Source: https://www.sec.gov/litigation/admin/33-7772.htm
Timestamp: 2019-04-23 16:55:03+00:00

Document:
The Commission deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 (the "Securities Act") and Sections 15(b)(4) and 21C of the Securities Exchange Act of 1934 (the "Exchange Act") against BT Alex. Brown Incorporated ("BT Alex. Brown").
In anticipation of the institution of these proceedings, BT Alex. Brown has submitted an offer of settlement, which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. §201.100 et seq., BT Alex. Brown, without admitting or denying the findings contained herein, except that it admits to the jurisdiction of the Commission over it and over the subject matter of these proceedings, consents to the entry of the findings, the issuance of the cease-and-desist order, and the imposition of the remedial sanctions set forth below.
BT Alex. Brown is a Delaware corporation with its principal place of business in Baltimore, Maryland. It is the successor by merger, since September 1, 1997, to Alex. Brown and Sons Incorporated ("Alex. Brown"). BT Alex. Brown is a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act. At all times relevant to the events described herein, Alex. Brown was a registered broker-dealer.
This is a municipal finance case involving misrepresentations and breaches of duty by Alex. Brown in connection with an advance refunding bond issue of the Commonwealth of Pennsylvania. Alex. Brown agreed with the Treasurer's Office of the Commonwealth that Alex. Brown would sell a portfolio of U.S. Treasury securities to the Commonwealth for the refunding at a markup of 4.5 basis points in price. Without effective disclosure, Alex. Brown instead marked the portfolio up 45 basis points. In addition to exceeding the agreed amount, this markup was excessive under all of the facts and circumstances. Alex. Brown also failed to fully disclose the purpose, nature, and extent of a fee-splitting arrangement with the Commonwealth's financial adviser, including the fact that it was sharing fees with the financial adviser in order to obtain the Treasury business.
When interest rates fall, state and local governments often seek to reduce their borrowing costs by paying off outstanding bonds through the issuance of new bonds paying lower interest rates. When the old bonds cannot be paid off until a future call date, the municipality can still obtain a benefit from lower interest rates through an advance refunding. An advance refunding can lock in current interest rates and ensure that the municipality will realize debt service savings over the life of the new bonds.
In an advance refunding, the municipality issues new "refunding" bonds and immediately invests the proceeds in a portfolio of U.S. Treasury or agency securities structured to pay the principal and interest obligations on the old bonds until the call date and then to pay off the outstanding principal and any call premium. The portfolio of government securities is normally placed in a defeasance escrow to guarantee repayment of the old bonds.
There are two significant dates in an advance refunding bond issue. On the pricing date, the price of the refunding bonds is set, the composition of the defeasance escrow is determined, and the escrow securities are priced and sold -- but not delivered -- to the issuer. At the closing, which usually occurs two to three weeks after the pricing date, the refunding bonds are issued and the escrow securities are delivered to the defeasance escrow.
In mid-1991, Alex. Brown entered into a relationship with Patrick H. McCarthy, a Philadelphia-based attorney, pursuant to which McCarthy acted as a finder of municipal securities business for Alex. Brown's Public Finance Department. McCarthy had been a senior adviser, fundraiser, and transition chief for the Treasurer of the Commonwealth of Pennsylvania.6 Although McCarthy held no official title and was not employed by the Treasurer's Office, he was actively involved in the day-to-day operations, decisions and policies of the Treasurer's Office. McCarthy was de facto the most powerful person in the office after the Treasurer and the Executive Deputy Treasurer, with whom McCarthy worked closely.
In 1991, McCarthy met with a senior Alex. Brown banker who was then the head of Alex. Brown's Public Finance Department (the "Senior Banker"). McCarthy promoted to the Senior Banker his ability to obtain Public Finance engagements for Alex. Brown from, among others, the Pennsylvania Treasurer's office. Alex. Brown agreed to pay McCarthy's law firm 20 to 25 percent of the gross revenues earned by Alex. Brown's Public Finance Department, and 20 to 25 percent of the net revenues realized by the firm's Sales, Trading, and Underwriting Department on assignments McCarthy provided assistance in securing for Alex. Brown. Under this arrangement, from 1991 through 1994 Alex. Brown paid McCarthy's law firms more than $369,000 for various Public Finance engagements which McCarthy directed to Alex. Brown.
The contractor [Alex. Brown] shall maintain the highest standards of integrity in the performance of this agreement and shall take no action in violation of state or federal laws, regulations, or other requirements that govern contracting with the Commonwealth.
Except with the consent of the Commonwealth, neither the contractor nor anyone in privity with him shall accept or agree to accept from, or give or agree to give to, any gratuity from any person in connection with the performance of work under this agreement except as provided therein.
In late 1993, the Commonwealth of Pennsylvania was considering bond refundings totaling over $ 1 billion. The Governor's Budget Office, which was responsible for all Pennsylvania debt issues, appointed Arthurs Lestrange & Company ("Arthurs Lestrange"), a Pittsburgh-based broker-dealer, to serve as the Commonwealth's financial adviser for the refundings. (Arthurs Lestrange had proposed the refundings to the Commonwealth.) The Treasurer's Office, which was generally responsible for the investment of Commonwealth funds, was charged with obtaining investments for the escrows for the refundings. Ultimately, two refundings resulted: (1) the Commonwealth of Pennsylvania $494,145,000 General Obligation First Series, which closed in March 1994 (the "March Refunding") and (2) the Commonwealth of Pennsylvania $469,616,337.34 General Obligation Bond Second Series 1994, which closed in June 1994.
In January 1994, McCarthy telephoned the Senior Banker about the refundings. McCarthy explained to the Senior Banker that the Commonwealth was planning to issue refunding bonds, but that Arthurs Lestrange was too small to handle the purchase and sale of the escrow securities. McCarthy then offered the Senior Banker the following proposal: Alex. Brown could be named the escrow provider if it would agree (1) to take all of the financial risk associated with the sale of the escrow securities and (2) to pool revenues with Arthurs Lestrange and allocate 60 percent of the total revenues to Arthurs Lestrange. McCarthy also told the Senior Banker that the Treasurer's Office was dissatisfied with the size of the markup that another broker-dealer had charged for the escrow portfolio on another recent Commonwealth refunding, and indicated that Alex. Brown would have to provide the escrow for a markup in the range of three to five basis points.
The Senior Banker received approval from his superiors at Alex. Brown to provide the escrow securities on the terms that the Senior Banker described to them. Thereafter, the Senior Banker discussed the transaction and the projected markup on the escrow with the then Deputy Treasurer for Finance (the "Deputy Treasurer"), who was the senior official in the Treasurer's Office with direct responsibility for investments. The Senior Banker proposed a markup of 5 basis points in price, emphasizing the risks that Alex. Brown would assume by purchasing the Treasury portfolio on the pricing date and selling it to the Commonwealth for delivery on the closing date, contingent on the refunding closing. The Deputy Treasurer would only agree to a 4 basis point markup, but the Executive Deputy Treasurer and McCarthy overruled him based on the Senior Banker's assertions. The Treasurer's Office thereafter orally agreed to pay Alex. Brown a markup of 4.5 basis points in price on the escrow portfolio for the March Refunding. A basis point is 1/100 of one percent, and a markup of 4.5 basis points is a markup of .045 percent, or .00045.
This is to inform you that Arthurs Lestrange as Financial Adviser, and Alex. Brown, as Escrow Agent, intend to pool and then mutually apportion their respective compensation for serving as Financial Adviser and Escrow Agent on the upcoming refunding. The efforts so far by each firm have been so inextricably integrated with the other firm that we are, in effect, working as partners on a day-to-day basis.
On a deal this size, with its significant complexity and critical-timing issues, close professional cooperation by the entire Commonwealth team (the issuer's overall financial adviser and the issuer's technical support-the escrow agent) will only serve to maximize benefits for the issuer.
In February 1994, during the planning for the March Refunding, the Senior Banker was working with his staff at Alex. Brown to structure the defeasance escrow for the transaction. The Senior Banker told a quantitative analyst on his staff that the markup on the escrow securities was to be 4.5 basis points in price, and instructed the analyst to calculate the markup using a factor of .0045. The analyst told the Senior Banker that a factor of .0045 resulted in a 45 basis point markup, not a 4.5 basis point markup. The Senior Banker responded by stating that he had an agreement with the Treasurer's Office for a markup using a factor of .0045. In fact, the Senior Banker had agreed to a markup of 4.5 basis points in price, and had never received approval to mark up the securities by a factor of .0045, or 45 basis points.
The March Refunding was priced on March 16, 1994. The Deputy Treasurer attended the pricing at Alex. Brown's offices in Baltimore. An analyst who worked with the Senior Banker on the March Refunding testified that, on the pricing day, the Senior Banker had him show the Deputy Treasurer Alex. Brown's purchase price for the escrow securities, the markup factor of .0045, the sales price to the Commonwealth for the escrow securities, and the resulting dollar amount of the markup. However, the Deputy Treasurer testified that he only learned about the 45 basis point markup the next day, after he had his staff research publicly available pricing information to calculate the markups that Alex. Brown had charged. The Deputy Treasurer then brought this overcharge to the Senior Banker's attention. In response, the Senior Banker falsely claimed that Alex. Brown had charged only the agreed-upon 4.5 basis point markup. The Senior Banker knew, as his staff had told him, that the .0045 markup factor Alex. Brown used was the equivalent of a 45 basis point markup.
The Deputy Treasurer also raised this issue with McCarthy, who pointed out the Senior Banker's credentials and experience in these matters and supported the Senior Banker's assertion that only a 4.5 basis point markup had been charged. McCarthy told the Deputy Treasurer that he was wrong. Despite the overcharge identified by the Deputy Treasurer, the refunding closed on March 30, 1994.
After the March Refunding closed, Alex. Brown and Arthurs Lestrange combined and allocated their pooled fees in accordance with their 60/40 fee-splitting agreement. The total pooled fees from the transaction were $2,604,457.10. Arthurs Lestrange contributed $210,000 to the pool, which was its fee for serving as the Commonwealth's financial adviser. Alex. Brown contributed $2,394,457.10 ($1,782,140.70 from the markup on the escrow securities, $418,316.40 in carry7, and a forward supply contract brokerage fee of $194,000). In accordance with the split formula, Arthurs Lestrange received $1,562,674.26 and Alex. Brown received $1,041,782.84 from the transaction.
The Senior Banker departed Alex. Brown after the March Refunding. Subsequent to the March Refunding, the Deputy Treasurer continued to protest that Alex. Brown had taken a 45 basis point markup on the escrow portfolio.8 No one at Alex. Brown ever admitted that he was right. In response to the Deputy Treasurer's request to Alex. Brown for pricing information on the March Refunding escrow, on July 12, 1994, Alex. Brown sent the Deputy Treasurer a memorandum which accurately set forth, among other things, the markup on the escrow portfolio in dollars and in decimal terms (.00449). However, the memorandum also falsely stated, "This represents a markup of 4.49 basis points on a per $1000 basis."
Section 17(a) of the Securities Act prohibits materially false or misleading statements, or material omissions when there is a duty to speak, in the offer or sale of any security. Section 17(a)(1) requires a showing of scienter; however, Sections 17(a)(2) and 17(a)(3) do not require such a showing. Aaron v. SEC, 446 U.S. 680, 697 (1980). Violations of Sections 17(a)(2) and 17(a)(3) may be established by showing negligence. SEC v. Hughes Capital Corp., 124 F.3d 449, 453-54 (3rd Cir. 1997); SEC v. Steadman, 967 F.2d 636, 643 n. 5 (D.C. Cir. 1992). Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit materially false or misleading statements, or material omissions when there is a duty to speak, made with scienter, in connection with the purchase or sale of any security. Both knowing and reckless conduct satisfy the scienter element. See, e.g., Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990). A duty to speak arises, and material omissions become fraudulent, when a person or entity has information that another is entitled to know because of a fiduciary or similar relationship of trust and confidence. See Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-55 (1972); Chiarella v. United States, 445 U.S. 222, 228 (1980); In re Arleen W. Hughes, 27 SEC 629 (1948), aff'd sub nom. Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949).
As financial adviser to the Treasurer's office, Alex. Brown acted as a fiduciary in the Pennsylvania refundings. The Treasurer's office reposed trust in the skill and integrity of Alex. Brown, and placed the Commonwealth's pecuniary interest in Alex. Brown's charge with respect to the refundings. The Treasurer's office also had a "just foundation for belief" that Alex. Brown was acting in the Commonwealth's best interest. See Antinoph v. Laverell Securities, 703 F.Supp. 1185 (E.D. Pa. 1989); Lazin v. Pavilion Partners, 1995 U.S. Dist. LEXIS 15255, Civ.A. No. 95-601, 1995 WL 614018 (E.D. Pa. Oct. 11, 1995). The express terms of Alex. Brown's financial advisory contract with the Treasurer's Office (which was signed by the Senior Banker) created a relationship of confidence, and bound Alex. Brown to act according to "the highest standards of integrity."
Courts have imposed on a fiduciary affirmative duties of utmost good faith, and full and fair disclosure of all material facts, as well as an affirmative obligation to employ reasonable care to avoid misleading its client. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963). A broker-dealer that seeks to sell securities from its own account, as principal, to a client to whom it owes fiduciary duties must follow well-established standards. Under both common law and federal securities law, the broker-dealer can only deal with its fiduciary client as a principal by making full disclosure -- before entering into the transaction -- of the nature and extent of any adverse interest that the broker-dealer may have with the client. See In re Arleen W. Hughes, 27 SEC at 635-36; Restatement (Second) of Agency § 390 (1958). This standard requires disclosure of more than the fact that the broker-dealer will act as principal in the transaction. See, e.g., In re R.H. Johnson & Co., 36 S.E.C. 467 (1955), aff'd, 231 F.2d 523 (D.C. Cir. 1956); Norris & Hirshberg, Inc. v. SEC, 177 F.2d 228, 233 (D.C. Cir. 1949) (holding that a broker-dealer that sent a fiduciary client confirmations stating that it acted as principal in certain transactions nevertheless violated the anti-fraud provisions by failing to disclose its capacity as principal rather than agent at the time of the transaction). A broker-dealer subject to fiduciary obligations must disclose "all material circumstances fully and completely." Arleen W. Hughes, 27 SEC at 636; see also Restatement (Second) of Agency § 390, comment a.
Alex. Brown violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder in connection with the sale of escrow securities to the Commonwealth of Pennsylvania for the March Refunding. The Treasurer's Office authorized Alex. Brown to mark up the escrow portfolio 4.5 basis points in price, but Alex. Brown instead took a 45 basis point markup. After the pricing and before the closing of the refunding, when the Deputy Treasurer confronted the Senior Banker on the size of the markup, the Senior Banker claimed that Alex. Brown's markup on the portfolio was only 4.5 basis points as had been agreed.9 Alex. Brown's misrepresentation was material because a reasonable investor in the position of the Commonwealth would have wanted to know that the financial adviser to the Treasurer's Office had unilaterally determined to charge more for the escrow securities than the Commonwealth had agreed to pay, in particular given the Commonwealth's concern at the time over the high markups charged by another broker-dealer in a recently completed refunding.
Alex. Brown acted knowingly or recklessly. Several weeks before the pricing of the issue, the Senior Banker's own staff told him that the markup he wanted them to apply was 45 basis points, and not 4.5 basis points. Further, in the same March Refunding, Alex. Brown also brokered a forward supply contract for a fee of 4.5 basis points in price paid by the contract provider. In that instance, the "4.5 basis points" was calculated correctly using a factor of .00045. A different approach was taken on the refunding escrow, where, notwithstanding the agreement to a markup of 4.5 basis points, the markup was calculated using a factor of .0045 -- ten times the factor used on the forward supply contract. Alex. Brown's subsequent false characterization of the markup on the March Refunding escrow portfolio as "4.49 basis points on a per $1000 basis" is further evidence of scienter.
If the Alex. Brown analyst showed the Deputy Treasurer the markup factor of .0045 and the resulting dollar amount of the markup on the pricing day, this did not satisfy Alex. Brown's obligation as a fiduciary to make full and complete disclosure of all material facts in the sale of the escrow securities to the Commonwealth, given Alex. Brown's express agreement that the markup would be 4.5 basis points and its assurances after the pricing that the markup had indeed been 4.5 basis points. If Alex. Brown wanted to change the terms of its deal with the Commonwealth, it needed to disclose that fact clearly, and at a time and in a manner calculated to ensure that its client would fully appreciate what Alex. Brown was doing. Cf., SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 854 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969) (disclosure requires "effective" disclosure).
As to the pricing of the escrow securities sold to the Commonwealth, Alex. Brown also violated Sections 17(a)(2) and 17(a)(3) of the Securities Act by effecting that transaction at prices not reasonably related to the current wholesale market prices for the securities under the particular facts and circumstances, including the pertinent tax regulations. See, e.g., Grandon v. Merrill Lynch & Co., 147 F.3d 184, 192 (2d Cir. 1998) (under the shingle theory, a broker-dealer has a duty to disclose excessive markups); In re Lazard Freres, Securities Act Release No. 41318 (April 21, 1999). Alex. Brown's markup and carry on the March Refunding was over one-half of one percent of Alex. Brown's contemporaneous cost for the Treasury securities sold to the Commonwealth.12 At the time, other dealers generally charged materially lower markups on escrow securities when the prices were determined through competition or bona fide arm's length negotiation. Based on all the relevant facts and circumstances, Alex. Brown knew or should have known that the prices it charged were not reasonably related to the prevailing wholesale market prices of the securities. 13 The excessive markups operated as a fraud or deceit because, unbeknownst to the Commonwealth, the excessive markups diverted money from the U.S. Treasury to Alex. Brown, and thereby jeopardized the tax-exempt status of the Commonwealth's refunding bonds.
On the basis of this Order and BT Alex. Brown's offer of settlement, the Commission finds that BT Alex. Brown willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
In view of the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer of Settlement submitted by BT Alex. Brown.
E. The amounts to be paid to the United States as described in paragraphs C and D above shall be electronically transferred to the United States or its designees pursuant to instructions to be provided, in writing, to counsel for BT Alex. Brown by the United States Attorney's Office for the Southern District of New York. Copies of payments made to the United States and the issuers as described in paragraphs C and D above and any cover letters accompanying them shall be sent by BT Alex. Brown to Brian A. Ochs, Assistant Director, Division of Enforcement, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0805.
2 These provisions and regulations are designed to prevent abuse of the benefit the federal government affords municipalities by not taxing interest paid on municipal bonds. See Joint Comm. on Taxation, 91st Cong., 2d Sess., General Explanation of the Tax Reform Act of 1969, at 185-86 (Comm. Print 1970).
3 Over time, Treasury regulations provided several definitions of fair market value and market price for purposes of valuing open market government securities for advance refundings. For example, a regulation generally applicable to advance refunding transactions that settled on or before June 30, 1993 defined market price as "the mean of the bid and offered prices on an established market" on the day of pricing; if, however, the price paid by the issuer was higher than the mean of the bid and offered prices, then the higher price could be treated as the market price of the security if the issuer acquired it in an "arm's length transaction without regard to any amount paid to reduce the yield . . . ." Treas. Reg. § 1.103-13(c)(1)(iii)(B) (1979). Generally, after June 30, 1993 (the period of the Commonwealth of Pennsylvania refundings described here), fair market value was defined as "the price at which a willing buyer would purchase the [security] from a willing seller in a bona fide, arm's length transaction." Treas. Reg. § 1.148-5(d)(6)(i) (1993).
4 In contrast, in a "negative arbitrage" situation-when the yield on open market securities purchased at fair market value would be below the yield on the refunding bonds-overcharging by dealers for open market escrow securities takes money away from the municipality rather than the Treasury by reducing, dollar for dollar, the present value savings the municipality obtains through the advance refunding.
5 There are several lawful methods to limit the yield of the defeasance escrow in a positive arbitrage situation. One method is to purchase from the Bureau of Public Debt at the Department of the Treasury below-market-interest Treasury securities-known as State and Local Government Series securities ("SLGS")-customized to match the yield limitation. Alternatively, the municipality can purchase open market securities of shorter durations (and lower yields) than those required to satisfy the escrow requirements; when these securities mature, the cash proceeds are invested for the remaining period of the escrow in non-interest-bearing SLGS. When either of these methods is used, the Treasury obtains a benefit by issuing debt at interest rates lower than those prevailing in the taxable market.
6 The Treasurer served two terms, beginning in January 1989, and ending in January 1997.
7 Profit on open market escrow securities generally has two components: markup and carry. Markup is the difference between the price that the dealer charges the issuer and the prevailing wholesale market price. In re Lehman Bros. Inc., Exchange Act Release No. 37673 (Sept. 12, 1996), 62 SEC Dkt. 2324, 2330. Carry is the difference between (a) the interest and accretion produced by the escrow securities between the sale date and closing date and (b) the cost of financing those securities during that period. See Board of Governors of the Federal Reserve System, Trading Activities Manual, Part 2 at 2-8 (March 1994).
8 During this period, McCarthy defended Alex. Brown against the Deputy Treasurer's protests. McCarthy told the Deputy Treasurer that he (McCarthy) would handle the discussions between the Treasurer's Office and Alex. Brown over the markup dispute. Thereafter, McCarthy and the Executive Deputy Treasurer repeatedly told the Deputy Treasurer that he was wrong about the markup charged by Alex. Brown, that it had actually been 4.5 basis points, and that it was reasonable.
9 The conduct of the Senior Banker may be imputed to the firm. See SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1089 n. 3 (2d Cir. 1972); Converse, Inc. v. Norwood Venture Corp., 1997 Fed. Sec.L.Rep. (CCH) §90,121 (S.D.N.Y. 1997); Blanchard v. Edgemark Financial Corp., Fed. Sec.L.Rep. (CCH) §90,439 (N.D. Ill. 1999).
11 Alex. Brown's Legal Department had previously vetoed paying McCarthy's firm a portion of securities trading revenues pursuant to the existing payment arrangement with McCarthy because of a determination that such revenues could not be paid to unregistered persons. There is no evidence that Alex. Brown knew about the payment by Arthurs Lestrange to its consultant or that either Alex. Brown or Arthurs Lestrange knew about the compensation to McCarthy's law firm.
12 Absent countervailing evidence, the best evidence of prevailing market price for a broker-dealer is the dealer's contemporaneous cost for the security. In the Matter of Alstead, Dempsey & Co., Inc., 47 SEC 1034, 1035 (1984).
13 In addition to the tax regulations which governed the pricing of escrow securities and the practice of broker-dealers in competitive escrows or arm's length negotiated escrows, the pertinent circumstances here included, among others, the negotiations between Alex. Brown and the Commonwealth's representative on an appropriate escrow markup, and the fee-splitting arrangement with Arthurs Lestrange.

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