texas : : W. RANDAL MILLER : Spring, Texas : : KENNETH B. KARPF : Spring, Texas : : AND : : DUNCAN E. WINE : Houston, Texas : _____________________________________________: OPINION OF THE COMMISSION BROKER-DEALER PROCEEDINGS Ground for Remedial Action Fraudulent Markups and Markdowns Registered broker-dealer and three of its registered principals were alleged to have charged fraudulent markups and markdowns. Held, law judge's findings of violations remanded for further findings. APPEARANCES: Roger A. Tolins, of Tolins & Lowenfels, for D.E. Wine Investments, Inc., W. Randal Miller, Kenneth B. Karpf, and Duncan E. Wine. Phillip W. Offill, Jr. and Karen L. Cook, for the Commission's Division of Enforcement. Appeal filed: December 28, 1995 Last brief filed: March 20, 1996 I. D.E. Wine Investments, Inc., a registered broker-dealer, ("DEW" or the "Firm"), W. Randal Miller, Kenneth B. Karpf, and Duncan E. Wine, each of whom was a registered principal of the Firm, appeal from an administrative law judge's decision. Following a hearing, the law judge found that respondents charged retail customers fraudulent markups and markdowns in 1992 and 1993. Specifically, the law judge found that the Firm violated Section 17(a) of the Securities Act of 1933 (the "Securities Act"), Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Rule 10b-5 thereunder, and Section 15(c)(1) of the Exchange Act and Rule 15c1-2 thereunder. The law judge found that Miller, Karpf, and Wine each violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and aided and abetted violations of Section 15(c)(1) of the Exchange Act and Rule 15c1-2 thereunder. <(1)> The law judge suspended DEW's registration as a broker-dealer for 30 days and ordered it permanently to cease and desist from committing or causing any violation and committing or causing any future violations of the provisions it was found to have violated. The law judge also ordered the Firm to pay a penalty of $20,000, and "account and disgorge," jointly and severally with the other respondents, the amount of $33,873.53 with prejudgment interest. In addition, the law judge suspended Miller, Karpf, and Wine for 30 days from association with any broker or dealer and ordered them permanently to cease and desist from committing or causing any violation and committing or causing any future violations of the provisions they were found to have violated. Miller, Karpf, and Wine also were each ordered to pay a penalty of $5,000, and "account and disgorge," jointly and severally with the other respondents, the amount of $33,873.53 with prejudgment interest. Respondents seek a reversal of the law judge's decision. To the extent that we make findings in this opinion, they are based on an <(1)> During the relevant period, Miller was the Firm's compliance officer, Karpf was a director of the Firm and vice president of trading, and Wine was Chairman of the Board and president of the Firm. Miller developed the Firm's markup and markdown policies and procedures and participated in implementing them. Miller had responsibility for reviewing each transaction for pricing before execution. Karpf reviewed all order tickets before trades were executed. Wine approved the Firm's policies regarding markups and markdowns and delegated responsibility for pricing to Miller and Karpf. ======END OF PAGE 2====== independent review of the record, except with respect to those findings made by the law judge that are not challenged on appeal. II. This case concerns the actions of respondents with respect to the pricing of the following securities (hereinafter the "Securities") purchased from and sold to DEW's retail customers between December 1992 and July 1993: the common stock of Dynacq International, Inc. and Market Data Corporation, and the warrants of First National Film, Inc. The law judge found that, in setting prices for the Securities, respondents were responsible for charging their customers undisclosed, excessive markups and markdowns, and that, in doing so, they violated the antifraud provisions of the securities laws. Most of the facts in this case are not in dispute, although the parties strongly disagree about the appropriate method for calculating the Firm's markups and markdowns. During the period at issue, the Firm was a market maker in the Securities, and the market for each was active and competitive. Based on these facts, the law judge calculated the markups and markdowns by looking at the following four types of trading data (the first being the most, and the last being the least, preferred kind of evidence): (i) interdealer (or wholesale) sales by the Firm on the same day as the retail sale in question; (ii) interdealer purchases by the Firm on such day; (iii) the most contemporaneous interdealer purchase or sale by the Firm that occurred no more than three days before the retail sale in question; and (iv) interdealer trades that occurred on the same day as the retail trade but did not involve the Firm, i.e., "away trades." Where the trade in question involved a markdown, the law judge used the same approach but reversed the order of the first and second prongs of the analysis, i.e., when calculating markdowns, he first considered interdealer purchases by DEW and then interdealer sales. Using this approach, the law judge determined that DEW charged retail customers markups and markdowns between ten and thirty- seven percent in eighty-nine transactions. III. Respondents do not dispute that charging undisclosed, excessive markups and markdowns can, under certain circumstances, violate the antifraud provisions of the securities laws, but deny that they did so here. They claim that the law judge's method of calculating the Firm's profit here was invalid. <(2)> As we discuss below, we agree that the law judge's analysis was flawed. <(2)> The Division of Enforcement also questions the validity of portions of the law judge's analysis, but agrees with his ultimate conclusion that respondents charged fraudulent markups and markdowns on the retail trades at issue. ======END OF PAGE 3====== It is well recognized that undisclosed markups or markdowns on sales to or purchases from retail customers can violate the securities laws if they are not reasonably related to the prevailing market price and if such pricing was done with scienter. <(3)> It also has been recognized that, at the least, markups on equity securities of more than ten percent generally are not reasonably related to the prevailing market price, <(4)> and that markdowns are generally lower than markups. <(5)> We now turn to the appropriate method for calculating markups and markdowns considering the facts of this case. As we have repeatedly held, a market maker in a competitive market, like DEW, is entitled to base its retail prices on the interdealer prices it and other market makers charge or pay other non-market maker dealers in contemporaneous trades. <(6)> Retail markups must be reasonably related to the price market makers are contemporaneously charging other non-market makers to buy the relevant security, <(7)> and retail markdowns must be reasonably related to the <(3)> See, e.g., Alstead, Dempsey & Company, Inc., 47 S.E.C. 1034, 1035 (1984) (noting that the Commission has found excessive markups violative of the antifraud provisions since 1939). See also Richard R. Perkins, 51 S.E.C. 380 (1993); Meyer Blinder, 50 S.E.C. 1215 (1992). <(4)> See, e.g., Peter J. Kisch, 47 S.E.C. 802, 808 (1982); J.A. Winston & Co., Inc., 42 S.E.C. 62, 69 (1964). This is not to say that markups of ten percent or less may not also be violative. See Edward J. Blumenfeld, 47 S.E.C. 189, 192 (1979) (observing that markups in excess of seven percent have been found to be fraudulent). <(5)> Thill Securities Corporation, 42 S.E.C. 89, 94 n.7 (1964). See also Michael Alan Leeds, 51 S.E.C. 500, 503 (1993); Hamilton Bohner, Inc., 50 S.E.C. 125, 128 (1989). <(6)> See, e.g., Adams Securities, Inc., 51 S.E.C. 1092, 1095 (1994). By contrast, a dealer that is not a market maker must base its markups on the prices it pays in contemporaneous transactions to acquire the security, and must base its markdowns on the prices it charges in contemporaneous transactions to sell the security unless, in either case, there is "countervailing evidence" of the prevailing market price. David Disner, Securities Exchange Act Rel. No. 38234 (Feb. 4, 1997), 63 SEC Docket 2246. <(7)> See Adams, 51 S.E.C. at 1094-5; Adams Securities, Inc., 51 S.E.C. 311, 313 n.8 (1993). ======END OF PAGE 4====== price market makers are paying other non-market makers seeking to sell the security. <(8)> Where there is more than one interdealer trade that could provide the basis for determining the prevailing market price, we have generally used the trade that is closest in time to, or most contemporaneous with, the retail trade in question, whether the interdealer trade occurred before or after the retail trade. <(9)> In this context, we note that "contemporaneous" does not necessarily mean the same day. <(10)> Where there is little interdealer trading in a security, we have on <(8)> Leeds, 51 S.E.C. at 502. Where there are no interdealer trades involving a market maker, we may consider interdealer trades between non-market makers as evidence of the market price. <(9)> See Disner, 63 SEC Docket at 2251 n.14; Thomas F. White & Co., Inc., 51 S.E.C. 932, 935 n.11 (1994), aff'd without opinion, 68 F.3d 482 (9th Cir. 1995) (Table); Adams, 51 S.E.C. at 1095 n.13; Linder, Bilotti & Co., Inc., 42 S.E.C. 807, 809 n.4 (1965). We note that the law judge declined to consider interdealer trades that occurred after the retail trades at issue because he felt that "[i]t strains logic to hold a dealer to a price yet to be determined." As a general proposition, we believe that the law judge erred in rejecting the relevance of interdealer trades occurring after retail trades. A dealer is bound, as discussed herein, to set his retail prices based on the prevailing market price, which is generally gauged by reference to the interdealer transaction that is effected at the appropriate side of the market (bid or asked depending on whether it is a retail purchase or sale, respectively) and that is closest in time to the retail trade at issue. Notwithstanding this general rule, however, it may be inappropriate to evaluate retail prices based upon the most contemporaneous interdealer trade where that trade occurred after the retail trade at issue, if (i) using that trade would result in a finding of a higher markup or markdown than would be the case if a trade that occurred close in time but before the retail trade at issue were used, and (ii) it would be unfair to assume that the person responsible for the retail pricing at issue could have anticipated the price at which the subsequent interdealer trade was executed. <(10)> First Pittsburgh Securities Corp., 47 S.E.C. 299, 306 (1980)("Contemporaneous cost is not limited to same-day cost."); DMR Securities, Inc., 47 S.E.C. 180, 182 (1979)(same). ======END OF PAGE 5====== occasion deemed an interdealer trade that occurred several days before or after a retail trade to be the best evidence of market price at the time of that retail trade. <(11)> On the other hand, in a very active market, with rapid price fluctuation, it may be necessary to undertake an hour-by-hour or minute-by-minute analysis of interdealer trading to gauge accurately the prevailing market price at a particular point in time. <(12)> As the foregoing discussion indicates, the law judge's analysis conflicted in several important respects with our prior holdings. It was error for the law judge, in determining the prevailing market price, to give a preference to trades involving DEW over other market makers. <(13)> Interdealer trades involving market makers other than DEW were equally valid indications of market price as those in which the Firm, also a market maker, was a party. Thus, the law judge should have based his analysis of the markups on the most contemporaneous interdealer sale by any market maker to a non-market maker, and should have based his analysis of the markdowns on the most contemporaneous inter-dealer purchase by a market maker from a non-market maker. If the only contemporaneous interdealer trade was between two market makers, it may be used as the basis for determining the prevailing market price. <(14)> The law judge also erred in failing to use interdealer trades that occurred after the retail trade in question as the basis for determining the prevailing market price. As discussed, the prevailing market price should be determined based upon the most contemporaneous interdealer <(11)> See Orion Securities, Inc., Securities Exchange Act Rel. No. 35001 (Nov. 23, 1994), 58 SEC Docket 140, 148- 9 (using interdealer trades that occurred over a month after the trades at issue as a basis for calculating markdowns); LSCO Securities, Inc., 50 S.E.C. 518, 520 (1991) (using interdealer trade more than two weeks after the retail trade at issue as the basis for calculating markups). <(12)> See, e.g., George Salloum, Securities Exchange Act Rel. No. 35563 (April 5, 1995), 59 SEC Docket 43, 49-50. <(13)> The law judge's analysis regarding interdealer trades away from the Firm mirrored that of the Division, which characterized such trading information as "irrelevant" to a determination of the prevailing market price. <(14)> But see Adams, 51 S.E.C. at 1094-5 (recomputing markups where they initially had been calculated based upon market maker purchases rather than market maker sales); LSCO, 50 S.E.C. at 522 ("Markups are computed on the basis of the asked side of the market, and the NASD's computations did not take the bid-asked spread into account."). ======END OF PAGE 6====== transaction, whether it occurred before or after the particular retail trade at issue. <(15)> Finally, the law judge erred in basing these markups, in some cases, on DEW's contemporaneous costs. Although, as indicated, <(16)> it may be appropriate to calculate the markups of a firm that is not a market maker based upon its contemporaneous costs, it is not appropriate to do so for a firm, like DEW, that has such status as a general matter, unless no other evidence is available. We have recognized that, if a market maker were required to base its retail sales prices on the interdealer bid, i.e., a market maker's cost, "it might frequently be compelled to sell at retail at prices lower than the interdealer offer and might be deterred from taking the risk of maintaining positions." <(17)> Thus, as discussed, a market maker's markups are evaluated by reference to the asked side of the market, and its markdowns by reference to the bid. Although we reject the law judge's analysis in many respects, we decline to accept respondents' argument that they were entitled to base their retail prices on quotations. <(18)> While we have in the past looked at quotations when there was insufficient other evidence of the prevailing market price, we consider such evidence a less reliable measure of the <(15)> But see n.9, supra. <(16)> See n.6, supra, and the accompanying text. <(17)> General Investing Corporation, 41 S.E.C. 952, 954-55 (1964). See also Adams, 51 S.E.C. at 313; Blinder, 50 S.E.C. at 1224; Kisch, 47 S.E.C. at 808. <(18)> In addition to claiming that they were entitled to rely on quotations in setting their retail prices, respondents contend that In virtually every instance in which the Division has challenged a price involving a customer securities transaction by [the Firm], there is a relevant inter- dealer transaction in the securities of the particular issuer which reflects a price supportive of the prices arrived at by [DEW] with its customers. Respondents further contend that, if the markups are calculated based upon the highest interdealer prices charged on the same dates as the retail trades in question, the total amount of excessive markups, as found by the law judge, would be reduced by $18,706 to $15,168. As discussed in this opinion, we believe such trading data is directly relevant to an evaluation of the Firm's pricing and should have been considered by the law judge in his analysis. ======END OF PAGE 7====== market. <(19)> As we have previously stated, "[b]y their very nature, quotations only propose a transaction; they do not reflect the actual result of a completed arms-length sale." <(20)> Here, it appears that there is an abundance of information concerning interdealer trades in the Securities. It therefore should be unnecessary to resort to quotations for evidence of the prevailing market price. As the foregoing discussion indicates, the manner in which the law judge decided this case is not consistent with our longstanding analysis. We have therefore decided to remand this matter for further factual findings and a revised analysis that conforms to the principles we have enunciated herein. To the extent the parties stipulated to findings that are not <(19)> See, e.g., Adams, 51 S.E.C. at 1094 (rejecting firm's policy of setting retail prices based on "bona fide" but unvalidated quotations in an active and competitive market); Perkins, 51 S.E.C. at 382 n.11; LSCO, 50 S.E.C. at 522 ("We have approved the use of . . . validated quotations as a basis for determining market price, but only in the absence of actual inter-dealer transactions."). See also Bison Securities, Inc., 51 S.E.C. 327, 331 n.15 (1993) ("quotations, particularly in low-priced, thinly traded securities . . . are an extremely flawed measure of price"); James E. Ryan, 47 S.E.C. 759, 762 (1982). <(20)> Alstead, Dempsey, 47 S.E.C. at 1036. We have also held that quotations may provide a proper basis for computing markups only where their reliability "can be tested by comparing them with actual inter-dealer transactions during the period in question." Id. ======END OF PAGE 8====== inconsistent with this opinion, those findings should not be disturbed by this opinion. An appropriate order will issue. <(21)> By the Commission (Chairman LEVITT and Commissioners JOHNSON, HUNT, CAREY and UNGER). Jonathan G. Katz Secretary <(21)> Respondents' motion for oral argument is denied at this time. If respondents subsequently choose to appeal the law judge's decision on remand, they can move for oral argument at the appropriate time. ======END OF PAGE 9====== UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. 39517 / January 6, 1998 Admin. Proc. File No. 3-8543 _____________________________________________ : In the Matter of : : D.E. WINE INVESTMENTS, INC. : Houston, Texas : : W. RANDAL MILLER : Spring, Texas : : KENNETH B. KARPF : Spring, Texas : : AND : : DUNCAN E. WINE : Houston, Texas : _____________________________________________: ORDER REMANDING PROCEEDING TO ADMINISTRATIVE LAW JUDGE On the basis of the Commission's opinion issued this day, it is ORDERED that this proceeding be, and it hereby is, remanded to an administrative law judge for further action in accordance with such opinion. By the Commission. Jonathan G. Katz Secretary