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Initial Decision of an SEC Administrative Law Judge
In the Matter of
|
In the Matter of
MGSI Securities, Inc., |
: |
INITIAL DECISION January 12, 2000 |
Appearances:
Mitchell E. Herr and Terry Tennant, for the Division of Enforcement, Securities and Exchange Commission
Jacks C. Nickens and Paul D. Flack, for Respondents Connie L. Bally and Larry J. Bagwell
Daniel R. Kirschbaum for Respondent James W. Ogg
Before:
William J. Cowan, Administrative Law Judge
The Securities and Exchange Commission ("Commission") initiated this proceeding on September 10, 1998, pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b), 19(h) and 21C of the Securities Exchange Act ("Exchange Act") against MGSI Securities, Inc.("MGSI"), Bradford A. Orosey, Larry J. Bagwell ("Bagwell" or "Mr. Bagwell"), Connie L. Bally ("Bally" or "Ms. Bally"), Joseph O. Fallin, and James W. Ogg.
I held a hearing in Houston, Texas from May 10 through May 18, 1999, at which allegations against Respondents Bally and Bagwell, described below, were tried. Respondent Joseph O. Fallin submitted an Offer of Settlement, which the Commission accepted in its Order Making Findings and Imposing Remedial Sanctions and a Cease-and-Desist Order as to Joseph O. Fallin, dated May 5, 1999. The hearing as to Respondent Bradford A. Orosey was continued by my Order issued April 20, 1999, because Mr. Orosey had submitted an Offer of Settlement. The Commission accepted Mr. Orosey's Offer of Settlement in its Order Making Findings and Imposing Remedial Sanctions and a Cease-and-Desist Order as to Bradford A. Orosey, issued May 25, 1999.
Respondent James W. Ogg has reached an agreement in principle with the Division of Enforcement ("Division") to settle matters as to him. I continued the hearing as to Mr. Ogg, pending completion of the settlement and its submission to the Commission. (Tr. 85.) 1 On December 16, 1999, I issued an Order directing that a report be filed as to the status of the matter. In a Joint Status Report filed pursuant my December 16, 1999 Order, the Division and counsel for Mr. Ogg reported that a settlement continues to be worked on and that a Commission decision on such a settlement can be expected within ninety days of its filing. Accordingly, this matter remains pending as of the date of this initial decision.
By motion filed August 18, 1999, the Division moved for entry of an order making findings, imposing a cease-and-desist order and revoking the broker-dealer registration of MGSI by default for failure to appear at the hearing and answer the charges made against it in this proceeding. The Division later moved, on December 14, 1999, to set disgorgement and penalties with respect to MGSI. On December 30, 1999, counsel for Bally and Bagwell filed a response in opposition to the Division's motion for disgorgement and penalties. On January 6, 2000, the Division filed a reply in support of their motion to set disgorgement and penalties with respect to MGSI. On or about January 7, 2000, counsel for Bally and Bagwell filed a response to the Division's reply. These motions are discussed infra. The hearing proceeded to consider only the allegations against Bally and Bagwell (hereinafter "the Respondents"). This decision covers charges against MGSI, Bally, and Bagwell.
I received a Pre-Trial Brief from the Division and a Pre-Hearing Brief from Bally and Bagwell. In addition, on May 6, 1999, Respondents submitted an unauthorized "Response to Enforcement Division's Prehearing Brief." The Division waived objection to receipt of that filing. (Tr. 229.)
The following post-hearing briefs have been received:
The record consists of 1,924 pages of hearing transcript and 222 exhibits. 2
The Division alleges that from 1992 to 1994, Respondents, while registered representatives licensed by the National Association of Securities Dealers ("NASD") and associated with MGSI, violated the anti-fraud provisions of the federal securities statutes. Ms. Bally and Mr. Bagwell are charged with committing or causing violations of, and willfully violating, Sections 17(a)(1), 17(a)(2), and 17(a)(3) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, by making false and misleading statements of material fact and omissions of material fact in connection with offer and sale and/or purchase of high-risk Collateralized Mortgage Obligations ("CMOs") to certain municipalities.
Regarding Respondent Bally, the Division alleges that, in connection with the purchase and sale of CMOs to Lewis & Clark County, Montana, from August 1993 to July 1994, Ms. Bally:
The Division claims that, as a result of the above alleged fraudulent misrepresentations and omissions of Respondent Bally, Lewis & Clark County was fraudulently induced to stock its investment portfolio with numerous high risk CMOs which incurred a significant decline in value.
Regarding Respondent Bagwell, the Division alleges that, in connection with the sale of CMOs to the City of Joplin, Missouri from June 1992 to February 1994, Mr. Bagwell:
The Division claims that, as a result of the above alleged fraudulent misrepresentations and omissions of Respondent Bagwell, the City of Joplin was fraudulently induced to stock its investment portfolio with numerous high risk CMOs which incurred significant declines in value.
The CMOs sold by Ms. Bally and Mr. Bagwell are types of mortgage-backed securities whose cash flows are derived from the mortgage payments of individual borrowers.5 The primary risk of mortgage-backed securities derives from the unpredictability of the timing of their cash flows, which is attributable to changes in the pattern of prepayments on underlying mortgages. Prepayments increase as interest rates decline, while prepayments decrease as interest rates rise. (Div. Ex. 241 at 3.) Another characteristic of mortgage-backed securities is that principal is repaid each month, due to regular scheduled amortization and payments. Accordingly, even though the maturity of underlying mortgages might be thirty years, most of the principal in mortgage-backed securities will be paid back earlier, causing reference in such instruments to "average life," which is the weighted-average time until principal is returned to the investor, instead of maturity. (Id.)
There are numerous categories of CMOs. Speaking generally, some of the CMO categories, such as the so-called PAC bonds, and TAC (Targeted Amortization Class) bonds, have been designed to limit the effect of changing prepayments on the cash flow of the bond, thus making cash flows of these investments more stable. (Id. at 4.) In order to create categories of these investments with more stable cash flows, other classes as noted above must be structured with correspondingly greater sensitivity to changing prepayments. These securities are called "support class" bonds. (Id.) Thus, the stability of the CMO categories like PACs and TACs come at the expense of the support class bonds which have been created specifically to absorb the instability removed from the stabilized classes. (Div. Ex. 243 at 5-6.)
CMOs also vary in terms of their interest payments. The types include: Fixed Coupon, under which bonds earn a fixed rate of interest on the principal outstanding; Principal Only ("PO"), which do not receive any interest payment; Interest Only ("IO"), which receive only interest or pay a small amount of principal; Floating Rate, which pay an amount of interest equal to an index plus a margin; and Inverse Floaters ("IF"), where the coupon varies inversely with changes in a specified interest rate index. The value of POs and IOs are extremely dependent upon prepayment expectations, and IFs are very sensitive to interest rate changes, as well as prepayment expectations. Indeed, IFs provide the counter balance to the more stable Floating Rate class, absorbing the effect of interest rate change risk that was removed to create the Floating Rate class. (Div. Ex. 241 at 4.)
POs and IFs are examples of security types in a CMO deal that tend to exhibit greater risk and uncertainty. These support class bonds appeal to investors who generally take more risk in exchange for the higher potential yields that such investments may provide, such as hedge funds and large money managers. On the other hand, buyers of the PAC and Floating Rate bonds tend to be investors like banks and insurance companies looking for more predictable cash flows. (Id. at 5.) These types of support class bonds were sold by Ms. Bally to Lewis & Clark County and by Mr. Bagwell to the City of Joplin, Missouri.
For all classes of CMOs relevant here, return of principal is guaranteed, if held to maturity. Market values, however, fluctuated with prepayment experience and interest rate movements. Changes in prepayments experience and interest rates caused the market value of the CMO securities at issue here to decline, and average lives to extend. The consequences of these developments are the subject of this proceeding.
The Division contends that the National Association of Securities Dealers ("NASD") requires detailed disclosures by brokers of risks associated with CMOs in sales of these securities. The need for such disclosure is, the Division maintains, derived from the principle of fundamental fairness enunciated in NASD's Manual, under Rules of Fair Practice (Div. Ex. 405A). In the section entitled "Fair Dealing With Customers," the NASD Board states that, when new products are introduced, members should "[M]ake every effort to make customers aware of the pertinent information regarding the products." (Id. at 2047.) In its Manual, NASD also adopted conduct rules governing communications with the public about CMOs via advertising media, such as print, radio and television. (Div. Ex. 1029.) These conduct rules for advertising, originally adopted in early 1993, included requirements for communications about CMOs such as educational materials which fully explained the nature of CMOs and their features, including the effect on value and prepayment rates of interest rate changes. (Id. at 4179.) The rules are detailed and specific as to the required content of CMO advertising.
NASD Notice to Members 93-18, issued in March 1993, also dealing with advertising, further advised that a CMO advertisement might be misleading if it advertised a CMO yield alone, without extensive disclosure, such as illustrations depicting yield variations under different prepayment assumptions, average lives and maturities. (Div. Ex. 238.) Also in this publication, the NASD instructed that yield and average life predictions in print advertising be based upon consensus prepayment assumptions from a nationally recognized service, such as Bloomberg. (Id. at 100.) NASD Notice to Members 93-73, issued in October 1993, which deals with Members' obligations to customers when selling CMOs, stated that brokers must ensure that their customers understand the characteristics and risks of CMOs, including that average life and yield estimates depended upon the accuracy of prepayment assumptions, and must provide information about the sensitivity of POs and IFs to interest rate changes. (Div. Ex. 239.)
Respondents contend that these NASD publications do not constitute statutes, rules or regulations. As to NASD Notice to Members 93-73, Respondents argue that, even if it is considered authoritative, it merely requires that members ensure that customers understand the characteristics and risks associated with CMOs. Absent is any reference to Bloomberg medians or varying LIBOR, they say. Respondents further contend that any obligations arising from these publications are imposed on "members," which would not include registered representatives like Ms. Bally or Mr. Bagwell, but to MGSI, the member firm.
Further, Respondents assert that NASD Notice to Members 93-18 provides guidelines, not rules, and is related to advertising, not other forms of communications. Further, this publication does not require disclosure of the Bloomberg median, varied LIBOR, or prepayment projections at any particular speed. Moreover, Respondents contend that they had not even seen these Notices, which went to the member firm. (see Tr. 413-14.)
The Division presented testimony of expert witnesses that certain minimal disclosures had become standard in marketing CMOs by the time that the sales of securities in issue here were made. (Div. Ex. 241 at 14; See also Tr. 682.) These disclosures, it is alleged, came to be standard in cases where the customer did not have independent access to the analytics needed to evaluate the security. (Tr. 90, 188, 681-82; Div. Ex. 243 at 12.) Among the disclosures said to have become a universal standard for CMO sales in such circumstances is an unbiased prepayment forecast for the CMO in question. The Bloomberg median, a consensus of Wall Street prepayment forecasts for the underlying collateral, is available at all points in time and is commonly used as a point of departure for assessing a particular CMO, the Division contends. (Div. Ex. 243 at 10; Tr.130, 179.)
Also included in the standard disclosures, according to the Division, are yield tables centered on the Bloomberg median. (Div. Ex. 243 at 12.) For floating rate CMOs (here, IFs), the Division contends that it is standard to disclose yield tables that vary the interest rate index, such as by providing a two-dimensional, so-called "7 x 7" yield table. (Div. Exs. 243 at 13, 244 at 50, 72, 80, 86.) In addition, the standard disclosures must be specific to each CMO and must be communicated in writing, according to the Division. (Tr. 51, 175, 160-61, 189-90.)
The Respondents argue that there is no universal disclosure standard that the brokers charged here were required to follow. They contend that there is no published standard that compels disclosure of the Bloomberg median, yield tables centered around that median, or "7 x 7" yield tables that vary the interest rate for floating rate securities like IFs. They point to the inability of the Division's expert witness Mr. Davidson to cite to a publication of such a standard, to identify when it was adopted, or to have recalled including it in his book on CMOs published in 1994. (Tr. 91-98.) Division expert witnesses Williams and Weiner were similarly unaware of any publication of such a standard (Tr. 1850-51, 694-95.) Nor is there an industry marketing standard that would have required these specific disclosures, Respondents maintain. (Tr. 1662.)
At the outset, I find that there is no statute, rule or regulation that would have required Ms. Bally or Mr. Bagwell to make the specific disclosures suggested by the Division and its expert witnesses for the securities at issue here, i.e., the Bloomberg prepayment forecast consensus, yield tables centered on that Bloomberg median, or the so-called two-dimensional "7 x 7" yield table that varied LIBOR for IFs. Nor is there any evidence of a published standard at the time these sales were made which contained specific disclosure requirements that prudent brokers would be expected to follow when selling CMOs. The most that can be said from the evidence adduced here is that some investment professionals adopted a practice under which information about Bloomberg consensus prepayment forecasts, yield tables centered on such forecasts and a yield table that varied LIBOR for IFs was provided to customers who lacked the capability to perform their own analytics. Others saw the disclosure requirement differently, that it was enough to provide more general disclosure of market, extension and liquidity risks of the offered securities. (Resp. Ex. 902A at 8-12.)
The NASD publications cited by the Division do not clearly provide disclosure requirements for registered representatives when offering CMOs to their customers. The closest any of these publications come to imposing specific disclosure requirements is NASD Notice to Members 93-18. This is the Notice which conveys CMO Advertising Guidelines to NASD members. These are self-styled guidelines that "[p]rovided a framework for members to assess the accuracy and appropriateness of Collateralized Mortgage Obligations (CMO) advertising." (Div. Ex. 238.) This publication's primary purpose is exactly that - to provide guidelines for CMO advertising by NASD members. The print advertising guidelines in this publication, including a Standardized CMO Advertisement, require that statements of yield and average life be based on consensus prepayment assumptions from a nationally recognized service, like Bloomberg, or the member must be able to justify the assumption used. However, it is not directly applicable to the transactions here because its primary purpose was to provide members with advertising guidance, not to provide brokers with specific disclosure requirements.
Even as to advertising, Notice to Members 93-18 offered "guidelines" which, while obviously of considerable importance, fell at least one step short of a binding rule. In addition, while the Bloomberg-based consensus prepayment forecast is specifically mentioned, the guidelines permitted departure from that specific disclosure if the assumption used could be justified. There is a sentence in this publication which states that, in addition to providing advertising guidance, it is intended also to augment the business conduct framework for all communications and sales practices relating to CMOs. However, there is no persuasive evidence that this publication was intended by NASD, or seen by its members, as imposing new specific disclosure requirements for CMO sales, such as yields centered around the Bloomberg consensus prepayment forecast, and no suggestion that the brokers here were so informed.6
The NASD Notice to Members that is more directly relevant here is 93-73. (Div. Ex. 239.) This is the Notice to Members that spells out Members' obligations to customers when selling CMOs, as distinguished from Notice to Members 93-18, which principally concerned advertising CMO products. Notice 93-73 contains, inter alia, the following advice: (1) Members and their associated persons must ensure that customers understand the characteristics and risks of CMOs; (2) investors need to understand what prepayment assumptions are and that they are factored into the offering price, yield and market value of an offered CMO; (3) market values of POs are extremely sensitive to prepayment rates, which, in turn, vary with interest rate changes;7 and (4) investors in IFs should be made aware of the risks and characteristics of the IF being purchased in light of their high price volatility as interest rates move. (Id.) Nothing in this notice requires the kind of specific disclosures which the Division contends are required for CMO sales to investors unable to perform their own analytics. But this Notice does provide a pretty good summary of what disclosures the brokers charged here were reasonably required to make in order to render their sales presentations not misleading and in violation of the Securities laws.8 Moreover, if the expert testimony in this proceeding was culled to ascertain the level of disclosure virtually all could agree was the least that was required, a similar list would be developed.
Respondent Connie L. Bally is a registered representative who has worked in the securities industry since 1984. (Tr. 320.) From 1984 through 1999, Ms. Bally worked for numerous securities dealers, including: Charles Schwab; Eppler, Guerin & Turner; Austin Investment Source/Source Securities; Landmark Investments, Inc.; Dover Group, Inc.; Schaefer Securities, Inc.; UMIC Inc.-Union Planters Investment Bankers Group; Howard, Weil, Labouisse, Friedrichs, Inc.; Marcus, Stowell & Beye ("MS&B"); MGSI Securities, Inc.("MGSI"); and TDI. (Div. Ex. 85, Tr. 320-1, 329-332, 339, 342-3, 352.) Ms. Bally has been involved in the sale of mortgage-backed securities since at least 1987, and received training in the sale of mortgage-backed securities and CMOs at these firms. (Tr. 327, 353-354.)
The allegations that Ms. Bally made fraudulent misrepresentations and omissions in the sale of securities to Lewis & Clark County, Montana involve transactions from August 1993 through July 1994, when she was employed as a registered representative with MGSI. (Tr. 343.) Before the instant action, Ms. Bally had received only one customer complaint, which occurred when she was employed at Landmark Investments. That complaint was investigated by the NASD, which, according to Ms. Bally, found that she did not do anything deliberately wrong. (Tr. 343-45.)
Ms. Bally was familiar with a so-called NASD "know your customer" rule from her course of study and examination for the Series 7 SEC license required to sell securities. (Tr. 387-8.) She believed that the rule required her to know the investment sophistication level of her customers, to be sensitive to the level of sophistication of her customers, to provide securities that are appropriate for her customers, to make sure that her customers had a reasonable basis for an investment decision, and that her customers understood a security well enough to make an intelligent investment decision. (Tr. 389.) More specifically as to the type of securities involved in this matter, Ms. Bally understood that the NASD required that its members ensure that their customers understood the characteristics and risks associated with CMOs. (Tr. 391-2, Div. Ex. 239.)
Randall R. Redpath was the Finance Officer for Lewis & Clark County, Montana, during the time relevant to the securities sales at issue here. As such, he was charged with the responsibility to make investments of the County's public funds during this time period. The investment funds managed by Mr. Redpath consisted of a pool of cash balances in approximately 300 public funds earmarked for, inter alia, schools, fire departments and irrigation districts. They comprised Lewis & Clark County's operating cash, cash reserve and bond proceeds, funds that were used for the day to day cash flow of the county. (Tr. 263-4.)
Mr. Redpath was subpoenaed to testify in this proceeding but did not respond to the subpoena. Much of the information in this record concerning Mr. Redpath is contained in Div. Ex. 234, which is the transcript of Mr. Redpath's sworn interview conducted by SEC investigative staff on January 11, 1996. This exhibit was received in evidence as a prior sworn statement, under the provisions of Rule 235, 17 C.F.R. § 201.235(a)(4), over the objection of Ms. Bally's counsel. (Tr. 231-51.) The Division, which argued for admission of the prior sworn statement of Mr. Redpath at the hearing, has on brief requested that I not rely on that testimony in reaching my decision, "[t]o avoid creating an appellate issue." Div. Br. at 16, fn16. In the Respondents' Initial Brief, counsel for Respondent Bally renews the objection to the admission of this statement, for the reasons stated at the hearing.
I reject the arguments of both the Division and Respondents. The prior sworn statement is admissible for the reasons indicated at the hearing. It is desirable, in the interests of justice, to receive this sworn statement into evidence, notwithstanding the rule against hearsay testimony or the lack of opportunity to cross-examine. Gotham Securities Corp., et al., Admin. Proc. 3-4352 (April 10, 1974); SEC v. Glass Marine Industries, Inc., 194 F. Supp. 879 (D. Del. 1961). Findings supported by this exhibit are only those that are cited to Div. Ex. 234. As to those findings, due consideration has been given to the fact that the witness was not available for cross-examination, i.e., it has been accorded less weight than it would have received had it been subject to cross-examination. Nevertheless, the exhibit presents sworn testimony and provides useful information regarding Mr. Redpath, his background, and his transactions with Ms. Bally. The interests of justice will be better served by its admission.
Mr. Redpath was a graduate of the University of Montana, with a Bachelor's degree in Business Administration (concentration in Accounting), and took graduate courses in Public Administration at that same institution. (Div. Ex. 234 at 7.) While taking no courses on investments at the University of Montana, he did attend a four week night course at Carroll College presented by the brokerage firm of D.A. Davidson on stocks and bonds, and attended a one day investment seminar at another broker-dealer, Government Securities Corporation ("GSC"), in Houston in September 1992. Only the latter covered CMOs and derivative securities. (Id. at 8-9.) The GSC seminar explained the characteristics of inverse floaters and POs, among other securities. (Id. at 10.) Mr. Redpath also had a three-hour conversation with a representative from the brokerage firm Dain Bosworth explaining what CMOs were and how they worked. (Id. at 15-16.)
His employment history included several auditing positions, followed by service in the Treasurer's office in Gallatin County, Montana, where he was responsible for accounting and financial reporting, but not investment decisions. (Id. at 12-14.) Mr. Redpath became the Finance Officer with the Lewis & Clark County Treasurer's office in November 1991, where he was initially responsible for accounting and financial reporting, but soon was given the additional responsibility of making investment decisions for the county. (Id. at 16-17.) He was a member of the Government Finance Officers Association ("GFOA") and received its publications. (Tr. 283-84.) He was considered by his immediate superior, the County's Treasurer, Clerk and Recorder, to be a very honest person with integrity. (Tr. 314.)
Mr. Redpath had no personal investment experience, i.e., he did not have a brokerage account, and never bought a stock, bond or other security for himself. (Div. Ex. 234 at 59.) He had no computer software program that could determine yields for CMOs at specific PSA speeds or otherwise analyze CMOs. (Id. at 250.) He believed that if something was a Fannie Mae, or Freddie Mac, it was fully insured by the U.S. government and not risky. (Id. at 144.) Because of what he considered an inadequate background in the area, he relied upon Ms. Bally a lot and felt that, while not managing the County's portfolio, she was managing the securities that she had sold him. (Id. at 148.)
Notwithstanding his professed inadequate securities background, Mr. Redpath did have some idea that the CMO securities offered to him by Ms. Bally entailed greater risk than the fixed rate instruments he had in the County's portfolio because they offered greater yield. (Id. at 150.) He understood that a certain hierarchy of riskiness existed with different CMO securities, running from fixed rate securities at the low risk end of the spectrum to IFs at the high risk end, with POs somewhere in between, because of his demonstrated ability to move in and out of POs. (Id. at 150-52.)
The investment funds managed by Mr. Redpath consisted of an approximate $20 million pool of cash balances that were earmarked for such things as schools, fire departments and irrigation districts. They comprised the County's operating cash, reserve cash, and bond proceeds. (Tr. 263.) At the time that Mr. Redpath joined Lewis & Clark County, most of these funds had been invested in STIP, the State Short Term Pool (Div. Ex. 234 at 21.), which offered the liquidity required for daily cash flows, but which was providing very low interest. (Id. at 24, 40.) Before Mr. Redpath began doing business with Ms. Bally, the County had invested two to three million dollars of its long term available funds in CMOs, and had good experience, getting principal back very rapidly. (Id. at 25-26.) These CMOs were fixed rate PAC instruments. (Id. at 18-19.)
Mr. Redpath performed an analysis to determine how much of the County's funds could be invested in longer-term products that had the potential for greater returns, like CMOs. From this analysis, Mr. Redpath concluded that the County had ten million dollars - a level which it was never required to dip below - to invest long term. (Div. Ex. 234 at 23-24.) By long term, Mr. Redpath meant longer than STIP, one to two years, which was similar to his experience with the PAC CMOs in the County's portfolio that had returned principal quickly. (Id. at 28, 30.) Mr. Redpath, however, agreed that he may have told Ms. Bally that he could hold something for twenty or thirty years, given that the moneys invested long term would come from the portion of the County's investment pool which would never be touched by the County. (Id. at 40.)
Mr. Redpath received a "massive amount of calls" and several visits from brokers seeking the County's business. (Div. Ex. 234 at 83-84; Tr. 281) He purchased CMOs from Dain Bosworth after engaging in a three-hour call during which the broker explained CMOs and how they operated. (Div. Ex. 234 at 16.) He also purchased IFs from the GSC brokerage firm before purchasing any from Ms. Bally. (Id. at 92.)
Mr. Redpath professes to have been unaware of the increased risks associated with the Support Class derivative CMOs as compared with the Fixed Rates CMOs in the County's portfolio (Id. at 144.), but was aware that the Support Class derivative securities were less conservative than the Fixed Class. (Id. at 150.) He understood, as well, that IFs needed to be balanced with floating rate securities to offset risk in the overall portfolio and purchased more stable floating rate securities for this purpose from GSC's broker, Scott Stafford. (Id. at 256.)
He was willing to make the move from more conservative investments to less conservative to get higher yield. (Id. At 150.)9 He stated that he had been "pushed" to get higher yields by the budget office. (Div. Ex 234 at 299.) From all of Mr. Redpath's experience, education, dealings with brokers, and available literature, he understood that the primary risk of the CMO securities at issue in this case was that interest rates would increase and the value of the securities would decline, and that these investments offered the potential of increased yield for the assumption of the associated risks.10
Connie Bally located Mr. Redpath as a potential securities customer through a "cold call" from a lead list furnished to her at MS&B. (Tr. 379, 528.) She ascertained in her initial contacts with Mr. Redpath that he had 30-year CMOs in the County's portfolio, and that he was interested in preservation of principal and increased yields over STIP rates or local CDs. (Tr. 530.) She further understood that the County's investments were restricted to obligations of the U.S. Treasury and direct and indirect obligations of agencies of the government. (Id.)
She believed that Mr. Redpath understood the characteristics and risks of CMOs. (Tr. 555.) Mr. Redpath received a prospectus and a Federal Financial Institution Examination Council ("FFIEC") stress test with the confirmation for each CMO purchase from Ms. Bally when she was with MS&B. (Resp. Ex. 506; Tr. 533.) He looked through the first few prospectuses for the securities Ms. Bally sold him, but did not read them. (Div. Ex. 234 at 286-87.) Ms. Bally further furnished a Bloomberg yield table for each security she was presenting to Mr. Redpath both while at MS&B and at MGSI. She knew that Mr. Redpath did not have a Bloomberg terminal and was basing his decisions whether or not to purchase a security from information she supplied. (Tr. 385-87.) In fact, her business practice was to provide to Mr. Redpath for each security offered for sale a Bloomberg spread sheet, furnished to her by her trading desk, that contained, inter alia, information about the historical PSAs for the security, yield and average life at various PSA speeds, including speeds slower than the historical speeds. (Tr. 368-69, 493, 539-40, 561, 567, 569-70.)
Ms. Bally found the historical information on PSA speeds that is contained on the Bloomberg screens she used to be valuable and would provide it to her customers whether or not it had been specifically requested. (Id.) While the Bloomberg median prepayment consensus forecast was encompassed within the prepayment speeds shown on the screens provided by Ms. Bally to her customer in almost every instance (Tr. 667.), she did not focus her client's attention on the Bloomberg median, but preferred to work off of historical prepayment speed information. (Tr. 408.) While Ms. Bally professed not to know what a Bloomberg median actually was at the time of the sales to Mr. Redpath, (Tr. 479; see also Tr. 408, 481.), this testimony is not credible in light of her prior sworn statement (Div. Ex. 228 at 271.) and her understanding and working knowledge of all other elements of Bloomberg sheets described in her testimony at the hearing.
The Bloomberg screens provided to Mr. Redpath by Ms. Bally for IF securities did not vary the LIBOR because Mr. Redpath did not ask her for such a presentation. (Tr. 497-98.) Ms. Bally understood that it would have been important when buying an IF to see the various yields with changes in LIBOR, as well as changes in long-term interest rates. (Div. Ex. 228 at 164.)
Ms. Bally's practice was to go over the relevant information on the Bloomberg sheet with Mr. Redpath when she called to offer him a particular CMO. (Tr. 540.) She believed that he was well versed at reading Bloomberg pages from the many conversations she had with him over the two and a half years that she dealt with him. (Id.) She frequently circled certain information on the sheet for discussion purposes in telephone calls with Mr. Redpath. This highlighting was intended as a point of departure for discussion of elements of the particular offering. (Tr. 431.)
(i) Representative Transactions
FNMA 1993-205H (PO)
Ms. Bally sold the first block of this security to Mr. Redpath on September 24, 1993. (Div. Ex. 65.) This was a Support Class PO backed by 30-year FNMA 7 percent collateral. This new issue bond had a Pricing Speed of 400 PSA, at which its yield would be 2.97 percent with an average life of 6.8 years. At the time that it was offered for sale, the Bloomberg median prepayment consensus speed for this security was 302 PSA, at which speed it was expected to yield 1.81 percent and have an average life of 10.71. (Div. Ex. 243 at Exs. 21, 22.) The Bloomberg screen furnished to Mr. Redpath by Ms. Bally for this security showed PSA speeds ranging from 200 to 1,000. Although this range encompassed the value of the Bloomberg median prepayment consensus, it was not specifically identified. At 200 PSA, the yield was projected to be 1.337 percent and the average life 15.83 years. At 1,000 PSA, the yield was projected to be 25.61 percent and the average life 0.89 years. (Resp. Ex. 430.) As this was then a new security, there was no historical PSA information available. (Id.) The sale price was 82 3/4. (Div. Ex. 65.)
The second purchase of this security by Mr. Redpath from Ms. Bally at MGSI occurred on January 19, 1994. By this time the price had dropped and the purchase was made at 68.5. The Bloomberg median prepayment consensus speed at this date declined to 274 PSA, which carried a projected yield of 4.15 percent and an average life of 11.86 years. (Div. Ex. 243, Ex. 23.)
Finally, Ms. Bally sold the third block of FNMA 1993-205H to Mr. Redpath on March 7, 1994, at a price of 39.75, less than half the price of the first purchase. (Tr. 466.) The Bloomberg median prepayment consensus speed on this date for this security was 231 PSA. (Div. Ex. 243, Ex. 26.) Ms. Bally provided yield tables to Mr. Redpath that showed PSA speeds ranging from 200 to 800. Although this range encompassed the value of the Bloomberg median prepayment consensus, it was not specifically identified. At 200 PSA, the yield projected was 5.9 percent and the average life 15.57 years. At 800 PSA, the yield projected was 120.4 percent and the average life 1.07 years.11 The yield table also disclosed the following historical PSA speeds for this security: (Div. Ex. 69.)
| Feb 94 | Jan 94 | Dec 93 | Nov 93 | Oct 93 |
| 269 | 518 | 705 | 719 | 407 |
Ms. Bally circled the column of yields at 500 PSA (yield 35.29 percent at the offered price, with an average life of 3.69 years.) She also circled the January 1994 historical PSA speed of 518. (Id.)
At the time of the sale of the third block of this security, Ms. Bally was aware that interest rates had changed drastically beginning in early 1994, that the Federal Reserve Bank kept raising interest rates and that there was turmoil in these markets. (Tr. 457, 600.) She offered the third block of this security to Mr. Redpath as a "cheap insurance policy" and an opportunity to "dollar cost average." (Tr. 458; Div. Ex. 69.) Three weeks after this purchase, on March 30, 1994, Ms. Bally advised Mr. Redpath that she could sell this security for 40.25, enabling him to realize a gain of $4,000.
FNMA 1994-19S (IF)
Ms. Bally sold FNMA 1994-19S, a TAC Class Inverse Floater backed by 30-year FNMA 7.5 percent collateral to Mr. Redpath in two transactions on March 31, 1994, and on April 15, 1994. For the second transaction, Ms. Bally furnished a Bloomberg screen presenting yield tables ranging from PSA speeds of 150 to 750. The Bloomberg median prepayment consensus speed (not specifically identified as such on the tables presented by Ms. Bally) was 226 PSA, down from the Bloomberg median for the first transaction of 276 PSA. (Div. Ex. 243 at 25-26.) At the Bloomberg median, the yield would have ranged between 8.6 and 11.6 percent. (Div. Ex. 74 at 4.) For a price of 73 20/32, at 150 PSA, the yield projected was 7.56 percent and the average life 12.31 years. At 500-750 PSA, the projected yield was 30.29 percent, and the average life 1.35 years. (Id.) The historical PSA speeds shown on this screen were as follows:
| APR 94 | MAR 94 | FEB 94 |
| 512 | 556 | 600 |
Ms. Bally circled yields and average lives at 500 PSA, which projected a yield of 30.29 percent and an average life of 1.35 years and the historical PSA speed for April 1994 of 512. (Id.)
None of the Bloomberg screens furnished by Ms. Bally to Mr. Redpath for this sale disclosed the impact that changes in LIBOR would have on this security's yield. (Id.) Ms. Bally further provided handwritten notes on the screens she provided with commentary that included: "Deep discount," "great yield," and "short average life." (Id.)
(ii) Consequences of the transactions
Mr. Redpath followed a course of increasing investments in POs and IFs that were offered to him for sale by Ms. Bally. His original purpose was to invest only the portion of the County's funds that were available for long term investment in such securities because of the opportunities for increased yields and the remote likelihood that such funds would be required for immediate needs.12 However, these investments at times came to constitute 85 to 89 percent of the County's total investment portfolio. (Tr. 313.) This investment approach was successful in 1992-1993 (Tr. 291.), which coincided with a period of declining interest rates. However, with rising interest rates and tumult in the markets in 1994, the wisdom of this investment strategy became doubtful as average lives extended, yields declined, and prices fell. (Tr. 267, 313.) The market values of the CMOs held by Lewis & Clark County by December 1994 - January 1995 were approximately $7.5 million below their cost. (Tr. 310.)
As a consequence of these developments, the County and School District No. 1, whose funds were included in the pooled amount managed by Mr. Redpath, jointly asked the state auditor's office to look into the MGSI and GSC brokerage firms. The state auditor barred these firms from further business in Montana, pending the outcome of the investigations. (Tr. 268.) These investigations concluded in settlements, whereby GSC refunded to the State approximately $415,000, and MGSI $25,000, to settle the claims. (Tr. 268, 279.) Lewis & Clark County also retained an investment professional to review the portfolio and reinstituted an investment committee to set County investment policy. (Tr. 267, 269.) In addition, the State of Montana has adopted regulations that bar local governments from investing in CMOs. (Tr. 269.)13
Lewis & Clark County is still holding some CMOs purchased from MGSI until such time as it can sell them and realize a return of at least 2-4 percent over the life of the investment. (Tr. 307-310.)
Ms. Bally is charged with violating antifraud statutes by, among other things, omitting to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. Rule 10b-5, 17 C.F.R. § 240.10b-5. Section 17(a) of the Securities Act is a comprehensive anti-fraud statute dealing with perpetration of fraud in the offer of sale of securities. Section 17(a)(1) makes it unlawful "to employ any device, scheme, or artifice to defraud." Section 17(a)(2) prohibits the use of false statements or omissions of material fact to obtain money or property. Section 17(a)(3) forbids any person from engaging "in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon" a purchaser of securities. Section 10(b)5 of the Exchange Act and Rule 10b-5 thereunder make it unlawful for any person, directly or indirectly, in connection with the purchase or sale of a security, to make an untrue statement of material fact; omit to state a material fact; use any device, scheme or artifice to defraud; or engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person.
The antifraud statutes are intended to reach a broad category of behavior. General Bond & Share Co. v. SEC, 39 F.3d 1451 (10th Cir. 1994). They contain broad prohibitions against manipulative, deceptive or fraudulent practices; C.E. Carlson, Inc. v. SEC, 859 F.2d 1429 (10th Cir. 1988), (citing Richardson v. MacArthur, 451 F.2d 35, 40 (10th Cir. 1971); and do not attempt to specify each particular form of proscribed misconduct. In re Silicon Graphics, 183 F.3d 970 (9th Cir. July 2, 1999). These broad prohibitions notwithstanding, the specific acts or omissions alleged to be fraudulent must be measured against standards of disclosure that would ensure that these statutes were not violated. The appropriate standard for disclosure in these circumstances is that brokers selling CMOs were required to ensure that their customers understood: (1) the characteristics and risks of CMOs; (2) what prepayment assumptions are and that they are factored into the offering price, yield, and market value of an offered CMO; (3) market values of POs are extremely sensitive to prepayment rates, which, in turn, vary with interest rate changes; and (4) the risks and characteristics of IFs being purchased in light of their high price volatility as interest rates move. I find that the record evidence as a whole supports this disclosure standard; i.e., that even if NASD Notice to Members 93-78 can be construed as inapplicable to these brokers, the disclosure requirements discussed in that Notice are fully supported by and are fully consistent with the testimony of the Division's and the Respondent's expert witnesses.14
Applying these standards to Ms. Bally's conduct, it is first clear that Ms. Bally believed that her customer, Mr. Redpath understood the characteristics and risks of CMO securities because she was aware that: (1) he had purchased CMOs previously, albeit the less risky PAC class of CMOs; (2) she had furnished to him prospectuses and a FFIEC stress test for each CMO he bought from her while she was at a predecessor firm, MS&B, (3) she provided yield tables by fax and discussed them with him for each sale; and (4) he seemed knowledgeable about these securities, given what she knew about his background and experience. From all appearances to Ms. Bally, (and to Mr. Redpath's supervisor, see Tr. 283), he seemed to know what he was doing.
It is necessary to discuss whether, in fact, Mr. Redpath understood the characteristics and risks of CMO securities, and to assess Ms. Bally's culpability if we conclude that he did not. We are hobbled a bit in this inquiry because Mr. Redpath did not appear at the hearing and was not subject to cross-examination. From the record evidence, one may conclude, in hindsight, that Mr. Redpath was not fully aware of the characteristics and risks of CMOs. However, Ms. Bally provided enough information to enable Mr. Redpath to ascertain the nature of these financial instruments and to enable him to assess whether he wanted to deal with them. She did not withhold materials that would have shown these securities in a less favorable light. It appears that Mr. Redpath did not do all that he should have done to study the characteristics and risks of the bonds that Ms. Bally was offering for sale. He was content to sit back and realize the high interest and gains he was obtaining from purchases and trades in CMOs offered by Ms. Bally and others, without questioning his seeming good fortune or doing serious analysis of the risks associated with the interest-rate sensitive securities he was purchasing and selling.
Ms. Bally provided the information that she was required to provide. It cannot be said that she omitted material facts necessary to make her statements not misleading. The information that she routinely provided contained all of the data required for a person of reasonable competence in this field to assess the risks associated with the proffered investment opportunities. There is no doubt that Mr. Redpath was a person of reasonable competence in these matters as the facts laid out above plainly reveal. While the standard being applied speaks of ensuring that the customer understood the characteristics and risks of the securities, that standard can be met by something short of getting inside the customer's head to see if he really did fully appreciate the complexity and the risks of the instruments she offered for sale. That is something that cannot be definitively known except in hindsight. All of the outward signs Ms. Bally observed were consistent with her view that Mr. Redpath knew the characteristics and risks of the CMO securities.
Ms. Bally satisfies the second test dealing with prepayment assumptions as well. Her business practice was to furnish to Mr. Redpath for each security she was presenting to him for sale a Bloomberg yield table that disclosed information about the historical PSAs for the security, and yield and average life at various PSA speeds. While not specifically identifying the Bloomberg median consensus prepayment speed projection for each security, the range of prepayment speeds in the Bloomberg yield tables customarily furnished by Ms. Bally to Mr. Redpath was sufficiently broad that it included that Bloomberg median value.15 These yield tables that she conveyed to him disclosed which prepayment assumptions were built into the offering price, yield and market values, and depicted what would happen to these values at several different prepayment speeds. More was not required.
Ms. Bally repeatedly testified that she worked from historical PSAs, a practice that the Division treated with derision, suggesting a certainty that the past would not be prologue to the future. It felt that it was misleading on her part to focus on historical information about prepayments when forecasts of the future were available. However, it was not an unreasonable practice, and certainly not a misleading one, to present and focus on historical data for something as volatile as interest rate trends. As Ms. Bally wisely testified, she had no ability to predict interest rate directions. She thought, reasonably in my view, that historical information about prepayment rates would be useful to a customer contemplating an investment in securities with high interest rate sensitivity. She regularly presented yield tables that depicted a range of prepayment scenarios, which included recent historical information, and their implications.16 There is, moreover, no hard evidence that the Bloomberg medians actually predicted the trend of future interest rates better than historical data, the testimony of the Division's experts notwithstanding. (Tr. 1744-45.)17
The Division also made much of the fact that Ms. Bally circled certain data on the Bloomberg yield tables that she furnished to Mr. Redpath, which often was based upon an historic PSA. Div. Ex. 69 shows that, in early March 1994, Ms. Bally circled the 500 PSA column on the yield table in a fax to Mr. Redpath, which corresponded with the January 1994 monthly PSA, even though the February figure, 269 PSA, was then available. The Division sees this as misleading, but the lower February PSA is actually stated on the yield table, and that table includes a PSA speed even lower than the most recent historical (February) PSA level. From this table, a person with reasonable competence in this field and fair eyesight could see, for example, that at PSA 200, the yield would be 5.9 percent and average life 15.57 years. Moreover, the historical PSA data reflects a down-up-down pattern, ranging from 407 PSA in October 1993, up to 719 PSA in November, then down to 518 PSA in January, and down further to 269 PSA in February. So, it is only with hindsight that we can confirm the Division's view that, at this juncture, interest rates were trending up and would continue to do so.
The third standard, that the broker must ensure that the customer understands that market values of POs are extremely sensitive to prepayment rates, which, in turn, vary with interest rate changes, also has been satisfied here. This is confirmed by the information that Ms. Bally routinely provided to Mr. Redpath and the fact that Mr. Redpath purchased the same PO (FNMA 1993-205H) at vastly different prices, which reflected an implicit understanding that market values were highly sensitive to prepayment rates, which in turn varied with changes in interest rates. (Tr. 716.) The Division's arguments that Ms. Bally misled Mr. Redpath in his subsequent purchases of FNMA 1993-205H, when she described them as a cheap insurance policy, and a good opportunity to dollar average, are not persuasive. Mr. Redpath was not so unsophisticated that he was unaware of the consequences of these subsequent purchases at lower prices. The more persuasive view is that he was aware that the market value of these securities was very sensitive to prepayment rate swings influenced by changing interest rates.
The fourth disclosure standard relates to IFs. It requires the broker to ensure that the customer understands the risks and characteristics of IFs being purchased in light of their high price volatility as interest rates move. The record evidence supports the view that this standard is best met by the provision of a two-dimensional, so-called "7 x 7 table," for inverse floaters (available on Bloomberg), which shows the effects on coupon and yield of changes in the interest rate index and prepayment speeds. (Div. Ex. 243 at 13-14.) It is clear that Ms. Bally did not provide Mr. Redpath with any table showing the effect upon coupon or yield from changes in the interest rate index (here, LIBOR) for FHLMC 1602-SA (IF) or other IFs. (Tr. 501-02.) Ms. Bally contended that she did not supply such a table because Mr. Redpath did not request it. (Id.) She was aware that there was a formula stated on the IF security from which one could compute the coupon changes resulting from changes in the interest rate index, and believed Mr. Redpath had the ability to do that (Tr. 382, 420.), but accepted that he could not compute yield changes on those securities from LIBOR and prepayment changes without a Bloomberg format. (Tr. 421.)
The information provided by Ms. Bally to Mr. Redpath associated with IF securities fell short of the best information she could have supplied, i.e., the Bloomberg 7 x 7 yield tables that varied coupon and yield with changes in LIBOR and prepayment speeds. There is some uncertainty in the record as to the availability of these types of Bloombergs in the time frame at issue and as to Ms. Bally's awareness of these co-varied tables at the time of these transactions. (see Tr. 420.) Nevertheless, a complete picture of the sensitivity of this type of security to interest rate changes was not communicated to Mr. Redpath.
The question remains whether the omission of this information rises to the level of being misleading and a violation of the fraud statutes. I conclude that it does not. First, the business relationship that existed between Ms. Bally and Mr. Redpath includes an impressive information transfer, even though it did not routinely include the co-varied LIBOR yield tables for IFs.18 The information she provided should have enabled a customer with the background of Mr. Redpath to assess the characteristics and risk of all of the CMOs he was purchasing, including those IFs that were sensitive to movement of the interest rate index. The degree of sophistication of the investor here is also relevant to this issue. Ms. Bally believed that she was dealing with a knowledgeable customer. She was aware that Mr. Redpath was a C.P.A., and that he was quite capable of making calculations based upon formulas in the securities that provided him requisite information on his security purchases, and that, if he needed more, he could ask for it, and she would supply it.19 I do not believe it was her duty to take steps even beyond those she did take to ascertain if in fact Mr. Redpath was as knowledgeable as his statements and his credentials suggested.20
This is not a case where the negligence of the victim can be seen as excusing a fraud by the broker. The victim (Mr. Redpath) may have been negligent in the execution of his fiduciary responsibilities to Lewis & Clark County, but he was not perceived as "credulous and unwary"21 by the broker charged here. Neither can it be said that Ms. Bally unscrupulously defrauded Mr. Redpath by preying upon his negligence. For all she knew, he was on top of his job, asking the right kind of questions and making the right kinds of calculations and judgments.
Finally, there has not been demonstrated on this record an intent on Ms. Bally's part to deceive. Ms. Bally's motives, while mercenary, lacked scienter, that is, she did not have a mental state embracing an intent to deceive. Malone v. Microdyne Corp., 26 F.3d 471, 478 (4th Cir. 1994), quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, n. 12 (1976).22
The Division has alleged numerous examples of mendacious activity on the part of Ms. Bally. (Div. Br. at 22-33.) Many of these examples reflect, not lies, as the Division contends, but genuine confusion about terminology and its use in questions. For example, the questioning of Ms. Bally regarding use of historical information, the definition of short term, and her knowledge of the Bloomberg system, was by and large inconclusive and cannot be regarded as dispositive on the question of her mendacity.
In addition to the one relatively clear example of mendacity mentioned above concerning her knowledge of Bloomberg median availability, only one other is significant enough to require further comment. That concerns the FFIEC test. Ms. Bally is charged with misrepresenting the significance of the FFIEC test. The record confirms that she was aware that the test was good information. (Div. Ex. 228 at 70-71; but see Tr. 510-11.) She provided the FFIEC test results to Mr. Redpath, but might have downplayed their value to him by observing that the test applied to financial institutions, and not public funds, such as Lewis & Clark County. (Tr. 515.) The test does apply to financial institutions, as Ms. Bally said, but provides all investors with good information on risk. I conclude that her failure to advise Mr. Redpath of the usefulness of these test results was not intended to deceive, but reflected her understanding of the applicability of the test. Her testimony as to her knowledge of Bloomberg medians, which lacked credibility, was of little consequence, given the information she did provide to Mr. Redpath as to the nature of the CMO securities she was offering for sale and the inclusion of the Bloomberg median value in the range of PSA assumptions supplied on yield tables. These are the sole indications in this record of misrepresentation or untruthfulness. Neither rises to the level of decisional consequence on the issue of scienter. The record taken as a whole fails to demonstrate that Ms. Bally intended to defraud or manipulate her client in the manner here suggested by the Division.
For all of the above reasons, I conclude that the Division has not supported the contention that Ms. Bally made fraudulent representations and omissions in the sale of the following CMOs to Lewis & Clark County, Montana in violation of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder:
Neither has the Division proved that Ms. Bally violated Section 17(a) of the Securities Act of 1933 or Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.
Consequently, there is no basis for ordering Ms. Bally to cease and desist such violations, for imposing any remedial sanction, for disgorging any ill-gotten gains or for paying any civil penalty.
Larry J. Bagwell began working as a bond salesman with MS&B in late 1990, and moved on to MGSI in June 1991, where he remained until September 1994. (Tr. 1184-85.) He received some training in CMOs at MS&B, including occasional classes covering such things as floating rate CMOs and Bloomberg yield tables, and better training in CMOs at MGSI. (Id.) He became reasonably familiar with CMOs and sold them throughout this period of time. (Tr. 1186.) He knew how to use the Bloomberg system. (Tr. 1224.) Mr. Bagwell holds NASD Series 7 and 63 licenses. (Tr. 1233.)
The allegations that Mr. Bagwell made fraudulent misrepresentations and omissions in the sale of CMO securities to the City of Joplin, Missouri involve transactions from June 1992 through February 1994, when he was employed with MGSI. Mr. Bagwell understood that it was his responsibility as a broker to ensure that his customers understood the characteristics and risks of CMOs and other securities, as well. (Tr. 1235-36.)
Linda Sharp received a Bachelor of Science degree in Business Administration, with a major in Accounting, from Missouri Southern State College in 1982. (Tr. 726.) Her education did not include any courses in finance or investments. (Tr. 726-7.) She began her career right after receiving her B.S. degree by accepting a position with Cusack, Mense, Brown and Company, a small Certified Public Accounting firm in Joplin, Missouri. (Tr. 727.) In 1984, she moved to Baird, Kurtz and Dobson, a larger, regional CPA firm in Joplin, with two partners of her original firm. (Id.) While with Baird, Kurtz and Dobson, Ms. Sharp passed the CPA examination. (Id.)
At these firms, Ms. Sharp performed auditing work for government and not-for-profit entities and tax work during the tax season. She was involved with the City of Joplin's audits for 10 years. During her tenure with the two CPA firms, Ms. Sharp's exposure to investments was limited to obtaining bank confirmations of Certificates of Deposit ("CDs") held by the firms' municipal clients. (Tr. 728-9.) She provided no investment consulting services. (Id.) Her personal investment experience was limited to buying five shares of Wal-Mart stock and a mutual fund. (Tr. 734.)
Ms. Sharp became Director of Finance for the City of Joplin on March 2, 1992. (Tr. 729.) Among her duties was investing money, pooled in a Treasurer's fund, that the City obtained from sales and property taxes and other revenue sources. These funds were to be used for Joplin's regular operations. Ms. Sharp believed that her foremost responsibility was to keep Joplin's funds safe and to earn the best return she could. (Tr. 735.) When Ms. Sharp assumed her position as Director of Finance, the City had about $11 million in Certificates of Deposit in local banks, and $9 million in a money market checking account. (Tr. 736.) When the CDs became due, Ms. Sharp was getting bids of around 3 percent interest from local banks offering to renew the instruments for six months. (Tr. 737.) She concluded that these banks were not interested in these deposits, since the offered interest rate was so low, and she sought new vehicles for investment.
Ms. Sharp prepared a simplified cash flow worksheet to determine how much money could be put into investments, such as mortgage-backed securities like "Ginnie Maes," obligations of the Government National Mortgage Association, and CMOs, to obtain a greater yield. (Tr. 935, 976,) She purchased Ginny Maes from a local bank during her first months on the job. She understood that these obligations were guaranteed to return her investment. (Tr. 739-40,), and she believed them to be "nice, safe" investments. (Tr. 937.) Although Ms. Sharp understood that these securities would return a higher yield than CDs, she did not have a good understanding of the risk/reward relationship when she entered into the purchase of Ginny Mae securities (Tr. 939.) She did, however, understand the common principle that when one invests for a higher yield, one can expect to assume some additional risks. (Tr. 1040.) Ms. Sharp stated that she would not have purchased CMOs if she thought that Joplin could lose money (Tr. 754, 838-39.) and did not think she was gambling or speculating by making investments in CMOs. (Tr. 753-54.)
Ms. Sharp was a member of the Missouri Finance Officers and Treasurers Association and the GFOA. She attended GFOA's annual conference and seminars in 1992 and 1993. (Tr. 811.) At the 1993 conference, Ms. Sharp attended a session dealing with CMO investments and their application in government portfolios. (Resp. Ex. 132; Tr. 1060-61.) The session included presentations on "Understanding the Risks and Benefits of CMOs," "What Needs to be Done Prior to Purchasing a CMO," "Stable or Risky CMO Tranches: Which Do You Own?" (Resp. Ex. 128.) She also visited the offices of MGSI and Westcap Securities and received information on CMOs, as well as on the Bloomberg analytic system. (Resp. Ex. 126; Tr. 1103.) Ms. Sharp had in her possession in 1992 or early 1993 an article entitled "Collateralized Mortgage Obligations: Not Perfect Investments as Claimed." (Tr. 1027-28.)
Larry Bagwell reached Ms. Sharp by making a cold call phone contact on June 3, 1992. (Tr. 1481.) In this call, he obtained basic information as to the City of Joplin's investments, including the fact that the City had $11 million that was not needed for cash flow, $8 to 9 million of which was returning about 6 percent in investments maturing in the near future. (Tr. 1481.) Mr. Bagwell also sent to Ms. Sharp a PSA Government Securities Manual. (Div. Ex. 173; Tr. 748-49.) In a second call on June 15, 1992, Mr. Bagwell spent 54 minutes explaining CMOs to Ms. Sharp, in the context of describing a range of investment possibilities. (Tr. 1485-96.) On July 31, 1992, Mr. Bagwell faxed Ms. Sharp a yield matrix for a CMO security, on which he numbered various portions. (Resp. Ex. 8.) He proceeded to take Ms. Sharp through each of the items on the matrix for the purpose of explaining them to her. (Tr. 1511.) Mr. Bagwell believed that Ms. Sharp was engaged in the subject of the 54-minute call from her frequent questions and participation in the call (Tr. 1495.) and that she seemed to understand the elements of the yield table. (Tr. 1511.) 23
Ms. Sharp did not have access to a Bloomberg terminal or other computer analytics for CMOs. (Tr. 764-65.) She relied upon Mr. Bagwell for analytic information and for assurance that the securities she purchased were priced fairly and made sense for Joplin. (Tr. 766; 1226.)
Mr. Bagwell's practice was to review the specifics of bonds that he was offering for sale to Ms. Sharp orally by phone. It was unusual for him to fax her information about a proposed sale. (Tr. 771.) 24 Mr. Bagwell explained that this practice was customary for him with all of his customers. (Tr. 1538-40.)
Mr. Bagwell claims to have presented complete information to Ms. Sharp by phone for each bond offered for sale. This included, for a new issue, the price of the bond, the starting coupon, the pricing PSA speed, the underlying collateral, information on yield and average life for a range of PSA levels, and, for IFs, the effects of changes in the LIBOR interest rate index. (Tr. 1536-38.) Mr. Bagwell claims further that it was his normal business practice to vary the CMO up and down 300 basis points from the Bloomberg consensus median and disclose this information to his customer orally for every transaction. (Tr. 1173.) He retained the yield tables and his notes from these calls. (Resp. Exs. 2, 8.)
Ms. Sharp's recollection and contemporaneous notes paint a different picture. She testified that she took down on a "sticky note" all of the numbers that Mr. Bagwell communicated to her on a typical sales call. (Tr. 831, 835; Div. Exs. 147, 148.) The data she recorded fell well short of the information that Mr. Bagwell claims to have communicated.
This discrepancy is not easily resolved. It is unlikely that Mr. Bagwell communicated the full range of information he outlined at Tr. 1536-38 for each and every transaction with Ms. Sharp. It is equally unlikely that Ms. Sharp wrote down all of the information he did communicate on the sticky notes she used for this purpose. Her note-keeping habits and general casual demeanor with respect to her investment responsibilities do not give one confidence that she wrote down all of the data Mr. Bagwell revealed to her.
For several reasons, I conclude that Mr. Bagwell's testimony is more credible on this issue than Ms. Sharp's, but there remains uncertainty about the depth of information he actually provided to Ms. Sharp in his various sales calls. He revealed one instance where he made a note of the fact that, because he was calling Ms. Sharp from home instead of his office (dealing with a family illness), he was unable to communicate to Ms. Sharp information on yields or collateral. (Resp. Ex. 2 at MGJ 1111; Tr. 1524-25.) This suggests a likelihood that, ordinarily, he provided a fuller range of information in his other calls to Ms. Sharp. Then there is Ms. Sharp's practice of recording information from Mr. Bagwell on "sticky notes." Such notes have a limited amount of space. It seems highly probable that Ms. Sharp limited her notetaking to only those facts she needed for her own record-keeping. Consequently, these notes cannot be relied upon to divulge all of the information Mr. Bagwell provided. Finally, there is Ms. Sharp's statement that when Mr. Bagwell called, she was off doing a jillion other things. (Tr. 932.) From this, as well as examples in the record of Ms. Sharp's faulty memory,25 I conclude that her recollection of the telephone calls from Mr. Bagwell deserves somewhat less credence than his, and that Mr. Bagwell at least disclosed the information contained in his notes and holding pages, whether or not Ms. Sharp's notes are fully in accord.
This is not to suggest that Mr. Bagwell is totally credible either in relative terms or on the more important issue of whether he communicated more than he recorded on his notes and holding pages. It is clearly self-serving of him to now claim that a full range of disclosure was made in all instances save the one when his sales call was made from home. Although MGSI taped broker calls on a rotating basis, no such records of sales calls to Ms. Sharp have been disclosed here. Thus, there is nothing in the record to corroborate Mr. Bagwell's claims. I conclude that he conveyed to Ms. Sharp all of the information contained in his notes and holding pages for the securities at issue here. The record does not support his assertion that his business practice included the full disclosure described in his testimony at Tr. 1536-38, or that this practice was followed in all cases.
Mr. Bagwell provided monthly portfolio reports to the City of Joplin. During March through September 1994, these reports deleted a market value column that had previously been included. Throughout 1993 and into January and February 1994, these reports had displayed cost values in the market value column of the report. (Tr. 1444, 1472.) In January and February 1994, this column continued to show cost figures, which were now above market value, due to the implications of increasing interest rates on these values. (Tr. 1445.) In 1993, the reverse was the case, i.e., the market value column showed cost figures which were below market value. (Tr. 1444.) Ms. Sharp was advised that the market value column contained cost figures in late 1992. (Tr. 1902.) In March 1994, MGSI deleted this column and informed Ms. Sharp of the reason why, i.e., that it had contained cost information and did not reflect market value. (Tr. 1908.)26
(i) Representative transactions
FHLMC 1602 SA (IF)
Mr. Bagwell sold this support class IF security to the City of Joplin on September 14, 1993. Its collateral was 30-year, 6.5 percent mortgages. (Div. Ex. 244 at 65.) The pricing speed was 200 PSA. The coupon for this security is tied to the one-month LIBOR interest rate index, so that for each 1.0 percent change in LIBOR, the coupon would increase or decrease by 3.25 percent. (Id.) The security is an Inverse Floater, so the coupon moves inversely with the change in direction of the LIBOR. (Id.) The information conveyed to Ms. Sharp by Mr. Bagwell about this security included the effect on yield and average life at 200, 300, and 400 PSA, but he did not vary LIBOR. (Id. at 70; Tr. 1406-07.) The cap and the formula which produces the coupon was disclosed. Ms. Sharp had the ability to use the formula to determine current coupon based upon the one month LIBOR. (Tr. 1407; Div. Ex. 147.) Since this is an IF, a two dimensional matrix, such as a 7 x 7 yield table, would be the preferred mechanism for disclosing risks at various interest rate and prepayment levels. (Div. Ex. 147 at 69-70.) Such information was not provided in writing. All of Mr. Bagwell's disclosures as to this security were made in a telephone call to Ms. Sharp. (Div. Ex. 147.) For the period beginning with the City of Joplin's purchase through March 1999, this security actually yielded a 2.931 percent return. (Div. Ex. 244 at 71.)
FNMA 1993-225 SO (IF)
Mr. Bagwell sold this support class IF security to the City of Joplin on October
28, 1993 and on November 2, 1993. (Div. Exs. 148, 149, 244 at 51.) The underlying collateral consisted of three groups of loans, the largest percentage being 6.5 percent 30-year mortgage loans. (Div. Ex. 244 at 51.) The coupon for this security is tied to the one-month LIBOR interest rate index, so that for each 1.0 percent change in LIBOR, the coupon would increase or decrease by 3.30 percent. (Id.) This security is an Inverse Floater where the coupon moves inversely with the change in direction of the LIBOR. The information conveyed to Ms. Sharp about this security by Mr. Bagwell confirmed by contemporaneous notes of both Mr. Bagwell and Ms. Sharp include the yield and average life at the pricing speed of 200 PSA. (Div. Exs. 148, 144 at MGJ 2968.) Ms. Sharp also noted the 3.3 times one-month LIBOR formula. (Div. Ex. 148.) Although Mr. Bagwell testified that he made wider disclosure generally about the securities he offered to Ms. Sharp, there is nothing to corroborate this testimony as it might apply to this security. In addition, this is an IF security, for which a two-dimensional yield representation, such as a 7 x 7 yield table, would be the preferred disclosure. Such information was not provided in writing. All of Mr. Bagwell's disclosures as to this security were made in a telephone call to Ms. Sharp. (Id.) For the period from December 1993 through March 1999, this security actually yielded a 4.53 percent return. (Div. Ex. 244 at 57.)
FNMA 1993-184M (PO)
Mr. Bagwell sold this support class security to the City of Joplin on September 8, 1993. (Div. Ex. 244 at 27.) The underlying collateral consisted of new 30-year mortgage loans at an average rate of about 7.5 percent. (Id.) This is a Principal Only security, which has a zero coupon. The yield is achieved by purchasing at a discount and receiving principal repayment at par or 100 percent. (Id.) Principal repayment is highly sensitive to prepayment speeds. (Id.) The pricing speed was 200 PSA for this new security. (Id. at 28.) Information conveyed to Ms. Sharp by Mr. Bagwell confirmed by contemporaneous notes of both individuals was a 9.01 percent yield and an average life of 1.6 years, based upon a 600 PSA. (Div. Exs. 144 at MGJ 2970, 150, 151.) As with other securities and his business practice, all the information about this security was conveyed orally to Ms. Sharp by Mr. Bagwell. During the period that the City of Joplin held this security through March 1999, the bond paid down $201,403 of its $4,225,000 principal, with no principal repaid during the last five years. (Div. Ex. 244 at 33.) The security had a negative rate of return over the holding period. (Id.)
FNMA 1993-228G (PO)
This support class security was sold by Mr. Bagwell to the City of Joplin on October 14, 1993, and October 23, 1993. The underlying collateral was new 30-year mortgage loans with an average interest rate of about 7.5 percent. (Div. Ex. 244 at 20.) This is a Principal Only security, which has a zero coupon. The yield is achieved by purchasing at a discount and receiving principal repayment at par or 100 percent. (Id.) The pricing speed for this security was 350 PSA, at which yield would be 2.5 percent, with an average life of 9.2 years. (Id.) For the October 14, 1993 transaction, Mr. Bagwell sold the security while at home. He advised Ms. Sharp that it was a "super PO, and cheap," and "really didn't even explain yields or collateral," because he did not have his dealer sheets with him at home. (Div. Ex. 160; Tr. at 1347.) This was outside of his normal practice. (Tr. 1347.) The next day, after the purchase, Mr. Bagwell went over further details of this security, including a discussion of the security's likely performance at prepayment speeds of 500 to 1,000 PSA, but disclosed nothing at or below the pricing speed of 350 PSA. (Div. Ex. 144 at MGJ 2968.) On October 23, 1999, Mr. Bagwell sold the City of Joplin more of this security. The disclosure focused on a prepayment speed of 572 PSA, which was the one-month historical prepayment rate for this bond. (Id.; Div. Ex. 244 at 22.) Since October 1993, this security paid down to $1,909,529 from $2,000,000, and has not repaid principal in the last 5 years. (Div. Ex. 244 at 26.) The security has had a negative return over the holding period. (Id.)
FNMA 203 SA (IF)
This support class security was sold by Mr. Bagwell to the City of Joplin on September 9, 1993. The underlying collateral was 30-year mortgage loans at 6.5 percent. This is an Inverse Floater security where the coupon moves inversely with the change in direction of the LIBOR.
(Div. Ex. 244 at 58.) The coupon for this SA class security purchased by Joplin is tied to the one-month LIBOR interest rate index. For each 1.0 percent change in LIBOR, the coupon would increase or decrease by 2.6 percent. (Id.) The information provided to Ms. Sharp by Mr. Bagwell related to this purchase, confirmed by their contemporaneous notes, included yields and average lives at 200 and 250 PSA and the coupon formula. (Div. Exs. 144 at MGJ 2970, and 163.) The pricing speed was 200 PSA. (Div. Ex. 244 at 60.) As with other IFs, the preferred disclosure for this security would include information conveyed as a two-dimensional matrix that varies the short term interest rate index (LIBOR here) and prepayment speed. Mr. Bagwell did not disclose such information. (Tr. 1400.) Actual yield for this security over the period from the time of purchase by Joplin through March 1999, was 4.767 percent. (Div. Ex. 244 at 64.)
FHLMC 1653 SB (IF)
This support class security was sold to the City of Joplin by Mr. Bagwell on December 15, 1993. Its collateral consisted of mortgage loans with a weighted-average remaining term of 358 months and a weighted-average coupon of 7.46-7.60 percent. (Div. Ex. 244 at 41.) This is an Inverse Floater security where the coupon moves inversely with the change in direction of the LIBOR. (Id.) The coupon for this SB class security purchased by Joplin is tied to the one-month LIBOR interest rate index. For each 1.0 percent change in LIBOR, the coupon would increase or decrease by 7.0 percent. (Id.) The prepayment pricing speed for this security was 235 PSA. Mr. Bagwell disclosed yield and average life predicated on 300 and 700 PSA, as well as the coupon formula and collateral information. (Div. Exs. 144 at 2967, 168.) He also advised that the coupon would drop to 18.20 percent if LIBOR went to 3.5 percent, but did not disclose a two dimensional matrix showing the effects on yield and average life of changes in LIBOR and prepayment speeds. (Div. Ex. 168.) For the holding period from date of purchase through March 1999, this security yielded 1.753 percent and returned no principal for over five years. (Div. Ex. 244 at 50.) Joplin sold this security on May 5, 1995, for a loss of $619,041. (Id.)
FNMA 1993 205H (PO)
This support class security was sold to the City of Joplin by Mr. Bagwell on January 14, 1994. The collateral for this security consisted of new 30-year mortgage loans at a weighted-average rate of 7.56 percent. (Div. Ex 244 at 34-35.) This is a Principal Only security, which has a zero coupon. The yield is achieved by purchasing at a discount and receiving principal repayment at par or 100 percent. (Id.) The pricing speed for this issue when new in September 1993 was 400 PSA; however, by the time of this sale in January 1994, interest rates had risen and projected prepayment estimates had declined to about 195 PSA. (Id. at 35; Div. Ex. 157; Tr. 1361.) Mr. Bagwell disclosed to Ms. Sharp yields and average lives at prepayment speeds of 518 PSA and 850 PSA. (Div. Ex. 144 at MGJ 2966; Tr. at 1371-72.) The 518 PSA was the January 1994 historical prepayment speed for this security at January 24, 1994. (Div. Ex. 157.) This security had not repaid any principal for over five years and had a negative rate of return for the holding period ending at March 1999. (Div. Ex. 244 at 40.)
FNMA 1993 206SE (IF)
This support class security was sold to the City of Joplin by Mr. Bagwell on September 27, 1993. (Div. Ex. 244 at 153.) Its underlying collateral consisted of 30-year, 6.5 percent mortgage loans. (Div. Ex. 244 at 81.) This is an Inverse Floater security where the coupon moves inversely with the change in direction of the LIBOR. (Id.) The coupon for this SE class security purchased by Joplin is tied to the one-month LIBOR interest rate index. For each 1.0 percent change in LIBOR, the coupon would increase or decrease by 3.2 percent. (Id.) The pricing speed for this issue was 200 PSA. In addition to collateral information and the coupon formula, Mr. Bagwell disclosed to Ms. Sharp information about average lives and yields at 200, 250 and 300 PSA. (Div. Exs. 144 at MGJ 2969, 155 at MGJ 1124.) He did not vary LIBOR in his telephone conversations with Ms. Sharp related to this IF security, nor did he furnish two dimensional matrix depictions of changes in yield and average lives at various LIBOR index rates and different prepayment speeds. (Div. Ex. 244 at 85.) The actual yield for this security over the holding period through March 1999 was 2.364 percent, and no principal had been repaid over this span. (Id.)
FHLMC 1584 SB (IF)
This support class security was sold to the City of Joplin by Mr. Bagwell on August 17, 1993.27 The underlying collateral was mortgage loans having a weighted-average remaining term of 358 months, and a weighted-average coupon of 7.10 percent. (Div. Ex. 244 at 73.)
This is an Inverse Floater security where the coupon moves inversely with the change in direction of the LIBOR. (Id.) The coupon for this SB class security purchased by Joplin is tied to the one-month LIBOR interest rate index. For each 1.0 percent change in LIBOR, the coupon would increase or decrease by 4.18 percent. (Id.) The pricing speed for this security was 185 PSA. Mr. Bagwell disclosed yields and average lives at 185 and 250 PSA, as well as collateral information and the coupon formula. (Div. Exs. 144 at 2971, 170.) He further varied LIBOR to the extent of disclosing the "corners" of the two-dimensional yield table (Div. Ex. 169), where LIBOR increased or decreased by 3 percentage points. (Tr. 1385-86.) This security has actually yielded a total rate of return of 3.289 percent for the period from the date of purchase by Joplin through March 1999. No principal had been repaid in that time span. (Div. Ex. 244 at 80.)
(ii) Consequences of the transactions
Ms. Sharp followed a course of purchasing CMO securities offered to her by Mr. Bagwell and selling them at times to realize profits. Her intent was to achieve a better yield for moneys that the City of Joplin would not require to meet cash flow needs. (Tr. at 986.) She had identified about $11 million that was "extra" and not required to meet ongoing requirements that could be invested in securities with some additional extension risk in order to get better yields. (Resp. Ex. 2 at 1.) Ms. Sharp bought similar CMO securities from Mr.Crow, with Westcap Corporation. (Resp. Ex. 126.) During the period from November 1992 through October 1993, she invested an average of $15.6 million, producing $2.7 million of interest and trading gains, for a total return in the City's fiscal year 1993 of 12.96 percent. (Resp. Ex. 66.) As a result of these and subsequent purchases, Joplin increased its interest income substantially and profited from sales of these securities as long term interest rates declined.
As interest rates began to rise in 1994, the performance of the City's interest rate-sensitive CMO portfolio changed. Moreover, publicity about the negative experience of other municipalities and governmental units with CMOs led to increased attention on Joplin's portfolio. A new City Manager became concerned about market value declines and asserted approval authority over Ms. Sharp's investment decisions. (Tr. 885.) She was sent to discuss the City's investments with a Kansas City law firm under false pretense (Tr. 884-85.) and was shortly thereafter dismissed as Joplin's Finance Director. (Tr. at 980.) That law firm then pursued legal claims on the City's behalf against MGSI and Westcap.
Mr. Bagwell is charged with violating the above-cited antifraud statutes by, among other things, omitting to state material facts necessary in order to make the statements he made not misleading. It is alleged that Mr. Bagwell violated these statutes by painting materially misleading pictures of the CMOs he sold by emphasizing only the upside potential yields using favorable prepayment assumptions, while failing to disclose that the CMOs would be far less attractive investments under other prepayment assumptions. He is further charged with fraudulent misrepresentation in monthly portfolio reports he provided to the City of Joplin from September 1993 through September 1994.
Turning first to the allegations that Mr. Bagwell knowingly provided false market values in the January and February monthly reports to Joplin, and later surreptitiously removed the market value column to hide losses in the account due to interest rate increases during 1994, the credible testimony of a principal of MGSI, Mr. Iverson, cited above, presents a plausible explanation for the problem with the market value column. The fact that the column actually understated market value during 1993 provides support for the position of the respondent here, that the column, when displayed, always showed cost figures and was actually deleted to avoid misrepresentation of market values when those values declined. Ms. Sharp was informed at the outset of her relationship with MGSI that the market value column on the monthly report contained cost figures, and was again reminded in early 1994 of that fact and the reason for its deletion from reports subsequent to February 1994. Moreover, that the column reflected the cost of the securities, as opposed to market value, should have been apparent to the recipient from her own records. I conclude that there was no misrepresentation here. (Tr. 1902, 1908.)
As to the disclosure issues, I will again employ the standard used to assess Ms. Bally's conduct, since similar securities were sold by Mr. Bagwell to the City of Joplin. Under that standard, it is first required that the broker ensures that his customer understand the characteristics and risks of CMOs. Mr. Bagwell had a 54-minute telephone conversation with Ms. Sharp, which he used to acquaint her with the CMOs he would be offering for sale. He followed this up with a telephone call to explain the elements of a Bloomberg yield table. Although Ms. Sharp did not recall these calls, the record contains Mr. Bagwell's notes (Resp. Ex. 2.) and a copy of the marked yield table (Resp. Ex. 8.) which provide support for his testimony on this subject. (Tr. 1485-95.) He also sent her a PSA Government Securities Manual (Div. Ex. 173; Tr. 748-49.) to further inform her about government securities, although this document in fact provides relatively skimpy information about CMOs. Mr. Bagwell visited Ms. Sharp after some early CMO purchases, but before the ones at issue in this case, and provided Bloomberg yield tables for those securities she had purchased and other information. (Resp. Ex. 32.) These tables depicted the risks associated with changing prepayment rates on yield and average lives. In addition, Ms. Sharp had received prospectuses and yield tables from her purchases of CMOs from Westcap in early 1993, which depicted the yields and average lives under numerous prepayment scenarios. (Resp. Ex. 126.) Mr. Bagwell reasonably concluded that Ms. Sharp was familiar with CMOs, including their peculiar characteristics and risks, either from information he provided, or that he knew her to have received from other sources.28 I conclude that he satisfied the standard of ensuring that his client understood the characteristics and risks of CMOs.
In fact, Ms. Sharp was exposed to other information from which she learned or should have learned even more about these securities. She attended a GFOA conference from May 2-5, 1993, at which CMOs were extensively discussed. (Resp. Ex. 132.) She received publications dealing with this subject (Resp. Ex. 72; Tr. 1027-28.), and she had discussions with bankers and auditors about the risks of these instruments in the relevant time frame. (Tr. 781-82, 1024.) Her own reports, written after the interest rate rise, reflected a full understanding of the nature of CMOs and their attendant risks. (Resp. Exs. 63, 66.) Even discounting the value of the second report because it was written in an environment where her job was in jeopardy, one cannot escape the conclusion that Ms. Sharp fully appreciated the nature of the investments she made with Mr. Bagwell. Her protestations to the contrary are not persuasive and are contradicted by other facts in evidence.
The second standard requires disclosure of prepayment assumptions and their effect on yield, average lives, and price. For each security questioned by the Division, Mr. Bagwell's holding pages and notes, and, in most instances, Ms. Sharp's notes, confirm that Mr. Bagwell conveyed information about prepayment assumptions and their effect on the subject variables. However, the information was conveyed orally, and was not uniform or consistent with respect to the range of prepayment scenarios across all securities sold. For example, for FHLMC 1602 SA (IF), Mr. Bagwell quoted effects across three different PSA speeds, including the pricing speed, but for FNMA 1993 184M (PO), he focused only on one, PSA 600, when the pricing speed was 200 PSA. I do not believe that the latter example constituted adequate disclosure regarding prepayment assumptions. Similarly, disclosure was inadequate for FNMA 1993-225 SO (IF) because only one PSA speed was discussed; and for FNMA 1993 205H (PO), because Mr. Bagwell focused on one PSA speed, 518, and a higher speed, 800 PSA, when the bond's actual PSA had declined to 195.29
There is also the question whether oral disclosure was sufficient, even in the cases where a broader range of prepayment assumptions was conveyed. I conclude that there is a clear reason to prefer written disclosure, because the effects of varying prepayment assumptions on yield, price and average lives is much more apparent in a visual context. Nevertheless, I conclude that oral disclosure would suffice, provided the information was complete enough to paint a true picture of the risks of the security offered for sale at various prepayment speeds. As noted, the information disclosed by Mr. Bagwell about the effect of prepayments on price, yield and average lives for the sales of FNMA 1993-184M (PO), FNMA 1993-225 SO (IF) and FNMA 1993 205H (PO) was not fully adequate to satisfy the standard.30
The third prong of the disclosure standard is that the broker must ensure that the customer understands that market values of POs are extremely sensitive to prepayment rates, which, in turn, vary with interest rate changes. I conclude that here, as with the general risk standard first considered, there is enough information in the record to conclude that Ms. Sharp appreciated this fact. Particularly, Ms. Sharp's reports, and the information provided by Mr. Bagwell and Mr. Crow of Westcap would be sufficient to meet this test.
The fourth disclosure standard relates to IFs. It requires that the broker ensure that the customer understands the risks and characteristics of IFs being purchased in light of their high price volatility as interest rates move. The record confirms that this standard would best be met by the provision of a two-dimensional matrix that shows the impact on yield of changes in prepayment speeds and the interest rate index. (Div. Ex. 244.) Such information was not provided by Mr. Bagwell at the time of the sales of the securities in question here. In one case, FHLMC 1584 SB (IF), it appears that Mr. Bagwell varied LIBOR by discussing with Ms. Sharp the "corners" of a two-dimensional yield table that varied LIBOR. (Div. Ex. 169.) However, the record will not support a conclusion that this was Mr. Bagwell's normal business practice. He did communicate the coupon formula to Ms. Sharp regularly, but this was not fully adequate to achieve satisfactory disclosure of the effect of interest rates on yields and market value of IFs. (See, e.g., Div. Ex. 244 at 45.)
In sum, Mr. Bagwell did not fully satisfy reasonable disclosure standards relating to the provision of prepayment speed assumptions and interest rate index changes for several of the securities he sold to the City of Joplin. We turn next to assess whether there was an intent to deceive Ms. Sharp by these omissions.
Scienter is a state of mind embracing an intent to deceive, manipulate or defraud. Aaron v. SEC, 446 U.S. 680 (1980); Hochfelder, 425 U.S. 185 at 193. Scienter is established by showing that the respondent acted intentionally or with severe recklessness. Hackbart v. Holmes, 675 F.2d 1114, 1117 (10th Cir. 1982). Recklessness, in turn, is defined as "an extreme departure from the standards of ordinary care...which presents the danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it."
Meyer Blinder, 50 S.E.C. 1215, 1229-30 (1992) (quoting Sundstran Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977). For purposes of Sections 17(a)(1) and 10(b)5 and Rule 10b-5, proof of scienter need not be direct, but may be "a matter of inference from circumstantial evidence." Herman & MacLean v. Huddleston, 459 U.S. 375, 390 n.30 (1983); Pagel, Inc. v. SEC, 803 F.2d 942, 946 (8th Cir. 1986).
I find insufficient evidence, either direct or circumstantial, of an intent to deceive on the part of Mr. Bagwell when he provided less than full disclosure of certain information to Ms. Sharp for the securities identified above. It seems clear that Mr. Bagwell went about his responsibilities in an organized and business-like fashion. He was clearly motivated to make sales, but he also respected the rules of the game, as he understood them. Thus, he developed the City of Joplin as a potential customer by engaging in a lengthy telephone call explaining the CMO securities he would be offering for sale, and following up with a more detailed explanation of the variables on a Bloomberg yield table. He supplied explanatory materials and post-sale yield tables. While his customary procedure of conveying information about specific securities by phone left something to be desired, I cannot find any evidence that this modus operandi was intended to deceive his customers. It appears more that he was a broker most comfortable with telephonic communications.
There is also no indication that he deliberately withheld critical evaluative information that his customers needed, nor any suggestion that he refused or delayed responding to requests for additional information from his customer. He did not knowingly disregard any rule or disclosure requirement. Nor can it be said that he unduly pressured Ms. Sharp to make the CMO purchases. Describing a bond as "cheap," (Resp. Ex. 168 at MGJ 1684.) or that he "really liked" a particular security (Resp. Ex. 9.), alleged by the Division as examples of undue sales pressure, is more in the nature of sales puffery than pressure. In short, Mr. Bagwell is at fault for providing less than complete disclosure as to certain securities, and for providing an inconsistent level of detail about the various bonds he offered for sale. The fact that he satisfied disclosure requirements for some of the securities he sold to Joplin belies an intent to manipulate or deceive with respect to others, given that the bonds he offered for sale were similar in terms of risks. Further, the fact that he purchased some of the same securities that he sold to Joplin for himself and sold some to his mother and his son, as well, further suggests an absence of deception as to their worthiness. (Tr. 1569-73; Resp. Ex. 213.)
I also find that the City of Joplin was not so unsophisticated a purchaser that it would have been misled by the disclosure lapses identified on this record. Ms. Sharp could and should have paid more attention to the risks of the securities she was purchasing, but she was not the victim of a deceitful, manipulative broker here. She had enough information from Mr. Bagwell and others accumulated over the relevant time period, the right educational and experiential background, and sufficient knowledge at her disposal to enable her to form her own judgments about the wisdom of these purchases. 31 Banca Cremi v. Alex. Brown, 955 F. Supp. 499 (D. Md. 1997), aff'd, 132 F. 3d 1017 (4th Cir. 1997).
For all of the above reasons, I conclude that the Division has not supported the contention that Mr. Bagwell made fraudulent misrepresentations and omissions in the sale of the following CMOs to the City of Joplin, Missouri, in violation of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder:
Neither has the Division proved that Mr. Bagwell violated Section 17(a) of the Securities Act of 1933 or Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.
Consequently, there is no basis for ordering Mr. Bagwell to cease and desist such violations, for imposing any remedial sanction, for disgorging any ill-gotten gains or paying any civil penalty.
As noted above, the Division has moved for entry of an order making findings, imposing a cease-and-desist order and revoking MGSI's registration as a broker-dealer by default. The Division has further moved on December 13, 1999, in a "Motion to Set Disgorgement and Penalties with Respect to MGSI Securities, Inc.," that MGSI be ordered to disgorge $290,959, plus pre-judgment interest, and that a First Tier Penalty of up to $50,000 be imposed upon MGSI. MGSI has not responded to these motions, but counsel for Bally and Bagwell oppose the Division's latter motion.
MGSI is found in violation of the Securities laws, as charged in the Order Instituting Administrative and Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Sections 15(b), 19(h) and 21C of the Securities Exchange Act of 1934, by its failure to appear and answer these charges.
MGSI will not be ordered to disgorge $290,959, the Division's calculation of MGSI's ill-gotten gains from the trades of Ms. Bally and Mr. Bagwell. Disgorgement should be ordered only when it is clear that ill-gotten gains have been realized, and that such gains are attributable to proven violations of the securities laws. See Canady, Securities Exchange Act of 1934 Rel. No. 41250 (April 5, 1999) (where the S.E.C. excluded from a disgorgement order commissions paid by non-testifying customers.) The findings and conclusions herein with respect to these transactions do not support the notion of ill-gotten gains on MGSI's part for failure to supervise Bally and Bagwell. Nor is it in the public interest to assess a civil penalty in these circumstances. The orders below will be sufficient to render justice in this instance.
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b) (1997), I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on July 7, 1999, and corrected by my order issued July 28, 1999.
It is ordered that MGSI cease and desist from violations of the Securities laws, as charged in the order instituting these proceedings.
It is ordered that the registration of MGSI Securities, Inc. as a broker-dealer be revoked.
It is ordered that the allegations against Connie L. Bally and Larry J. Bagwell be dismissed.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360 (1997). Pursuant to that rule, a petition for review of this initial decision may be filed within twenty-one days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision upon such party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to any party, the initial decision shall not become final as to that party.
__________________________
William J. Cowan
Administrative Law Judge
1 References to pages in the Stenographic Transcript of the hearing held beginning May 10, 1999, and ending May 18, 1999, shall be shown as "(Tr.___.)."
2 The Division's Exhibits have been identified in the hearing transcript and marked as "DX-___." Respondents' Exhibits were identified in the hearing transcript and marked as "Defendants Exhibit ___." For purposes of clarity and to avoid confusion around the use of the letter "D" in both sets of exhibits, each Division Exhibit will be referred to herein by number as "(Div. Ex.___.)"; and each Respondent Exhibit will be referred to herein by number as "(Resp. Ex.___.)".
3 "PSA speed" is a measure of the rate of prepayments in the pool of mortgages that form the collateral for CMOs. "PSA" refers to the Public Securities Association prepayment model. (See Div. Ex. 241, at fn. 3.)
4 An Inverse Floater is a bond whose monthly coupon varies inversely to the value of a particular interest rate index, usually a short-term interest rate, such as the 1-month London Interbank Offer Rate ("LIBOR"). Inverse Floaters are a type of so-called "support class" security derived from the division of CMO collateral into securities structured to have stable cash flows, such as so-called "Planned Amortization Class ("PAC") bonds, and less stable "support class" securities. (Div. Exs. 243 at p.6; 241 at p. 4.)
5 A substantial portion of the mortgage-backed securities market consists of securities issued by Government National Mortgage Association ("GNMA"), Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC").
6 These NASD Notice to Members were communicated directly only to members, not to the registered representatives charged here. However, Members were charged with the responsibility to keep their brokers advised about such NASD Notices, and the evidence suggests that they did so. (Tr. at 413-14.)
7 While this Notice is not artfully crafted, in that it does not affirmatively impose a disclosure sentence in the section on POs, whereas it does for other securities it covers, I believe that it reasonably can be assumed from the Notice as a whole that investors in POs should be made aware of the sensitivity to prepayment rate changes and the relationship between prepayment rate changes and the general level of interest rates.
8 This Notice is dated October 1993, which is after some of the sales at issue here. However, the standards set forth in this document present reasonable expectations as to the information required to be provided by brokers selling CMOs in the time frame of 1993-1994, as the record here so demonstrates.
9 I have evaluated Mr. Redpath's statements to the contrary at page 151 of Div. Ex. 234 in response to leading questions from the Division's interrogators, and find them less credible than his original assertions at Page 150.
10 For example, Mr. Redpath was aware, in early 1994, that the price of the CMOs he had purchased earlier had declined, and that that decline affected yields and average lives. He continued to purchase these securities (e.g., the third purchase of FNMA 1993-205H in early March 1994 at less than half the price of the original purchase). (Div. Ex. 69.)
11 These tables centered on a price of 41 24/32, but the purchase was made at 39 24/32. (Tr. 597.)
12 See Div. Ex. 234 at 23-24.
13 Statewide, there had been about $100 million invested in CMOs. $30-38 million of this was from Lewis & Clark County's investments. (Tr. 277.)
14 While the Division's experts argued that more specific disclosure was required by industry practice, I have concluded that there was no generally accepted universal disclosure standard at the time of these sales that would encompass the kind of specific disclosures discussed in their testimony. It is fair to conclude, however, that the Division's experts would not disagree that at least the kind of disclosure required by NASD Notice to Members 93-78 should have been made, even though they thought much more was required.
15 It is not universally accepted that the Bloomberg median was the appropriate projection for these securities. The Bloomberg median is a projection of the long-term average of the speed at which the underlying mortgages will prepay. While widely used, it is more appropriate for long term tranches than the short-term tranches involved here. (Resp. Ex. 902A at 20, 23; see also Tr. 1732.)
16 Respondents state that it is undisputed that Ms. Bally provided Mr. Redpath Bloombergs for every transaction at issue in this case. Resp. Reply at 22. The Division seemingly disputes this, noting that the record contains Bloombergs furnished by Ms. Bally for only three transactions. Div. Reply at 18-19. However, Ms. Bally testified that her business practice was to send Bloombergs to Mr. Redpath. (Tr. 399, 539-40.) She stated in a prior sworn statement that there were instances where she did not fax him anything before a sale, (Div. Ex. 228 at 48.) but the record better supports the view that her regular business practice was to fax him the Bloombergs.
17 The Division's expert Weiner testified that conceptually, historical experience is a worse predictor of future performance than the Bloomberg median because it uses a rear-view mirror to forecast what is going forward. (Tr. 710, emphasis added.) Division witness Davidson testified that it would be inappropriate to use historic speeds for this purpose because they are not a projection of future performance (Tr. 150.), and that historic PSAs were interesting, but not relevant in a time of changing interest rates. (Tr. 690-91.) However, Division witness Weiner agreed that projection models employed historical data (Tr. 691.), and that such data was useful information, although what is really important is to look forward. (Tr. 712.) Given that historical information is useful and employed in models to develop future forecasts, it cannot be said to be unreasonable or misleading to provide and focus upon such information in sales contacts.
18 Mr. Redpath estimated that he and Ms. Bally had 300 to 400 telephone conversations over the year and a half period of their business relationship. (Div. Ex. 234 at 268.)
19 One time, he asked where would LIBOR have to go for the coupon to go to zero, and she undertook to provide that information. (Div. Ex. 228 at 160.)
20 There is also evidence that Mr. Redpath was reserved in his communications with Ms. Bally, suggesting an unwillingness on his part to explore the subject of these transactions in any more detail than he needed (Tr. 553.) This is confirmed by his declination of an opportunity to attend a seminar that MGSI sponsored on August 19, 1993 (Tr. 554.)
21 Div. Reply at 29.
22 The Division concedes that scienter is required to prove violations of Section 17(a)(1) and Section 10(b). (Div. Brief at 71.) While the Division also stated that scienter need not be shown to establish violations under Section 17(a)(2) or (3), it did not distinguish between which allegations of misconduct it was pursuing under which Section of the statute.
23 Ms. Sharp did not recall much about the 54-minute call or the exercise that Mr. Bagwell described of going through the yield matrix with numbered items (Tr. 753; 1068.), but I conclude that Mr. Bagwell did have such conversations with Ms. Sharp, from his credible testimony and contemporaneous records. (Resp. Exs. 2 and 8.)
24 Mr. Bagwell provided Ms. Sharp with Bloomberg yield table for securities she had previously purchased in a visit he made to her office in June 1993. (Resp. Ex. 32; Tr. 1546-51.)
25 It is also worth noting at this juncture that I found Ms. Sharp often offered unreliable testimony and had a poor memory. Some of this is undoubtedly excused by the passage of time, there having passed about six to seven years since these transactions occurred. (Tr. 752, 853, 901, 1000.) The record contains several other instances where I had to advise Ms. Sharp to respond directly to the questions instead of offering responses indicating doubt or possibility. (see, e.g. Tr. 752, 852, 938.) In general, I found her testimony insufficiently reliable to counter conflicting testimony of Mr. Bagwell.
26 Ms. Sharp could not recall such conversations (Tr. at 866.), but I found the testimony of Mr. Iverson more credible on this point.
27 The Division notes that this sale falls outside the statute of limitations, so it does not seek a civil money penalty related to the sale. It does, however, seek disgorgement of the commission earned by Mr. Bagwell for this sale because the statute of limitations does not apply to disgorgement, citing Barbato, Securities Exchange Act of 1934 Rel. No. 41034 (Feb. 10, 1999).
28 I have concluded that Ms. Sharp's testimony here that she did not understand the relationship between assumptions about prepayments and their effect on CMOs lacks credibility because it is inconsistent with prior sworn testimony given closer in time to these events and the discrepancy is inadequately explained. (She claimed to have had a bad cold the day of the prior sworn testimony, or probably didn't understand the question) (Tr. 940-42.) Moreover, her own reports reflect a rather clear understanding of these relationships. (Resp. Exs. 63, 66.)
29 I note that this security also arose in the context of Ms. Bally's sales to Lewis & Clark County, but she provided yield tables that depicted a greater range of prepayment speeds and their impacts.
30 For FNMA 1993-228G (PO), where Mr. Bagwell did not communicate any information on yields or collateral, he did call the next morning, presenting an array of prepayment assumptions, albeit all above the pricing speed. I conclude that this constituted a good faith attempt to satisfy the disclosure standard.
31 "Competent adults who do not need to be led around on a leash do, occasionally, buy a piece of blue sky." State of West Virginia v. Morgan Stanley & Co., et al., 459 S.E.2d 906, 914 n.17 (W.Va. 1995).
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