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Initial Decision of an SEC Administrative Law JudgeIn the Matter of
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In the Matter of AUBREY O'CONNOR,
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INITIAL DECISION September 28, 2001 |
| APPEARANCES: | Phillip W. Offill, Jr. for the Division of Enforcement, Securities and Exchange Commission Kenneth Ward, pro se |
| BEFORE: | Lillian A. McEwen, Administrative Law Judge |
SUMMARY
This Initial Decision concludes that Respondent Ward did not violate the federal securities laws as alleged in the instant case and dismisses the proceeding against him.
PROCEDURAL HISTORY
The Securities and Exchange Commission (Commission) instituted these proceedings pursuant to Section 8A of the Securities Act of 1933 (Securities Act) and Sections 15(b)(6), 19(h), and 21C of the Securities Exchange Act of 1934 (Exchange Act). The Order Instituting Proceedings (OIP) was filed on June 4, 1997. On October 27, 1999, the Commission accepted offers of settlement from Aubrey O'Connor (O'Connor), Gregory Bowen, and Rick Pierson (Pierson). See Aubrey O'Connor, Order Making Findings and Imposing Sanctions as to Aubrey O'Connor, 70 SEC Docket 2986 (Oct. 27, 1999); Order Making Findings and Imposing Sanctions as to Gregory Bowen, 70 SEC Docket 2991 (Oct. 27, 1999); Order Making Findings and Imposing Sanctions as to Rick Pierson, 70 SEC Docket 2995 (Oct. 29, 1999). James Winter died on February 11, 1999. See James Winter, Order Discontinuing Proceedings, 69 SEC Docket 1327 (Mar. 31, 1999). Thus, the hearing proceeded as to Kenneth Ward (Ward) only.
THE HEARING
On April 21 through 24, 1998, a public hearing was held in Houston, Texas. Ward testified on his own behalf and called one additional witness. He presented fourteen exhibits that I admitted. The Division of Enforcement (Division) called nine witnesses and presented sixty-three exhibits that I admitted.
ISSUES PRESENTED
The OIP alleges that Ward willfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder between October 1992 and March 1994. Ward is alleged to have committed these violations in connection with fraudulent sales of securities to two "public clients," the City of Bryan, Texas (City of Bryan) and the City of League City, Texas (League City). If I conclude that the allegations in the OIP are true, I must then determine what, if any, remedial sanctions are appropriate pursuant to the federal securities laws.
FINDINGS OF FACT
I based the following findings of fact and conclusions on the entire record and the demeanor of the witnesses who testified at the hearing. I applied preponderance of the evidence as the applicable standard of proof. See Steadman v. SEC, 450 U.S. 91 (1981). I rejected all arguments and proposed findings and conclusions that were inconsistent with this decision. I find the following facts to be true.
Respondent Kenneth Ward
Ward was born on October 22, 1951, in Beaumont, Texas, and had been living in Katy, Texas for sixteen years on the date of the hearing. He had never been the subject of a National Association of Securities Dealers (NASD) or Commission action until the instant case. Although he attended college after his discharge from the Air Force, Ward did not obtain a degree. (Tr. 31-35.) He worked in the securities industry as a salesman from 1980 until 1992 when he was recruited by O'Connor to work at the broker-dealer formerly known as Government Securities Corporation of Texas (GSC).1 (Tr. 36, 51, 54.)
During 1993 and 1994, O'Connor was the GSC sales manager, promoting the firm's inventory and facilitating transactions. (Tr. 850.) He also supervised the portfolio strategy department, which supported the sales staff. (Tr. 851.) Around November 1992, Mary Kathryn Campion (Campion) began employment at GSC, where she generated graphs, analyzed cash flow, and arranged portfolio analyses for sales agents. (Tr. 611-12.) She also worked in the portfolio strategy department talking with clients, performing research, and generating spreadsheets. (Tr. 852.) Until her departure from GSC in November 1995, Campion was director of financial strategies, reporting to the sales manager, O'Connor. (Tr. 614.) She used spreadsheet models, computer programs, and a Bloomberg terminal to assist the traders. (Tr. 617-18.) At the time of the hearing, Campion was a Ph.D. candidate in economics at the University of Houston and a portfolio strategist, analyst, and salesperson at Stifel Nicolaus & Co. (Tr. 610, 612.) Pierson, Jerry Short, and Leslie Gaylord, at the GSC trading desk in turn bought from primary dealers such as Paine Webber and Kidder Peabody. (Tr. 852-53.) This management team also included Charlie Mitchell a compliance officer and Frank Klaus as compliance director. (Tr. 854.)
Ward generally depended on GSC management to determine whether particular securities were suitable for his clients. He sold securities to the City of Bryan and League City based on what GSC "thought as a whole" about the securities. (Tr. 933, 935.) Ward usually contacted clients and informed them about risks associated with every security he sold. (Tr. 936-37.) The GSC sales staff, including Ward, was closely supervised. Telephone conversations were recorded at their desks and at the trading desk. (Tr. 838.) In addition, all correspondence with clients had to be approved by a supervisor or by the compliance staff. (Tr. 839.) All incoming correspondence was first opened by the mailroom staff, who routed customer complaints directly to management. (Tr. 841.) The sales staff did not write their own sell tickets, but were kept apprised of GSC daily inventory. Brokers earned a commission that varied, depending on the particular security. GSC conducted in-house training sessions that lasted at least ninety days, followed by strict supervision for one year. (Tr. 860-61.) GSC also periodically conducted seminars for customers, and management also met individually with customers. (Tr. 865-66.) GSC compliance policy included suitability guidelines, and methods to ensure that customers understood the risks associated with the securities that GSC sold. Those securities included inverse floaters, described below. (Div. Ex. 52 at 2, 29, 34, 39-47.)
Inverse Floaters
Some of the securities GSC sold were collateralized mortgage obligations (CMOs), a type of mortgage-backed security. Mortgage-backed securities are created by pooling a large number of residential mortgages, which are used as collateral for the issuance of securities. These securities are considered "high yielding safe investments" because the U.S. government, or instrumentality, guarantees most mortgage-backed securities. Daniel R. Amerman, Mortgage Securities 5 (1993). (Resp. Ex. 13 at 3.) CMOs provide regular payments to investors, which include varying amounts of both principal and interest. (Resp. Ex. 13 at 6.)
The maturity of a CMO occurs when the investor receives the final principal payment, based on the last date the principal from the collateral could be paid in full. This date is theoretical because of prepayments. (Resp. Ex. 13 at 6.) Prepayments are any payments made by the homeowner in excess of the scheduled monthly mortgage payment. Because of prepayments, the cash flows from mortgage-backed securities are uncertain. Thus, while an investor in a mortgage-backed security may know that eventually he will recover the principal, he does not know the timing of the principal payments. (Div. Ex. 70 at 11-15, Resp. Ex. 13 at 1-4.) This uncertainty concerning the timing of prepayments is called prepayment risk. (Div. Ex. 70 at 16-21, Resp. Ex. 13 at 5-6.)
Prepayments, and in turn cash flows, yield, and the life of the security are influenced by interest rates. For example, when interest rates decline, homeowners tend to refinance their mortgages and prepayments accelerate. Other factors such as seasonality (homes purchased so as to move in before school starts) and general business conditions (more or fewer job opportunities that involve moving) also affect prepayments. (Div. Ex. 70 at 16-21, Resp. Ex. 13 at 5-6, 9.) Because of the effect prepayments have on the yield of the CMO, it is important to estimate the rate of prepayment, or prepayment speed. See Amerman, supra, at 202.
"It is the amount and timing of [prepayment] from a mortgage that makes the analysis of mortgages and mortgage-backed securities complicated." Frank J. Fabozzi & Chuck Ramsey, Collateralized Mortgage Obligations: Structures and Analysis 1-2 (3d ed. 1999). Brokerage houses estimate prepayment speeds based on several factors; however, there is rarely agreement on these forecasts and there is usually significant variation in estimates. See Amerman, supra, at 202. The Public Securities Association developed a prepayment benchmark that is one convention used to estimate prepayment speeds and is expressed in terms of "100 PSA" with slower or faster speeds representing a percentage of the benchmark. The higher the PSA, the faster the estimated repayments. See Fabozzi & Ramsey, supra, at 21, 23. The prepayment benchmark is often characterized as a prepayment model, suggesting that it can be used to predict prepayments. This characterization is inappropriate. "[The prepayment benchmark] is simply a market convention." Id. at 23 n.2, 33.
CMOs distribute prepayment risk among bond classes, or "tranches." This results in prepayment risk being reduced for some investors, while allowing other investors to take on increased prepayment risk in return for higher yields. (Resp. Ex. 13 at 10-14.) Different investors are attracted to different tranches depending on their investment needs. See Fabozzi & Ramsey, supra, at 5. Floaters are one kind of CMO tranche. A floater carries an interest rate tied to a variable interest rate index, such as the London Interbank Offer Rate (LIBOR) or Cost of Funds Index (COFI). Inverse floaters, another CMO tranche, offset floaters because while the coupon rates of floaters move in the same direction as the index rate, the coupon rates on inverse floaters vary inversely with the index rate. (Div. Ex. 52 at 41, Resp. Ex. 13 at 15-16.)
Inverse floaters are leveraged securities with price volatility. A small change in interest rates causes a dramatic change in the coupon rate. Accordingly, prepayment risk is magnified. Inverse floaters earn high returns if interest rates decline or remain constant, but lose substantial value if interest rates increase. Inverse floaters are considered a high-risk tranche. (Div. Ex. 52 at 39-40, Resp. Ex. 13 at 15.)
Ward was familiar with the unique characteristics of inverse floaters: "If interest rates go up, the yield goes down. If the interest rates go down, the yield comes up." (Tr. 81, 84.) The principal is guaranteed, but the interest is adjustable according to the formula that is set by the underwriter when the bond is issued. (Tr. 84.) Inverse floater CMOs, rated AAA, are permitted pursuant to Item 7, in the Texas Public Funds Investment Act of 1987, as an obligation of the United States or its agencies or instrumentalities because "Freddie Mac or Fannie Mae are the guarantor." (Tr. 71.) Furthermore, "the market believes that these are [AAA] rated securities and rates them that way." (Tr. 72.) Thus, Ward believed that the inverse floater CMOs were obligations of the United States because the underlying mortgage pool was guaranteed by the federal government, and consistent with the Texas Public Funds Investment Act of 1987. (Tr. 72.)
In February 1994, the Federal Reserve Board raised interest rates. This set off a disastrous chain reaction in the CMO market. The jump in rates halted prepayments, which extended the average maturity of CMOs, especially inverse floaters. CMO holders flooded the market, trying to sell. CMO liquidity dried up, and the fear of illiquidity further reduced the number of purchasers. One investment fund filed for bankruptcy, forcing the liquidation of its large CMO portfolio. Later in 1994, Kidder Peabody, the most active CMO underwriter and market maker collapsed, and forced the liquidation of the largest CMO portfolio on Wall Street. The market in CMOs virtually collapsed in 1994. (Tr. 946-48; Resp. Ex. 13 at 17.)
GSC information about securities furnished to Ward's clients had language that clearly stated the risks associated with CMOs and complex derivatives such as inverse floaters:
Although this information has been obtained from sources which GSC believes to be reliable, GSC does not guarantee that it is accurate or complete, and it should not be relied upon as such. All assumptions, opinions and estimates constitute GSC's judgment as of this date and, along with prices and yields, are subject to change without notice. The yield and/or average life shown consider prepayment assumptions that may or may not be met. Changes in prepayments may significantly affect yield and/or average life. Please contact your GSC representative for information on how these securities react to different market conditions. Any US Government or Agency guaranty applies to the underlying principal and interest payments and does not cover the market value or any premium paid. (Div. Ex. 14 at 1.)
* * *
This material is for informational purposes only and is not intended as an offer to sell or a solicitation of an offer to buy any security. It merely provides information and/or alternatives that GSC believes is appropriate for your consideration. Although this information has been obtained from sources which GSC believes to be reliable, GSC does not guarantee that it is accurate or complete, and it should not be relied upon as such. All assumptions, opinions and estimates constitute GSC's judgment as of this date and, along with prices and yields, are subject to change without notice. (Div. Ex. 22 at 1.)
* * *
Although this information has been obtained from sources which GSC believes to be reliable, GSC does not guarantee that it is accurate or complete, and it should not be relied upon as such. All assumptions, opinions and estimates constitute GSC's judgment as of this date and, along with prices and yields, are subject to change without notice. The yield and/or average life shown consider prepayment assumptions that may or may not be met. Changes in prepayments may significantly affect yield and/or average life. The interest rate on inverse floating securities will vary in the opposite direction of changes in the index to which it is tied. An investment in securities with interest payments inversely tied to an index involves significant risks not associated with investment in a conventional debt security, and multiplication in the Indexing Formula magnifies this risk. The historical experience of the index should not be taken as an indication of its future performance. Please contact your GSC representative for information on how these securities react to different market conditions. (Resp. Ex. 12 at 5.)
The City of Bryan, Texas
Ward began visiting prospective public fund clients with Aubrey Stowell (Stowell) while he was employed at the brokerage firm Marcus, Stowell and Bye in September 1990. That fall, Ward and Stowell visited three agents for the City of Bryan, Mary Kaye Moore (Moore), Kathy Davidson (Davidson), and Glenda Ross (Ross). (Tr. 908-09; Ward Br. at 2.) The City of Bryan had an unusual source of revenue for its investments. It owned and operated an electric utility company, which supplied power to thousands of customers. The City of Bryan furnished Ward and Stowell with "their debt service requirement schedules and their cash flows in and their cash flows out and copies of their portfolios . . . ." (Tr. 909.) Stowell had the firm's certified public accountant/strategist analyze the data and he and Ward made a second presentation to the City of Bryan a month later. Ward subsequently showed bonds to the City of Bryan over the next few months, and "they started doing business" in 1991. (Tr. 910.)
The City of Bryan Investment Policy was promulgated by the city council on April 28, 1992. The primary objectives were safety, liquidity, and yield. In reference to safety, the written objective was "to ensure the preservation of capital in the overall portfolio." The Investment Policy recognized that "diversification is required in order that potential losses on individual securities do not exceed the income generated from the remainder of the portfolio." (Div. Ex. 1 at 3, ¶ 3A.) In reference to liquidity, the "investment portfolio will remain sufficiently liquid to enable the City to meet all operating requirements which might be reasonably anticipated." (Div. Ex. 1 at 3, ¶ 3B.) As to yield, the "investment portfolio shall be designed with the objective of attaining the maximum possible rate of return throughout budgetary and economic cycles . . . ." (Div. Ex. 1 at 3, ¶ 3C.) "Authorized and suitable investments" include "obligations of the United States or its agencies and instrumentalities" and "other obligations, the principal and interest on which are unconditionally guaranteed or insured by the State of Texas or the United States . . . ." (Div. Ex. 1 at 6.)
The city council realized the importance of diversifying:
Diversification of investments as to investment type, issuer, institution, and maturity serve to reduce overall portfolio risk while attaining market average rates of return. The City recognizes that in a diversified portfolio, occasional unrealized market losses are inevitable and must be considered within [the] context of the overall portfolio's return and current market conditions.
(Div. Ex. 1 at 7.) Because the City of Bryan's investment strategy was "passive," the city council emphasized that "normally a security should not be sold until such time as the current market value of the security is at least equal to the purchase price of the security plus accrued interest." (Div. Ex. 1 at 8.)
Moore, Davidson, and Ross acted as an investment committee to whom Ward merely submitted suggestions. Moore, the City of Bryan finance director, "was interested in maintaining a certain kind of yield." Every month, that yield goal was sent to the two women who "ran the investment portfolio," Ross and Davidson. (Tr. 65-67, 360.) In October 1993, Ross left the City of Bryan and Davidson and Moore made the "investment decisions." (Tr. 361.) Davidson obtained information on portfolio management from the Government Finance Officers Association and from seminars. (Tr. 362.) Although Davidson did not do a thorough examination of the City of Bryan's holdings herself, she did regularly obtain the market value of the securities in the portfolio from dealers, which she reported in the "financials." (Tr. 362.) Moore, Davidson, and Ross all attended seminars sponsored by the Government Finance Officers Association and thus were formally educated about the investments they made through Ward. The City of Bryan knew the characteristics of each security it held, including the maturity dates and the yield because Moore, Davidson, and Ross generated monthly bond portfolio performance reports for the city council. (Tr. 147, 168; Ward Br. at 2-3.)
Ross was responsible for reviewing the City of Bryan's investment policy to minimize risk and maximize return. She spent two years obtaining information from GSC and from other broker-dealers, and attending seminars and Government Finance Officers meetings nationally and in Texas. (Ward Br. at 2.) Ross "met with dealers, discussed investment strategies and that kind of thing." (Tr. 360.) Ross had greater expertise in handling the City of Bryan's portfolio, and was responsible for learning about "investment transactions" so that she could advise Davidson and Moore. (Tr. 364-365.)
Davidson, a high school graduate with thirty hours of college credit, was a student at Midland College at the time of her testimony. After working as a bookkeeper and teller at a small-town bank, Davidson was hired by the City of Bryan as "the accounting manager" where she held that position for twelve years until she was promoted in 1993 to finance officer. (Tr. 356-57.) As accounting manager, Davidson "managed the City's accounting, oversaw the computerized accounting system, and still did budget work and financial reporting work." (Tr. 359.) She was appointed finance officer after a reorganization relieved her of some duties, and allowed her to move to finance officer where she "basically did the financial reporting and budgeting." (Tr. 359.) She had done that work in "the early [1980s] for several years" when she handled cash projections and investments. She also supervised an assistant. (Tr. 359-60.)
As of March 31, 1991, before Ward had sold it any securities, the City of Bryan had a portfolio of over $58 million, including more than $6 million in instruments that matured between the years of 2017 and 2020. (Resp. Ex. 1 at 3-4.) By December 31, 1991, the City of Bryan had purchased an inverse floater, with a maturity date of 2020, for over $1 million. (Resp. Ex. 2 at 6.) By February 29, 1992, the City of Bryan's portfolio contained CMOs totaling 15.67% of the portfolio's total assets. (Resp. Ex. 3 at 4.) During the month of April 1992, prepayments on the CMOs had increased 31.2% over prepayments during the preceding month. (Resp. Ex. 4 at 1.) During March 1993, the City of Bryan bought over $11 million in CMOs "in an attempt to pick up additional yield in lieu of having excess liquidity funds . . . from accelerated CMO roll-offs" so that the CMOs constituted 43.7% of the City of Bryan's portfolio. (Resp. Ex. 5 at 1, 3.) By October 31, 1993, the City of Bryan had invested over $7 million in securities with maturity dates of 2017 or later. (Resp. Ex. 6 at 14-15.) The City of Bryan also owned two floaters at a cost of over $2 million that matured in the first half of 1995. (Resp. Ex. 6 at 18.)
The City of Bryan had experience with CMOs before Ward established a formal relationship with its agents, having bought its first CMOs (maturing in 2018 and 2020) in January 1991, for over $2 million, from a firm other than Ward's. The City of Bryan did not purchase a security from Ward's firm until July 30, 1991. (Tr. 81; Ward Br. at 2.) The City of Bryan prepared monthly investment reports. (Tr. 428-429.) The monthly report for December 1991 stated "the 2.5 million combination of the Freddie Mac LIBOR inverse and Fannie Mae COFI Annual reset floating rate securities were purchased to yield a combined rate of approximately 8.8443 with an average final maturity of 4.21 years." (Tr. 429; Resp. Ex. 2.) However, the stated maturity date of the bond purchased in 1991 was 2020. (Tr. 430.)
Ward brought the City of Bryan with him from Marcus, Stowell, and Bye to GSC. He signed a customer information new account sheet on October 22, 1992, two years after his relationship with the City of Bryan began. (Tr. 74; Div. Ex. 2.) The GSC compliance department actually filled out the new account form for the City of Bryan. (Tr. 74-75; Div. Ex. 3.) Ward knew that the City of Bryan "wanted investment grade securities in its portfolio" and he signed blank versions of the same forms.2 (Tr. 76-79; Div. Ex. 4-5.)
By the fall of 1993, the City of Bryan had $24 million invested in TexPool (a public funds investment pool created by the State of Texas acting by and through the Texas Treasury Safekeeping Trust Company). Moore controlled those funds, and she contacted Ward at GSC to discuss "that she would like to see if we could enhance the yield and still remain within our investment policies." (Tr. 443, 907.) Because "inverse floaters are guaranteed as to principal," Ward believed that they were consistent with the kinds of obligations that the statutory guidelines described as appropriate for investment by the City of Bryan. (Tr. 56-57.) Ward also understood that the City of Bryan wished its account to be invested so that safety, liquidity, and yield would be factors considered in descending order of priority. (Tr. 59, 929.) GSC's back office confirmed a trade for the City of Bryan's purchase of an inverse floater on October 28, 1993. (Tr. 80-81; Div. Ex. 6.) The inverse floaters bought in the fall of 1993 began to generate a cash flow immediately, and the City of Bryan continued buying inverse floaters in late 1993. (Tr. 93-96, 153-54, 446; Div. Exs. 7-11.) After October 1993, the City of Bryan did business with several different firms, including GSC, and bought CMOs from brokers other than Ward. (Tr. 363-64.) The City of Bryan bought a Fannie Mae 1992 - 210 S bond on November 3, 1993, that paid out or was "cash flowed out of existence" by May 25, 1994." (Tr. 447-453; Resp. Ex. 7.)
The rapid prepayments that the City of Bryan experienced from 1991 through 1993 led the employees of the City of Bryan to be lulled "into a sense of false security in thinking that could be expected for other securities that we purchased as well." (Tr. 432.) On March 31, 1993, the City of Bryan had a total portfolio of over $45 million. (Tr. 437.) On September 30, 1993, when GSC computed a principal investment balance of over $24 million for the City of Bryan in TexPool, the interest rate in the TexPool was 3.676 % for that investment. (Tr. 438, 442.)
The City of Bryan "wanted inverse floaters that paid off very quickly," but even if interest rates rose, Ward concluded that an inverse floater would not be a bad investment for them "because the principal would be guaranteed." (Tr. 106-07.) Thus, Ward proposed a transaction in which the City of Bryan purchased "the 115 SD tranche of inverse floaters." (Tr. 108.) Ward authorized figures to be faxed to the City of Bryan on March 11, 1994, reflecting the 115 SD tranche at a 500 PSA along with a Bloomberg yield table and the City of Bryan cash flow analysis. (Tr. 139; Div. Ex. 17.) Ward would not have offered the City of Bryan the security with projected cash flows at 200 PSA. (Tr. 140-46; Div. Ex. 16, Resp. Ex. 13 at 7.)
In March 1994, O'Connor told Ward that he might "have the securities being taken over for a sister company which was a mutual fund that dealt with pension funds." (Tr. 175-76.) A yield table was prepared at the request of O'Connor, as part of a proposition for a swap so that the City of Bryan would sell certain securities in order to purchase the FNMA 1993 115 SD inverse floater, and other securities, even though interest rates had been raised during the quarter. (Tr. 146-49, 151; Div. Ex. 18.) A swap analysis was also faxed to Davidson at Ward's direction, and he discussed it with her. (Tr. 155-56; Div. Ex. 20.) Ward thought that O'Connor had asked Ward to offer the swap to the City of Bryan because O'Connor was familiar with the client's portfolio. O'Connor himself authorized the GSC analysis of the swap proposal that was sent to the City of Bryan. (Ward Br. at 7.) The inverse floater was initially turned down by the City of Bryan in the first week of March, but they did buy it on March 29, 1994. (Tr. 175-76; Ward Br. at 7.)
On March 28, 1994, Ward told Davidson "that Mr. O'Connor had come to him and had a money manager that owned a portion of this portfolio." (Tr. 185-86.) Ward told Davidson that he "expected the prepayment speeds to pick up," based on advice from the trading desk and from the portfolio strategy department. (Tr. 187.) He also told her that he could purchase the bonds in the portfolio at cost so that the City of Bryan could buy the 115 SD inverse floater. (Tr. 205.) The package that included the 115 SD inverse floaters were "going away" at the time of the conversation between Ward and Davidson, and Moore also wanted "to keep the yield up on the portfolio." (Tr. 213.) The GSC compliance officer approved the swap transaction; Campion especially wanted PSA speeds run at a "reasonable range" of 350 to 550 before the swap occurred. (Tr. 217-19.) Ward proposed the swap to Davidson, and after she contacted Moore, the City of Bryan approved the swap. (Ward Br. at 7.)
Although Moore was the finance director for the City of Bryan, Davidson was the buyer who approved transactions. Therefore, Davidson was the person to whom Ward showed securities. (Tr. 223-24.) When Ward offered the 115 SD inverse floater to Davidson, he also showed her "other securities during that same time frame." (Tr. 163.) He expected the summer of 1994 to be similar to the summer of 1993. (Tr. 1994.) Ward expected, and the trading desk and portfolio strategy department kept telling him, "prepayments would pick up and be as high as they were the previous summer." (Tr. 163.) Since most of the securities purchased by the City of Bryan in 1991 to 1993 "cash flowed out of existence," Ward expected prepayment speeds to continue to be high and did not think there was any reason for interest rates to go any higher. (Tr. 164.) Ward and the City of Bryan "talked about prepayment speeds and the extension risks on securities on a regular basis, on a monthly basis." (Tr. 165, 168.) He relayed information and projections from the firm's trading desk, Bar-Tel reports (a computer generated sheet based on Bloomberg figures, and other material, so that interest and principal payments could be calculated), and from other broker-dealers to the City of Bryan, before the March 29, 1994 purchase. (Tr. 168-69, 280-82; Div. Ex. 17.) However, the bonds might have been overpriced. (Tr. 710, 725, 727.) At GSC, O'Connor and other GSC managers were responsible for the "swap material and the market valuations." (Ward Br. at 7.) The term of the swap was that the City of Bryan exchanged, with GSC, three PAC bonds for a treasury note, a floating interest CMO, and the 115 SD inverse floater.3 (Div. Ex. 22 at 6.)
Davidson knew what an inverse floater was and that there was some risk. However, she did not realize "that just minor changes . . . in interest rates could drastically extend the life of an inverse floater." (Tr. 371.) Although Ward never discussed this matter at great length, there were discussions of particular securities and of his estimate of its performance. (Tr. 165-75, 372.) Davidson relied on other brokers and on Ward for information about evaluation and likely performance of the securities in the portfolio. Ward had visited the City of Bryan several times over a couple of years to discuss investment alternatives before and after his employment by GSC. (Tr. 366.) He also discussed "the performance of the securities" that the City of Bryan owned. (Tr. 367.) Usually, Ward called to identify a security "he would like [the City of Bryan] to look at or consider buying." He would fax information about the security that the investment committee reviewed and discussed. (Tr. 367.) The information usually included Bloomberg printouts. (Tr. 368.) Ward discussed "the price and the yield and the settlement date and the maturity date" for the 115 SD inverse floater. (Tr. 369-70.)
Davidson assumed that the higher the PSA speed the more quickly principal and interest payments would be made. (Tr. 372.) However, she told Ward that she "was not knowledgeable about PSA speeds, and he basically was my source of information about these securities." (Tr. 373.) As for Ward's representations about PSA, Davidson interpreted them to be merely a "projected payout" for the security. She also assumed that the projection could be obtained by any broker-dealer, since it was based on "historical data as well as projected data for future performance." (Tr. 375.) Davidson knew that for inverse floaters "the yield is inverse to market interest rates" and that the yield could go to zero. (Tr. 422, 424.)
The 115 SD inverse floater turned out to be a highly volatile instrument. (Tr. 931.) However, if interest rates had stayed the same, or been lowered, the 115 SD inverse floater "would have cash flowed out of existence." (Tr. 932.) Ward had never sold an inverse floater that "had any kind of losses" for the client. (Tr. 933.) In addition, Ward depended on GSC management to determine whether the securities were suitable for his clients, and he sold them to the City of Bryan based on what GSC "thought as a whole" about the securities. (Tr. 668-72, 688, 933, 935.) Ward contacted clients and informed them about risks associated with every security he sold. (Tr. 936.) But he did not guarantee the profitability of any securities purchased by the City of Bryan by promising to repurchase them if they had not paid off by September 1995. (Tr. 235.) He discussed extension risk with the City of Bryan many times. (Tr. 895-98.)
The City of Bryan purchased "various types of securities," such as deposits in TexPool, certificates of deposit (CDs), treasuries, and CMOs. (Tr. 60.) In April 1994, the City of Bryan bought $5 million in treasury bills. (Tr. 61.) Ward offered the City of Bryan "some shortened surety type instruments," but they purchased inverse floaters instead from 1993 through 1994. (Tr. 61-62.) He believed that the liquidity standard meant that the City of Bryan had "to keep enough cash on hand to meet the basic requirements of the City," and that its other investments "in TexPool or CDs in relatively overnight investments" served that purpose, as well as maximized yield in the portfolio while maintaining cash flow. (Tr. 62-64.) The City of Bryan sent Ward the same monthly report that the city council received, describing "cash flows and their yields and the bonds that had rolled off and those kinds of things . . . ." (Tr. 65-67.)
During May 1994, Debra Canant (Canant) became the investment coordinator for the City of Bryan. Shortly thereafter, she purchased about $6 million in treasury bills from GSC for the City of Bryan, and she told Ward that she had reviewed the City of Bryan's investment portfolio. (Tr. 233-34.) Canant had the portfolio analyzed by several financial advisers and then concluded that because 50% of the portfolio was "in CMO-related instruments," the portfolio "was not as diversified as it should have been." (Tr. 481, 484.) She was also told that "we paid 90 cents on the dollar for a security that was worth - or would have been selling in the market for 80 or below at the time we purchased it." (Tr. 484-85.) That security was the 115 SD inverse floater. (Tr. 485.) In the summer or fall of 1994, the City of Bryan told the press that "if we held the particular securities to the stated maturity, that we would recover our principal investment." (Tr. 470.)
She told Ward to sell the 115 SD inverse floater at a loss. (Tr. 498.) Canant did not give Ward a market order for the sale, but rather a suggested price for them that turned out to be "nowhere near the price that was being offered by primary dealers" to the GSC trading desk. (Ward Br. at 7.) Eventually, the City of Bryan retained counsel, who sued GSC and Ward. (Tr. 501.) The City of Bryan settled the matter with GSC, but the City of Bryan retained the 115 SD inverse floater in its portfolio, deciding "to keep the 115 SD" inverse floater after all. (Tr. 236, 460-463.)
Ehud I. Ronn was accepted as an expert in the area of financial economics and derivative securities. (Tr. 718.) His expert opinion was that the 115 SD inverse floater had a fair value of $69.55 to $71.25 on March 29, 1994, the date of its sale to the City of Bryan. (Div. Ex. 70 at 2.) He also opined that between the issue date of June 1, 1993, and March 29, 1994, the security declined in value 18.19%. (Div. Ex. 70 at 28.) He also concluded that the GSC projected interest rate of 14.8625% was not reasonable. (Div. Ex. 70 at 21.) In order to arrive at these conclusions, Mr. Ronn generated twenty pages of complex formulas, computations, and graphs.
The City of League City, Texas
In 1992, League City had proceeds from construction bond sales that it was able to invest for an earned profit. (Tr. 514-15.) Ward introduced himself to Michael Campbell (Campbell), the finance director of League City in the fall of 1992, and Campbell invited him to bid for investment of the proceeds of League City's recent bond issue. The GSC portfolio strategy department structured the winning bid and League City thus became a GSC client. (Tr. 908.) Campbell worked for League City from July 1987 until July 1993; as finance director and tax assessor, he was responsible for city investments. (Tr. 510-11.)
The "Investment Policy for the City of League City," on its face was "prepared by Michael W. Campbell, Sr., Finance Officer." (Div. Ex. 28 at 1.) Its objectives in order of importance were: "1. To assure the safety of all public funds. 2. To maintain sufficient liquidity so as to provide adequate and timely working capital. 3. To achieve the highest possible rate of return on the investment of City funds." (Div. Ex. 28 at 3.) However, there is no indication that the policy was ever "approved by the governing body" as required by state law. (Div. Ex. 28 at 13.) The only form of a council "resolution" is a blank 1990 form that authorizes League City to invest in TexPool. (Div. Ex. 28 at 36-37.) I, therefore, find that League City did not have a written investment policy that I can credit.
As of February 28, 1990, League City had about $9 million invested in CDs. (Div. Ex. 28 at 21.) On January 26, 1993, League City by "Mike Campbell" opened an account with GSC by purchasing "FS 92-33 FD" shares, with the investment objective of "Income" and a risk factor of "Invest Grade" checkmarked on the new GSC account form. (Div. Ex. 31 at 1.) GSC agreed to "determine the suitability of any securities sold" to League City pursuant to question twenty-four of the Broker/Dealer Questionnaire form signed on February 2, 1993, by Ward. For League City, the Broker/Dealer Questionnaire was completed by Greg Putnam, a GSC compliance officer. (Tr. 246-47; Div. Ex. 29; Ward Br. at 9.) Campbell had also promised to forward League City's investment policies and objectives to Ward "as soon as possible." (Div. Ex. 29 at 5.) Campbell informed Paul Nutting (Nutting), the city administrator, and Joseph Murphy (Murphy), the director of administrative services for League City, by memorandum on February 2, 1993, that he would be purchasing securities for League City from GSC: "It is my intention to purchase various government and agency securities to offset the low yields currently being received from TexPool from this corporation." (Div. Ex. 29 at 1.) Thus, five days after Campbell's actual purchase of securities, Campbell informed League City of his intention to purchase them; there is no indication that Campbell ever supplied GSC or Ward with a written investment policy for League City, as he had promised. In addition, the attachment to the February 2, 1993, memorandum to Nutting and Murphy also informs them that Campbell had not provided League City's investment policies and objectives to Ward as of February 2, 1993. (Div. Ex. 29 at 5.)
League City, on January 28, 1993, had total assets of $15 million, and investment of $1 million with an investment objective of "buy and hold" for the securities that League City bought from GSC on January 28, 1993, which consisted of "442-FNMA ADJ CARO." (Div. Ex. 30.) League City's goal was to increase operating income and offset the interest it paid on its bonds, like many public clients that Ward had. (Ward Br. at 8.) During the summer of 1993, Campbell attended a seminar in Austin, Texas, where he learned about inverse floaters, and he asked Ward about them. Ward met with Campbell and the investment committee after their PAC bonds had begun to pay principal immediately and other bonds were paid off quickly. By late 1993, the bond with 12% to 15% yield that Ward had sold League City had also "cash flowed out of existence." League City had borrowed $10 million in the municipal bond market at 5.5% but was earning only 3.5% in TexPool, and thus lost 2% annually from its bond sales.
Campbell understood at the beginning of the business relationship that Ward might recommend an investment, and that Campbell would decide whether "to approach the investment committee" with the recommendation. (Tr. 527.) Campbell began buying securities for League City from GSC in January 1993. (Tr. 528.) Campbell left his employment at League City in July 1993 as a result of his being convicted of a felony related to League City funds. (Tr. 532.) At the time of his testimony, Campbell was still on probation for theft. (Tr. 533.)
For each of the securities that League City bought through Campbell, GSC provided League City with a table of projected cash flow. (Tr. 538.) Because the securities "paid off faster" than anticipated, League City decided to reinvest some funds. (Tr. 538-39.) League City did not purchase inverse floaters with the first $15 million investment with GSC. (Tr. 264-65.) Because inverse floaters have guaranteed principal, Ward had thought they were among the securities that League City could invest in; therefore, Ward showed Campbell several Bloomberg printouts and discussed inverse floaters with him. (Tr. 274.) In addition, Ward explained the risks posed by inverse floaters to Campbell and routinely presented League City with the graphs, charts, and analysis that Campion and GSC had generated. (Tr. 259-62, 276-77, 281-82.)
A typical inverse floater before 1994 would be the Fannie Mae 1992 61 SD, purchased for $750,000 by League City on May 27, 1993; it paid out at about $100,000 a month until the obligation was paid up in November 1993. (Tr. 552-53; Resp. Ex. 11.) Generally, for the securities that Ward recommended, "the cash flows came out basically" as Ward told Campbell they would. (Tr. 554.) By June 3, 1993, League City might have invested over $17 million in securities that included inverse floaters and might have sustained losses of over $43,000. (Div. Exs. 41-43, 58 at 1-2, 59 at 15, 62 at 1.)
After Campbell's departure, Ward did business with Nutting and Lonna Stein (Stein), the finance officer. Nutting, with a master's degree in public administration, had worked for League City from March 6, 1978, until January 17, 1995, and was its city administrator during 1993 and 1994. Although Nutting was responsible for managing League City's investment portfolio during that period, Murphy, Campbell, and his successor Stein reported to him on those matters. (Tr. 576-78.) Nutting received no formal training in portfolio management, and he delegated his duties in the area to others. (Tr. 579.)
Stein was employed, at the time of the hearing, as comptroller and tax assessor/collector for League City. During 1993 and 1994, she had been the finance officer, the department head "over the financial area, which includes general ledger, accounts payable, payroll, tax, accounts receivable, all collections." (Tr. 556.) As a member of the investment committee, she assumed the duties of Campbell during June 1993, and dealt with Ward and GSC; the investment committee decided which securities to purchase. (Tr. 557.) Most of the time, Ward offered a security that the investment committee purchased. (Tr. 558.) For the investment committee meetings, the members used a fax from Ward's office "that would state all the specifics about the security" under consideration for purchase. (Tr. 571.) League City's investment committee knew all the characteristics of inverse floaters, including extension risk, which Ward discussed with them frequently. (Tr. 896-97.)
Campbell had routinely reported maturity, or anticipated maturity, and yield of securities to Nutting. (Tr. 583-84.) In August 1993, Nutting learned from Campbell's file that League City "had significantly more securities than we had anticipated." (Tr. 585.) Nutting thought that the original plan was to purchase "short-term securities" followed by "reinvesting them when maturities came due. So when we looked in the file, it appeared that we had about $18 million of city revenues invested in that and some of the funds had been combined in certain instruments." (Tr. 585.) The "amount of money that we had invested in these securities" shocked Nutting. (Tr. 596.)
[I]t was my determination that we did not want to be that invested in securities. Our original game plan had been we [sic] generally had done pretty well in bank deposits, CDs and TexPool. And although we were planning to invest in some securities, to the amount that we were investing that was not the game plan that I had set up. So what we wanted to do was talk to him and find out how we could transition back into our original game plan.
(Tr. 586-87.) Nutting discussed the original game plan, and that he wanted "to be out of securities entirely as soon as possible," with Ward at a meeting late in the summer of 1993. (Tr. 586-88.)
Nutting learned from Ward, that the immediate sale of all the securities would result in some loss. He discussed "swapping securities" with Ward so that funds would be available in mid-1995 for construction projects. (Tr. 588.) Stein executed the new transactions on three instruments and Ward reported to Nutting the cash flow from them. When Nutting saw the figures he "was a little concerned" because "there was a lot of interest coming back and then the principal . . . came back towards the end of whatever would be the maturity of the securities." (Tr. 589.)
In early 1994, Nutting told Ward that he was not satisfied with the inverse floaters in the portfolio. (Tr. 294-97.) At that time, League City maintained 70% to 80% of its cash reserves in TexPool because the original bond purchases from GSC "had all prepaid at a much faster rate than we had originally expected." (Tr. 298-99, 314-16.) On March 28, 1994, Ward reminded Nutting in writing that the PSA speeds are assumptions "set by the issuer but cannot be guaranteed by actual performance." (Tr. 302.) Nutting concluded that in order to pay for $8 million in ongoing sewer projects, if he did not have "principal to pay the bills, then I've got to use interest or other funds to pay those bills." (Tr. 590.) It appeared to Nutting that League City would get all of their money back by 1995, but it looked like there was no equitable distribution of principal, and short-term borrowing from other funds would be necessary to ensure completion of the construction. (Tr. 590.) Ward pointed out League City was "making a lot of interest on the securities," and so Nutting decided "we could make it work," because "we had enough cash in the bank that even if the flow was not what I expected it to be, it could work." (Tr. 590-91.)
Before February 1994, Nutting thought "we had made a decision to buy . . . mortgage securities" that were "relatively short-term, that they were guaranteed by the full faith and credit of the United States government, and that they were in fact issued by the government." (Tr. 592.) Ward sent Stein a seven-page Bloomberg projected cash flow run on three bonds on February 3, 1994, which League City had bought in the fall of 1992. (Tr. 267-77.) GSC also provided League City Bar-Tel reports. (Tr. 280-82; Div. Ex. 34 at 1.) The February 1994 audit report contained a discussion of CMOs, which "seemed to be a different instrument." (Tr. 592.) However, the cash flow for the CMOs for several months was "at least in the ballpark" of the cash flow tables that had been given to Nutting. (Tr. 593.) The investment committee members contacted Ward in the middle of 1994 when they discovered the difference between the cash flows and the Bloomberg report projections. (Tr. 566-67.) Ward offered to "get rid of the securities for the City of League City, but Mr. Nutting said no." (Tr. 568.) By the end of September 1994, GSC generated new cash flow tables for Nutting "that indicated we had no principal due for years." Nutting expected the numbers to be "firm" and Nutting sent Ward a letter, after reading some pamphlets. (Tr. 594-595; Div. Ex. 46.) Ward responded to the letter. (Tr. 595; Div. Ex. 47.)
As of February 14, 1994, League City had a portfolio of $15 million, with 35% of that amount (over $5 million) invested in inverse floaters. GSC senior management believed that they were suitable investments for League City. (Div. Ex. 72 at 1.) The FNMA 1993 115 SD inverse floater that League City purchased from GSC on June 1, 1993, had a fair value of $69.55 to $71.25 per $100 face value of the instrument on March 29, 1994. (Div. Ex. 70 at 2, 16.) The effective maturity on June 1, 1993, was eight and a half years. (Div. Ex. 70 at 13.) From June 1, 1993, to March 29, 1994, the security declined 6.75% in value. (Div. Ex. 70 at 18.) On January 27, 1994, the fair value of the same FNMA 1993 115 SD inverse floater was no lower than $85.56 and perhaps as high as $95.79. (Div. Ex. 70 at 18.) As of January 8, 1997, however, the bond's price was $52.28 per $100 face value. (Div. Ex. 70 at 19-20.)
Nutting had called Ward before filing a formal complaint against GSC and asked whether GSC could buy the securities back. Ward gave him a bid, but Nutting refused to sell at that time. (Tr. 899.) The Texas State Securities Board forced GSC to buy the securities back, so that League City would not have to take a loss by selling in the open market at the point in time when the complaint was filed against GSC. Ward left GSC in October 1994. (Tr. 331.)
CONCLUSIONS OF LAW
The OIP alleges that Ward willfully violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Section 17(a) of the Securities Act prohibits any person from committing fraud in the offer or sale of securities. Section 17(a)(1) makes it unlawful to directly or indirectly employ any device, scheme, or artifice to defraud; Section 17(a)(2) provides that no one shall obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary to make the statements made not misleading; Section 17(a)(3) proscribes any transaction, practice, or course of business which operates or would operated as a fraud or deceit upon a purchaser of securities. Section 10(b) of Exchange Act outlaws the direct or indirect employment of manipulative and deceptive devices in connection with the purchase or sale of securities. Rule 10b-5 of the Exchange Act makes 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.
To prove a violation of Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, the Division must show: (1) that a misrepresented or omitted fact was made in an offer, attempt to induce a purchase or sale, or an actual purchase or sale of a security; (2) that the misrepresented or omitted fact was "material"; and (3) that the respondent acted with the requisite "scienter." See Basic Inc. v. Levinson, 485 U.S. 224, 240 (1988); Aaron v. SEC, 446 U.S. 680, 701-02 (1980). Scienter is "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). It is established by a showing that the respondent acted intentionally or with severe recklessness, defined as highly unreasonable conduct involving not merely simple or inexcusable negligence, but "an extreme departure from the standards of ordinary care." Meyer Blinder, 50 S.E.C. 1215, 1229-30 (1992) (quoting Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)); see also Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990); SEC v. Carriba Air, Inc., 681 F.2d 1318, 1324 (11th Cir. 1982). Proof of recklessness may be inferred from circumstantial evidence. See Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978).
A finding of negligence is adequate to establish a violation of Sections 17(a)(2) and 17(a)(3) of the Securities Act. See Jay Houston Meadows, 52 S.E.C. 778, 785 & n.16 (1996), aff'd, 119 F.3d 1219 (5th Cir. 1997); see also SEC v. Steadman, 967 F.2d 636, 643 & n.5 (D.C. Cir. 1992) (citing Aaron, 446 U.S. at 701-02); Newcome v. Esrey, 862 F.2d 1099, 1102 n.7 (4th Cir. 1988).
Section 17(a)(2) of the Securities Act and Rule 10b-5 of the Exchange Act provide that only material misstatements and omissions are actionable. The materiality element is satisfied where there is a substantial likelihood that under all circumstances, a reasonable investor would consider the omitted or misstated information significant in making an investment decision. See Basic Inc., 485 U.S. at 231-32 (citing TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). A statement is misleading if the information disclosed does not accurately describe the facts, or if insufficient data is revealed. See Basic Inc., 485 U.S. at 232; United States v. Koening, 388 F. Supp. 670, 700 (S.D.N.Y. 1974).
In SEC v. American Commodity Exch., 546 F.2d 1361, 1365 (10th Cir. 1976), the court indicated that actual sales by the defendant were not necessary to establish a violation of the antifraud provisions of Section 17(a) of the Securities Act. To the same effect see United States v. Dukow, 330 F. Supp. 360 (W.D. Pa. 1971), and Fund of Funds Ltd. v. Arthur Andersen & Co., 545 F. Supp. 1314 (S.D.N.Y. 1982). The Dukow court held that even though the defendant was not a party to sales made by brokerage personnel, he was part of the scheme and was not exonerated from charges of securities fraud. 330 F. Supp. at 364. "[T]he securities laws include as a seller entities which proximately cause the sale . . . or whose conduct is a `substantial factor in causing a purchaser to buy a security.'" Fund of Funds Ltd., 545 F. Supp. at 1353 (quoting Lawler v. Gilliam, 569 F.2d 1283, 1287 (4th Cir. 1978)).
The OIP alleges Ward violated the antifraud provisions when he received and disregarded written and oral instructions from the City of Bryan and League City that their investment policies and objectives included liquidity, a short duration, and a low amount of risk, and induced the City of Bryan and League City to liquidate safe and stable investments in order to purchase unsuitable inverse floaters that Ward offered and sold to the public clients. (OIP ¶ IV.B.) The Division argues that although the inverse floaters Ward sold to the City of Bryan and League City had government guaranteed principal, the characteristics and risks of these securities made them "patently unsuitable" for these clients. (Div. Br. at 13.)
Analytically, a suitability claim is a subset of an ordinary fraud claim brought under Section 10(b) of the Exchange Act. See Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020, 1031 (2d Cir. 1993). A broker is prohibited from making recommendations that are "unsuitable in light of the customer's stated investment objectives, in connection with actual misrepresentations and omissions." See Joseph J. Barbato, 53 S.E.C. 1259, 1275 (1999). To prevail on its claim, the Division must prove that the inverse floaters were unsuited to the public clients' needs; that Ward knew or reasonably believed that the inverse floaters were unsuited to the public clients' needs; that Ward recommended the inverse floaters anyway; and that with scienter, Ward made material misrepresentations, or failed to disclose material information relating to the suitability of the inverse floaters. See Banca Cremi, S.A. v. Alex. Brown & Sons, Inc., 131 F.2d 1017, 1032 (4th Cir. 1997); Brown v. E.F. Hutton Group Inc., 991 F.2d 1020, 1031 (2d Cir. 1993). As is discussed below, Ward's disclosure of the characteristics of inverse floaters adequately informed the City of Bryan and League City as to the risks inherent in the securities. The Division has failed to prove that the information provided by Ward failed to accurately reflect the suitability of the inverse floaters.
The Division has failed to prove by a preponderance of the evidence that the inverse floaters were "patently unsuitable" for the City of Bryan's needs. Its Investment Policy does not forbid the purchase of inverse floaters, and there is no specific chronological or arithmetical value assigned to liquidity for the portfolio. Indeed, the city counsel encouraged diversification and accepted the possibility of losses: "The City recognizes that in a diversified portfolio occasional unrealized market losses are inevitable and must be considered within context of the overall portfolio's return and current market conditions." (Div. Ex. 1 at 7.) The Division has been unable to establish that any investment in inverse floaters or related losses endangered the preservation of capital in the overall portfolio or prevented the City of Bryan from meeting all operating requirements that might reasonably be anticipated. (Div. Ex. 1 at 3.)
Ward did not induce the City of Bryan to liquidate safe, stable investments to purchase unsuitable inverse floaters. The City of Bryan had experience with CMOs, including Ginnie Mae securities, prior to doing business with Ward and was aware of the risks of such securities. (Tr. 81, 897; Resp. Ex. 2 at 6.) The City of Bryan also had 30-year mortgage-backed securities in its portfolio. (Tr. 897-98.) Davidson and Moore had differences of opinion as to length of securities and average lives. (Tr. 885.) As late as September 1993, the City of Bryan had over $24 million of its $45 million portfolio still in TexPool. (Tr. 437-38, 442, 907.) Moore was not induced by Ward, but rather by the prospect of a higher yield than the 3.676% received from TexPool. (Tr. 438, 442-43, 447-53; Resp. Ex. 7.) I find the professions of ignorance and incompetence by various employees of the City of Bryan to be lacking in credibility and I do not credit them. A committee of experienced and trained city employees who considered Ward's advice to be mere suggestions made investment decisions. (Tr. 65-67.)
The Division has also failed to prove that the inverse floaters were "patently unsuitable" for League City's needs. League City did not even purchase any inverse floaters with the first $15 million that it invested through GSC and Ward. (Tr. 254-65.) Ward could not have disregarded League City's written investment policy because it probably did not have one. (Div. Ex. 28 at 13, 36-37.) If it did have one, Campbell had not provided it to Ward as late as February 1993. (Tr. 250; Div. Ex. 29 at 5.) League City had invested in the volatile inverse floaters in the hope of offsetting interest that it paid out for its own bonds. (Ward Br. at 8.) As with the City of Bryan employees, I find the professions of ignorance and incompetence by various employees of League City to be lacking in credibility. Campbell had at least six years of experience in finance, and Nutting and Stein were even more knowledgeable and experienced. (Tr. 556-60, 576-79.)
The Division has not proved that Ward induced League City to liquidate safe, stable investments to purchase unsuitable inverse floaters. Campbell and League City were not induced by Ward, but rather by the fact that they had borrowed $10 million in the municipal bond market at 5.5% and were losing 2% annually as a result of the 3.5% they were earning from TexPool. (Ward Br. at 7-8.)
Finally, there is no evidence Ward knew or reasonably believed that the inverse floaters were unsuitable for the public clients and recommended the securities anyway. Before the instant case, Ward had never sold an inverse floater that resulted in client loss. (Tr. 933.) I find that Ward reasonably believed that the inverse floaters sold to the City of Bryan and League City were suitable investments based on the clients' needs and investment objectives.
In addition to material misrepresentations or omissions regarding the suitability of the inverse floaters generally, the OIP alleges that Ward made a number of specific material misrepresentations or omissions in the offer or sale of the inverse floaters. The alleged misrepresentations and omissions include, but are not limited to, the following: stating that GSC and its registered representative had the expertise to select appropriate and suitable investments for their clients; referring to the instruments as "FNMA" securities, rather than inverse floaters, in order to conceal the fact that the instruments were volatile CMO tranches; stating that the inverse floaters were investments with guaranteed principal, good yield, and short average lives, whose maturity would extend, at most, to two years or less; stating that there was no risk, or only a remote risk, that the inverse floaters could have a duration of longer than that specified by the City of Bryan and League City; failing to disclose that the characteristics of the inverse floaters, including duration and yield, were highly sensitive to changes in interest rates; and failing to disclose that the inverse floaters were subject to extension risk of as much as thirty years. Ward also allegedly provided the City of Bryan and League City with documents, including Bloomberg yield and cash flow tables, trade recaps, and fixed income transaction analyses, which materially misrepresented, or failed to fully disclose, the characteristics and risks of the inverse floaters. Finally, in March 1994, Ward allegedly induced the City of Bryan to enter into an adjusted trade, pursuant to which GSC purchased from the City of Bryan, at above market prices, three conservative securities and sold to the City of Bryan, through numerous oral and written misrepresentations, an inverse floater at an undisclosed markup of more than 10% above market value.
The Division has failed to prove that Ward falsely stated that GSC and its registered representatives had the expertise to select appropriate and suitable investments for their clients. Ward was experienced and trained in securities, having been a salesman since 1980, with no disciplinary action taken against him. (Tr. 31-36, 51, 54.) Ward was able to rely on Campion and other experienced employees at GSC for analyses and assistance. (Tr. 611-18, 838-39, 850-54, 933-37.) GSC also had in-house training, seminars, supervisors, and an active compliance department, all of which contributed to Ward's and GSC's expertise in selecting appropriate and suitable investments. (Tr. 860-66; Div. Ex. 52 at 2, 29, 34, 39-47.)
I am unable to conclude from the record or from the evidence as a whole that Ward used the designation "FNMA" to conceal the fact that the securities were inverse floaters. I reject as incredible the testimony of Stein that might require such an inference. (Tr. 557-62.) Instead, I credit Stein's later testimony that the League City investment committee used information faxed from Ward's office "that would state all the specifics about the security" under consideration. (Tr. 571.) As with the City of Bryan, Ward was relegated to the role of making suggestions for League City. Campbell decided whether to present a security to the investment committee after receiving documents sent regularly by Ward. (Tr. 54, 546-47; Div. Ex. 58.)
The remaining material misstatements and omissions Ward allegedly made relate to the characteristics and suitability of the inverse floaters. The Division attempts to prove the false or misleading nature of Ward's statements through the benefit of hindsight. However, Ward's statements and actions were not groundless. He had a firm basis for his predictions. He did not make untrue statements, even though his predictions did not materialize. See Marbury Mgmt., Inc. v. Kohn, 470 F. Supp 509, 512-13 (S.D.N.Y. 1979), aff'd in part, rev'd in part, 629 F.2d 705 (2d Cir. 1979). The Division argues that Ward should never have stated that inverse floaters were investments with guaranteed principal, good yield, and short average lives, whose maturity would extend, at most, to two years. The problem with this argument, of course, is that it is made with the benefit of hindsight and knowledge of what actually occurred with only certain inverse floaters. As is stated above, I credit Ward's testimony that he always accurately described the risks and characteristics of inverse floaters, and hold that he adequately informed the City of Bryan and League City as to the risks inherent in the securities. I am unable to conclude from the record before me that the characteristics and risks of inverse floaters were misrepresented or hidden by Ward.
The Division argues that Ward willfully misrepresented the PSA speeds presented to the public clients. Ward's Bloomberg screen defaulted to low PSA speeds; however, the screens provide a range of PSA speeds rather than one particular estimate. (Div. Ex. 23.) Ward passed the accurate GSC-generated PSA speeds to the clients. (Tr. 914-23.) The trading desk at GSC was looking at all information including information available from Wall Street firms. (Tr. 169.) Ward reasonably believed, as did the trading desk and portfolio strategy department, that PSA speeds would continue to be high, as they were in the summer of 1993. Ward did not believe an increase in short-term interest rates would adversely affect prepayments on mortgages because mortgages are more affected by the 30-year treasury rates. (Tr. 164.) He thought that if interest rates went up it would only be temporary. (Tr. 165.) He also based estimates of prepayment risk on the historical speed of repayment. (Tr. 166.)
The City of Bryan learned about prepayment and extension risk from Ward and other brokers. (Tr. 167-68.) Ward personally discussed prepayment and extension risks in the context of the 115 SD inverse floaters. (Tr. 165.) The same is true for League City; Ward discussed extension risk with League City several times. (Tr. 897.) Ward used the Bar-Tel report and reviewed the City of Bryan's portfolio and the PSA speeds within the portfolio. (Tr. 166-67.) Ward and the City of Bryan discussed the direction of interest rates every time they had a conversation. (Tr. 168.) The City of Bryan was not dependent on Ward for investment decisions; his role was advisory.
Ward admitted that he based his advice to the customers partly on the "prepayment history" of the instruments. (Tr. 937; Div. Ex. 11 at 2.) When Ward did that, he disobeyed the admonishment that GSC itself appended to its data on inverse floaters:
An investment in securities with interest payments inversely tied to an index involves significant risks not associated with investments in a conventional debt security, and multiplication in the Indexing Formula magnifies this risk. The historical experience of the index should not be taken as an indication of its future performance.
(Resp. Ex. 12 at 5.) Ward concedes, along with some of the witnesses, that he indeed mistakenly estimated future performance of the inverse floaters based on their past performance. Thus, Ward demonstrates that he is not perfect. The law prevents me from requiring perfection of a registered representative. In regard to any alleged misstatements or omissions, whether dealing with the suitability of the inverse floaters or otherwise, the Division has failed to prove that Ward acted with the requisite scienter. There is no proof that Ward received greater sales credit for the sale of the inverse floaters. Furthermore, inverse floaters were not the only securities that Ward offered to the City of Bryan and League City, and there is no evidence that Ward's commissions would have been smaller if the clients had decided against the inverse floaters and picked differently.
As for the swaps, Ward's failure to obtain the best price for the inverse floater for the City of Bryan resulted from his reasonable reliance on GSC data and employees. The collapse of the CMO market in 1994 led to the fall in the market price of CMOs for both clients. Ward could not have predicted the movement in interest rates that was the catalyst for the collapse. His mistakes do not rise to the level of fraud. Unlike the executive who falsely denied the reality of merger negotiations, Ward told the clients the truth about inverse floaters and the swap generally as he saw it. See Basic Inc., 485 U.S. at 238. Thus, because Ward did not act intentionally or with recklessness, he did not act with the requisite scienter to make him culpable under the securities laws as charged here. See Aaron, 446 U.S. at 695. Even if negligent, he neither made an "untrue statement" of material fact under Section 17(a)(2), nor engaged in any transaction, practice, or course of business which operated as a fraud or deceit upon the City of Bryan or League City.
Suitability standards were enumerated in GSC's Compliance Policy. Transactions are to be suitable in light of the type of customer, the size of the customer's portfolio and total assets, and the customer's stated investment objective. Furthermore, any transaction which would result in a concentration of derivative securities greater than 20% must by reviewed by compliance and deemed suitable prior to execution. (Div. Ex. 52 at 2.) NASD Notice to Members 93-73, Members' Obligations to Customers When Selling Collateralized Mortgage Obligations (CMOs), states that inverse floaters are only suitable for sophisticated investors, which "must be aware of the risks and characteristics of the [inverse floater] being purchased." I find that Ward acted consistently with these guidelines. The Division has not proved that Ward violated Section 17(a) of the Securities Act or Section 10(b) of the Exchange Act or Rule 10b-5 thereunder as alleged in the OIP. Accordingly this case must be dismissed.
RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), it is certified that the record includes the items set forth in the record index issued by the Secretary of the Commission on January 20, 2000.
ORDER
IT IS ORDERED that the proceeding against Respondent Kenneth Ward be, and it hereby is, 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 (1998). 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 a party, the Initial Decision shall not become final as to that party.
______________________________
Lillian A. McEwen
Administrative Law Judge
| 1 | References to "(Tr. __.)" herein are to the record of the hearing in this matter. Although exhibits were identified at the hearing using sequential numbers followed by a dash and then numbers previously used to identify documents (e.g., "6-11"), the numbers after the dash have been omitted herein for the sake of simplicity. The exhibits introduced by the Division are designated "(Div. Ex. __.)." Exhibits introduced by Ward are designated "(Resp. Ex. __.)." |
| 2 | Investment grade is defined as a bond with a rating of AAA to BBB. See Barron's Dictionary of Finance and Investment Terms 276 (4th ed. 1995). |
| 3 | A PAC bond, or planned amortization class bond, is a tranche class offered by some CMOs. It is unlike other CMO classes because it offers certainty of cash flow except in extreme prepayment situation and trades at a premium to comparable traditional CMOs. See Barron's Dictionary of Finance and Investment Terms 402 (4th ed. 1995). |
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