==========================================START OF PAGE 1====== SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 38423 / March 20, 1997 Admin. Proc. File No. 3-7164 _________________________________________ : In the Matter of : : C. JAMES PADGETT : STUART GRAFF : ROBERT E. GIBBS : SHAW SULLIVAN : JOHN W. SUTTON : JOHN BEAIRD : DIRK NYE : _________________________________________: OPINION OF THE COMMISSION BROKER-DEALER PROCEEDINGS Grounds for Remedial Action Fraud Failure to Supervise Where former principals of former registered broker-dealer were responsible for fraudulent markups in the sale of securities, distributed fraudulent sales scripts used by the firm's sales agents, and failed to supervise in connection with violations by former branch managers, held, it is in the public interest to bar former principals from association with any broker or dealer. Where former branch managers of former registered broker- dealer instituted fraudulent policies and practices of "no net selling" and "tie-ins," held, it is in the public interest to bar former branch managers, provided that, after a period of two years, they may apply to become associated in a non-supervisory, non-proprietary capacity. Where former regional vice president failed to supervise in connection with violations by former branch managers, held, it is in the public interest to bar former regional vice president, provided that, after a period of four years, he may apply to become associated in a non-supervisory, non- proprietary capacity. ==========================================START OF PAGE 2====== APPEARANCES: Michael E. Schoeman and James McSpiritt, of Schoeman, Marsh & Updike, and Donald T. Trinen of Hart & Trinen, for C. James Padgett and Stuart Graff. David A. Zisser, of Berliner Kaplan Zisser & Walter, P.C., for Robert E. Gibbs, Shaw Sullivan, John W. Sutton, and John Beaird. Brian Cook for Dirk Nye. Robert M. Fusfeld for the Commission's Division of Enforcement. Appeal filed: April 8, 1993 Last brief received: September 2, 1993 Oral argument held: October 9, 1996 I. C. James Padgett, Stuart Graff, Dirk Nye, Robert E. Gibbs, John W. Sutton, Shaw Sullivan, and John Beaird appeal from the findings of an administrative law judge. Stuart Graff was chairman of The Stuart-James Co., Inc. ("Stuart-James"), a former broker-dealer registered with the Commission. James Padgett was the firm's president, and became chairman upon Graff's departure. Dirk Nye was a regional vice-president of Stuart-James. Robert Gibbs, Shaw Sullivan, John Sutton, and John Beaird were branch managers. The Division of Enforcement appeals in those instances where the law judge found that no violation had occurred and with respect to the sanctions entered against Nye, Gibbs, Sullivan, Sutton, and Beaird. The law judge found that Padgett and Graff were responsible for markup violations and negligently distributed and encouraged the use of fraudulent telephone solicitation scripts by Stuart- James' sales agents. The law judge found that Gibbs, Sutton, Sullivan, and Beaird violated antifraud provisions of the securities laws because of their policies or practices of encouraging or requiring sales agents to exact "tie-in" arrangements from customers, and that Padgett, Graff, and Nye failed to supervise with a view toward preventing the tie-in violations. The Division of Enforcement has appealed the law judge's findings that Gibbs, Sutton, Sullivan, and Beaird did not violate antifraud provisions of the securities laws because of their policies or practices of "no net selling," and that Padgett, Graff, and Nye did not fail to supervise with regard to the no net selling allegations. The Division of Enforcement also has appealed the law judge's finding that Padgett and Graff did not ==========================================START OF PAGE 3====== act with scienter with respect to distribution of the sales scripts. -[1]- The law judge barred Padgett and Graff from association with any broker or dealer. He suspended Nye from association with any broker or dealer for six months and barred him from association in a supervisory or proprietary capacity with a right to reapply in eighteen months. The law judge suspended Beaird and Gibbs from association with any broker or dealer for four months and suspended them from association in a supervisory or proprietary capacity for an additional eight months. Sutton was suspended from association with any broker or dealer for six months and suspended from association in a supervisory or proprietary capacity for an additional six months. Sullivan was suspended from association with any broker or dealer for six months and barred from association in a supervisory or proprietary capacity. II. Padgett and Graff appeal from the law judge's finding that they and Stuart-James violated the antifraud provisions of the securities laws by charging undisclosed excessive markups in the sale of securities. A. The primary issue with respect to this charge is the price to be used as the basis for calculating the markups. The parties do not dispute that calculations using interdealer trades on the first day of aftermarket trading yield markups that are not excessive. Calculations using the firm's contemporaneous ---------FOOTNOTES---------- -[1]- The law judge also made findings against the firm and three other respondents, Douglas Ward, a regional vice-president and branch manager, and branch managers Ronald Lasek and Michael Czaja. Ward, Lasek, and Czaja have not appealed and, because the Division has not appealed any findings with regard to them, the law judge's decision has become the final opinion of the Commission. Notice that Initial Decision has Become Final, Admin. Proc. Rel. No. 32297 (May 12, 1993) 54 SEC Docket 154. Thomas Meinders, another branch manager who was originally named as a respondent, agreed to a settlement and was dismissed from the proceeding. Thomas R. Meinders, Securities Exchange Act Release No. 27927 (April 20, 1990), 46 SEC Docket 74. The law judge also made findings with respect to Meinders based on his testimony at the hearing. The law judge's findings against Ward, Lasek, Czaja, and Meinders remain relevant to the failure to supervise charges against Padgett, Graff, and Nye. ==========================================START OF PAGE 4====== cost for the securities, however, produce markups ranging from 38% to 200%. In 1986, Stuart-James underwrote the initial public offerings ("IPOs") of UMB Equities, Inc. ("UMBE") and Find SVP, Inc. ("Find"). 2/ The firm sold 100% of each IPO to its own customers. Prior to each IPO, the firm contacted its customers and arranged for them to sell shares purchased in the IPO back to the firm on the first day of aftermarket trading. While there is considerable dispute over the degree to which Stuart-James actually prearranged particular trades, there is no dispute that the firm's customers generally sold their IPO shares back to Stuart-James. These repurchases resulted in the firm having almost exclusive access to the supply of securities in the initial aftermarket. Stuart-James then resold the securities primarily to its retail customers. Consequently, the early market between dealers, the interdealer market, was an insignificant portion of the overall market. 3/ On the first day of aftermarket trading, the firm was responsible for almost all trades -- both sales and purchases -- in the retail market, and for well over 90% of the combined retail and wholesale trades for each security. Stuart-James was responsible for 92.5% of the total purchase volume in UMBE common stock and 92.1% of the total sell volume. For the UMBE warrants, the firm's purchases were 93.1% of total purchase volume and its sales were 92.9% of total sell volume. In the Find common stock, Stuart-James effected 98.9% of total market buy transactions, and 97.3% of total sales. The vast majority of these transactions occurred with the firm's retail customers. Moreover, even though the actual number of its wholesale transactions was small, Stuart-James was the selling party in a substantial percentage of transactions in the wholesale market for securities of UMBE and Find. 4/ 2/ The law judge's findings that are the subject of the appeal relate to the UMBE securities (both the stock and warrants sold in the IPO) and to the Find stock. The law judge's findings did not pertain to Find warrants because he found that there was insufficient evidence of the prices used by Stuart-James with regard to the Find warrants transactions. 3/ For each of the securities at issue here, the retail market ranged from about 11 to 35 times larger than the wholesale market for the same security. 4/ Stuart-James accounted for over 40% of the wholesale sales of the UMBE stock and warrants and for about 55% of Find stock. The firm was responsible for under 1.5% of the wholesale purchases of UMBE securities and for none of the wholesale purchases of Find securities. ==========================================START OF PAGE 5====== B. The prices a broker-dealer charges retail customers for securities must be reasonably related to the prevailing market price of the security. 5/ The prevailing market price is the current interdealer price, that is, the price at which dealers trade with one another. 6/ However, where an integrated dealer so dominates and controls the market for a security that it can effectively set the wholesale prices, the best evidence of the security's market price is the firm's contemporaneous cost in acquiring the security, rather than the interdealer price. 7/ In a long line of cases stemming from the 1984 and 1985 decisions, Alstead, Dempsey & Co, Inc. and Pagel, Inc., we repeatedly and consistently have found domination on facts analogous to those here: A firm sells all or a substantial percentage of an IPO to retail customers and then as a market maker in the secondary market, trades a significant amount of the total aftermarket volume. 8/ In such a case, the firm has "unique access to its customers to obtain its supply of [securities] for secondary market activities." 9/ We have found that a firm's domination may be such that it "exercises a substantial influence over the price of the stock such that, as a practical matter, the firm, and not competitive market factors, determines the price of the stock." 10/ Such control of the supply of stock "enable[s] the underwriter to control wholesale pricing to such an extent as to preclude an independent, competitive market from arising, notwithstanding the presence of 5/ See, e.g., Alstead, Dempsey & Co., Inc., 47 S.E.C. 1034, 1035-36 (1984). 6/ Id. 7/ See, e.g., Id. at 1035-36; Pagel, Inc., 48 S.E.C. 223, 226 (1985), aff'd, 803 F.2d 942 (8th Cir. 1986). 8/ Meyer Blinder, 50 S.E.C. 1215, 1218 n.14 (1992). 9/ Alstead, 47 S.E.C. at 1035-36 (94% of the IPO placed with firm's own customers). See also Pagel, 48 S.E.C. at 226 ("Because the identity of those customers is known only to the underwriter, tapping that supply for resale lies uniquely within the underwriter's control."). 10/ Meyer Blinder, 50 S.E.C. at 1218, n.15. (pointing out that in Alstead, although the firm dominated the market for two securities, it controlled the market for only one, and we therefore used interdealer prices charged by the firm where the firm did not control the market). See also G.K. Scott & Co., Inc., 51 S.E.C. 961 (1994), aff d, 56 F.3d 1531 (D.C. Cir. 1995)(table); Michael A. Leeds, 51 S.E.C. 500 (1993); Steven B. Theys, 51 S.E.C. 473 (1993). ==========================================START OF PAGE 6====== other dealers who may be entering quotations." 11/ The underwriter is, as a result, "empowered `to set prices arbitrarily.'" 12/ This is so notwithstanding that a market maker may have only a small share of the interdealer market. 13/ The undisputed trading data for the first day of aftermarket trading in the instant case shows that Stuart-James both dominated and controlled the market for the securities at issue. Stuart-James, having sold all but a small portion of the IPOs to its retail customers, had "unique access to its customers to obtain its supply of [securities] for secondary market activities." 14/ With the remainder of the supply of the securities fragmented among several other dealers, "`trading in the aftermarket [was] necessarily contingent on [Stuart-James's] customers furnishing the supply.'" 15/ Such control of the supply of the securities enabled the firm to control wholesale pricing to such an extent as to preclude an independent, competitive market from arising, notwithstanding the presence of other dealers in the market. The wholesale market accounted for only a small amount of the total trading volume. We find that Stuart-James both dominated and controlled the first day of aftermarket trading for the relevant securities. As Alstead, Pagel, and their progeny make clear, where domination and control by a market maker are present, we will look to that dealer's contemporaneous cost as the most reliable indicator of the prevailing market price, absent countervailing 11/ Pagel, 48 S.E.C. at 225-26. See also Leeds, 51 S.E.C. at 503-04 (citing Pagel). 12/ George Salloum, Securities Exchange Act Release No. 35563 (April 5, 1995), 59 SEC Docket 43, 47 (quoting Pagel, 48 S.E.C. at 256). 13/ We look to "whether . . . a market maker in the security . . . engaged in a significant amount of the total after- market volume" and "whether there are a limited number of other market makers for the security that account for only a small percentage of the total trading volume." Theys, 51 S.E.C. at 477 (emphasis added). 14/ Alstead, 47 S.E.C. at 1035-36. 15/ Salloum, 59 SEC Docket at 46-47. ==========================================START OF PAGE 7====== evidence. 16/ Use of Stuart-James' contemporaneous cost for the UMBE securities and the Find stock produces markups ranging from 38% to 200%. We find these markups to be grossly excessive. Padgett and Graff argue, citing Peter J. Kisch, that the market to which we should look to determine domination and control is the wholesale market only. 17/ In Kisch, we concluded that a market maker was a dominant force in the market, but that it did not have sufficient presence to control market prices. Due to the firm's market dominance we concluded that the firm's "unrestricted latitude" in setting its quotes rendered the firm's quotes an unreliable source of the prevailing market price. 18/ However, because the firm did not control market prices, actual interdealer transactions were occurring in a competitive environment. Thus, the transaction prices and quotations of market makers other than Kisch were reliable indicators of the prevailing market price. Padgett and Graff assert that the market Kisch dominated was "presumably retail." From this presumption, they argue that our holding in Kisch "appears" to be that, "although a firm may `dominate' a retail market, if it is only 1 [sic] of many market- makers and it does less than half of the wholesale trading volume, retail prices may be set with reference to the wholesale market `away'" (emphasis in original). Their presumption, however, is incorrect. Our discussion in Alstead elaborates on the Kisch decision, and makes clear that the market Kisch dominated was the interdealer market. 19/ We used interdealer prices in Kisch because, notwithstanding the firm's dominance in the market, its influence over prices was insufficient for us to find that the firm controlled the market. As noted above, our cases consistently reject the relevance of interdealer activity where the firm so dominates and controls the market for a 16/ Respondents contend that the only two cases available to give guidance in 1986 were Alstead and Peter J. Kisch, 47 S.E.C. 802 (1982). They overlook Pagel, decided in 1985, which amplifies the principles of domination and control articulated in Alstead and Kisch. 17/ 47 S.E.C. 802 (1982). The wholesale market for the UMBE securities consisted of approximately 724,000 shares of stock and 209,000 warrants; the wholesale market for the Find securities comprised about 2,400,000 shares of stock and 1,700,000 warrants. As noted above, the retail market for these securities far outstripped the wholesale market, ranging from over 11 to over 35 times larger. 18/ Id. at 808-809. 19/ Alstead, 47 S.E.C. at 1036. ==========================================START OF PAGE 8====== security that the interdealer prices are not set in an independent, competitive market and do not, therefore, represent the prevailing market price for the security. Our analysis here is consistent with that pleaded by the Division in the Order Instituting Proceedings in this case. The law judge, while reaching the same result we do, applied an alternative theory in finding the violation. In litigating the case, and in its initial brief to the law judge, the Division emphasized the firm's activity before the aftermarket began to show the method by which Stuart-James dominated and controlled the aftermarket trading in the securities. Padgett and Graff disputed the Division's contention that Stuart-James dominated and controlled the aftermarket, citing the extent of the away interdealer market for the securities and arguing that Stuart- James' participation in the interdealer market was insufficient to enable it to control prices. In response, the Division's Reply Brief before the law judge changed course and argued that Stuart-James dominated and controlled an internalized market, consisting of a large number of prearranged, crossed trades in which the IPO customers sold their shares to other Stuart-James customers at prearranged prices. The Division argued that this internal market largely took place between the IPO closing and the opening of aftermarket trading. The law judge adopted the Division's internal market theory, finding that Stuart-James created an internal market for UMBE securities and the Find stock that was insulated from normal market forces and that was dominated and controlled by Stuart- James. 20/ Because of our findings discussed above, we do not reach the issue of the internal market. 20/ On appeal, Padgett and Graff reargued their position, taken before the law judge, concerning the first day of aftermarket trading, but focussed their arguments on challenging the law judge's use of the Division's internal market theory. They argued that the theory was incorrect as a matter of law, not supported by the facts, and, in any event, improperly applied against them without adequate notice. To ensure fairness to Padgett and Graff, after oral argument in this matter, on October 10, 1996, we ordered additional briefing solely on the issue of domination and control of the first day of aftermarket trading. Padgett and Graff have requested additional oral argument; we do not find that the briefs warrant additional argument and their motion is hereby denied. Our decision in this matter should not be construed as expressing any opinion on the validity of the internalized market theory. ==========================================START OF PAGE 9====== Padgett and Graff were responsible for setting the firm's pricing policies 21/ and were deeply involved in the day-to- day operations of the firm. In addition, Padgett and Graff knew that the firm sold 100% of the offerings to its own customers. 22/ We find that Padgett and Graff knew or were reckless in not knowing that the firm dominated and controlled the first day of aftermarket trading in the securities and that customers therefore would be charged excessive markups if the markups were not based on contemporaneous cost. Accordingly, they have the necessary scienter for violation of the antifraud provisions. Padgett and Graff argue that they relied upon Marc Geman, counsel for Stuart-James, to inform them if the firm's pricing policies did not comply with applicable law and that, having not been so advised, they reasonably relied upon Geman's "advice." Padgett and Graff have not satisfied the elements of their claim of reliance on advice of counsel. In order to establish reliance on counsel, they must show that they: made complete disclosure to counsel; sought advice regarding the legality of the conduct; received advice that the conduct was legal; and relied, in good faith, on that advice. 23/ Counsel also must be independent. 24/ We question Geman's ability to provide independent advice in his capacity as counsel for Stuart-James, given his role as co-founder, part-owner, and director of the firm. 25/ In any event, Padgett and Graff have not demonstrated that they made complete disclosure to Geman of the factual circumstances with respect to the UMBE and Find offerings and that they sought advice about those offerings. While Padgett and Graff argue that Geman had advised them that, as a general 21/ This responsibility is evidenced by their activities in meetings that they held prior to the opening of aftermarket trading for the securities, in which they discussed the prices at which the securities would trade. 22/ See Leeds, 51 S.E.C. at 505. 23/ See Markowski v. SEC, 34 F.3d 99, 105 (2d Cir. 1994). See also Harold B. Hayes, 51 S.E.C. 1294, 1299 (1994). 24/ Carlson, Inc. v. SEC, 859 F.2d 1429, 1436 (10th Cir. 1988). See also Draney v. Wilson, 592 F. Supp. 9 (D.C. Ariz. 1984). 25/ See Arthur Lipper Corp. v. SEC, 547 F.2d 171, 181-82 (2d Cir. 1976), reh'g denied, 551 F.2d 915 (2d. Cir. 1977) (where primary interest of counsel to broker-dealer lay in "promoting [firm's] interests," counsel "was not in a position to give petitioners [firm and principal owner] wholly disinterested advice and petitioners could not have reasonably have [sic] thought he was."). ==========================================START OF PAGE 10====== matter, the firm's markup policy comported with existing legal standards, they received no such advice pertaining to the two offerings at issue here and consequently could not have relied upon any such advice. We therefore find that Padgett and Graff willfully violated Section 17(a) of the Securities Act of 1933 ("Securities Act") and Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5 thereunder by charging undisclosed excessive markups in the sale of securities. III. Padgett and Graff appeal from the law judge's finding that they acted negligently in the distribution and use of fraudulent sales scripts. The Division has appealed the law judge's finding that Padgett and Graff did not act with scienter in regard to distribution of the sales scripts. A. The charges involve Stuart-James' manual entitled "Training Program for New Brokers" (the "Manual"), as used during the period from approximately August 1986 until October 1987. The Manual set forth a three-call sales method and included example scripts for each call. The initial call was a "cold call," designed to make the acquaintance of prospective customers and to pique their interest. The second call was to build a rapport with the prospect. Agents were instructed to note that they were following several stocks closely and were waiting for the right price. The third call served to "close the deal" on one of the stocks referred to in a previous call. The sample script for the closing call suggested a method, referred to as the "A.B.C. Close," in which, among other things, the agent would have a customer purchase a large block of stock and claim that buying the block would give the customer "the opportunity to take a 50% short-term gain on 1/2 of [his] holdings and keep the rest of the stock for long-term performance." The closing script also contained "power phrases," one of which encouraged an agent to tell the prospect "you have the potential of seeing a return of 25-100% within 6 to 12 months. This is the kind of return you want to see and that you deserve, isn't it?" A later portion provided scripted answers to frequently encountered customer objections and contained similar claims regarding the likelihood of large returns. For example, part of the suggested response to "I'm not interested" was "[w]ould the possibility of getting a 30% return on your money be of interest to you?" A suggested response to "I don't have the money" was "well, if an opportunity came along that I felt would give you a return of 30%, 40%, even 50% on your investment, would you be ==========================================START OF PAGE 11====== interested?" Another suggested answer to an objection regarding risk stated "[t]hat's what penny stocks are all about. That's why you can make 50, 100, 500, even 1000% on your money." 26/ Distribution of the Manual began in May 1986, and it was in use by mid-year. The Manual remained in use, with some modifications, beyond October 1987. Evidence shows that agents used the scripts in the Manual both verbatim and to create their own scripts, which they then used to solicit customers. Both Padgett and Graff oversaw the Manual's creation and also encouraged its use in the firm. During a regional vice- presidents' meeting prior to the Manual's distribution, Padgett and Graff reviewed the body of the Manual and noted suggestions and changes. The Manual they reviewed did not contain the scripts. During the meeting, Padgett or Graff requested Paul Guglielmino, a consultant, to contact the regional vice- presidents and compile for the Manual samples of the scripts that were already in use at the firm. 27/ The scripts were then added to the Manual. Neither Padgett nor Graff actually saw or reviewed the scripts prior to the Manual's distribution. Padgett told Guglielmino that the manual should go to the branches as quickly as possible after the scripts were added. Geman, the firm's head of compliance, never reviewed the scripts. He attributed this to Guglielmino being an "outside source" and to the fact that the Manual was "assembled and distributed away from the administration of the firm." Padgett and Graff saw the scripts for the first time at a meeting more than a year later, in 1987. At that meeting, one or two managers asked specific questions regarding the scripts' propriety. After reading the scripts, Padgett and Graff ordered a firm compliance official to have certain scripts removed from the Manual. The above-cited scripts, with the exception of the 26/ In contrast to these scripts, an earlier chapter of the Manual discussing compliance issues stated "indications of where a stock may open, prices it may reach from time to time, either short or long term specific price projections, etc. are the hallmark of fraud in our industry. Any salesman heard making specific price projections or unwarranted statements regarding a stock's performance will be terminated." Later in the manual, an article on cold calling reproduced from a trade magazine also stated "[p]romising certain gain, for instance, is a boiler-room tactic. The fact that such promises are often read verbatim off scripts doesn't do much for the reputation of scripts." 27/ Guglielmino was a business professor at Florida Atlantic University. Guglielmino was not a lawyer, nor to Padgett's knowledge was he an expert in the securities field. ==========================================START OF PAGE 12====== "A.B.C. Close" script (with its prediction of a 50% price increase), were deleted. B. We have long held that predictions of specific and substantial increases in the price of a speculative security within a relatively short time are fraudulent. 28/ 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. 29/ Applying these principles, we find that use of the scripts was fraudulent. The securities offered and sold by the firm were highly speculative, and the scripts in the Manual were misleading. The scripts either made blatant predictions of substantial, rapid gains, or were designed to lead potential investors to believe such gains were probable. 30/ Because the predictions in the scripts were generic, they could not be supported by any reasonable basis when used verbatim in connection with the sale of a specific security. In addition, the scripts contained predictions that were directly contrary to discussions on proper sales practices contained elsewhere in the Manual. 31/ 28/ See, e.g., 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"). Padgett and Graff argue that the law judge's use of these cases, and their progeny, for the proposition that such predictions are "inherently fraudulent" violates First Amendment protections on speech. We disagree. The First Amendment does not protect false, misleading, or fraudulent speech. Virginia Pharmacy Board v. Virginia Citizens Consumer Council, 425 U.S. 748, 777 (1976). 29/ See, e.g., Lester Kuznetz, 48 S.E.C. 551, 553 (1986). 30/ Contrary to Padgett and Graff's arguments, predictions of price ranges as well as specific prices can constitute fraud. See, e.g., Miller, 43 S.E.C. at 235. 31/ Padgett and Graff argue that only three sales agents testified that they used the scripts and that there is insufficient evidence to prove that agents made misleading predictions. The three agents, however, clearly testified that they used the scripts, and language closely derived from the scripts, to recommend securities. The Manual was widely disseminated among all branch offices of the firm. We do not find it surprising that only a few agents would be willing to admit to misconduct. ==========================================START OF PAGE 13====== Padgett and Graff, after reviewing the Manual and directing the addition of the scripts, had a duty to determine the contents of the Manual or reasonably to delegate that function. 32/ Padgett and Graff's actions were at least unreasonable, if not reckless. Guglielmino, who was a non-attorney business professor, did not have securities compliance experience. Despite knowing that Guglielmino lacked compliance experience, Padgett and Graff did not review the Manual after directing Guglielmino to add the scripts. Nor did Padgett and Graff take any action to see that a firm compliance official reviewed the scripts to ensure that the language was acceptable. In addition, Padgett told Guglielmino that the Manual should be distributed as soon as possible, making it unlikely that there would be adequate time for proper review of this important addition to the Manual. 33/ Under the circumstances, we find Padgett and Graff willfully violated Sections 17(a)(2) and (3) of the Securities Act. 34/ 32/ See, e.g., Collins Securities Corp., 46 S.E.C. 20, 36 (1975) (broker-dealer officials, such as a firm's president, are responsible for compliance and must act reasonably). Cf. John H. Gutfreund, 51 S.E.C. 93, 111 (1992)(a firm official, such as the president, retains responsibility for compliance unless and until a particular function is reasonably delegated to another person, and the official neither knows, nor has reason to know that the person in question is not properly performing his duties); Kirk Knapp, 50 S.E.C. 858, 862 (1992)(discussion of same duties in review of NASD proceedings based on failure reasonably to supervise); Universal Heritage Investments Corp., 47 S.E.C. 839, 845 (1982)(same). 33/ Padgett and Graff argue that they did not themselves distribute and encourage use of the scripts. We fail to see Padgett and Graff's distinction between ordering the distribution of the Manual (and the addition of the scripts to the Manual) and distributing and encouraging the use of the scripts section itself. 34/ Aaron v. SEC, 446 U.S. 680, 695-96 (1980)(Sections 17(a)(2) and (3) of the Securities Act do not require a finding of scienter). Padgett and Graff argue that negligent conduct cannot support a finding of "willful" conduct. Section 15(b) of the Exchange Act, under which this proceeding was brought, requires a finding of a violation of the securities laws to be "willful." The courts have long held that willfulness here means no more than intentionally committing the act that constitutes the violation. Tager v, SEC, 344 F.2d 5, 8 (2d Cir. 1965); Arthur Lipper Corp. v. SEC, 547 F.2d at 180. ==========================================START OF PAGE 14====== IV. The Division of Enforcement has appealed the law judge's failure to find that Gibbs, Sutton, Sullivan, and Beaird (the "branch office managers") committed antifraud violations by establishing policies or practices of "no net selling" of securities in which the firm made a market. A. Stuart-James was an integrated market maker in securities the firm had underwritten. The firm's sales compensation policies made crossing, or matching transactions between selling and buying customers within the firm, advantageous for sales agents and branch managers. For principal transactions, the firm's trading department established "strike," or "inside," prices which were posted within the firm. A strike price was a price greater than the Nasdaq bid and less than the Nasdaq ask quotation. 35/ The gross compensation on a principal transaction represented the difference between the firm's strike price and the execution price (approximately the Nasdaq quote). 36/ The sales agent received between 45% and 55% of the gross compensation, depending on the agent's monthly production. The firm's trading department established strike prices for "net" sales (a sale to the firm's trading department) differently from "cross" trades (where a selling customer and a buying customer were matched within the firm). A sales agent received greater compensation from the crossed trades, encouraging this practice. 37/ There was even more incentive for an agent to 35/ Hence the strike prices were "inside" the quotes. The strike price appears to have been used solely for internal compensation calculations and was arbitrary in the sense that it did not reflect the lowest ask or highest bid quotation. Although referred to as an "inside" price, the strike price is not to be confused with the best quotation (lowest ask and highest bid price) as listed on Nasdaq. 36/ The firm and the parties referred to this compensation as a "commission." We use the term "compensation" to avoid confusing the remuneration received from principal transactions with traditional commissions charged on agency transactions. 37/ For example, if the Nasdaq quotes were $.10 bid and $.20 ask, and the firm's net "strike" prices were $.12 and $.16, a customer net sale would occur at $.10, producing a gross commission of $.02 per share. A customer purchase would produce a $.04 per share gross commission. The total gross commission for the two trades, split between the sales agent (continued...) ==========================================START OF PAGE 15====== cross trades among customers in his own "book" of customers. If a cross was arranged between customers of different agents in the same office, the firm's trading department took a small amount of the spread, decreasing slightly the gross compensation. A cross between customers of the same agent resulted in the entire spread becoming gross compensation. 38/ Aided by the firm's compensation policy, Gibbs, Sullivan, Sutton, and Beaird actively discouraged agents in their branch offices from net selling. Each frequently encouraged and exhorted agents to "support the stocks" by crossing sell orders. Each also stressed to the agents that they should "build their books" by keeping their customers' money under management and crossing within their books of customers. Additionally, Sutton, Sullivan, Gibbs, and Beaird posted sell tickets in their offices, either on a blackboard or by similar means, to facilitate the crossing of sell orders with buy orders from other agents within their offices. Gibbs, Sullivan, Sutton, and Beaird used various means to discourage net selling, including telling sales agents that selling would lead to price declines and teaching agents how to maximize compensation through cross trades. The branch office managers also variously told sales agents to "stall" or attempt to talk customers out of selling, refused to accept sell tickets, denounced agents who had not attempted to cross sell orders, and threatened agents with the loss of future IPO allocations if they net sold. 37/(...continued) and the firm, would be $.06 ($.02 plus $.04). The remaining $.04 of the spread would inure to the firm as trading revenue. For a crossed trade, however, the firm would set its strike price at $.15, resulting in a $.05 gross commission on each side of the transaction. Thus, a crossed trade would provide a $.10 gross commission, an obvious advantage to the salesman who could cross trades. 38/ Although a crossed trade would produce less total compensation to the firm, it might benefit the firm in other ways. Crossing would tend to support prices of securities in which the firm made a market and to reduce the risk that the firm, acting as a market maker, might have to alter its prices to accommodate a customer net sale. For example, if there were consistently more sellers than buyers, a market maker would lower its bid price to reflect the increasing supply of stock. Falling bids might prompt a rash of selling, causing further price declines. If the market maker was able to sell the stock to another customer in a cross trade, however, it would not have to alter its pricing to accommodate a net sale. ==========================================START OF PAGE 16====== The branch office managers' policies and practices resulted in delays in the execution of sell orders. Delays in execution of customer orders varied from fifteen minutes, to hours, to as long as several days. Customers were not informed of the branch office managers' policies and practices regarding net selling. Customers also were exposed to the risk of price declines while agents tried to cross sell orders. B. The law judge's findings that the branch office managers did not commit no net selling violations were based on his interpretation of the charges. The law judge found, in essence, that the violation charged required that the evidence prove that the branch office managers actually prohibited all net selling, or so delayed sell orders as to be tantamount to a prohibition. We disagree. The law judge interpreted the pleadings too narrowly. The documents containing the charges provided fair notice of the theory that the Division sought to prove. The Order charged that various branch office managers established a "policy or practice" whereby customers "were not permitted to sell" certain securities "unless and until [the sales agent] . . . found another customer to purchase the securities." This language does not describe a situation where net sales were literally never permitted, but rather a policy of not permitting them. The Division's Summary of Allegations, filed pursuant to the law judge's order to make a "clear and definitive statement . . . regarding the allegations," left no reasonable question as to what the Division was attempting to prove. The Division stated, regarding the no net selling allegations, that a general pattern and practice was implemented [by the branch office managers] to obstruct the rights of customers to freely sell securities. Very simply, customers were unaware that they were generally not allowed to sell securi- ties underwritten by Stuart-James unless and until another customer agreed to purchase those securities. 39/ Thus, the charge to be tried was fairly presented. 39/ Oral statements of Division counsel at the pre-hearing conference and in the opening statement of the hearing repeated this construction of the allegation. Additionally, this theory was tried at the hearing. Witnesses were repeatedly questioned, and extensively cross-examined, concerning the branch office managers' efforts to discourage net selling, as well as the delay of sell orders occasioned by policies and practices restricting net selling. Finally, the Division's brief before the law judge squarely addressed the delay of sell orders. ==========================================START OF PAGE 17====== It is axiomatic that broker-dealers are obligated to deal fairly with customers. 40/ This includes the obligation to execute transactions promptly. 41/ Customers face the market risk of a price decline during any delay in execution. This is especially so in low-priced securities, which may exhibit great volatility. Thus, the potential for delay in the execution of a sell order is a fact that a reasonable investor would consider important. Hence, a policy or practice that may result in delay is itself a material fact that warrants disclosure. We find that Gibbs, Sullivan, Sutton, and Beaird acted fraudulently. Each established policies or practices that had the effect of not permitting net selling or of delaying sell orders. These policies and practices led to actual delays in execution, as well as creating the potential for delay on any sell order. Customers were unaware that when they attempted to sell a security their order might be delayed, thereby exposing the unknowing customers to the risk of a price drop. Gibbs, Sullivan, Sutton, and Beaird acted with the requisite degree of scienter. By discouraging agents from executing customer net sell orders and encouraging them to cross orders, they acted, at a minimum, in reckless disregard of the customers' interest in prompt execution and sale. In many instances, the branch office managers knew that orders were being delayed due to their practices or policies. We therefore find that Gibbs, Sullivan, Sutton, and Beaird willfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. 42/ 40/ See, e.g., Duker & Duker, 6 S.E.C. 386, 388 (1939). 41/ See, e.g., Carl J. Bliedung, 38 S.E.C. 518, 521 (1958); David M. Haber, Securities Exchange Act Release No. 35564 (April 5, 1995), 59 SEC Docket 59. The law judge arbitrarily drew a distinction between executions of sell orders delayed less than and greater than one day. He found delays of less than one day outside the scope of the pleadings and not fraudulent. As discussed, such a construction is unwarranted by the pleadings, and the distinction is incorrect as a matter of law. 42/ The law judge found that Lasek and Ward violated antifraud provisions by establishing policies and practices of no net selling. As mentioned, the action against them is final, supra, n.1, and we discuss their actions as relevant to the failure to supervise charges against Padgett, Graff, and Nye. As the law judge found, Lasek required agents to attempt to cross sell orders, regularly announced that there would be no net selling, rejected sell orders, and even (continued...) ==========================================START OF PAGE 18====== V. The Division of Enforcement has appealed the law judge's determination that Padgett, Graff, and Nye did not fail to supervise with regard to the no net selling violations. 43/ A. Padgett and Graff established most of the firm's policies. They particularly emphasized to managers and employees such corporate policies as agents building their books, supporting the stocks, 44/ and getting new money for new issues. As the firm's senior management, Padgett and Graff also were responsible for the firm's compensation system, and understood that the system created incentives to cross sell orders. Padgett and Graff also were involved integrally with the firm's everyday operations. Graff had daily conversations with the firm's regional vice presidents to discuss general buying and selling volume, and Padgett occasionally spoke with managers regarding trading volume. In addition, both Padgett and Graff instructed the firm's head trader to keep them informed of "unusual" inventory positions. Their awareness of the firm's inventory positions necessarily would have alerted them to whether the firm's inventory had been increased by customer net selling. 42/(...continued) ripped up sell tickets. Ward also discouraged net selling and, as the law judge noted, admitted, on occasion, directing branch managers to stop net selling certain securities. We also address Meinders' actions. Meinders admitted encouraging agents to cross sell orders and facilitating crossing within his office. On occasion, he rejected sell orders and directed agents instead to find a buyer to cross. Although the law judge did not find a violation against Meinders and the branch office managers, we find that Meinders, like the branch office managers, committed fraud for the purposes of assessing the failure to supervise charges against Padgett, Graff, and Nye. 43/ The law judge addressed the failure to supervise charges because he found that Lasek and Ward committed no net selling violations. The law judge did not address the failure to supervise charges associated with the conduct of Gibbs, Sullivan, Sutton, Beaird, and Meinders because he found that they did not commit no net selling violations. 44/ Padgett defined "support" of issues underwritten by the firm to mean "a commitment to purchase [a] stock in the aftermarket." ==========================================START OF PAGE 19====== On occasion Graff also directly involved himself in trading. In March 1986, the price of a stock in which the firm made a market (and which it had underwritten) began to decline. Graff intervened and ordered Douglas Ward, a regional vice-president, to "stop the selling" in the particular security. Ward interpreted Graff's directive as an order to stop all net selling and transmitted this order to managers in his region. 45/ Ward testified that Graff gave him similar instructions on other occasions. One incident in particular illustrates the level of Padgett and Graff's involvement in supervision of practices related to customer sell orders at the firm. In 1987, Padgett, Graff, Nye, other top managers, and approximately 200 agents attended a western regional meeting held in the Denver Tech Center ("DTC meeting"). Graff addressed the meeting and vigorously stressed the concept of "supporting the stocks." Attendees testified that Graff told them that he did not want to see net selling of stocks that the firm had underwritten. Three agents also testified that Graff, while holding up a pink sell ticket and a blue buy ticket, stated that agents were not to bring a pink ticket to their manager without a blue ticket. 46/ They were to cross sell orders and not net sell the stocks. Two agents also testified that Graff stated that managers, as well as Padgett and Graff personally, would examine net sales. In addition, Meinders testified that, following the meeting, Graff told managers gathered behind a partition in the meeting room to find a reason to fire any agent who continually net sold. 47/ Padgett apparently called certain managers following the DTC meeting and inquired about their reasons for net selling. 45/ Graff stated that a "panic" was developing in the stock's trading. Graff explained that he told Ward to stop the selling because Graff believed salespeople were soliciting sales for no reason, contributing to the downward price movement. 46/ Additionally, Meinders stated that Graff told the agents at the meeting that, if an agent was going to "net sell a security or sell a security," he should have a very good reason, and, if at all possible, he would like every pink ticket accompanied by a blue ticket. Similarly, an agent who attended the DTC meeting testified that Graff told the agents that they better have a "d--- good reason" if they brought a pink ticket without a blue ticket. 47/ An agent in the Colorado Springs office managed by Meinders testified that, not long after the DTC meeting, Sutton visited Meinders' office and reiterated what Graff had said. Sutton told the brokers that, if there was no "legitimate" reason for net selling, the broker would be fired. ==========================================START OF PAGE 20====== Padgett and Graff stated that, on the contrary, they tried to instill in the firm a policy against selling securities for improper reasons. Graff testified that, prior to the DTC meeting, Mark Geman, the firm's compliance officer, who was also an attorney, had alerted Graff to possible "churning" in some offices that had net selling increases near month's end. Graff was concerned that agents might be generating "unnecessary selling" for the sake of increasing commissions. Graff stated that he therefore told the agents at the DTC meeting that transactions would be scrutinized more closely, and that managers would follow up to make sure selling was based on sound reasons. Graff denied ever telling managers to fire agents, as Meinders testified. Both Padgett and Graff admit that some of their actions may have given agents and managers the impression that the firm discouraged net selling. Dirk Nye, as the western regional vice president, had supervisory responsibility over the offices managed by Gibbs, Lasek, Meinders, Sullivan, and Sutton. Nye stressed to the managers concepts such as retaining money under management (which he referred to as "building a book"), and supporting stocks through crossing. He occasionally contacted Gibbs if Gibbs' office had a large amount of net selling. On these occasions, Nye reminded Gibbs that he should monitor money under management. Similarly, on at least one occasion, Nye called another manager, Lasek, to question him about his office's buy-to-sell ratio. Nye also was aware of the prevalence of crossing in the offices in his region and acted as a facilitator for crossing within the region. Managers would occasionally call Nye when their individual offices could not cross large sell orders. Nye then attempted to assist the offices in finding buyers. In addition, Nye dealt directly with the agents in the offices under his supervision. In connection with net selling, Nye told agents to support the stocks. Various agents also testified that, when Nye visited the offices, he told agents not to net sell securities, especially on the opening day of trading of an IPO. B. The law judge apparently believed that the Division's position, and the evidence upon which it relied, partook of both failure to supervise and affirmative encouragement of violative conduct. 48/ He reasoned that it was "illogical and inappropriate to make a finding of supervisory failure" under 48/ Evidence of the agents' view of the DTC meeting came to light during the hearing. The Division sought to amend the allegation to conform to the evidence by alleging that Padgett, Graff, and Nye violated Exchange Act Section 15(b)(4)(E) in that they "aided, abetted, counseled [and] commanded" the managers' violations. The law judge denied the motion. ==========================================START OF PAGE 21====== such circumstances. The law judge did not specifically find that Padgett and Graff affirmatively encouraged violative conduct. There is no inconsistency in the Division introducing evidence that alternatively could support either a failure to supervise or an aiding and abetting violation, so long as the trier of fact does not make inconsistent findings. 49/ The law judge's reasoning would foreclose the possibility of ever pleading or litigating alternate theories of violation. 50/ Padgett and Graff stressed corporate philosophies ("building a book" and "supporting the stocks") that had the effect of discouraging net selling. Both also were aware, in varying degrees, of the trading in stocks underwritten by the firm, with Graff becoming directly involved when he thought there was "excessive" selling. The DTC meeting occurred against this backdrop. What transpired at that meeting demonstrates that Padgett and Graff were well aware that encouragement of a no net selling policy might be occurring within the firm. While the actual actions and statements made at the DTC meeting are disputed, even Padgett and Graff's version of what occurred demonstrates that, at the very least, Padgett and Graff knew that there was a problem with the treatment of sell orders in the firm. Both concede that managers and salesmen received the wrong message about net selling, especially from the DTC meeting. Padgett's calls to managers following the DTC meeting, which caused various managers in turn to contact Graff for an interpretation of Padgett's meaning, were insufficient to counter the message communicated by Padgett at the DTC meeting. Padgett also admitted that he had spoken to several ex-employees who complained about problems that they encountered if they tried to execute net sales. Following the DTC meeting, Padgett and Graff could not claim to be unaware of the practice of no net selling at the firm. Padgett and Graff knew, at a minimum, of employee confusion about net selling. Neither, however, took any action to investigate or address a specific problem about which they were aware. Their inaction allowed the branch managers to continue their practices of interfering with net selling. 49/ See, e.g., Fox Securities Co., Inc., 45 S.E.C. 377, 383 (1973). See also R.A. Johnson & Co., Inc., 48 S.E.C. 943, 947 n.14 (1988) (NASD Proceeding); Anthony J. Amato, 45 S.E.C. 282, 286 (1973) (NASD Proceeding). 50/ While the law judge may have erred in his reasoning, we will not, at this stage, amend the allegation as the Division requests. ==========================================START OF PAGE 22====== Nye encouraged use of the same corporate policies as Padgett and Graff and attended the DTC meeting. Nye also discussed net selling with the managers under his supervision, as well as the salesmen in their offices, more closely than Padgett and Graff. He directly involved himself in crossing larger trades between offices in his region. The assistance he provided in crossing between offices helped cement the idea, already encouraged by the office managers, that crossing was the expected norm. His comments to salesmen also encouraged crossing. Under the circumstances, Nye acted in disregard of the effect that his actions, and those of the managers, would have on the prompt execution of sell orders. Padgett and Graff argue that they cannot be held liable for failing to supervise someone who in turn failed to supervise, apparently referring to Nye. Their argument does not reflect the facts here. Padgett and Graff knew, at a minimum, of confusion in the firm related to net selling, which they did not act upon. Under such circumstances, it is immaterial whether others also failed to supervise. We therefore find that Padgett, Graff, and Nye failed to supervise reasonably with a view to preventing violations by Gibbs, Sullivan, Sutton, and Beaird. 51/ VI. Gibbs, Sullivan, Sutton, and Beaird have appealed the law judge's finding that they encouraged sales agents to obtain tie- in arrangements from customers as a condition of the customer being allowed to purchase securities in IPOs underwritten by the firm. A. Gibbs, Sullivan, Sutton, and Beaird established policies and practices of encouraging their sales agents to sell IPO securities only to those customers who would agree to sell their securities back to the firm at the beginning of aftermarket trading. The branch office managers made clear to sales agents that it would be profitable to have IPO customers sell their shares back to the firm. They encouraged, and even coerced, sales agents to get customers to sell when the agents wanted the shares back. The managers emphasized that the sales agents were expected to establish and maintain control over their clients; the sales agents understood that their customers were to resell IPO securities back to the firm when the agents wanted the customers to do so. In addition, the sales agents' testimony indicates that their respective managers had encouraged them, in 51/ We also find that Padgett and Graff failed reasonably to supervise Ward, Lasek, and Meinders, and that Nye failed reasonably to supervise Meinders. ==========================================START OF PAGE 23====== order to ensure that their customers would sell back to the firm, to obtain tie-in agreements from their customers as a condition of the customers' IPO purchase. 52/ The various means that the branch office managers used to establish these policies and practices included diagramming, before trading in each new issue opened, the benefits of crossing stock between new issue customers and aftermarket buyers, berating agents who did not "control" clients, and threatening to take new issue allotments away from agents who would not "establish and maintain control" over clients. One branch office manager even instructed agents to prepare aftermarket sell tickets for the IPO customers at the same time they found buyers for the stock. B. Tie-in agreements of the sort alleged by the Division are fraudulent devices. IPO purchasers, who might on their own choose to hold a security, are obligated to sell it back to the firm with which they have a tie-in agreement if they wish to avoid the loss of participation in future IPOs. Such tactics, in the absence of full disclosure to the market, create a false impression of the extent of market activity. 53/ Tie-in agreements also increase a firm's control over the supply of a security by ensuring that IPO purchasers will sell their IPO shares back to the firm rather than to the firm's competitors. Control over the supply of the security increases a firm's ability to control the security's price. 54/ Having such 52/ The law judge also found that branch managers Czaja and Meinders encouraged, and that Lasek required, sales agents in their respective branches to sell IPO securities only to customers who would agree to sell at the opening of aftermarket trading. Their actions remain relevant to the failure to supervise charges. 53/ For this reason, tie-in agreements operate as a fraud upon the market and defraud aftermarket purchasers. We do not accept the Division's contention that tie-in agreements perpetuated a fraud upon IPO purchasers and upon potential IPO purchasers who are denied the ability to buy IPO securities because they refused to enter into a tie-in agreement. While these actions may have constituted abusive sales practices, we do not view them as fraudulent because the tie-in agreements presumably were disclosed in connection with the sale of the IPO securities. 54/ Such control would enable the firm to artificially inflate both the repurchase and resale prices, creating the appearance of active interest in the issue. In a competitive market, an increased supply of the security could reasonably be expected to depress prices. ==========================================START OF PAGE 24====== ready access to securities that could be bought from IPO purchasers and resold to other firm customers in crossed transactions was in turn important in enabling sales agents to reap the advantages of the firm's compensation structure. The policies and practices regarding tie-ins were thus part of an overall scheme connected to the no net selling allegations. Gibbs, Sullivan, Sutton, and Beaird encouraged sales agents to obtain tie-in agreements. Testimony demonstrates that the branch office managers sought to have IPO customers resell in the aftermarket when the firm wanted them to sell. The branch office managers repeatedly exhorted the sales agents to establish and maintain control over their clients. The sales agents' testimony indicates that they understood the emphasis on controlling their clients as encouraging them to exact tie-in agreements as a condition of the customers' IPO purchase. The branch office managers' actions emphasized matters of importance to the firm, and to agents' compensation, rather than the best interests of firm customers who purchased in the aftermarket. The branch office managers acted in reckless disregard of the interests of such purchasers, who would make their investment decisions unaware that the market may have been distorted by the existence of the tie-in arrangements. The branch office managers also acted in disregard of the effect their actions might have on the marketplace. The branch office managers contend that the allegation against them was insufficiently precise. They claim that the Division abandoned the "encouragement" aspect of the tie-in allegation and focused solely on whether tie-in arrangements were required. They also assert that they lacked notice that the conduct at issue was fraudulent. The Division alleged that the branch office managers established a policy or practice whereby sales agents were encouraged or required to allow a customer to purchase securities in an initial public offering underwritten by [Stuart-James] only if the customer agreed either to purchase additional securities when aftermarket trading started, or sell securities bought in the underwriting at the opening of trading. The Division also alleged that these "tie-in" arrangements were not disclosed to other market participants. Further pleadings did not abandon this original formulation. Moreover, both the "encouragement" and "requirement" aspects were fully litigated during the proceedings below. As discussed, the polices or practices amounted to a device or scheme that perpetrated a fraud, principally by falsely creating an appearance of bona fide market activity, upon aftermarket purchasers. The securities laws cannot specifically ==========================================START OF PAGE 25====== anticipate and proscribe every fraudulent tactic that the wily may employ. However, here the branch office managers' objective was to induce the IPO purchasers to resell their securities to the firm at the firm's behest, rather than because of the investors' own investment goals. It should be obvious to a securities professional acting as a branch manager that such conduct will distort the market for such securities. 55/ Accordingly, we find that Gibbs, Sullivan, Sutton, and Beaird willfully violated Section 17 of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 there- under. 56/ VII. Padgett and Graff have appealed the law judge's finding that they failed reasonably to supervise the branch managers -- Gibbs, Sullivan, Sutton, and Beaird -- with a view to preventing their tie-in violations. 57/ In addition, Nye has appealed the law judge's finding that he failed reasonably to supervise the branch managers under his supervision. 58/ A. As noted in our discussion of the failure to supervise in connection with the no net selling violations, the evidence shows that Padgett and Graff were integrally involved in day-to- day management of the firm. Padgett and Graff established most of the firm's policies. Padgett and Graff were deeply involved in the first day of trading of IPOs and in the preparations for the opening of trading. In addition, they were aware of the firm's compensation structure, which encouraged sales agents to 55/ Although tie-in arrangements of the type alleged by the Division have not been the subject of any litigated decision of which we are aware, they are encompassed by the broad phrasing of the antifraud provisions. The branch office managers contend that we may not establish law through adjudication, but must, instead, rely on the rulemaking process. The alleged conduct at issue here, however, falls within the ambit of conduct prohibited under existing law. See SEC v. Chenery Corp., 332 U.S. 194, 202- 03 (1947)(agency may proceed through rulemaking or adjudication). 56/ We also find that Czaja, Lasek, and Meinders violated the same antifraud provisions. 57/ Padgett and Graff also claim that they did not fail to supervise Czaja, Lasek, Meinders. 58/ Nye also claims that he did not fail to supervise Meinders. ==========================================START OF PAGE 26====== cross trades. Finally, they must have been aware that a high percentage of IPO securities were sold and crossed on the first day of aftermarket trading. This, in the law judge's view, gave them notice that improper methods of stimulating trades might be involved and required them to take appropriate steps to ascertain the facts and prevent further misconduct. Nye is also liable for failing to supervise. He was, if anything, in closer and more constant touch with the managers than were Padgett and Graff. Nye had, according to Meinders, warned against tie-in sales at a managers' meeting. Nonetheless, after Meinders failed, on one occasion, to have IPO customers buy more shares in the aftermarket, Nye stressed the importance of crossing sales from IPO purchasers with purchases from aftermarket buyers. Meinders followed Nye's instructions. Nye also regularly visited the offices that he supervised and observed the conduct of the sales agents. B. We are in accord with the law judge's finding that there were red flags that should have alerted Padgett, Graff and Nye to the need to investigate the branch offices and to seek to prevent misconduct. The firm's compensation structure, and the repeated exhortations of Padgett, Graff and Nye concerning the agents' need to build their books and support the firm's stocks, should have alerted them to the potential for abusive sales tactics. As noted above, Padgett, Graff, and Nye were, at the very minimum, aware of employee confusion about no net selling. Such knowledge should have led them to inquire not only whether no net selling was occurring, but also how such a practice was being implemented. In addition, the law judge pointed to the very large number of transactions on the opening day of secondary trading of IPOs, which "put them on notice that improper methods to stimulate transactions might be involved and required them to respond with appropriate steps to ascertain the facts and prevent further misconduct." We agree. In addition, although Graff received copies of Meinders' new issue plans and reports that discussed tie-in arrangements, Padgett and Graff rehired Meinders after he left the firm. Nye was even more aware of Meinders' plans. Once Graff, Padgett, and Nye were on notice of Meinders' use of tie-in agreements, it was reckless to allow him to be reemployed by the firm without the closest of supervision. ==========================================START OF PAGE 27====== Accordingly, we find that Padgett, Graff, and Nye failed to supervise reasonably with the view to preventing violations by Gibbs, Sullivan, Sutton, and Beaird. 59/ VIII. During the hearing in this case, the Commission dismissed proceedings against Meinders, a branch manager, with the proviso that he comply with specified undertakings. 60/ Those undertakings included testifying at the hearing in substantial conformity with a proffer contained in his offer of settlement. Padgett, Graff, Nye, and the branch office managers argue that, in accepting Meinders' offer of settlement, the Commission prejudged Meinders' credibility and the Division engaged in improper ex parte communication with the Commission. We previously rejected these arguments regarding Meinders' offer of settlement. 61/ The fact that this Commission accepted Meinders' settlement does not mean there was a determi- nation to prejudge Meinders' credibility. There can be no prejudgment unless an agency has in some manner adjudicated the facts in advance of hearing them. 62/ Simply because an agency is exposed to the facts of a case during the course of its statutory function does not mean that it will prejudge those facts. 63/ While it is Commission practice to consider offers of settlement from one or more respondents in a multi-respondent proceeding in advance of determining facts involving other respondents in the same proceeding, we are aware of only one previous case discussing whether this practice results in prejudgment. 64/ 59/ We also find that Padgett and Graff failed reasonably to supervise Czaja, Lasek and Meinders, and that Nye failed reasonably to supervise Meinders. 60/ Securities Exchange Act Release No. 27927 (April 20, 1990), 46 SEC Docket 74. 61/ The Stuart-James Co., Inc., 50 S.E.C. 468 (1991). 62/ See City of Charlottesville v. FERC, 774 F.2d 1205, 1212 (D.C. Cir. 1985), cert. denied, 475 U.S. 1108 (1986)(quoting, Cinderella Career and Finishing Schools, Inc. v. FTC, 425 F.2d 583, 591 (D.C. Cir. 1970)). 63/ See Hortonville Joint School Dist. No. 1 v. Hortonville Education Ass'n, 426 U.S. 482, 493 (1976). 64/ Edward Sinclair, 44 S.E.C. 523, 528-29 (1971), aff'd, Sinclair v. SEC, 444 F.2d 399, 401-02 (2d Cir. 1971) (where Commission participated in decision to accept settlement (continued...) ==========================================START OF PAGE 28====== At the time this Commission considered Meinders' settlement offer there had been no adjudication of this matter, and Meinders had not testified. At the hearing, the law judge heard Meinders' testimony, now part of the record, and observed his demeanor. The law judge specifically stated that Meinders was "generally forthright and candid." Further, the law judge found that during "extended cross-examination . . . only a handful of inconsistencies between Meinders' hearing testimony and his investigative testimony" appeared. In light of the entire record, we find no reason to disagree with the law judge's assessment. 65/ Consideration of the offer of settlement while the proceedings were still pending against Meinders and the other respondents was proper and did not violate the Administrative Procedure Act ("APA"), 66/ or our rules regarding ex parte communications. 67/ When we first considered this argument, we noted the many factors necessary in making a responsible determination whether to settle with a respondent. The APA requires that the Commission give all interested parties the opportunity for the submission and consideration of offers of settlement when time, the nature of the proceeding, and the public interest permit. 68/ The APA and Commission rules 64/(...continued) from firm that was not binding on other respondents, no merit to argument that Commissioner prejudged later case against individual broker employed by that firm). 65/ The credibility determination of the initial decision maker is entitled to considerable weight since it is based on hearing the witnesses' testimony and observing their demeanor. See Universal Camera Corp. v. NLRB, 340 U.S. 474, 496 (1951); Jonathan Ornstein, 51 S.E.C. 135, 137 (1992). 66/ "An employee or agent engaged in the performance of investigative or prosecutorial functions for an agency in a case may not, in that or a factually related case, participate or advise in the decision, recommended decision, or agency review pursuant to Section 557 of this title, except as witness or counsel in public proceedings. This subsection does not apply . . . (C) to the agency or a member or members of the body comprising the agency." 5 U.S.C. Section 555(d). 67/ 17 C.F.R. 200.111, addressing ex parte communications. 68/ 5 U.S.C. Section 554(c)(1) provides that agencies shall give all interested parties the opportunity for "the submission and consideration of facts, arguments, offers of settlement, (continued...) ==========================================START OF PAGE 29====== prohibit ex parte communications relating to the decisional process. However, circumscribed Division communications with the Commission in connection with a proffered settlement by one respondent in a multi-party proceeding are not part of the decisional process regarding other parties. Thus, the Commission may consider offers of settlement from a respondent during the course of proceeding against other respondents. Padgett and Graff contend that the Commission failed to comply with the "notice" and "opportunity to cure" requirements of Section 9(c) of the APA. 69/ Proceedings such as these, however, fall within the statutory exception expressly provided in Section 9(c) of the APA for cases of willfulness. 70/ Willfulness for Section 9(c) purposes should not be interpreted more stringently than the Commission's willfulness standard under the Exchange Act. 71/ In any event, we have found scienter- based violations, which would satisfy any definition of willful. Padgett and Graff also argue that the proceeding was barred by a statute of limitations and that the length of the proceeding violated the APA. They claim the proceeding should have been commenced within one year from the time of discovery or three years from the time of violation and is barred under the Supreme Court's ruling in Lampf. 72/ The Lampf decision, however, applies to private rights of action. 73/ Section 6(b) of the APA states that "within a reasonable time, each agency shall proceed to conclude a matter presented to it." 74/ Padgett and Graff claim prejudice in that witness testimony became stale. We are unable to identify, and Padgett and Graff do not point to, specific prejudice resulting from witness memory loss. Nor have 68/(...continued) or proposals of adjustment when time, the nature of the proceeding, and the public interest permit . . . ." 69/ 5 U.S.C. Section 558(c). 70/ See Sterling Securities Co., 37 S.E.C. 837, 839 (1957). See also Dlugash v. SEC, 373 F.2d 107, 110 (2d Cir. 1967). 71/ See, e.g., Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965), cert. denied, 434 U.S. 1009 (1978); Arthur Lipper Corp. v. SEC, 547 F.2d 171, 180 (2d Cir. 1976). 72/ Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991), reh'g denied, 501 U.S. 1277 (1991). 73/ SEC v. Rind, 991 F.2d 1486, 1489 (9th Cir.), cert. denied, 510 U.S. 963 (1993). 74/ 5 U.S.C. 555(b). ==========================================START OF PAGE 30====== Padgett and Graff's legal rights been prejudiced. 75/ While delay is undesirable, this proceeding has been contested vigorously by all parties, and the record, as Padgett and Graff acknowledge, is "immense." We reject Padgett and Graff's claims that the proceeding must be dismissed because of delay. IX. As the senior management of Stuart-James, Padgett and Graff oversaw a firm that practiced fraud on a widespread basis. The record in this proceeding reveals that the interests of the firm, almost without fail, were elevated above the fair treatment of customers. We have found that Padgett and Graff committed multiple violations of a very serious nature. They were responsible for large scale pricing violations and the distribution of fraudulent sales scripts. They also failed to supervise reasonably while numerous managers instituted fraudulent policies and practices. We note that both have run afoul of regulators on other occasions. Padgett has been sanctioned several times by the NASD over a more than 10-year period, including for, among other things, failing to supervise regarding markup violations. Graff also has been sanctioned previously by the NASD. Based on the extent and severity of their misconduct and their disciplinary histories, we believe that the public interest mandates barring Padgett and Graff from association with any broker or dealer. We have found that Nye failed to supervise numerous branch managers who instituted fraudulent policies and practices. Nye's conduct was completely at odds with diligent supervision and his actions at times came close to commanding violations. Under the circumstances, we believe that the public interest warrants barring Nye from association with any broker or dealer, provided that, after a period of four years, he may apply to become associated in a non-supervisory, non-proprietary capacity. We have found that branch managers Gibbs, Sullivan, Sutton, and Beaird instituted fraudulent policies and practices in their branch offices. Their fraudulent policies and practices were inimical to the fair treatment of customers and interfered with the operation of fair and efficient markets. 76/ Under the circumstances, we believe that the public interest warrants barring Gibbs, Sullivan, Sutton, and Beaird from association with any broker or dealer, provided that, after a period of two years, 75/ See Kingsley, Jennison, McNulty & Morse, Inc., 51 S.E.C. 904, 911 (1993). 76/ We note that the NASD has previously sanctioned both Gibbs and Sutton and that the State of Idaho has sanctioned Sullivan. ==========================================START OF PAGE 31====== they may apply to become associated in a non-supervisory, non- proprietary capacity. An appropriate order will issue. 77/ By the Commission (Chairman LEVITT and Commissioners WALLMAN, JOHNSON, and HUNT). Jonathan G. Katz Secretary 77/ All of the contentions advanced by the parties have been considered. The contentions 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 SECURITIES EXCHANGE ACT OF 1934 Rel. No. 38423 / March 20, 1997 Admin. Proc. File No. 3-7164 _________________________________________ : In the Matter of : : C. JAMES PADGETT : STUART GRAFF : ROBERT E. GIBBS : SHAW SULLIVAN : JOHN W. SUTTON : JOHN BEAIRD : DIRK NYE : _________________________________________: ORDER IMPOSING REMEDIAL SANCTIONS On the basis of the Commission's opinion issued this day, it is ORDERED that C. James Padgett be, and he hereby is, barred from association with any broker or dealer; and that Stuart Graff be, and he hereby is, barred from association with any broker or dealer; and, it is also ORDERED that Dirk Nye be, and he hereby is, barred from association with any broker or dealer, provided that, after a period of four years, he may apply to become associated in a non- supervisory, non-proprietary capacity; and, it is FURTHER ORDERED that Robert E. Gibbs be, and he hereby is, barred from association with any broker or dealer, provided that, after a period of two years, he may apply to become associated in a non-supervisory, non-proprietary capacity; and that Shaw Sullivan be, and he hereby is, barred from association with any broker or dealer, provided that, after a period of two years, he may apply to become associated in a non-supervisory, non-proprietary capacity; and that John W. Sutton be, and he hereby is, barred from association with any broker or dealer, provided that, after a period of two years, he may apply to become associated in a non-supervisory, non-proprietary capacity; and that John Beaird be, and he hereby is, barred from association with any broker or dealer, provided that, after a period of two ==========================================START OF PAGE 2====== years, he may apply to become associated in a non-supervisory, non-proprietary capacity. By the Commission. Jonathan G. Katz. Secretary