Mutual Fund Frequent/Late Trader Barred, Ordered to Pay Disgorgement and Penalties Totaling $728,000

Gregory O. Trautman, Exchange Act Rel. 61167, December 15, 2009

Time since appeal – 1 year 9 months 20 days
Time since last brief – 1 year 6 months 24 days

Trautman was the CEO of a broker dealer. The ALJ found he schemed to defraud mutual funds through illegal late trading and fraudulent market timing of mutual fund shares on behalf of both customers and the firm. The Commission entered the following sanctions: a bar from associating with a broker-dealer; a cease and desist order; $608,000 of disgorgement, plus additional prejudgment interest; and a $120,000 penalty. Trautman's firm made $22.6 million in revenues from the scheme and mutual fund customers lost an estimated $102 million.

Late trading is the illegal and fraudulent practice of permitting mutual fund share orders received after 4 p.m. Eastern time when the market closes to receive that day's price instead of the next day's price. Frequent trading involves attempts to exploit pricing inefficiencies resulting from the fact that mutual fund prices are only calculated once at the end of the trading day. Although frequent trading is not per se illegal it violates the rules of most mutual funds that permit only a limited number of trades by investors. The practice harms long term shareholders and increases fund expenses. The opinion provides a detailed explanation of why both practices are harmful to investors and cites many of the Commission's significant cases in the area.

Trautman's firm actually established a mutual fund timing department. Many of the institutional clients of this department have been subject to civil or administrative cases. The firm developed a number of procedures designed to hide its trading activities from mutual funds. The Commission found that Trautman was personally involved in these activities and acted with scienter. It also found that Trautman aided and abetted the firm's violations.

The Commission took into account conduct that occurred before the limitations period in evaluating motive, intent and knowledge. As an evidentiary matter, it noted that it will not consider previous regulatory sanctions based solely on CRD printouts – instead it requires that the actual settlement records be introduced into evidence. The Commission also rejected Trautman's argument that no penalty or disgorgement should be imposed due to his financial condition. It noted that such a showing is only one factor that it will consider in determining monetary sanctions.

Disgorgement and Penalties Upheld – Will Be Inevitable Where There Is Egregious Fraud Regardless Of Inability To Pay

Maria T. Giesige, Exchange Act Rel. 60000, May 29, 2009


Time since appeal filed – 6 months 30 days
Time since last brief filed – 4 months 24 days
Pages – 13
Footnotes – 27

This is an important decision. Although the Commission could have imposed the monetary sanctions because the evidence was not introduced at trial it ruled that due to the egregious nature of the fraud penalties and disgorgement would have been imposed in any event.

The Commission ruled that disgorgement is appropriate, regardless of respondent's inability to pay because she "received this money as compensation for the very transactions that constituted the violations . . . ." It also upheld third tier penalties of $500,000 noting that inability to pay is "but one factor" to be considered. "Where the egregiousness of [the] conduct outweighs any consideration of . . . inability to pay . . . the public interest requires that the civil penalty be imposed."

This appears to be a significant tightening of the Commission's position. This case means that inability to pay will not automatically result in the Commission deciding not to impose disgorgement or penalties and that when there is significant fraud disgorgement and penalties are all but inevitable.

Giesige was associated with a broker-dealer and later registered as an investment adviser. The ALJ found that she made material misstatements and omitted material facts in selling securities of Carolina Development Co., sold unregistered securities, and also acted as an unregistered broker-dealer because because she sold away by not notifying her employer of her sales. The ALJ entered a cease and desist order, barred from association with a broker, dealer, or investment adviser, ordered disgorgement of $21,000 and ordered her to pay a $500,000 penalty.

The Commission upheld the ALJ's findings and sanctions. Giesige did not challenge the findings of violations on appeal. Nor did she challenge the cease and desist order or the bars. She asked that the disgorgement and penalty amounts be removed due to her inability to pay.

Discussion

Giesige was a rep from 1986 until 2007. In 2005 and 2006 on her recommendation fifty of her clients bought $1.49 million of Carolina Development securities. Giesige and her husband personally invested $29,000 in Carolina. Carolina purported to be in the real estate development business and touted the prospect of an impending public offering of its stock. It never registered its securities with the SEC and it took no steps to consummate an IPO. Its securities traded on the OTC bulletin board. In late 2005 the Commission sued Carolina and obtained a preliminary injunction and the appointment of a receiver. The receiver found that Carolina had no business revenues. Its only source of money was new investors from whom it had raised $52 million. Its only assets were real estate and it had no financial books and records. The receiver liquidated the company for $8 million.

Giesige gave offering materials to customers that she admitted she did not understand. She made no effort to verify any of the information. Although the company claimed its financial statements were audited she never obtained a copy of the audited financials. Some of her customers testified that in recommending Carolina securities she gave the impression she had done substantial due diligence. Giesige received $21,000 in commissions and 13,900 shares of Carolina stock in sales commissions. She also claimed that an IPO at $9 per share was imminent despite knowing that the stock was quoted in the pink sheets for $.30 per share. She also made price projections – claiming that the price of the stock would rise from $3 to $9 per share in a few months. Most of her customers were unsophisticated and had limited income and savings. Many borrowed against their IRAs to fund their investments. She did not notify her broker-dealer employer of her sales of Carolina stock.

Despite being represented by counsel Giesige offered no evidence at the trial of her inability to pay disgorgement or penalties. She tried to introduce evidence of her financial condition in her post-trial brief. The ALJ refused to allow this evidence as untimely. The Commission specifically upheld this ruling by the ALJ based on Commission Rule 340(b) that requires post-trial submissions to cite to evidence in the trial record. Inability to pay must be introduced at trial in order to allow the Division of Enforcement to contest it.

Finally, the Commission found that Giesige's conduct was so egregious that it would not waive disgorgement or penalties in any event. It found her fraud knowing or extremely reckless.

Comment

The Commission announces that it will not waive disgorgement or penalties based on inability to pay where the fraudulent conduct was knowing or extremely reckless. Practitioners should also note that the Commission will not consider inability to pay evidence that is not introduced at trial. Attempting to introduce such evidence in post–trial briefs will not be countenanced.

David Henry Disraeli and Lifeplan Associates, Inc., Exchange Act Rel. 57027, December 21, 2007

Time between appeal and decision - 8 months, 23 days

Time between final brief and decision - 5 months, 19 days

Pages - 33

Comment

This case includes a comprehensive discussion of why misuse of offering proceeds is always material regardless of whether or not individual investors testify to the contrary.  It also notes that diversion of offering proceeds to pay personal expenses can not be cured by a general statement in offering documents that proceeds might not actually be used for the business purposes proposed.  This decision contains a comprehensive nine page explanation of why the sanctions are appropriate.  

Respondent was barred as an investment adviser, fined $85,000, and ordered to disgorge $84,300 plus prejudgment interest after he used $84,300 of a $100,000 private placement offering to pay personal living expenses.  The lesson from this case is that investment advisers, whether registered or not, are held to the highest standards of disclosure and honesty when dealing with clients and the most severe sanctions will be imposed even when the violations involve a relatively small amount of money and only a few investors.  

Also, a note of significance to practitioners.  The Commission ruled that respondent had waived his ability to claim inability to pay disgorgement or a civil penalty because he had not raised the issue before the trial judge.  Further, the financial statements he submitted were vague, and had no supporting documentation.  Finally, the Commission found that because waivers due to inability to pay are discretionary, it would not grant a waiver due to the egregious nature of Disraeli's violations.

Summary

This is an appeal from an ALJ's initial decision by a pro se investment adviser and a corporation he incorporated.  The ALJ found that both respondents violated the anti-fraud provisions of Securities Act Section 17(a) and Exchange Act Section 10(b).  The ALJ also found that Disraeli violated: Section 206 and Rule 206(4)-4(a) of the Advisers Act by making materially false statements in connection with the offer and sale of securities; Advisers Act Sections 203A and 207 by registering with the Commission when he did not qualify to register and by making material misstatements and omissions on his application; Advisers Act Section 204 and various rules thereunder by failing to maintain books and records. 

The ALJ revoked Disraeli's adviser registration, barred him from association with a broker-dealer or investment adviser, imposed a $120,000 civil penalty, ordered him to pay disgorgement of $84,300 plus prejudgment interest, and imposed a cease and desist order on both respondents.

The Commission upheld the sanctions except that it lowered the penalty to $85,000.

Discussion

Disraeli offered and sold stock in Lifeplan Associates in a private placement offering to his investment advisory clients.  He claimed the $100,000 to be raised would be used to form two investment funds, one to be a hedge fund, and the other to purchase consumer debt.  The offering documents claimed that Lifeplan was registered with the SEC as an investment adviser.  Disraeli told investors that the funds would earn 20% per year.  By December 2003, nine clients had bought $95,000 of stock in Lifeplan from Disraeli.  Not all paid the same price for their shares.  $83,500 of the money raised was immediately transferred to Disraeli's personal bank account from which he made payments for personal living expenses.  

After becoming concerned about his disclosures concerning use of proceeds, after consulting with a lawyer, Disraeli distributed a new offering document and a rescission offer.  Despite the fact that Disraeli had started spending the proceeds of the offering after raising $30,000, the new offering document claimed that he would escrow the offering proceeds until he had raised the $50,000 minimum.  In addition to claiming the proceeds would be used to organize and fund the two investment vehicles, it stated that there could be no assurance that the funds would actually be used for those purposes.  Neither offering memorandum disclosed the use of funds by Disraeli for personal expenses.  Nor did they disclose a federal tax lien against Disraeli.  None of the funds raised were used for the purposes specified in the offering materials and no investments were purchased.

After the SEC staff began an investigation, Disraeli produced a promissory note whereby he purported to agree to repay the $84,300.  The ALJ found that the evidence strongly suggested that the note had been backdated.  The ALJ also found Disraeli not to be a credible witness. 

One investor testified at the hearing that he knew that Disraeli was going to use the offering proceeds for personal expenses and claimed he did not believe the use of proceeds was material.  Several other investors signed affidavits with similar claims.  Another investor testified he was not aware of Disraeli's use of the offering proceeds and that he would not have invested had he known those facts.  

Needless to say, the Commission found the undisclosed use of the offering proceeds to be a material departure from the representations in the offering materials.  It also found that Disraeli's failure to escrow funds until the minimum had been raised to be a material departure from the offering materials.  

The Commission rejected Disraeli's claim his misrepresentations were not material because his investors did not consider them to be.  It noted that "the reaction of individual investors is not determinative of materiality, since the standard is objective, not subjective (footnote omitted)."   It also found that investor ratifications of his conduct do not exonerate him because materiality depends on a finding of the significance of the information to an objective reasonable investor.

In other words, the Commission ruled that the use of offering proceeds for purposes not specified in offering documents is material as a matter of law.

Also, the Commission rejected Disraeli's claim that he did not commit fraud because his investors were sophisticated.  It noted that "the sophistication of investors does not justify misleading them. (footnote omitted)"

The Commission also noted that Disraeli was not protected by the statement in the second offering document that the use of proceeds might not actually conform to the disclosed uses. It noted that "[a] statement that the use of proceeds may vary from a company's current intentions cannot cure the diversion of offering proceeds from specific business expenses identified in offering memoranda to the personal use of the company's officers (footnote omitted)."  

Disraeli claimed he could not violate the anti-fraud provisions of the Advisers Act because when the offering began, he was not a registered investment adviser.  However, Section 206 of the Advisers Act is not limited to registered advisers.  While the offering was occurring, Disraeli was charging his clients fees for investment advice.  He therefore met the definition of an adviser and was subject to the anti-fraud provisions of Section 206.

Disraeli also violated Rule 206(4)-4(a) which requires an adviser to disclose to clients any material facts about his financial condition that are reasonably likely to impair his ability to meet his contractual obligations to clients.  His misappropriation of offering funds, and undisclosed IRS lien were facts that should have been disclosed.

Disraeli was registered with the Commission as an investment adviser from 1993 to 1997 when he voluntarily withdrew his registration after a change in the statute that prohibits an adviser from registering with the Commission unless it has more than $25 million of assets under management or is an adviser to a registered investment company.   In 2002 the state of Texas entered a cease and desist order against Disraeli.  In 2003 Lifeplan filed a registration application with the Commission despite the fact that it had only about $4 million under management.  Disraeli claimed, pursuant to Commission rules that he believed Lifeplan would meet the minimum registration requirements within 120 days.  The rule is designed to exempt only "start up" advisers.  The rule should only be relied on when the registrant has actual indications of interests from clients that they will transfer sufficient assets to the adviser. 

Lifeplan did not qualify as a start-up because it was the successor to Disraeli's previous advisory business.  Disraeli admitted that he had no indications of interest from clients sufficient to meet the $25 million minimum.  Nor was Disraeli able to claim the "muti-state" exemption from the minimum for advisers who operate and are required to register in at least 30 states because he had not actually obtained actual clients in 30 states.