INITIAL DECISION RELEASE NO. 101 ADMINISTRATIVE PROCEEDING FILE NO. 3-8575 UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ______________________________ : In the Matter of : : JOSEPH J. BARBATO, : INITIAL DECISION NEAL C. HARPER, and : November 12, 1996 FREDERICK J. KRAUSE : : ______________________________: APPEARANCES: William H. Kuehnle, William T. Von Stein, John M. Katko, and Nancy E. McGinley for the Division of Enforcement, Securities and Exchange Commission Howard A. Tescher for Respondent Joseph J. Barbato BEFORE: Burton S. Kolko, Administrative Law Judge I. INTRODUCTION The Securities and Exchange Commission ("Commission") instituted this proceeding on December 16, 1994, pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b)(6) and 21C of the Securities Exchange Act of 1934 ("Exchange Act"). In the Order Instituting Proceedings ("Order"), the Division of Enforcement ("Division") alleged that Joseph J. Barbato, Neal C. Harper, and Frederick J. Krause violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.-[1]- These sections are referred to as the antifraud provisions of the federal securities laws. They make unlawful the use of the mails or facilities of interstate commerce in connection with the offer ---------FOOTNOTES---------- -[1]- The Commission entered orders making findings and imposing remedial sanctions on Mr. Harper, 59 SEC Docket 0003 (April 3, 1995), and Mr. Krause, 59 SEC Docket 1167 (May 25, 1995). ==========================================START OF PAGE 2====== or sale of any security by means of manipulative, deceptive, or fraudulent device, or untrue or misleading statement or omission of a material fact, or any other action or conduct which operates to defraud or deceive a customer. I held hearings in Orlando, Florida, on April 24 through 27, 1995; Tampa, Florida, on June 12 through 15, 1995; and Ft. Lauderdale, Florida, on August 16 through 18, 1995, to determine whether the allegations set forth in the Order are true, what remedial action is appropriate, and whether disgorgement is appropriate. The Division called fourteen witnesses, one by videotaped deposition. The Respondent called eight witnesses. The Division offered, and I received, over 400 exhibits. The Respondent offered, and I received, ten exhibits.-[2]- The Division filed Proposed Findings of Fact and Conclusions of Law and Brief in Support on January 10, 1996. Respondent filed Proposed Findings and Conclusions and Closing Arguments on January 16, 1996. Both parties filed reply briefs on February 27, 1996. A. Statute of Limitations On March 29, 1995, Mr. Barbato, relying primarily on the decision in 3M Co. v. Browner, 17 F.3d 1435 (D.C. Cir. 1994), moved to dismiss allegations of improper conduct occurring prior to December 16, 1989, on the grounds that the statute of limitations set forth in 28 U.S.C  2462 applied to this proceeding. Alternatively, Mr. Barbato moved to dismiss claims for disgorgement based on conduct occurring prior to December 16, 1989. On April 7, 1995, I denied Mr. Barbato's motion to dismiss. The Court of Appeals for the District of Columbia recently held that a Commission proceeding resulting in a censure and suspension of a securities industry supervisor was a proceeding "for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise" within the meaning of 28 U.S.C  2462. Johnson v. SEC, 87 F.3d 484, 485 (D.C. Cir. 1996). The court concluded that the five-year statute of limitations set forth in 28 U.S.C  2462 applies to Commission proceedings under 15(b) of the Exchange Act which seek to censure and suspend a securities supervisor. Id. at 492. The court also stated, however, that 28 U.S.C  2462 does not apply to proceedings seeking a sanction ---------FOOTNOTES---------- -[2]- The record does not contain Respondent's exhibits 2 through 7 because these exhibits were returned to a witness in the proceeding and that witness no longer has the exhibits in his possession. The parties have stipulated that the record is complete notwithstanding the fact that these exhibits are missing from the record. Stipulation Certifying that the Record is Complete, Joseph J. Barbato, No. 8575 (October 7, 1996). ==========================================START OF PAGE 3====== that is strictly remedial: "[W]here the effect of the [Commission's] action is to restore the status quo ante, such as through a proceeding for restitution or disgorgement of ill- gotten profits,  2462 will not apply." Id. at 491 (citations omitted). The Commission instituted this proceeding on December 16, 1994, pursuant to Section 8A of the Securities Act and Sections 15(b)(6) and 21C of the Exchange Act. The Order alleges violative conduct from in or about October 1986 to in or about January 1991. On June 28, 1996, Mr. Barbato renewed his motion to dismiss, based on the decision in Johnson. Johnson effectively has little impact on this decision. As the discussion below indicates, Mr. Barbato committed substantial violations of the antifraud provisions within the five-year statutory period. Nonetheless, I considered violations committed outside the five-year period in determining what sanctions should be assessed in the public interest. In addition, the court in Johnson explicitly stated that the statute of limitations in 28 U.S.C  2462 does not apply to the relief of disgorgement. Courts have also held that the statute of limitations in 28 U.S.C.  2462 does not apply to injunctions sought by the Commission. See, e.g., SEC v. Williams, 884 F. Supp 28, 30-31 (D. Mass 1995) (injunctive relief is remedial and not a penalty for purposes of Section 2462); SEC v. Glick, [1980 Transfer Binder] Fed. Sec. L. Rep. (CCH) 97,535, at 97,793-94 (D. Nev. 1980) (Section 2462 does not apply to Commission actions seeking injunctions). Therefore, 28 U.S.C.  2462 does not apply to a cease and desist order because, like an injunction, a cease and desist order is an equitable remedy not a penalty. Based on the foregoing, I DENY Mr. Barbato's renewed motion to dismiss. II. FINDINGS OF FACT AND CONCLUSIONS OF LAW My findings and conclusions are based on the record and my observations of the witnesses' demeanor. I applied preponderance of the evidence as the applicable standard of proof.-[3]- A. Allegations I find that the allegations in the Order are true. From October 1986 through January 1991, Mr. Barbato, in connection with the offer and sale of securities, acted in interstate commerce and used the mails, the telephone, and the facilities of ---------FOOTNOTES---------- -[3]- I have considered all proposed findings and conclusions and all contentions, and I accept those that are consistent with this decision. ==========================================START OF PAGE 4====== a national exchange, to violate the antifraud provisions of the federal securities laws, in that he willfully: (i) employed manipulative and deceptive devices and contrivances to defraud; (ii) obtained money by means of untrue statements and omissions of material fact which were necessary to make the statements he made not misleading; and (iii) engaged in acts, practices, and courses of business which operated as a fraud upon purchasers and sellers of securities. Specifically, Mr. Barbato: 1. improperly made predictions of specific and substantial increases in the price of speculative securities; 2. made material misrepresentations and omitted to state material information about the securities he was recommending; 3. made recommendations about securities that were unsuitable to the customer receiving the recommendations in light of the risks involved in investing in the securities; and 4. willfully caused trading in customer accounts he controlled which was excessive and unsuitable in light of those customers' investment objectives and the character of those accounts. B. Respondent Joseph J. Barbato received a Bachelor of Science degree in marketing from Central Connecticut State University. (Tr. 2172.)-[4]- Soon after graduating, Mr. Barbato pursued a career in professional golf which lasted approximately three years. (Tr. 2172-73.) Mr. Barbato sold solar panel systems for Delta Energy toward the end of his golf career. (Tr. 2173-74, 2304.) In May 1985, Mr. Barbato joined Stuart-James Co., Inc., ("Stuart-James"), a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act.-[5]- (Tr. ---------FOOTNOTES---------- -[4]- References to the hearing transcript will be cited as "(Tr. __)." References to Division Exhibits and Respondent Exhibits will be cited as "(Div. Ex. __)" and "(Resp. Ex. __)," respectively. -[5]- In April 1989, the Commission instituted proceedings against Stuart-James for federal securities fraud violations. See Stuart-James Co., 43 SEC Docket 966 (April 5, 1989). In September 1990, Stuart-James ceased doing business. On March 17, 1993, an administrative law judge revoked its (continued...) ==========================================START OF PAGE 5====== 2175, 2310.) Mr. Barbato succeeded professionally and financially while associated with Stuart-James. From January 1987 through July 1990, while working as a salesman and, later in his Stuart-James career, as a branch manager, Mr. Barbato earned approximately a total of $623,020. (Tr. 1407, 2335; Div. Ex. 300); see infra pp. 17-18. Most of this compensation was derived from commissions charged on transactions in accounts Mr. Barbato handled for customers. (Tr. 2335.) Mr. Barbato sold to his customers, almost exclusively, securities for which Stuart-James served as underwriter and market maker.-[6]- (Div. Ex. 298A; Tr. 1374, 2348-51.) He received higher commissions selling Stuart-James securities than he would receive selling other, non Stuart-James, securities. (Tr. 2351-52.) Mr. Barbato worked for Stuart-James from May 1985 to September 1990. (Tr. 2310, 2293.) From September 1990 to September 1994, Mr. Barbato worked as a registered representative for Prudential Securities, Inc., ("Prudential"), a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act. (Tr. 2293.) From September 1994 through the dates of the hearing, Mr. Barbato was employed as a registered representative for Raymond James & Associates, Inc., ("Raymond James"), a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act. (Tr. 2175, 2296.) C. Securities Throughout its existence, Stuart-James's predominant business consisted of underwriting and retail trading of low- priced, speculative securities. The Division's expert witness, Dr. Stewart L. Brown,-[7]- reviewed the prospectuses of a ---------FOOTNOTES---------- -[5]-(...continued) broker-dealer registration. Stuart-James Co., 53 SEC Docket 2622 (March 17, 1993). -[6]- Securities for which Stuart-James served as underwriter, as a participant in the underwriting, or as a market maker will be referred to as "Stuart-James securities." Much of Stuart-James's aftermarket business involved Stuart-James securities. (Tr. 1356-57.) From January 1987 to December 1989, approximately 96 percent of Mr. Barbato's trading was conducted solely in Stuart-James securities. (Tr. 1374; Div. Ex. 298A.) -[7]- Dr. Brown is a finance professor at Florida State University, a chartered financial analyst, and a consultant to a $38 billion pension fund. (Tr. 1341-47.) Dr. Brown has published articles in numerous scholarly and professional journals, lectured for the Florida Division of Securities and the National Association of Securities Administrators in the analysis (continued...) ==========================================START OF PAGE 6====== representative sample of securities offerings Mr. Barbato was recommending to his customers. Dr. Brown noted that many of the securities were typical penny stock issues. (Tr. 1353.) A penny stock is a low priced stock, less than five dollars per share, generally associated with a very small, risky company, typically a start-up company or a company that has not been in existence very long.-[8]- (Tr. 1351, 1353-56.) Penny stocks are often sold using high pressure sales presentations, characterized as boiler-room sales techniques, which attempt to induce clients to purchase securities based on overly optimistic projections, including price predictions. (Tr. 1351.) Mr. Barbato recommended that his customers purchase the securities of several companies. The following brief descriptions of five of those companies, some of which are penny stock issuers, are typical of the companies whose securities Mr. Barbato recommended. 1. Cedar Group, Inc. Cedar Group, Inc., ("Cedar"), was organized, in February 1989, primarily to negotiate the acquisition of M.S.W. International, Inc., a medium-sized Pennsylvania corporation engaged in the business of importing and distributing fasteners. (Div. Ex. 14 at Bates 873.) On or about November 8, 1989, Cedar made an initial public offering ("IPO") of securities, including $2,000,000 of debentures and 200,000 units, consisting of two shares of common stock and one warrant, at a price of $10 per unit. (Div. Ex. 14 at Bates 858.) The prospectus for the offering stated on its cover page: "This offering involves immediate substantial dilution in that the net tangible book value of the Common Stock upon completion of this offering will be substantially less than the public offering price. . . . The securities offered hereby involve a high degree of risk." (Div. Ex. 14 at Bates 858.) The prospectus also contained a section which listed twenty-five risk factors, including: (i) Cedar's lack of operating history and limited reserves; (ii) the inability to assure continued profits; (iii) the use of proceeds to pay past debts; (iv) the inability to assure that Cedar could satisfy its obligations under the debentures; and (v) the inability to assure that Cedar would be ---------FOOTNOTES---------- -[7]-(...continued) of retail securities accounts, and testified over fifty times as an expert witness in securities cases. Id. Dr. Brown's general area of expertise concerns churning, suitability, and damages in retail securities accounts. Id. -[8]- See Section 3(a)(51) of the Exchange Act and Rule 3a51-1 thereunder for the statutory definition of penny stock. ==========================================START OF PAGE 7====== able to effectively compete with its competitors. (Div. Ex. 14 at Bates 864-70.) 2. The Meadow Group, Inc. The Meadow Group, Inc., ("Meadow"), was formed, in February 1988, for the purpose of identifying and acquiring companies engaged in manufacturing, distribution, sales, or services. (Div. Ex. 98 at Bates 3864.) Meadow intended to effect acquisitions by means of a combination of cash, its own securities, and loans secured by the assets of the purchased entities. Id. On or about March 14, 1988, Meadow made an IPO of 50,000,000 shares of common stock. (Div. Ex. 98 at Bates 3863.) This offering was a "blind pool."-[9]- Stuart-James served as underwriter for the offering. (Div. Ex. 98 at Bates 3861.) The prospectus for the offering stated on its cover page, in large bold print: "These shares involve a high degree of risk and should be considered only by persons who can afford the loss of their entire investment." Id. The prospectus also contained a section which listed seventeen risk factors, including: (i) Meadow's recent formation and lack of operating history; (ii) the inability to assure profitable operations or even a successful business strategy; and (iii) the non-specific allocation of proceeds in the blind pool offering. (Div. Ex. 98 at Bates 3864- 67.) 3. Warrantech Corp. Warrantech Corp. ("Warrantech") was incorporated in June 1983. (Div. Ex. 73A at Bates 9494.) The company was organized for the purpose of developing, marketing, and administering extended service programs and administering manufacturers' written warranties. Id. In November 1984, Warrantech made an IPO for which Stuart-James served as an underwriter. (Div. Ex. 73A at Bates 9492.) On or about September 5, 1986, Warrantech filed a registration statement, including a prospectus, with the Commission for the issuance of securities. Id. Stuart-James was the soliciting agent. (Div. Ex. 73A at Bates 9508.) The prospectus contained a section which listed fifteen risk factors, including: (i) Warrantech's limited operating history, lack of significant revenues, and losses from operations; (ii) the ---------FOOTNOTES---------- -[9]- According to Meadow's prospectus, a "blind pool" offering is "an offering in which a significant portion of the funds raised are only generally allocated rather than specifically allocated. Thus, investors will entrust their funds with management, on whose judgment the investors must depend." (Div. Ex. 98 at Bates 3864.) ==========================================START OF PAGE 8====== immediate dilution of the value of the shares to investors of the offering; (iii) the inability to assure profitable operations; and (iv) the potential future sales of restricted securities and the possible depressive effect such sales might have on the price of the securities. (Div. Ex. 73A at Bates 9497-9500.) 4. Europa Cruises Corp. Europa Cruises Corp. ("Europa") was formed, in November 1988, to promote and operate day and evening cruises on two vessels which offered gambling and other entertainment. (Div. Ex. 37 at Bates 1169.) On or about June 22, 1989, Europa made an IPO of 4,000,000 shares of common stock. (Div. Ex. 37 at Bates 1167.) Stuart-James served as underwriter for the offering. (Div Ex. 37 at Bates 1164.) The prospectus for the offering stated on its cover page, in large bold print: "These securities involve a high degree of risk and should be considered only by persons who can afford the loss of their entire investment." Id. The prospectus also contained a section which listed twenty risk factors, including: (i) Europa's recent formation and limited operating history; (ii) the inability to assure profitable operations or even a commercially viable business; (iii) the inability to assure that Europa would be able to effectively compete with its competitors; (iv) the adverse effect of gaming and maritime regulations; and (v) the Commission administrative proceeding then pending against Stuart-James. (Div. Ex. 37 at Bates 1169-75.) 5. National Media Corp. National Media Corp. ("National Media"), during relevant times, engaged in the direct marketing of products principally through television, print media, and catalogs. (Div. Ex. 64 at Bates 2297.) The company, previously named National Paragon Corp., had gone into Chapter 11 bankruptcy in October 1985. Id. On or about January 31, 1989, National Media filed a registration statement for a proposed offering of its securities. (Div Ex. 64 at Bates 2286.) The prospectus stated, in bold print: "The securities offered hereby are speculative and involve a degree of risk. Investors may lose all or part of their investment. Consequently, prospective investors should consider carefully all the information contained in this prospectus . . . before purchasing these securities." (Div. Ex. 64 at Bates 2297.) The prospectus contained a section which listed fifteen risk factors, including: (i) National Media's history of losses; (ii) the company's working capital deficit; and (iii) the inability to assure that National Media would be able to effectively compete with its competitors. (Div. Ex. 64 at Bates 2297-2301.) ==========================================START OF PAGE 9====== D. Violations 1. Fraudulent Price Predictions The record demonstrates that Mr. Barbato made unwarranted price predictions in companies that had a high degree of risk associated with investing, were highly speculative, and had limited operating histories, limited revenues, and consistent histories of losses. Mr. Barbato made these predictions in order to induce customers to purchase the securities. Susan Campbell Gordon, a registered nurse and patient care coordinator, opened an account with Stuart-James in 1989. (Tr. 487-89, 528.) In early 1990, Mr. Barbato contacted Ms. Gordon by telephone to notify her that he had taken over her account from another Stuart-James representative. (Tr. 490.) Ms. Gordon never met with Mr. Barbato in person. Id. Ms. Gordon told Mr. Barbato that she had experience in dealing with listed securities, municipal bonds, mutual funds, and individual retirement accounts ("IRA"). (Tr. 519, 530-31.) In April 1990, Mr. Barbato called Ms. Gordon several times about investing in Cedar. (Tr. 500-02.) Mr. Barbato represented to Ms. Gordon that he had "inside information" about Cedar, that investing in Cedar at that time was "a great opportunity," and that she would double or triple her investment in Cedar. (Tr. 502-06, 538.) Ms. Gordon bought Cedar securities from Mr. Barbato based on these and other representations. (Tr. 502-07; Div. Ex. 229.) Rosalie Harrison, a widow from Daytona Beach, Florida, opened an account with Stuart-James in 1986. (Tr. 1096-98.) Mrs. Harrison had dealt with a number of brokers and had invested in the stock market on an infrequent basis prior to opening her Stuart-James account. (Tr. 1108.) In January 1988, Mr. Barbato contacted Mrs. Harrison and notified her that he had taken over her Stuart-James account from another representative. (Tr. 1099- 1102.) In October 1989, Mrs. Harrison purchased 10,000 shares of Meadow stock at a price of $0.1875 per share. (Tr. 1105; Div. Ex. 233 at Bates 8631.) Mr. Barbato touted the Meadow investment as a worthwhile investment, a good buy, and that the price of the securities would "triple in like three or four months." (Tr. 1105-06.) In May 1990, Mrs. Harrison purchased an additional 80,000 shares of Meadow securities at a price of $0.0625 per share based on another representation that the price of the stock would double or triple. (Tr. 1113; Div. Ex. 233 at Bates 8632.) William Camacho is a certified public accountant from Bristol, Rhode Island. (Tr. 112.) In 1986, after he saw an advertisement in a local newspaper for Stuart-James, he ==========================================START OF PAGE 10====== telephoned the company and spoke with Mr. Barbato. (Tr. 114.) Mr. Camacho had accounts with other brokerage firms in addition to the account he had with Stuart-James. (Tr. 328, 337.) Mr. Camacho told Mr. Barbato that he was interested in medium-risk investments. (Tr. 392-93.) He believed that the securities Mr. Barbato recommended to him were low- to medium-risk. (Tr. 115, 205, 317-20, 392.) Early in 1987, Mr. Barbato told Mr. Camacho that he should put his money into Warrantech, representing that the company would probably "make a lot of money in the future." (Tr. 135, 139-40.) In January 1987, Mr. Camacho bought 7,000 shares of Warrantech at $0.28125 per share for a total purchase price of $1,973.75. (Div. Ex. 201 at Bates 8307.) In June 1988, Mr. Barbato recommended that Mr. Camacho purchase additional shares of Warrantech securities projecting that the price would someday reach five to ten dollars. (Tr. 181-82.) Based on this representation, Mr. Camacho bought 4,000 more shares of Warrantech securities at $1.01 per share.-[10]- (Tr. 182.) Henry A. Schneider, a resident of Fort Lauderdale, Florida, has been disabled and out of work since approximately 1988. (Tr. 657-58.) He opened an account with Mr. Barbato and Stuart-James in October 1989. (Tr. 660.) Mr. Barbato told Mr. Schneider that Stuart-James dealt with low priced stocks, which Mr. Schneider understood as stocks under five dollars. (Tr. 660-61.) Mr. Schneider had limited knowledge of the stock market prior to opening his account with Stuart-James, and described his experience in investing in stocks as very poor, consisting of about three, albeit successful, transactions. (Tr. 662.) Mr. Schneider purchased securities in his Stuart-James account based on Mr. Barbato's representations and ---------FOOTNOTES---------- -[10]- From January 1987 through December 1988, Mr. Camacho made eight purchases of Warrantech Securities, for a total of 42,000 shares at a total purchase price of $22,489. (Div. Ex. 201 at Bates 8307, 8313, 8315, 8317, 8318, 8322, 8324, 8327; Div. Ex. 204.) The purchase price of Warrantech securities increased to $1.00 per share by June 1988 and was still $1.00 in December 1988. (Tr. 181, 190; Div. Ex. 201 at Bates 8324, 8327.) Mr. Camacho's account statement for the period ending December 30, 1988, shows that the Stuart-James bid and ask prices for Warrantech were $0.875 and $0.937, respectively. (Div. Ex. 201 at Bates 8327.) Although the price of Warrantech securities decreased, Mr. Barbato persuaded Mr. Camacho to purchase additional shares of Warrantech securities. (Tr. 369; Div. Ex. 201 at Bates 8331, 8337A.) In August 1990, accounting for a ten to one reverse split, Mr. Camacho's Warrantech securities were worth approximately $0.50 per share. (Div. Ex. 201 at Bates 8344.) ==========================================START OF PAGE 11====== recommendations. (Tr. 665-66, 671.) Mr. Schneider's first transaction with Mr. Barbato was a purchase of 750 shares of Europa at $2.23 per share. (Tr. 671; Div. Ex. 249 at Bates 8765.) Mr. Barbato told Mr. Schneider that Europa was a cruise line operating a gambling ship out of Tampa, the only one operating off of the west coast of Florida. (Tr. 671.) Mr. Barbato also told him that Europa could double in price within six months to a year. (Tr. 674-75.) In February 1990, Mr. Schneider bought 500 additional shares of Europa securities at $1.6875 per share. (Tr. 687; Div. Ex. 249 at Bates 8770.) In July 1990, he sold his 2,500 shares in Europa securities for $0.68 per share. (Tr. 672, 688; Div. Ex. 249 at Bates 8771.) William Riley Allen is a trial lawyer from Apopka, Florida. (Tr. 768.) In October 1989, Mr. Allen opened an account with Mr. Barbato and Stuart-James, and made his first purchase of securities. (Tr. 769; Div. Ex. 258 at Bates 8848.) At that time, he had no personal experience in securities investment and was reluctant to invest in the stock market because he was not educated in the field and was not comfortable turning over his money to someone he did not know. (Tr. 770-71.) Mr. Allen trusted and relied on Mr. Barbato and believed that Mr. Barbato would deal honestly with him. (Tr. 773, 795-96, 809-10.) In May 1990, Mr. Allen purchased 250 shares of National Media securities at $13.25 per share. (Tr. 791; Div. Ex. 258 at Bates 8858.) Mr. Barbato represented to Mr. Allen that the price of the securities would increase to around $21.00 per share by the fall of 1990. (Tr. 791-92.) Mr. Barbato's price prediction, coupled with representations that he personally owned shares of National Media, increased Mr. Allen's willingness to purchase the securities. (Tr. 792.) By September 1990, the price of National Media dropped to less than eight dollars per share. (Tr. 793; Div. Ex. 256.) Conclusion Mr. Barbato intentionally made unreasonable predictions of substantial price increases in speculative securities to his customers in order to induce purchases in those securities. In addition to the investor witnesses discussed above, the record also shows that Mr. Barbato made predictions of significant increases in the price of speculative securities to at least one other customer, Thomas Castronovo. (Tr. 36-37, 40-41, 105-06.) The prediction of a substantial increase in the price of any security without a reasonable basis for making such a prediction is fraudulent. SEC v. Hasho, 784 F. Supp 1059, 1109 (S.D.N.Y. 1992); Lester Kuznetz, 48 S.E.C. 551, 553 (1986). The Commission has repeatedly held that "it is inherently fraudulent to predict specific and substantial increases in the price of a speculative security." Cortlandt Investing Corp., 44 S.E.C 45, 50 (1969); ==========================================START OF PAGE 12====== Crow, Brourman & Chatkin, Inc., 42 S.E.C. 938, 944 (1966); Alexander Reid & Co., 40 S.E.C. 986, 991 (1962). The Commission has stated, moreover, that such "predictions of substantial price increases within relatively short periods of time with respect to a promotional and speculative security of an unseasoned company are a 'hallmark' of fraud and cannot be justified." Alfred Miller, 43 S.E.C. 233, 235 (1966) (citing Hamilton Waters & Co., 42 S.E.C. 784, 787-88 (1965)). Making predictions of price increases in these securities was unreasonable. See SEC v. R.A. Holman & Co., 366 F.2d 456, 458-59 (2d Cir. 1966) (finding no reasonable basis for price predictions when company sustained a loss, even though it had been profitable for three years); Hasho, 784 F. Supp. at 1109 (finding no reasonable basis for predictions about unseasoned companies either operating at a loss or with small profits); Lester Kuznetz, 48 S.E.C. at 553-54 n.3 (finding no reasonable basis for predictions that an investment was guaranteed or relatively safe where company had four years of operating losses). Mr. Barbato looked at the due diligence files kept by Stuart-James of the securities he recommended, which included prospectuses, public filings, news releases, and news articles, and, therefore, knew of the speculative nature of these securities. (Tr. 2315.) Nevertheless, Mr. Barbato persisted in making unwarranted predictions of price increases to his customers. Mr. Barbato's price predictions as to these securities, therefore, violated the antifraud provisions of the federal securities laws because they were willful misrepresentations. 2. Material Misrepresentations and Omissions The record shows that Mr. Barbato made material misrepresentations and failed to disclose material information when he recommended securities to customers, in violation of the antifraud provisions of the federal securities laws. Mr. Barbato did not disclose negative information to his customers about the companies whose securities he was recommending. Specifically, he misrepresented and omitted to state material facts about the risks of investing in the issuers and failed to disclose earnings information to investors. He also pressured investors to invest immediately, misrepresented to investors that he had inside information, and misrepresented to investors that he owned the stocks he was recommending. In addition, Mr. Barbato misrepresented and failed to disclose the amount of commissions he made from sales. Penny stock trading involves very high commissions and is often ==========================================START OF PAGE 13====== characterized by cross trading-[11]- and IPO flipping.-[12]- (Tr. 1351-52.) Brokers at Stuart-James sold, almost exclusively, Stuart-James securities in order to take advantage of the high spreads of the penny stocks and generate higher commissions. (Tr. 1357.) Brokers effectively purchased the securities they sold to customers from the Stuart- James trading department at a wholesale price. (Tr. 969.) Customers then purchased the securities from the broker at a higher retail or market "ask" price. (Tr. 969-70.) The same principle applied to sales by customers. (Tr. 972.) A customer would sell securities at the market "bid" price. Id. The Stuart-James wholesale bid price would be higher than the market bid price. Id. Gross commissions were calculated by multiplying the difference between the wholesale and retail price by the number of shares.-[13]- (Tr. 971.) If a broker matched a buying customer with a selling customer of the same security, the broker would generate commissions on both sides of the transaction. (Tr. 974.) In such a situation, the broker could also negotiate with the trading department and recover some, if not all, of the spread between the wholesale bid and ask prices.-[14]- (Tr. 974-76.) It would be, therefore, economically advantageous for a broker to match, or cross, a buyer and a seller. Salesmen would then receive as compensation 40, 45, 50, or 55 percent of their gross commissions, depending on their monthly sales performance. (Tr. 970-71.) ---------FOOTNOTES---------- -[11]- A cross trade occurs when a broker recommends that one customer buy a security on the same day that the broker recommends that another client sell the security. (Tr. 1352.) -[12]- Generally, a penny stock broker will persuade clients to invest in IPOs, which involve new issues and typically create profits for both the client and the broker, in order to entice clients to continue trading with the broker. (Tr. 1352.) -[13]- For example, if the market bid and ask prices of a security were $0.10 and $0.15, respectively, the Stuart-James wholesale prices might be $0.11 and $0.12. A sale of 10,000 shares of this security to a customer would generate $300 in gross commissions, the difference in price between $0.15 and $0.12 multiplied by the 10,000 shares. A sale of 10,000 shares of this security by a customer would generate $100 in gross commissions. Generally, Stuart-James established wholesale prices like this that favored purchases by customers rather than sales. -[14]- Therefore, on a matched trade of 10,000 shares with a retail bid and ask price of $0.10 and $0.15, the broker could generate $500 in gross commissions. ==========================================START OF PAGE 14====== Thomas Castronovo is an architect from Akron, Ohio. (Tr. 19-20.) In 1986, Mr. Castronovo saw an advertisement about investing with Stuart-James and called Mr. Barbato. (Tr. 20, 71.) Mr. Castronovo had some previous experience in securities investments. (Tr. 41-42, 69-71.) Mr. Barbato told Mr. Castronovo that he was one of the better brokers in his field, that he picked and recommended good companies to his customers, and that he had a very good record of making profits. (Tr. 21- 23, 74.) Mr. Castronovo relied on Mr. Barbato and purchased securities in his account based on Mr. Barbato's representations and recommendations. (Tr. 34, 75.) When making a recommendation to Mr. Castronovo to purchase securities, Mr. Barbato did not disclose any negative factors with respect to the securities he was recommending, including the risks associated with investing in the companies. (Tr. 22, 28- 29, 31-32, 41, 43, 102, 104-07.) Mr. Barbato did not discuss with Mr. Castronovo sales earnings or price to earnings ratios of the companies. (Tr. 106-07.) He did not provide Mr. Castronovo, as a regular matter, with detailed financial information or prospectuses. (Tr. 107.) Mr. Barbato misrepresented that he owned shares of, or had secret information about, companies he was recommending in order to persuade Mr. Castronovo to invest quickly in those companies. (Tr. 25-26, 31, 46-47, 77.) Mr. Barbato also misrepresented the compensation he received from purchasing and selling securities in Mr. Castronovo's account. (Tr. 29-30, 39-40, 43-45, 94, 104, 107-08.) Mr. Barbato also did not disclose to Mr. Castronovo that when he recommended a transaction in a security to Mr. Castronovo, he was recommending that another customer undertake the opposite transaction in the same security. (Tr. 48-49, 104.) In September 1989, based on Mr. Barbato's recommendation, Mr. Castronovo sold 28,000 shares of International Microcomputer Software, Inc., ("IMS") to fund a purchase of 1,500 shares of Europa at $1.75 per share. (Tr. 43, 80-81; Div. Ex. 217 at Bates 8534.) Mr. Barbato did not inform Mr. Castronovo that Europa's prospectus warned investors of the high degree of risk, nor did he disclose any of the risk factors listed in the company's prospectus. Id. Also, Mr. Barbato did not disclose the amount of his commission in the sale of IMS and the purchase of Europa. Id. Ted Spangenberg is a retired civil engineer from Chipley, Florida. (Tr. 1141-42.) In 1985, Mr. Barbato contacted Mr. Spangenberg about investing in the stock market. (Tr. 1143.) Mr. Spangenberg was still working at the time, but he retired shortly thereafter. (Tr. 1161.) He had accounts with other brokerage firms and subscribed to financial publications. (Tr. 1146, 1174-75, 1237-40.) During their first conversation, Mr. Spangenberg gave Mr. Barbato information on his income, assets, ==========================================START OF PAGE 15====== and investment experience. (Tr. 1144-45.) Mr. Spangenberg later opened an account with Mr. Barbato and Stuart-James and made his first purchase of securities in August 1985. (Div. Exs. 260, 260A.) He was interested in medium-risk investments. (Tr. 1217.) Mr. Barbato's sales presentations to Mr. Spangenberg were positive, persuasive, and aggressive. (Tr. 1174, 1219, 1258-59.) Mr. Barbato initiated the recommendations as to all of the stocks Mr. Spangenberg purchased. (Tr. 1227.) Mr. Spangenberg put his trust and confidence in Mr. Barbato and relied on Mr. Barbato to manage his account. (Tr. 1174, 1177-78, 1187, 1241, 1245, 1259.) Mr. Barbato never disclosed negative information about the securities he recommended. (Tr. 1172-73.) Mr. Barbato did not disclose to Mr. Spangenberg how he and Stuart-James calculated commissions or the amount of commissions he received on each transaction.-[15]- (Tr. 1168, 1200, 1211-12, 1257.) Mr. Camacho trusted Mr. Barbato, had confidence in his recommendations, and relied on Mr. Barbato in purchasing and selling securities in his account. (Tr. 122-24, 479.) Mr. Barbato pressured Mr. Camacho to invest immediately and induced Mr. Camacho to purchase securities by stating that he had inside information about the securities he was recommending. (Tr. 126, 133, 168-69, 180, 467, 477, 479.) Mr. Barbato also failed to disclose to Mr. Camacho negative information about the companies whose securities he was recommending, including earnings information or the risks involved in investing in the companies.-[16]- (Tr. 120-24, 126, 133, 154, 185, 224-27.) ---------FOOTNOTES---------- -[15]- In fact, Mr. Spangenberg thought the $5.00, $7.50, or $15.00 miscellaneous charge indicated on the Stuart-James confirmation slips was the amount of commission Mr. Barbato received on each transaction. (Tr. 1167-68, 1200, 1251-52, 1254- 55; see Div. Exs. 263B, 263C, 264.) Mr. Spangenberg recorded his transactions in a notebook which also showed the miscellaneous charges as commissions. (Tr. 1167-68, 1233; Div. Ex. 260A.) The order tickets for transactions in Mr. Spangenberg's account, however, show "commissions" at amounts substantially higher than the $5.00, $7.50, and $15.00 Mr. Spangenberg thought he was being charged. (Div. Ex. 264.) -[16]- When Mr. Barbato recommended to Mr. Camacho that he invest in Independent Air Holdings, Inc., ("Independent Air"), for example, he did not discuss with Mr. Camacho any of the risks involved in investing in the company. (Tr. 120-22.) Specifically, Mr. Barbato failed to disclose to Mr. Camacho that the prospectus for Independent Air, dated in October 1985, stated in large bold print, "These securities involve a high degree of risk . . . and substantial dilution and should not be purchased (continued...) ==========================================START OF PAGE 16====== Mr. Allen relied on Mr. Barbato's representations and recommendations when he purchased securities. (Tr. 773, 795-96, 809-10.) Mr. Barbato failed to disclose to Mr. Allen the significance of the bid and ask prices of the stocks Stuart-James sold or the way Stuart-James calculated commissions paid to Mr. Barbato. (Tr. 771-72.) Mr. Barbato recommended securities to Mr. Allen enthusiastically and urgently but failed to disclose the risks of investing in those securities. (Tr. 774-76, 780-81, 788-89.) When he recommended that Mr. Allen purchase National Media securities in May 1990, for example, Mr. Barbato failed to disclose any negative information about the company, including that National Media had products with very short life cycles and that the continuing success of the company depended on product development. (Tr. 789.) Mr. Barbato also represented that he personally owned shares of National Media, which increased Mr. Allen's willingness to purchase the securities. (Tr. 792.) In fact, when Mr. Allen purchased shares of National Media securities in May 1990 based in part on this representation, Mr. Barbato had already sold National Media in his IRA account. (Div. Ex. 185 at Bates 6826; Div. Ex. 184 at Bates 6812-13.) Mr. Barbato also failed to disclose to Mr. Camacho and Mr. Allen material information when he recommended they purchase Cedar securities. Specifically, he failed to tell them that an article in Forbes magazine, dated February 5, 1990, contained negative information about Cedar and criticized Stuart-James for "frantically flogging the shares" of Cedar. (Tr. 240, 782-84; Div. Ex. 21.) He also failed to tell Mr. Allen about another article published in Barron's magazine, dated May 7, 1990, which also contained negative information about Cedar and its stock. (Tr. 784-88; Div. Ex. 27.) Mr. Barbato did not tell Mr. Allen any other negative information about Cedar, including (i) that Stuart-James was attempting a "short squeeze" of Cedar stock;-[17]- (ii) whether the price of Cedar securities was ---------FOOTNOTES---------- -[16]-(...continued) by anyone who cannot afford the loss of his entire investment." (Div. Ex. 94 at Bates 3578.) The prospectus also listed fourteen risk factors. (Div. Ex. 94 at Bates 3582-86.) In October 1986, Mr. Camacho purchased 15,000 shares of Independent Air at $0.28 per share. (Tr. 121-22; Div. Ex. 201 at Bates 8304.) When Mr. Camacho received an Independent Air prospectus and questioned Mr. Barbato about the warnings, Mr. Barbato persuaded Mr. Camacho to ignore the prospectus. (Tr. 122-24.) -[17]- The record shows that Stuart-James was attempting to squeeze investors who had taken short positions in Cedar stock by pushing its brokers to recommend that customers purchase Cedar securities. Stuart-James hoped to inflate the price of Cedar and force short sellers to purchase the stock at the inflated price (continued...) ==========================================START OF PAGE 17====== declining; (iii) what the earnings had been for the previous year; and (iv) the background of people associated with Cedar.-[18]- (Tr. 780-83.) Mr. Barbato also failed to discuss the risks associated with investing in Cedar when he recommended to Ms. Gordon that she purchase the company's securities. (Tr. 504-06.) In April 1990, Mr. Barbato persuaded Ms. Gordon to invest in Cedar by representing to her that he had "inside information" about Cedar and that investing in Cedar at that time, therefore, was "a great opportunity." (Tr. 500-03, 538.) Mr. Barbato also represented to Ms. Gordon that he received small commissions of one and a half to three percent. (Tr. 513-14.) Mr. Barbato recommended securities to Mrs. Harrison with a sense of urgency and always provided "glowing" reports. (Tr. 1104.) When Mr. Barbato first recommended to Mrs. Harrison that she purchase Meadow securities in October 1989, for example, he did not say anything negative about the company's business prospects, stock, or earnings. (Tr. 1106-07.) Mr. Barbato also failed to discuss commissions with Mrs. Harrison, including the significance of the bid and ask prices. (Tr. 1106-12, 1136-39.) Conclusion The failure, by a registered representative, to disclose material information to customers, including various risk factors and past negative earnings of issuers, and the speculative nature of recommended securities, violates the antifraud provisions of the federal securities laws. Hasho, 784 F. Supp at 1109 (citing Hanly v. SEC, 415 F.2d 589, 595-97 (2d Cir. 1969); R.A. Holman & Co., 366 F.2d at 458; SEC v. Rega, [1975-76 Transfer Binder] Fed. Sec. L. Rep. (CCH) 95,222 at 98,148 (S.D.N.Y. 1975)). Misrepresentations and omissions are material given the "significance the reasonable investor would place on the withheld or misrepresented information." Basic Inc. v. Levinson, 485 U.S. ---------FOOTNOTES---------- -[17]-(...continued) in order to cover their short positions. The record shows that Mr. Barbato was aware of the attempted short squeeze and that he recommended purchases of Cedar to his customers without revealing this information. The fact that Stuart-James was engaging in such a practice made investment in Cedar very risky. The record shows that Mr. Barbato made recommendations to at least three of his customers, Mr. Camacho, Mr. Allen, and Ms. Gordon, without disclosing information about the short squeeze or other risks involved in investing in Cedar. (Tr. 240, 505-06, 780-81.) -[18]- The Barron's article, for example, suggested that officers of Cedar, and others associated with Cedar, had previous regulatory problems. (Div. Ex. 27.) ==========================================START OF PAGE 18====== 224, 240 (1988); see also TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). Mr. Barbato's repeated and intentional failure to disclose risk factors concerning the securities he recommended to his customers was, therefore, a failure to state material facts in violation of the antifraud provisions.-[19]- See Merrill Lynch, Pierce, Fenner and Smith, 13 SEC Docket 646, 653-54 (1977); B. Fennekohl & Co., 41 S.E.C. 210, 214-18 (1962). In addition, his advice to customers that they should ignore statements in prospectuses amounted to a willful misrepresentation that the securities were not risky in nature. This conduct also violated the antifraud provisions. See Lester Kuznetz, 48 S.E.C. at 553 (untrue statements that an investment was relatively safe violated the antifraud provisions). Mr. Barbato's sales techniques obscured the risks involved with investing in speculative securities and created an unwarranted air of certainty in such an investment. See Ross Securities, Inc., 41 S.E.C. 509, 514 (1963). Mr. Barbato made optimistic and enthusiastic representations and recommendations to his customers without a reasonable basis, and he pressured his customers to invest immediately. He also falsely represented to his customers that he possessed inside information in order to induce them to invest with him, in violation of the antifraud provisions. See Hasho, 784 F. Supp at 1109 ("The false assertion by a registered representative, in connection with the offer, purchase or sale of securities, that the registered representative possesses 'inside' or material non-public information regarding an issuer, is a material misstatement violative of the anti-fraud provisions of the federal securities laws.") (citing Bateman Eichler, Hill Richards, Inc. v. Berner, ---------FOOTNOTES---------- -[19]- Like the respondents in Martin Herer Engelman, Mr. Barbato violated the antifraud provisions of the securities laws because: [his] sales tactics were marked by assiduous avoidance of the term "risk" and emphasis on the assertedly phenomenal prospects of the stocks he recommended. [Mr. Barbato] actively solicited and induced securities purchases by presenting "facts" that were untrue, and omitted from the sales presentations facts -- including the bleak financial conditions of virtually all of the issuers . . . and the essential information that investors in the touted securities stood to lose their entire investment -- that an ordinary investor requires to make an informed investment decision. Martin Herer Engelman, 59 SEC Docket 1038, 1051-52 (1995), aff'd, No. 95-70564, 1996 U.S. App. LEXIS 15635 (9th Cir. June 26, 1996). ==========================================START OF PAGE 19====== 472 U.S. 299, 312 (1985); Hiller v. SEC, 429 F.2d 856, 857-58 (2d Cir. 1970)); see also Nye v. Blyth Eastman Dillon & Co., 588 F.2d 1189, 1194-96, 1198 (8th Cir. 1978). In addition, Mr. Barbato represented to his customers that he owned the stocks he was recommending when he had, in fact, already sold those stocks.-[20]- Such a representation is misleading and, therefore, fraudulent. See Cortlandt Investing Corp., 44 S.E.C. at 51. Misrepresenting the amount of commissions a registered representative receives on transactions in customers' securities is violative of the antifraud provisions. Hasho, 784 F. Supp at 1109-10 (citing SEC v. American Inst. Counselors, Inc., [1975-76 Transfer Binder] Fed. Sec. L. Rep. (CCH) 95,388, at 98,954 (D.D.C. 1975)). Further, failing to disclose to customers the amount of commissions that a registered representative earns on the purchase or sale of in-house securities "deprives the customer of knowledge that his registered representative might be recommending a security based upon the registered representative's own financial interest rather than the investment value of the recommended security." Hasho, 784 F. Supp at 1110. Therefore, when a registered representative misrepresents or fails to disclose his or her financial or economic incentive in connection with a stock recommendation, the registered representative violates the anti-fraud provisions. Hasho, 784 F. Supp at 1110 (citing Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1172 (2d Cir. 1970)). Dr. Brown analyzed Mr. Barbato's trading records from January 1987 through November 1989 and compiled supporting documents for his analysis. (Tr. 1357-59.) The statistics compiled by Dr. Brown show that the gross commissions charged in Mr. Barbato's customer accounts from January 1987 through November 1989 amounted to $839,258. (Tr. 1374; Div. Ex. 298A.) Mr. Barbato received, for the most part, 55 percent of his gross commissions during that time period, for a total of $461,592. (Div. Ex. 298A; see Tr. 2362-63, 2381, 2477.) Using a constant ---------FOOTNOTES---------- -[20]- Mr. Barbato's representations to his customers that he owned the securities he recommended was designed to emphasize his confidence in his recommendations and to cause his customers to rely upon his advice. See, e.g., Martin Herer Engelman, 59 SEC Docket at 1053 & n.38; Cortlandt Investing Corp., 44 S.E.C. at 51. Mr. Barbato argues, it seems, that because he believed that Stuart-James securities were good investments and he was willing to invest his own funds in these securities, his responsibility to his customers lessened. His responsibility to his customers, however, to disclose material information and to accurately represent information about the securities he was recommending, remained the same. See Cortlandt Investing Corp., 44 S.E.C. at 51. ==========================================START OF PAGE 20====== monthly commission estimate, Dr. Brown showed that the gross commissions charged in Mr. Barbato's customer accounts from January 1987 through July 1990 amounted to $1,132,765, and that Mr. Barbato received, during that time period, a total of $623,020.-[21]- (Div. Ex. 300; see Tr. 2381.) Dr. Brown calculated that Mr. Barbato's customers were charged an average of 12.8 percent on all buys and sells.-[22]- (Tr. 1374-75; Div. Ex. 299A.) Mr. Barbato also engaged in practices including making contrary recommendations to his customers and cross trading,-[23]- IPO flipping,-[24]- and sales to finance buys in order to generate higher commissions. Approximately 25 percent of all trades conducted by Mr. Barbato between January 1987 through November 1989 were cross trades. (Tr. 1362, 1378; Div. Ex. 293A, 296A, 303A.) Mr. Barbato, therefore, generated gross commissions on both the buy and sell side of the transaction and, in some cases, also from a portion of the spread between the wholesale bid and ask.-[25]- (Tr. 1381-83; Div. Ex. 304A.) In addition, almost one third of ---------FOOTNOTES---------- -[21]- Mr. Barbato testified that he made about $25,000 in gross commissions per month and that he received approximately 55 percent of that amount. (Tr. 2381.) -[22]- This commission calculation includes trades in Mr. Barbato's own account, which generated commissions at a rate of 3.8 percent. (Tr. 1372-77, 1386; Div. Ex. 299A, 302A.) -[23]- Cross trading "is a highly suspect practice." Costello v. Oppenheimer & Co., 711 F.2d 1361, 1369 n.10 (7th Cir. 1983). -[24]- Dr. Brown found that on at least one occasion, on March 17, 1988, Mr. Barbato engaged in IPO flipping of Meadow. (Tr. 1383-85; see, e.g., Div. Ex. 301.) On the first day of trading, Mr. Barbato's clients bought and sold Meadow securities and made $1,860 in gross profits in the first round of transactions. (Tr. 1384; Div. Ex. 301.) Mr. Barbato's second round clients then purchased Meadow at a much higher price, almost double what the first round clients sold for. (Tr. 1384- 85; Div. Ex. 301.) Dr. Brown concluded that Mr. Barbato made $13,080 in gross commissions on the first day of trading in Meadow. (Tr. 1385; Div. Ex. 301.) -[25]- Dr. Brown concluded, from his analysis, that Mr. Barbato received the full spread between the retail bid and ask price on approximately twenty five percent of his cross trades, or about 6.5 percent of his total trades, during this period. (Tr. 1382; Div. Ex. 304A.) ==========================================START OF PAGE 21====== all of Mr. Barbato's trades during this period were sales to finance buys. (Tr. 1367; Div. Ex. 294A.) The record demonstrates that Mr. Barbato misrepresented and failed to disclose to his customers the amount of commissions he made from trading Stuart-James securities. He did not disclose to his customers the significance of the bid and ask prices of the securities he recommended or that he was making a substantial amount in commissions based on those prices. Mr. Barbato did not tell customers that he received commissions on both ends of a sale to finance a buy. In addition, his customers were not aware that he received a larger commission when he matched a purchase by one customer with a sale from another customer in a Stuart- James security or when he engaged in IPO flipping. Mr. Barbato argues that some of his customers were experienced investors and that they knew and appreciated the risks associated with investing in low-priced securities. A customer's investment experience does not, however, justify or excuse a broker's misrepresentations and omissions. Further, such misrepresentations and omissions make it impossible for a customer to know and appreciate the risks involved with investing. Scienter, "a mental state embracing intent to deceive, manipulate, or defraud," is required to establish violations of Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Aaron v. SEC, 446 U.S. 680, 686 n.5 (1980); see also Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). Scienter is found where a broker acts with "intent to defraud or with willful and reckless disregard for the [customer's] interest." Miley v. Oppenheimer & Co., 637 F.2d 318, 324 (5th Cir. 1981). Based on the foregoing, I find that Mr. Barbato willfully made material misrepresentations and failed to disclose material information when he recommended securities to customers, in violation of the antifraud provisions of the federal securities laws. 3. Unsuitable Recommendations and Excessive Trading Unsuitable trading occurs where a registered representative engages in risky transactions that are directly contrary to the customer's stated investment objectives. Richard N. Cea, 44 S.E.C. 8, 18 (1969). A broker who knowingly recommends unsuitable investments violates the antifraud provisions of the federal securities laws. Clark v. John Lamula Investors, Inc., 583 F.2d 594, 600 (2d Cir. 1978); Cruse v. Equitable Securities of New York, Inc., 678 F. Supp. 1023, 1031-32 (S.D.N.Y. 1987); Mauriber v. Shearson American Express, Inc., 567 F. Supp. 1231, 1237 (S.D.N.Y 1983). Mr. Spangenberg had some prior investment experience when he opened his account at Stuart-James, but he was retiring and was interested in medium-risk investments. (Tr. 1146, 1161, 1174-75, ==========================================START OF PAGE 22====== 1217-18, 1237-40.) Similarly, when Mr. Castronovo and Mr. Barbato spoke about investing with Stuart-James, Mr. Castronovo informed Mr. Barbato that his financial condition was on course for his retirement, without much leeway for losses, and that he wanted low-risk investments. (Tr. 24; Div. Ex. 221.) Based on Mr. Barbato's representations, Mr. Castronovo believed that he was investing in sound companies, not high-risk companies, and that he would make money on his Stuart-James investments. (Tr. 74, 102.) During the time Mr. Castronovo invested with Mr. Barbato and Stuart-James, he also had accounts with other brokerage firms where he engaged in a limited number of high-risk investment practices. (Tr. 84-86, 101.) Regardless of Mr. Castronovo's practices at other brokerage firms, however, his stated investment objectives at Stuart-James remained low- risk.-[26]- When Mr. Schneider opened his account with Mr. Barbato and Stuart-James in October 1989, he had limited knowledge of the stock market, he was not working, and he did not have a steady income. (Tr. 657-58, 660-65, 685-86.) Based on Mr. Schneider's investment history prior to his involvement with Stuart-James, his financial and employment history, and the general nature of his dealings with Mr. Barbato, I find that, during his association with Mr. Barbato at Stuart-James, Mr. Schneider was an unsophisticated investor who also wanted to invest in low- to medium-risk investments. Mr. Barbato persuaded Mr. Camacho to open an IRA account with him at Stuart-James in order to invest in Stuart-James limited partnerships. (Tr. 200-04; Div. Ex. 202.) The new account data sheet for Mr. Camacho's IRA account reflects an investment objective of "Long Term Growth with Safety."-[27]- (Resp. Ex. 1.) Despite this investment objective, Mr. Barbato recommended, in April 1989, that Mr. Camacho invest, in his IRA account, over $5,000 in Meadow ---------FOOTNOTES---------- -[26]- Unlike Mr. Barbato, Mr. Castronovo's other broker gave him statistics and financial information on the companies in which he was investing, explained the nature of the transactions, including the risks involved, kept Mr. Castronovo informed of the performance of his investments, and accepted Mr. Castronovo's decisions not to purchase additional securities. (Tr. 93-94, 101-02.) -[27]- Mr. Camacho disputes the net worth figure of $100,001 - $250,000 represented on the new account form for his Stuart-James IRA. (Tr. 330; Resp. Ex. 1.) ==========================================START OF PAGE 23====== securities.-[28]- (Tr. 203; Div. Ex. at Bates 8355.) In August 1990, the value of Mr. Camacho's shares of Meadow dropped to about $500.-[29]- (Div. Ex. 202 at Bates 8360.) Mr. Barbato knowingly recommended high-risk securities to customers with stated low- and medium-risk investment objectives. Although Mr. Barbato knew that some of his customers were retired or retiring, that some of them had a fixed amount of investment funds and shaky financial situations, and that most of his customers had little knowledge about investing in securities or about the penny stock market, he persisted in recommending these high-risk investments. Mr. Barbato's actions regarding investments in Mr. Camacho's Stuart-James IRA account, for example, demonstrate that Mr. Barbato knowingly made unsuitable recommendations and effected unsuitable trading.-[30]- Mr. Barbato's fraudulent methods deceived his customers into believing they were investing in low- or medium-risk securities. He knew that recommendations to his customers of such highly speculative and risky securities were not appropriate in light of the stated investment objectives and financial goals and conditions of these customers. I find that Mr. Barbato willfully made unsuitable recommendations to his customers in violation of the antifraud provisions of the federal securities laws. Churning Churning occurs when a securities broker enters into transactions and manages a customer's account for the purpose of generating commissions and in disregard of the customer's interests. Miley, 637 F.2d at 324; McNeal v. Paine, Webber, Jackson & Curtis, Inc., 598 F.2d 888, 890 n.1 (5th Cir. 1979). The three elements of churning are: (i) control of the account by the broker, either explicit (discretionary trading) or de facto (through acquiescence, trust, or reliance); (ii) excessive trading in the account in light of the customer's investment objectives; and (iii) scienter on the part of the broker. Shad v. Dean Witter Reynolds, Inc., 799 F.2d 525, 529 (9th Cir. 1986); ---------FOOTNOTES---------- -[28]- Mr. Camacho's IRA account statement shows a purchase of 10,000 shares of Meadow at $0.20 per share on April 12, 1989, and another purchase of 18,400 shares of Meadow at $0.1875 per share on April 19, 1989. (Div. Ex. 202 at Bates 8355.) -[29]- Mr. Camacho's IRA account statement shows that, in August 1990, after a 40 to 1 reverse split of Meadow stock, Mr. Camacho owned 710 shares of Meadow with a bid price of $0.75 and an ask price of $1.125. (Div. Ex. 202 at Bates 8360.) -[30]- In fact, Mr. Barbato admitted that recommending Meadow for Mr. Camacho's IRA account was improper. (Tr. 2256.) ==========================================START OF PAGE 24====== Miley, 637 F.2d at 324; Mihara v. Dean Witter & Co., 619 F.2d 814, 821 (9th Cir. 1980). Churning violates Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Miley, 637 F.2d at 324; Mihara, 619 F.2d at 821. Churning also violates Section 17(a) of the Securities Act. See Hecht v. Harris, Upham & Co., 283 F. Supp. 417, 432-33 (N.D. Cal. 1968), modified and aff'd, 430 F.2d 1202, 1210 (9th Cir. 1970). See also 1 Stuart C. Goldberg, Fraudulent Broker-Dealer Practices,  2.3[c] (1978). The Division alleges that Mr. Barbato churned the accounts of Mr. Camacho and Mr. Spangenberg.-[31]- i. Control Mr. Barbato did not have discretionary trading authority over the accounts of Mr. Spangenberg and Mr. Camacho. A broker may have control of a customer account, however, if the customer is unable to evaluate the broker's recommendations and to exercise independent judgment. Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 676-77 (9th Cir. 1982) (citing Mihara, 619 F.2d 814; Hecht, 283 F. Supp. at 433); Eugene J. Erdos, 47 S.E.C. 985, 989-90 (1983), aff'd, 742 F.2d 507 (9th Cir. 1984). Some factors to consider in determining whether or not a broker controlled an investor's account include: the investor's sophistication; the investor's prior securities experience; the trust and confidence the investor has in the broker; whether the investor initiates transactions or whether the investor relies on the recommendations of the broker; the amount of independent research conducted by the investor; and the truth and accuracy of information provided by the broker. (Tr. 1389); 1 Goldberg, supra,  2.8[b][1]. Mr. Spangenberg did not initiate the transactions in his account. Rather, Mr. Spangenberg relied on and followed Mr. Barbato's recommendations. In addition, Mr. Spangenberg did not have certain material information when he authorized these transactions because Mr. Barbato misrepresented and omitted to state material facts regarding the companies whose securities he was recommending. Thus, although Mr. Spangenberg had some prior ---------FOOTNOTES---------- -[31]- Dr. Brown testified as an expert witness on behalf of the Division regarding churning in Mr. Spangenberg's and Mr. Camacho's accounts at Stuart-James. He analyzed various documents pertaining to the accounts, including monthly account statements, trade tickets, and trade runs. Dr. Brown assumed that Mr. Barbato was in de facto control of these two accounts and that both Mr. Spangenberg and Mr. Camacho had medium-risk investment objectives. (Tr. 1394, 1402.) Based on these assumptions and his analysis, Dr. Brown concluded that Mr. Barbato engaged in excessive trading in the accounts of Mr. Spangenberg and Mr. Camacho and, therefore, churned the accounts. (Tr. 1398, 1401.) ==========================================START OF PAGE 25====== investment experience, authorized the transactions in his account, and kept records of his trades, he lacked vital information about the investments he was making with Mr. Barbato and lacked knowledge of penny stock investing in general. Mr. Spangenberg, therefore, was unable to make an independent evaluation of Mr. Barbato's recommendations.-[32]- I find that Mr. Barbato had de facto control over Mr. Spangenberg's account. Mr. Camacho was more sophisticated in financial matters than Mr. Spangenberg. Mr. Barbato's misrepresentations, including the representation that Mr. Camacho should ignore prospectuses, also made it difficult for Mr. Camacho to independently evaluate Mr. Barbato's recommendations. Although Mr. Barbato misrepresented and omitted to state material facts to Mr. Camacho, Mr. Camacho had the financial background to track his investments, calculate profits and losses, and investigate more thoroughly the investments he was making. I find, therefore, that Mr. Barbato was not in de facto control of Mr. Camacho's account because Mr. Camacho had sufficient knowledge, ability, and understanding to make an independent evaluation of Mr. Barbato's recommendations.-[33]- ii. Excessive Trading The cost to equity maintenance factor, or the break even cost factor, and the turnover rate are measures used to determine excessive trading in an account. The break even cost factor is the percentage of return on the customer's average net equity ---------FOOTNOTES---------- -[32]- See Mihara, 619 F.2d at 821 (de facto control is met when the client routinely follows the recommendations of the broker); Hecht, 283 F. Supp. at 433 (control can be inferred from evidence that the customer invariably relied on the dealer's recommendations, especially when the customer is relatively naive and unsophisticated); Eugene J. Erdos, 47 S.E.C. at 988-90 (control found where customer did not have sufficient understanding to make an independent evaluation of broker's recommendations because, although customer had been investing in securities for some 50 years, she had never previously dealt in options and did not fully understand them). -[33]- See Follansbee, 681 F.2d at 677-78 (control not found where customer had sufficient intelligence and understanding to evaluate the broker's recommendations and to reject one when he thinks it unsuitable because the customer had a college degree in economics, had taken a course in accounting, had read corporate financial reports with understanding, was a regular reader of investment advisory literature, was an active participant in the broker's investment seminars, and kept meticulous records of his trades). ==========================================START OF PAGE 26====== needed to pay broker-dealer commissions and other expenses. See 1 Goldberg, supra,  2.9[b][5]. In other words, the break even cost factor determines the rate of return that the account has to earn on an annual basis just to cover transaction costs. (Tr. 1392.) The annual turnover rate of an account, which is the ratio of total purchases divided by the average equity, measures the number of times per year an account is turned over.-[34]- (Tr. 1389); see also 1 Goldberg, supra,  2.9[b][1]. According to Dr. Brown, the break even cost factor is the better measure where penny stocks are concerned because the commissions and transaction costs in penny stock accounts are much higher than in traditional securities accounts. (Tr. 1393.) During the period of March 1988 through July 1990, purchases in Mr. Spangenberg's account totaled $214,889, commissions generated totaled $38,884, the average equity during the period was $42,359, the turnover rate was 2.1, the break even cost factor was 38 percent, and net trading losses totaled $34,953. (Tr. 1394-96; Div. Ex. 310.) There was increased trading activity from July 1989 through July 1990 with total purchases of $123,558, total commissions generated of $17,314, average equity during the period of $27,608, a turnover rate of 4.1, and a break even cost factor of 57.9 percent. (Tr. 1395-96; Div. Ex. 310.) There was no reasonable expectation that Mr. Spangenberg's account would earn a return sufficient to cover the costs of the transactions and it was, therefore, excessively traded. (Tr. 1403); see Michael David Sweeney, 50 S.E.C. 761, 765 (1991) (finding excessive trading in account with break even cost factors of 22 to 44 percent); Shearson Lehman Hutton Inc., 49 S.E.C. 1119, 1121 (1989) (finding excessive trading in account with a break even cost factor of 50 percent). The high turnover rates further indicate that Mr. Barbato excessively traded Mr. Spangenberg's account. (Tr. 1403); see Richard N. Cea, 44 S.E.C. at 18-19; Shearson, Hammill & Co., 42 S.E.C. 811, 846-49 (1965); Samuel B. Franklin & Co., 42 S.E.C. 325, 327-28 (1964); J. Logan & Co., 41 S.E.C. 88, 93-97, 99 (1962), aff'd sub nom., Hersh v. SEC, 325 F.2d 147 (9th Cir. 1963); First Securities Corp., 40 S.E.C. 589, 590 (1961); R.H. Johnson & Co., 36 S.E.C. 467, 472, 479-80, 485 (1955), aff'd, 231 F.2d 523 (D.C. Cir. 1956). iii. Scienter ---------FOOTNOTES---------- -[34]- Dr. Brown explained that in retail securities accounts with one to three percent transaction costs a turnover ratio of two is possible excessive trading, a turnover ratio of four is probable excessive trading, and a turnover ratio of six is presumptive excessive trading. (Tr. 1390); see also 1 Goldberg, supra,  2.9[b][1]. ==========================================START OF PAGE 27====== Mr. Barbato recommended that Mr. Spangenberg engage in these securities transactions. (Tr. 2378, 2490.) He knew that his recommendations were unsuitable and contrary to Mr. Spangenberg's investment objectives. Mr. Barbato, therefore, acted willfully and with scienter,-[35]- and continued his fraudulent activity in order to generate large commissions. Mr. Barbato exercised control of trading in Mr. Spangenberg's account, he excessively traded the account, and he acted with scienter. I find, therefore, that Mr. Barbato churned Mr. Spangenberg's account in violation of the antifraud provisions of the federal securities laws. ---------FOOTNOTES---------- -[35]- "Churning, in and of itself, may be a deceptive and manipulative device under section 10(b), the scienter required by section 10(b) being implicit in the nature of the conduct." Armstrong v. McAlpin, 699 F.2d 79, 91 (2d Cir. 1983) (citations omitted). ==========================================START OF PAGE 28====== 4. Conclusion: Mr. Barbato Willfully Violated the Antifraud Provisions of the Federal Securities Laws Mr. Barbato made predictions of specific and substantial increases in the price of speculative securities, made material misrepresentations and omitted to state material information about the securities he was recommending, and made unsuitable recommendations and caused unsuitable and excessive trading. He intentionally engaged in a fraudulent course of conduct in order to generate large commissions. Mr. Barbato's activities, therefore, constitute willful violations of the antifraud provisions of the federal securities laws. III. PUBLIC INTEREST Factors to consider in determining what sanctions are appropriate in the public interest include: the egregiousness of the defendant's actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant's assurances against future violations, the defendant's recognition of the wrongful nature of his conduct, and the likelihood that his occupation will present opportunities for future violations. Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981). The Court of Appeals for the District of Columbia explained that "[t]he 'public interest' standard is obviously very broad, requiring that the Commission consider a full range of factors bearing on the judgment about sanctions that the expert agency ultimately must render." Blinder, Robinson & Co. v. SEC, 837 F.2d 1099, 1110 (D.C. Cir. 1988). Based on these considerations, I believe that severe sanctions should be imposed on Mr. Barbato. Mr. Barbato engaged in a fraudulent course of conduct from at least October 1986 to September 1990, when he left Stuart- James.-[36]- He convinced customers to invest with him ---------FOOTNOTES---------- -[36]- In assessing the appropriate sanctions for Mr. Barbato in the public interest, I primarily focussed on Mr. Barbato's conduct at Stuart-James, in business with his customers, from October 1986 to September 1990. The record suggests that Mr. Barbato continued his fraudulent activities at Prudential and Raymond James, even after the violative period covered in the Order. For example, there is evidence that Mr. Barbato engaged in unauthorized trading in the account of Nabil Hilwa and that he signed and filed a false Form U-4. These allegations are superfluous in the face of the overwhelming evidence against Mr. Barbato, as discussed above. ==========================================START OF PAGE 29====== using manipulative and deceptive tactics, and he profited greatly from his scheme. His conduct was repeated, ongoing, and pervasive, in that his fraud involved many transactions and touched several clients over an extensive period of time. He regrets little or nothing, and fails to recognize the severity and consequences of his actions.-[37]- At the time of the hearing, Mr. Barbato was an active registered representative, responsible for managing and maintaining numerous customer accounts. Mr. Barbato's conduct indicates that he is a dishonest, deceitful, and manipulative person. Although he presented investor witnesses and industry witnesses in his defense, the record demonstrates that Mr. Barbato "exhibited an obvious disregard for the well-being of his customers, in contravention of his duty as a securities professional." Martin Herer Engelman, 59 SEC Docket 1038, 1057 (1995), aff'd, No. 95-70564, 1996 U.S. App. LEXIS 15635 (9th Cir. June 26, 1996). His participation in the securities industry is dangerous and puts unwary investors at financial risk. He should not, therefore, be allowed to continue working in the securities industry. A severe sanction is warranted in this case. It is necessary in the public interest to bar Mr. Barbato from being associated with a broker or dealer and from participating in an offering of penny stock. It is also necessary to order that Mr. Barbato cease and desist from committing or causing violations or future violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Section 8A(e) of the Securities Act and Section 21C(e) of the Exchange Act provide that "the Commission may enter an order requiring accounting and disgorgement, including reasonable interest." The purpose of disgorgement is "to deprive a wrongdoer of his unjust enrichment and to deter others from violating the securities laws." SEC v. First City Fin. Corp., 890 F.2d 1215, 1230 (D.C. Cir. 1989). Dr. Brown estimated that the gross commissions charged in Mr. Barbato's customer accounts from January 1987 through July 1990 amounted to $1,132,765, and that Mr. Barbato received, during that time period, a total of $623,020 in commissions. See supra pp. 17-18. Mr. Barbato agreed that this estimate was accurate. (Tr. 2335.) ---------FOOTNOTES---------- -[37]- In March 1996, I issued an order regarding Mr. Barbato's devious conduct after the hearing, specifically his witness tampering. See Joseph J. Barbato, No. 3-8575 (March 15, 1996) (order on witness tampering). Although I did not consider this evidence in assessing the appropriate sanctions, such activity illustrates Mr. Barbato's character and emphasizes the need to remove him from the securities industry. ==========================================START OF PAGE 30====== Mr. Barbato argues that the Division has not proven that these commissions were connected to fraudulent transactions. The evidence suggests, however, that most of Mr. Barbato's transactions were part of his fraudulent course of business.-[38]- When calculating disgorgement, moreover, "separating legal from illegal profits exactly may at times be a near-impossible task." First City, 890 F.2d at 1231 (citing Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 171 (2d Cir. 1980)). Disgorgement, therefore, "need only be a reasonable approximation of profits causally connected to the violation." Id. Once the government presumptively shows that its disgorgement figure reasonably approximates the amount of unjust enrichment, the burden shifts to the respondent to "clearly" demonstrate that the disgorgement figure was not a reasonable approximation. SEC v. Lorin, 76 F.3d 458, 462 (2d Cir. 1996); SEC v. Patel, 61 F.3d 137, 140 (2d Cir. 1995); First City, 890 F.2d at 1232. Mr. Barbato failed to do so. Any risk of uncertainty as to the restitutional amount "should fall on the wrongdoer whose illegal conduct created that uncertainty." First City, 890 F.2d at 1232 (citations omitted). Accordingly, I find that Mr. Barbato should be ordered to disgorge $623,020 plus prejudgment interest. IV. ORDER Based on the findings and conclusions set forth above: I ORDER, pursuant to Section 15(b)(6) of the Exchange Act, that Joseph J. Barbato is barred from being associated with a broker or dealer and from participating in an offering of penny stock; I ORDER that Joseph J. Barbato cease and desist from committing or causing violations or future violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; and I ORDER that Joseph J. Barbato disgorge $623,020, plus prejudgment interest from August 1, 1990, through the last day of the month preceding which payment is made at the rate of interest ---------FOOTNOTES---------- -[38]- See SEC v. Lorin, 76 F.3d 458, 462 (2d Cir. 1996) (court has discretion to reason that because the purpose and effect of the scheme was to manipulate and stabilize the price of securities, appellants likely profited from the scheme in all of their trades in those securities); SEC v. Patel, 61 F.3d 137, 139-40 (2d Cir. 1995). ==========================================START OF PAGE 31====== established under Section 6621(a)(2) of the Internal Revenue Code, 28 U.S.C  6621(a)(2), compounded quarterly.-[39]- If and when Mr. Barbato pays any or all of the disgorgement amount and interest, the parties shall submit to the Office of Administrative Law Judges, within 60 days, a plan for the administration and distribution of those funds. This order shall become effective in accordance with and subject to the provisions of Rule 17(f) of the Commission's Rules of Practice, 17 C.F.R.  201.17(f) (1995). Pursuant to that rule, this initial decision shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 17(b) within 15 days after service of the initial decision upon that party, unless the Commission, pursuant to Rule 17(c), determines on its own initiative to review this initial decision as to a 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. _________________________ Burton S. Kolko Administrative Law Judge ---------FOOTNOTES---------- -[39]- I have used August 1, 1990, because it is the first day of the month following the transactions used to calculate Mr. Barbato's commissions. Cf. Rule 600, 17 C.F.R.  201.600 (1996) (Commission Rule explaining interest on sums disgorged). Payment should be made by certified check payable to the Securities and Exchange Commission. The check and a cover letter identifying the Respondent, Joseph J. Barbato, and the proceeding designation, Administrative Proceeding No. 3-8575, should be sent to the Office of the Comptroller, Room 2067, Stop 2-5, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, on the first day after this decision becomes final. A copy of the cover letter should be sent to the Commission's Division of Enforcement at the same address.