SECURITIES AND EXCHANGE COMMISSION Washington, D.C. INVESTMENT ADVISERS ACT OF 1940 Rel. No. 1774 / November 18, 1998 Admin. Proc. File No. 3-8854 __________________________________________________ : In the Matter of : : VALICENTI ADVISORY SERVICES, INC. : 100 Baldwin Street : Elmira, New York 14901 : : and : : VINCENT R. VALICENTI : __________________________________________________: OPINION OF THE COMMISSION INVESTMENT ADVISER PROCEEDINGS Ground for Remedial Action Fraudulent Sales Literature Registered investment adviser and its president distributed two pieces of fraudulent sales literature to prospective clients. Held, it is in the public interest to censure and fine respondents, to issue a cease and desist order, and to require respondents to send a copy of the Commission's opinion and order to clients and, for one year, to prospective clients. APPEARANCES: Michael R. Wolford and Steven E. Cole, of Wolford & Leclair LLP, for Valicenti Advisory Services, Inc. and Vincent R. Valicenti. Carmen J. Lawrence, Henry Klehm III, Daniel J. Goldstein, Samuel C. Watkins, Brian H. Fortune, and Daniel C. Feldman, for the Division of Enforcement. Appeal filed: July 30, 1997 Briefing completed: October 22, 1997 Oral argument: July 7, 1998 I. Valicenti Advisory Services, Inc. ("VAS" or "the firm"), a registered investment adviser, and our Division of Enforcement appeal from the initial decision of an administrative law judge. The law judge found that VAS willfully violated Sections 206(2) and 206(4) of the Investment Advisers Act ("Act") and Rule 206(4)-1(a)(5) thereunder by negligently misrepresenting certain facts in two pieces of promotional literature. [1] The law judge also found that, although Vincent R. Valicenti ("Valicenti"), VAS's president and sole owner, was a "cause" of the firm's violations within the meaning of Section 203(k)(1) of the Act, he did not aid and abet the violations. The law judge concluded that VAS should be censured, and that the proceedings against Valicenti should be dismissed. VAS argues that the law judge's findings of violation are erroneous, and that the proceedings against the firm should also be dismissed. The Division contends that VAS and Valicenti ("respondents") acted with scienter in issuing four pieces of fraudulent sales literature; that respondents made material misrepresentations in addition to those found by the law judge; and that a cease and desist order as well as significant sanctions and penalties should be imposed on respondents. Our findings are based on an independent review of the record. II. In early 1992, Valicenti decided to prepare materials advertising VAS's past performance for distribution to prospective clients. Peter Marchese, VAS's marketing manager, was assigned the task of preparing the necessary materials subject to Valicenti's specifications and close supervision. The law judge's findings of violation are based on the two pieces of sales literature that resulted, both of which were distributed to VAS prospects in 1992. The literature consisted of the chart and bar graph that are described below. **FOOTNOTES** [1]: Section 206(2)(15 U.S.C. 80b-6(2)) prohibits any transaction, practice, or course of business that operates as a fraud on any client or prospective client. Section 206(4)(15 U.S.C. 80b-6(4)) prohibits engaging in any act, practice, or course of business that is fraudulent, deceptive, or manipulative. Rule 206(4)-1(a)(5)(17 C.F.R. 275.206(4)-1(a)(5)) prohibits the distribution of any advertisement that contains any untrue statement of a material fact or is otherwise false or misleading. A. The 1991 Chart The 1991 Chart ("Chart") purported to show the rates of return realized by a "composite of [VAS] discretionary accounts with a balanced objective" over the five-year period 1987 through 1991. [2] According to Valicenti, in order to be considered "balanced," and therefore included in the Chart, an account's objectives "could not be at the extremes of high income or... growth," which he defined as any account with equity or bond holdings in excess of 70% of the total portfolio.[3] Under Valicenti's definition, the assets of a balanced account had to be a mix consisting of between 30% and 70% equities and 30% and 70% bonds. In 1987, VAS had approximately 74 balanced accounts meeting Valicenti's definition, in 1988 about 112 such accounts, and in each of the years 1989 through 1991 more than 120 such accounts. However, very few of these accounts were reflected in the 1991 Chart. Indeed, the Chart's rates of return reflected only 13 accounts for 1987, 17 accounts for 1988, and 19 accounts for each of the years 1989 through 1991. These accounts were selected from an original list of 22 chosen by Valicenti (from the more than 400 under VAS management in 1991) and assigned to Marchese for the calculation of performance results. We agree with respondents that, in the present context, the term "composite" simply means "compound" [4] or "combination". However, we consider that, when, as here, an adviser's sales literature states that the rates of return it is advertising are based on the combined performance of certain specified accounts, the plain meaning of that statement is that the rates reflect the performance of all accounts falling within the stated criteria, not merely a few chosen by the adviser. Our conclusion is supported by expert testimony in the record. Dr. Robert Hagin testified that it is a clear convention in the advisory industry that, when the term "composite" is used, it means all accounts that meet the stated criteria, an established practice in the industry since at least 1973. There must be "no sampling" and "no selectivity." Dr. Scott Lummer agreed with Hagin. Lummer stated that, in 1992, the word "composite" had a specific, well understood meaning in the investment adviser community -- the average of all accounts that met the specified criteria. Lummer stated, moreover, that a large percentage of investors who focus on performance numbers understand the meaning of the term "composite." Even Dr. Jeffrey Lessard, one of respondents' experts, conceded that respondents' use of the term "composite" to describe their results "may have been technically inaccurate." [5] Respondents argue that, in any event, the Division did not show that respondents misrepresented VAS's performance; i.e., the Division did not establish that the actual performance of VAS's discretionary, balanced accounts for the years in question was materially different from that depicted in the 1991 Chart. We do not agree. In our view, the evidence is more than sufficient to justify the conclusion that the results reported in the Chart were materially misleading. Most significant is the following evidence concerning the firm's performance for 1991. In the course of the Division's investigation, respondents were asked to supply a list of all accounts for the years 1987 through 1991 that met Valicenti's criteria for inclusion in the Chart. Since pre-1991 data were not available in VAS's computer system, respondents only supplied a list of such accounts for 1991. That list totaled 122 accounts and disclosed that the accounts' combined 1991 rate of return was only 20.629%, a figure more than 7% lower than the rate of 27.89% shown on the Chart for 1991. Respondents now question the accuracy of the information they themselves submitted to our staff. They claim that Valicenti did not know how the 122 accounts were selected; that the list improperly included accounts that were opened during 1991; and that the rate of return calculated for the accounts was not "market-weighted" like the other rates on the 1991 Chart. [6] These contentions are without merit. The record contains a letter from Valicenti to our staff describing in detail the criteria used in selecting the 122 accounts. Moreover, Joseph Valicenti ("J. Valicenti"), a VAS portfolio manager (and Valicenti's son), recalculated the rate of return for the accounts on the list leaving out those that assertedly were improperly included. The result was a 21.76% rate of return, only 1.1% higher than the rate originally supplied to our staff. J. Valicenti also calculated the market-weighted rate of return for the 122 accounts and arrived at a figure of 22.70%, still more than 5% lower than the 27.89% rate shown on the 1991 Chart. A wealth of other evidence demonstrates that respondents were intent on presenting a misleading portrayal of VAS's past performance. While purporting to be a composite of all balanced accounts managed by VAS, the Chart, as noted above, was based on only 13 to 19 accounts, although the number meeting Valicenti's definition ranged from about 74 to more than 120 during the years in question. Moreover, as the law judge found, Valicenti rejected all of Marchese's suggestions that would have provided more disclosure. [7] Thus, Valicenti rejected proposed disclosure that, among other things, would have revealed that the cited rates of return only reflected "a sample of discretionary accounts". Valicenti also chose not to disclose the actual number of accounts reflected in the Chart for each of the years in question. Although the percentage of VAS balanced accounts with less than $100,000 in assets ranged from about 28% to 45% of all such accounts during the years 1987 through 1991, Valicenti determined that the Chart should only include accounts with more than $100,000 in assets. He stated that accounts with less than that figure were very difficult to manage on a performance basis because of their very high transaction costs. No disclosure of the $100,000 requirement was made in the Chart. In fact, Valicenti rejected proposed disclosure that would have revealed the size of included accounts. The record does not show, and respondents do not claim, that the Chart was shown only to prospective clients with more than $100,000 to invest. We agree with Dr. Lummer that the Chart was materially misleading to VAS prospects who wanted to invest less than $100,000. The record further reveals that Valicenti tinkered with the results calculated by Marchese in order to show higher rates of return. At Valicenti's direction, Marchese prepared, and showed to Valicenti, a number of interim spreadsheets showing five-year performance figures for various combinations of the 22 accounts initially selected by Valicenti. One of the spreadsheets calculated the combined performance of 17 of those accounts for the year 1987. The calculation showed that the combined accounts had suffered a loss for the year, resulting in a -0.84% negative rate of return. Valicenti didn't like what he saw, and indicated to Marchese that the spreadsheet "didn't look like a good representation." Thereafter, Valicenti directed Marchese to make changes with respect to six of the 17 accounts in his computation, all six of which had had a negative 1987 performance. Valicenti ordered that three of the accounts be dropped completely from the Chart, and that the other three be omitted for the year 1987. At the same time, he directed Marchese to add two other accounts to the Chart, both of which had had a positive 1987 performance. By these expedients, Valicenti transformed a negative rate of return for 1987 (-0.84%) into a positive 2.60% rate for the year, the rate that appeared in the 1991 Chart. As noted above, the 2.60% rate that Valicenti achieved was based on only 13 of 74 accounts that met Valicenti's criteria. Valicenti claimed that the three accounts that were totally dropped were eliminated because they did not meet those criteria. However, he did not explain why the other three accounts apparently met his criteria for 1988 through 1991, but not for 1987. The 2.60% rate of return engineered by Valicenti not only improved the picture presented for 1987, but also boosted the cumulative rates of return shown in the 1991 Chart for the subsequent two to five- year periods. [8] Other aspects of the Chart were also misleading. Although the Chart purported to report the performance of the same group of accounts over a five-year period, that was not the case. Instead, as Valicenti was aware (and as noted above), differing numbers of accounts were reflected for different years. Moreover, despite the fact that the Chart was purportedly limited to balanced accounts, not all of the included accounts fit that description. Indeed, as Dr. Hagin pointed out, 6 of the 13 accounts reflected in the Chart for 1987 did not meet Valicenti's definition. Valicenti conceded that individual accounts in the Chart did not "necessarily" fall within his definition of "balanced". He stated, however, that, regardless of whether each individual account met his definition, his intent was to lump the assets of all the accounts in the Chart together and have the total reflect the appropriate mix of equities and bonds. This was clearly contrary to the Chart's representation that it reflected a composite of balanced accounts. **FOOTNOTES** [2]: Rates of return were shown separately for the accounts' total portfolio, the bond component of that portfolio, and the equity component of the portfolio. The Chart also showed cumulative rates of return for two, three, four, and five-year periods. [3]:All of VAS's accounts were "discretionary." [4]:The American Heritage Dictionary, Second College Edition (1985). [5]:We find contrary testimony by respondents' other experts unconvincing. One of them, John Piccione, went so far as to claim that the actual performance of a single account could be a composite. [6]:Market-weighted rates of return take into account the size of an individual portfolio in relation to the total of all portfolios. [7]:As noted above, Peter Marchese was VAS's marketing manager. [8]:See n.2, supra. B. The 1991 Bar Graph The 1991 Bar Graph ("Bar Graph") was also prepared by Marchese at Valicenti's direction. It purported to compare the five-year cumulative rates of return appearing in the Chart with the five-year performance of a sample of money managers. Valicenti instructed Marchese to order data from CDA Investment Technologies, Inc. that showed the performance results achieved by about 1135 money managers for accounts with a ratio of 50% equities to 50% bonds. The rates of return achieved by the money managers were shown in three columns; one showing the rates earned on a total portfolio equally divided between equities and bonds, the second showing the rates achieved for the portfolio's equity component, and the third showing the rates earned on the bond component. An asterisk was placed in each column indicating where VAS stood vis-a-vis the money managers. The assets reflected in the Chart were composed of about 54% equities. Since equities outperformed bonds during the relevant period, comparing the rates of return appearing in the Chart with the rates achieved for accounts with only 50% equities resulted in a somewhat more favorable portrayal of VAS's performance than was warranted. However, the record does not show that this circumstance improved the depiction of that performance in any material amount. Nevertheless, the Bar Graph was materially misleading since it compared the rates of return achieved by other money managers with the materially distorted VAS rates appearing in the Chart. The Chart and the Bar Graph presented a false portrayal of VAS's past performance and a misleading comparison of that performance with the performance of other money managers. Both of these items were materially misleading to prospective clients of the firm. We cannot agree with the law judge that, in creating these documents, Valicenti acted in good faith. On the contrary, the record shows that, in an effort to win new clients, he deliberately distorted the truth. [9] Valicenti rejected all disclosure that would have revealed that, contrary to the Chart's stated coverage, it reflected only a small sampling of accounts that differed in number in different years. He excluded accounts under $100,000 because of their higher costs but refused to disclose that fact. He manipulated the narrow range of accounts included in the Chart in order to achieve better results. He improperly included non-balanced accounts in the Chart. And, finally, he created a misleading comparison of the Chart's distorted rates of return with the rates of other money managers. We accordingly conclude that VAS, willfully aided and abetted by Valicenti, willfully violated Sections 206(1), [10] 206(2), and 206(4) of the Act and Rule 206(4)-1(a)(5) thereunder. We further conclude, pursuant to Section 203(k)(1) of the Act, that Valicenti was a cause of his firm's violations. [11] As indicated above, the Division argues that respondents issued two additional pieces of fraudulent sales literature: 1992 updates of the Chart and the Bar Graph. The law judge concluded that the record did not establish that the updates had ever been distributed to clients or prospective clients. On the basis of our review of the record, we are unable to conclude that the law judge erred in this regard. Accordingly, we make no findings with respect to these two items. III. Respondents argue that no sanctions are warranted. They assert, among other things, that their record in the advisory business is otherwise unblemished, that the advertisements at issue were an isolated occurrence, that no one was harmed by their actions, and that there is no basis for a cease and desist order since there is no reasonable likelihood of further violations on their part. We take a less sanguine view of respondents' violations. Investment advisers are fiduciaries whose actions must be governed by the highest standards of conduct. [12] However, respondents chose to ignore those standards, and perpetrated a serious fraud on prospective clients of the firm. Contrary to the claim made by respondents, their actions demonstrate a substantial likelihood of further misconduct on their part. Under all the circumstances, we have determined that it is appropriate in the public interest to censure respondents, to issue a cease and desist order, and to fine VAS $50,000 and Valicenti $25,000. We shall also require that respondents send a copy of our opinion and order to all of their existing clients and, for one year, to all prospective clients. An appropriate order will issue. [13] By the Commission (Chairman LEVITT and Commissioners JOHNSON and HUNT); Commissioners CAREY and UNGER not participating. Jonathan G. Katz Secretary **FOOTNOTES** [9]: As we have previously stated, credibility determinations can be overcome "only where the record contains `substantial evidence' for doing so." See Anthony Tricarico, 51 S.E.C. 457, 460 (1993), and the authorities there cited. We find such evidence here. [10]:Section 206(1)(15 U.S.C. 80b-6(1)) prohibits the employment of any device, scheme, or artifice to defraud any client or prospective client. [11]: We have found that Valicenti acted with scienter. A respondent is a "cause" of another's violation if the respondent "knew or should have known" that his act or omission would contribute to such violation. Section 203(k)(1). [12]:See, e.g., SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-192 (1963); Rosenfeld v. Black, 445 F.2d 1337, 1342-1344 (2d Cir. 1971). [13]: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. UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION INVESTMENT ADVISERS ACT OF 1940 Rel. No. 1774 / November 18, 1998 Admin. Proc. File No. 3-8854 __________________________________________________ : In the Matter of : : VALICENTI ADVISORY SERVICES, INC. : 100 Baldwin Street : Elmira, New York 14901 : : and : : VINCENT R. VALICENTI : __________________________________________________: ORDER IMPOSING REMEDIAL SANCTIONS On the basis of the Commission's opinion issued this day, it is ORDERED that Valicenti Advisory Services, Inc. (VAS) and Vincent R. Valicenti (Valicenti) be, and they hereby are, censured; and it is further ORDERED that VAS and Valicenti cease and desist from committing or causing any violation and committing or causing any future violation of Sections 206(1), 206(2), and 206(4) of the Investment Advisers Act and Rule 206(4)-1(a)(5) thereunder; and it is further ORDERED that, within 30 days of the entry of this order, VAS shall pay a civil money penalty in the amount of $50,000, and Valicenti shall pay a civil money penalty in the amount of $25,000, to the United States Treasury. Such payment shall be: (i) made by United States postal money order, certified check, bank cashier's check, or bank money order; (ii) made payable to the Securities and Exchange Commission; (iii) hand-delivered or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312; and (iv) submitted under cover letter which identifies VAS and Valicenti as respondents in this proceeding, and the file number of this proceeding. A copy of the cover letter and check shall be sent to Daniel J. Goldstein, counsel for the Division of Enforcement, Securities and Exchange Commission, Northeast Regional Office, 7 World Trade Center - 13th floor, New York, N.Y. 10048; and it is further ORDERED that VAS and Valicenti (respondents) shall mail a copy of this opinion and order, together with a cover letter in a form acceptable to the staff of the Commission, to each of their existing clients by certified mail, return receipt requested, within thirty (30) days from the date of this order. From the effective date of this order until the expiration of twelve (12) months, respondents shall provide a copy of this opinion and order to all prospective investment advisory clients not less than forty-eight (48) hours prior to entering into any written or oral investment advisory contract (or no later than the time of entering into such contract if the client has the right to terminate the contract without penalty within five (5) business days after entering into the contract). Also, within thirty (30) days from the date of this order, respondents shall execute and deliver to Daniel J. Goldstein at the Commission's Northeast Regional Office an affidavit that they have provided this opinion and order to their existing clients in accordance with the terms of this order. Finally, within thirteen (13) months from the date of this order, respondents shall execute and deliver to Daniel J. Goldstein at the Commission's Northeast Regional Office an affidavit that they have provided this opinion and order to their prospective clients in accordance with the terms of this order. By the Commission. Jonathan G. Katz Secretary