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Initial Decision of an SEC Administrative Law JudgeIn the Matter of
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In the Matter of
MARSHALL E. MELTON and ASSET
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INITIAL DECISION
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APPEARANCES:
Michael E. Mashburn and Edward G. Sullivan for the
Division of Enforcement,
Securities and Exchange Commission.
Neil A. Riemann for Respondents.
BEFORE:
James T. Kelly, Administrative Law Judge.
INTRODUCTION
The United States Securities and Exchange Commission (Commission) instituted this proceeding on April 6, 1999, pursuant to Sections 15(b) and 19(h) of the Securities Exchange Act of 1934 (Exchange Act) and Sections 203(e) and 203(f) of the Investment Advisers Act of 1940 (Advisers Act). The Order Instituting Proceedings (OIP) alleges that on May 4, 1998, the United States District Court for the Middle District of North Carolina entered a permanent injunction against Respondents Marshall E. Melton and Asset Management & Research, Inc. (AMR). The district court order permanently enjoined Mr. Melton and AMR from violating Section 17(a) of the Securities Act of 1933 (Securities Act), Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder. The district court order also enjoined AMR, aided and abetted by Mr. Melton, from causing violations of Section 206 of the Advisers Act. The OIP was issued to determine whether the allegations were true and, if so, what, if any, administrative sanctions would be in the public interest.
In their answers to the OIP, Respondents acknowledged that they had consented to a permanent injunction, but they stressed that they had done so without admitting or denying the factual allegations in the Commission's complaint. They maintained that they had settled the injunctive action because the cost of litigating in federal district court was prohibitive. They further stated that the corporate Respondent is inactive, although its charter has not been revoked. Respondents contend that no further administrative sanctions are warranted.
I postponed the hearing once to give Respondents an opportunity to obtain counsel, and then again, because Respondents and their attorney were involved in related civil litigation in the North Carolina state court system. I held the hearing on December 17, 1999, in Raleigh, N.C. The Division of Enforcement (Division) filed its proposed initial decision on February 17, 2000, and Respondents filed their proposed initial decision on March 17, 2000.1
The Parties' Challenges To Each Other's Documentary Evidence
During the hearing, I admitted into evidence a certified copy of the Commission's complaint in the underlying injunctive action (Tr. 20-23; DX 1). Respondents have challenged the admissibility of that exhibit, claiming that the complaint contains unproven allegations and has no place in the public interest determination.2 The Division has countered that the complaint can be considered as part of the public interest determination and is entitled to considerable weight.
In addressing the public interest, the Commission has long taken into account the circumstances under which it obtained a consent injunction. See Kaye, Real & Co., 36 S.E.C. 373, 375 (1955). In Kimball Securities, Inc., 39 S.E.C. 921, 923-24 (1960), the Division offered into evidence not only the district court complaint, but also the defendants' answers, affidavits submitted by both sides, and the district court hearing transcript. The hearing examiner admitted into evidence only the complaint, reasoning that the other papers would merely encumber the record. The Division sought review of the examiner's refusal to receive the other documents, while respondents sought review of the examiner's admission of the complaint. The Commission held that it was error not to admit all the documents. It explained that the documents on which the court had based its action served to place the injunction and its terms in perspective and should be included in the record for the purpose of assessing the public interest in relation to the injunction. In reliance on Kimball, I affirm my earlier determination to admit the district court complaint into evidence.
The more difficult issue here is the weight that should properly be given to the still-disputed allegations in the district court complaint-allegations that the Division has never proven and, if put to its proof, might or might not have been able to prove.
The Division relies on Charles Phillip Elliott, 50 S.E.C. 1273, 1277 (1992), aff'd, 36 F.3d 86 (11th Cir. 1994). There, the three-member Commission considered the question of sanctioning a pro se respondent who was the subject not only of a consent permanent injunction, but also a thirty-seven count criminal conviction. The Commission stated:
We recognize that the injunction was entered by consent and without findings of fact. Nevertheless, those circumstances do not prevent our acting on the basis of, or deriving conclusions from, the injunction. The [] Exchange Act empowers us to act in the public interest when a person has been enjoined, with no exception made in the case of a consent injunction.
As our previous decisions reflect, the action required in the public interest as the result of an injunction may be inferred from all the circumstances surrounding the injunctive action. Moreover, that precedent suggests that, in practical effect, the allegations in the complaint in an action settled by consent may, in a subsequent proceeding before us, be given considerable weight for purposes of assessing the public interest. Defendants in injunctive actions should be aware of this consequence.
The allegations against Elliott in the injunctive action portray him as the perpetrator of a serious fraud. However, we need not rely merely on the allegations in this respect. The evidence independently adduced in this proceeding also gives rise to grave concerns regarding Elliott's conduct.
Id. at 1277 (footnotes omitted, emphasis added).
The Eleventh Circuit affirmed, but it focused on Elliott's criminal conviction and the fact of the consent injunction; it did not address the Commission's determination that it could give considerable weight to the allegations in its own injunctive complaint.
Prior to Elliott, Commission opinions considering remedial sanctions based on consent injunctions did indeed look to "all the circumstances surrounding the injunctive action." Kimball, 39 S.E.C. at 923-24, offers the fullest explanation for the Commission's reasoning. In Gilbert F. Tuffli, Jr., 46 S.E.C. 401, 411 (1976), the Commission looked at "the moving papers" filed with the district court, including the defendant's answer to the injunctive complaint. In Michael Raymond Co., 38 S.E.C. 4, 5 (1957), the Commission looked to the verified complaint and an affidavit underlying a consent permanent injunction.3 Finally, in Kaye, the Commission looked to the affidavits and documentary evidence submitted to the district court in support of the allegations in its complaint. See 36 S.E.C. at 374.
Here, the Division seeks to apply one sentence of Elliott literally-decision makers need look at nothing more than the unverified allegations in the district court complaint and should give those allegations considerable weight, because precedent "suggests" that "in practical effect" the Commission has done so for decades. In so arguing, the Division reads out of Elliott the immediately preceding sentence. The Division assumes that Elliott did not merely distill the essence of prior Commission opinions like Kimball, Tuffli, Raymond, and Kaye, but that it overruled them without stating that it was doing so. Under such a reading, Elliott would represent a significant narrowing of the Commission's earlier approach to evaluating the public interest. The Division's assumption is not supported by a fair reading of Elliott; it also fails to address Blinder, Robinson & Co. v. SEC, 837 F.2d 1099, 1110-11 (D.C. Cir. 1988) (holding that the public interest standard is "obviously very broad," requiring the Commission to consider the full range of factors, and concluding that "the totality of the circumstances . . . are undoubtedly relevant").
The Commission has subsequently applied Elliott in two cases like the present one: Richard J. Puccio, 52 S.E.C. 1041, 1042, 1046 (1996) and Samuel O. Forson, 65 SEC Docket 24, 25 n.2 (July 21, 1997). Forson also rejected a pro se respondent's claim that certain of the allegations against him in the district court had not been adjudicated. The Commission stated: "having consented to the entry of an injunction based on those allegations, Forson may not question them now in an action based on that injunction." See 65 SEC Docket at 25.
Respondents' attack on Elliott rests on the judicial decisions holding that the unsworn factual allegations in a complaint, no matter how detailed, are simply not evidence. See, e.g., FDIC v. Deglau, 207 F.3d 153, 172 (3d Cir. 2000); Miller v. United States, 150 F.3d 770, 772 (7th Cir. 1998); Coverdell v. Department of Soc. and Health Servs., 834 F.2d 758, 762 (9th Cir. 1987). Any argument that the Commission has ignored binding judicial precedent in Elliott and its progeny must be addressed to the Commission, rather than an Administrative Law Judge.
Respondents' attack on Forson is based on the judicial decisions holding that a consent judgment must be construed and interpreted as a contract, and its scope must be ascertained within its four corners. See United States v. Armour & Co., 402 U.S. 673, 681-82 (1971); SEC v. Gellas, 1 F. Supp.2d 333, 336 (S.D.N.Y. 1998) (collecting cases). If a settlement agreement provides that "the complaint may be used in construing the terms of the order," the Supreme Court has looked to the allegations in the complaint. United States v. ITT Continental Baking Co., 420 U.S. 223, 238 (1975).
As stated by Justice Marshall for the unanimous Supreme Court in Armour:
Consent decrees are entered into by parties to a case after careful negotiation has produced agreement on their precise terms. The parties waive their right to litigate the issues involved in the case and thus save themselves the time, expense, and inevitable risk of litigation. Naturally, the agreement reached normally embodies a compromise; in exchange for the saving of cost and elimination of risk, the parties each give up something they might have won had they proceeded with the litigation. Thus the decree itself cannot be said to have a purpose; rather the parties have purposes, generally opposed to each other, and the resultant decree embodies as much of those opposing purposes as the respective parties have the bargaining power and skill to achieve. For these reasons, the scope of a consent decree must be discerned within its four corners, and not by reference to what might satisfy the purposes of one of the parties to it. Because the defendant has, by the decree, waived his right to litigate the issues raised, a right guaranteed to him by the Due Process Clause, the conditions upon which he has given that waiver must be respected, and the instrument must be construed as it is written, and not as it might have been written had the plaintiff established his factual claims and legal theories in litigation.
402 U.S. at 681-82 (footnotes omitted).
The question here is whether the "consequence" of which Elliott warned defendants in injunctive actions is automatic and unavoidable in every follow-up administrative proceeding of this sort (as the Division believes), or whether it may be the subject of bargaining in the injunctive case that must thereafter be honored under the "four corners" rule of Armour (as Respondents believe). See SEC v. Clifton, 700 F.2d 744, 748 (D.C. Cir. 1983) (by consenting to an injunction, a defendant may receive significant benefits in return, including the collateral administrative consequences of the consent decree). The Commission has not addressed the issue.
In this instance, the district court's injunctive order (DX 5) and Mr. Melton's and AMR's stipulations and consents (DXs 3, 4) do not contain a provision similar to that in ITT Continental Baking. When negotiating the settlement in district court, the Division (acting on behalf of the Commission) was careful to extract a concession from Mr. Melton and AMR that, in the event further litigation proved necessary on the disgorgement issue, Mr. Melton and AMR could not in that litigation contest the allegations in the complaint (see DX 3 &#para; 12, DX 4 &#para; 14). The Division did not extract a similar concession from Mr. Melton and AMR, precluding them from contesting the allegations in the complaint in the present administrative proceeding for purposes of the public interest determination. Whatever options the Commission sought to preserve for itself in Elliott, Puccio, and Forson, the Division has bargained away to Mr. Melton and AMR, or so the argument goes. Having struck this bargain, Armour and ITT Continental Baking bar the Division from asking the Commission (now acting as administrative decision maker, rather than district court plaintiff) to rewrite the settlement contract to lighten its burden in this proceeding. Of course, it is equally fair to say that Mr. Melton and AMR failed to extract an explicit concession from the Division that permitted them to contest the allegations of the district court complaint here-a guarantee they would have been prudent to get in writing after Forson. These are also matters that Respondents must present to the Commission, and not to an Administrative Law Judge.
In reaching my decision, I have not found it necessary to give considerable weight to the still-contested allegations in the district court complaint. I have given the district court complaint limited weight and have resolved the case based principally upon the transcript and the other exhibits introduced at the hearing. As a practical matter, it has made no difference to the outcome. At the November 9, 1999, prehearing conference, I asked the Division whether it could prove its case if I were not to rely on the allegations in the district court complaint. The Division thought that it could and this decision finds that it has.
Respondents also ask me to reconsider my determination to accept into evidence the preliminary report of the court-appointed receiver (Tr. 29-35; DX 2; see also Prehearing Conference of November 9, 1999, at 11-14). The analysis begins with Elliott, 50 S.E.C. at 1278 & n.24, where the Commission stated that "receiver's reports are competent evidence, to be accorded their natural and probable weight, taking into account their reliability."
Notwithstanding the "cf." citation to Federal Rule of Evidence 803(8)(C) in footnote 24 of the Elliott opinion, Respondents have made a strong showing that the receiver's preliminary report would not be allowed into evidence in federal district court under that particular hearsay exception. The receiver's preliminary report before me is neither the report of a "public office or agency," nor is it limited to setting forth "factual findings." See United States v. Jones, 29 F.3d 1549, 1554 (11th Cir. 1994) (judicial findings of fact from a prior case are not encompassed within Fed. R. Evid. 803(8)(C), only the findings of officials and agencies within the executive branch are the focus of the rule); Nipper v. Snipes, 7 F.3d 415, 417 (4th Cir. 1993) (same); Pearce v. E.F. Hutton Group, Inc., 653 F. Supp. 810, 813 (D.D.C. 1987) (draft report of Congressional subcommittee not admissible under Fed. R. Evid. 803(8)(C) because it consists of subjective comments, criticisms, arguments, and evaluations, rather than factual findings).
However, the Federal Rules of Evidence do not apply to administrative adjudications. See Gimbel v. CFTC, 872 F.2d 196, 199 (7th Cir. 1989); Calhoun v. Bailar, 626 F.2d 145, 148 (9th Cir. 1980). The Commission has cautioned its Administrative Law Judges to be inclusive in making evidentiary determinations. See City of Anaheim, 71 SEC Docket 191, 193 nn.5-7 (Nov. 16, 1999) ("if in doubt, let it in"); Alessandrini & Co., 45 S.E.C. 399, 408 (1973); Charles P. Lawrence, 43 S.E.C. 607, 612-13 (1967). The report is unquestionably relevant and (as discussed below) mostly trustworthy. Under Rule 320 of the Commission's Rules of Practice, I affirm my earlier determination to admit it into evidence. The real issue under Elliott is how much weight to give the receiver's preliminary report. The Division argues that it is entitled to full weight, while Respondents contend that it is entitled to none.
W. Walt Pettit, the court-appointed receiver, is an attorney specializing in debtor and creditor relations, bankruptcy workouts, and foreclosures (Tr. 68). He selected an accountant, an attorney, and an investment consultant to assist him in his duties (Tr. 72-75). Mr. Pettit did not attempt to determine if securities fraud had occurred (Tr. 105). He prepared his preliminary report "in a time crunch" (Tr. 100, 141), and acknowledges that some of the findings may be deleted from his final report (Tr. 99, 102, 119, 126). Mr. Pettit testified that his preliminary report is approximately 80% to 85% accurate (Tr. 141). I have not relied on any of the findings or conclusions in the preliminary report that the receiver now considers questionable.
All parties to the district court case had a full opportunity to present comments and criticisms on the report for at least three months after the receiver filed it (Tr. 99-103). The Division made appropriate use of this opportunity. Mr. Melton, facing criminal charges and concerned about his Fifth Amendment right against self-incrimination, did not submit any comments (Tr. 103, 233). See John Kilpatrick, 48 S.E.C. 481, 486 n.18 (1986) (collecting cases where an adverse inference was deemed appropriate from the invocation of the Fifth Amendment). When Mr. Melton has articulated a basis for his disagreement with the receiver's findings and conclusions, I have considered his explanation in reaching my decision. See infra note 4. To the extent that Mr. Melton simply disagreed with the preliminary report, but provided no explanation (Tr. 38-39, 48, 55), I have accepted the receiver's analysis.
Respondents questioned Mr. Pettit closely about pages 22-24 of his preliminary report, collecting the representations Mr. Melton supposedly made to investors (Tr. 130-33). The receiver did not personally interview such investors; rather, the receiver's counsel spoke to the investors or to their attorneys. The investors themselves wished to remain anonymous, and the preliminary report did not identify them by name. Summaries of interviews with anonymous investors engaged in litigation with Respondents are of limited reliability. Interviews with the attorneys of anonymous investors are of even more dubious reliability. I have not used pages 22-24 of the preliminary report in reaching my decision.
I have rejected the Division's claim that every one of Respondents' exhibits is irrelevant (Tr. 151, 153, 161, 164-67, 214, 217, 220). I also reject the Division's claim that Respondents in a case of this sort should be confined to presenting evidence of mitigation (Div. Prop. I.D. at 12). In general, Respondents may present evidence of two types to address the public interest standard: mitigation and/or rehabilitation. Mitigation focuses on the facts and circumstances surrounding the underlying misconduct, and the evidence should show that the wrongdoing at issue arose from some type of exigent circumstances that are unlikely to be repeated in the future. Rehabilitation focuses on a respondent's changed direction in his activities since the time of the underlying misconduct.
FINDINGS OF FACT
I base my findings and conclusions on the entire record and on the demeanor of the witnesses who testified at the hearing. I applied "preponderance of the evidence" as the applicable standard of proof. Steadman v. SEC, 450 U.S. 91, 97-104 (1981). I have considered and rejected all arguments and proposed findings and conclusions that are inconsistent with this decision.
Mr. Melton is forty-three years of age and a resident of Greensboro, N.C. He earned a bachelor of science degree in business and economics from the University of North Carolina, Greensboro, in 1979. He sold insurance products on a commission basis from 1979 to 1985 and from 1997 to the present. He was involved in the securities industry from 1982 to 1997, and was affiliated with a broker or dealer from 1992 to 1997 (Tr. 19, 235-36; DXs 7-10).
AMR was incorporated in North Carolina in 1991 and its office was in Greensboro (DX 6). At all relevant times, Mr. Melton was its sole shareholder and president (Tr. 17). The firm has been registered with the Commission as an investment adviser from 1993 to the present (Tr. 17; DX 23). In September 1996, AMR managed approximately $14 million in seventy-nine client accounts.
On September 24, 1996, the Division of Securities, Office of the Secretary of State, for the State of North Carolina suspended AMR's license as a registered investment advisor after determining that the firm had a negative net worth (DX 18). The suspension will remain in effect until such time as the company can bring its financial statement into compliance with the net capital requirements of the North Carolina Securities Act. Since the suspension, the firm has existed in name only. It has not filed annual reports with the State of North Carolina, nor has it filed for dissolution (Certificate of Existence, filed September 24, 1999).
Westview Capital, L.C. (Westview Capital), is a Florida limited liability company, formed on May 24, 1994 (RX 7). At all relevant times, its principal place of business was in Greensboro. Its activities included investments in securities, receipt of commissions from the sale of insurance or securities, and promotion of other financial transactions (Tr. 149). Mr. Melton was its managing member and 61% owner (Tr. 206, 239; RX 7). AMR was Westview Capital's investment adviser and managed its trading activities. The firm planned to open a chain of 100 brokerage offices, but other than the brief opening of one office in Chicago, it never did so (Tr. 37-38). As explained below, the firm was placed in receivership on March 31, 1997.
Ownership interests in Westview Capital were offered under a private placement memorandum dated June 10, 1994 (RX 7). The offering relied on the exemption from registration set forth in Section 4(2) of the Securities Act. All investors were required to be "accredited," as that term is defined in 17 C.F.R. § 230.501(a). Although Westview Capital sought to raise $5 million, the firm in fact raised less than half that amount (Tr. 38; DX 2 at 2). The receiver described several distributions that Westview Capital made from 1994 to 1996 that did not benefit its members, or were not authorized by the private placement memorandum. As illustrations, two such transactions are explained below.
In September 1995, Sydney Melton, the wife of Respondent Melton, loaned $100,000 to Rug Crafters, L.C. (Rug Crafters) (Tr. 79, 116, 218-19). Rug Crafters was a start-up company that planned to design and sell floor coverings, and it needed capital to purchase an essential piece of operating equipment (Tr. 79, 212-13, 218). Mr. Melton was a 10% owner of Rug Crafters (Tr. 212; RX 20 at 20-21). When a prospective lender backed out at the last minute, Mr. Melton asked his wife to loan her funds to Rug Crafters.
Mr. and Mrs. Melton were anxious to have Rug Crafters repay the loan as soon as possible, because they were constructing a luxury house and needed the money for that purpose (Tr. 218). In late 1995, however, Rug Crafters was in no position to repay its debt to Mrs. Melton (Tr. 43).
In January 1996, an elderly investor purchased a $300,000 interest in Westview Capital (Tr. 39-40). Almost immediately, Mr. Melton caused Westview Capital to pay $105,000 to Rug Crafters. Once Rug Crafters received that sum from Westview Capital, it wired Sydney Melton $104,373, thus repaying her loan in full and with interest (Tr. 41, 116, 221). Rug Crafters then executed an unsecured, interest bearing, demand note in favor of Westview Capital for $105,000 (RX 22).
Rug Crafters was a fledgling company with no operating history, and it needed capital equipment simply to begin operations. I agree with the receiver that providing unsecured loans for such equipment was not within the scope of the investments described in Westview Capital's private placement memorandum (Tr. 79). I reject Mr. Melton's testimony to the contrary (Tr. 43). Rug Crafters did develop its own private placement memorandum in November 1995 (RX 20), but that document is of limited relevance here. Respondents did not demonstrate that any investor ever signed a subscription agreement under the Rug Crafters' private placement memorandum. Nor is there credible evidence that Westview Capital investors were provided with the level of disclosure afforded by the Rug Crafters' private placement memorandum.
The effect of these transactions was that Mr. and Mrs. Melton were made whole while Westview Capital's investors were left holding the bag. Rug Crafters has never paid off its $105,000 note (Tr. 116, 220-21). The receiver has sued Rug Crafters for that sum, but the litigation is still pending (Tr. 135).
Westview Capital also paid $200,000 to Phillip Fagg and Melton Jewell (Tr. 81-82, 123-26). The receiver determined that these payments were used to satisfy loans made in 1993 by Messrs. Fagg and Jewell to Westview Capital, Inc., a North Carolina corporation controlled by Mr. Melton, and not affiliated with Westview Capital.
Westview Capital's private placement memorandum disclosed that $200,000 of the funds raised by the offering would be used for "debt repayment" (RX 7 at 6). However, the private placement memorandum did not explain that the "debt repayment" would satisfy the obligation of another company controlled by Mr. Melton, or that the debt had been incurred before the formation of Westview Capital. Respondents have not identified any services that Messrs. Fagg and Jewell rendered for the benefit of Westview Capital. The receiver opined that the debt repayment was outside the permitted use of investment funds under the private placement memorandum, and I agree.
Trading Partners, L.C. (TP), is a Florida limited liability company, formed on December 27, 1994 (RX 1). At all relevant times, its principal place of business was in Greensboro. TP was organized to engage in the day trading of securities. AMR was responsible for TP's trading activities prior to the suspension of AMR's license in September 1996. Kenneth Melton, the brother of Respondent Melton, was the managing member of TP. Through AMR and another of his companies, Falcon Financial Management Group, Inc. (Falcon Financial Management Group), Respondent Melton controlled TP (Tr. 14, 55, 84-85). As explained below, TP was also placed into receivership on March 31, 1997.
Ownership interests in TP were offered under a private placement memorandum dated February 14, 1995, and relied on the exemption from registration provided by Section 4(2) of the Securities Act and 17 C.F.R. § 230.506 (RX 1). The offering was for a maximum of $5 million. In fact, TP attracted only twenty investors, who contributed approximately $2 million. Fifteen of these twenty investors were also AMR clients.
TP's books and records show its investments losing money in 1995 and 1996. Despite its professed commitment to day trading, TP carried poorly performing investments on its books from month to month, rather than realizing losses by liquidating its losing positions in the market. In July 1996, TP sold most of its portfolio of securities and incurred losses of approximately $1 million.
Throughout 1995 and 1996, TP distributed about $190,000 to its investors. It characterized these distributions as trading profits, even though the firm's books and records showed significant unrealized trading losses. The receiver determined that TP had no trading profits and concluded that such payments were in fact a return of principal (Tr. 90).
The receiver also testified that investors' funds had been used for purposes outside the parameters of TP's private placement memorandum. For example, the private placement memorandum authorized Renaissance Investors, Inc. (Renaissance Investors), to receive an "incentive fee" of 19% of TP's net income, payable monthly (Tr. 58, 87-88; RX 1). Respondent Melton controlled Renaissance Investors (Tr. 14, 87). Although the books and records for 1995 and 1996 showed TP operating at a loss, TP paid Renaissance Investors $20,361 in 1995 and $13,273 in 1996 (Tr. 58, 88; DX 2). When asked to explain these payments, Mr. Melton was unable to do so. He testified that he did not exactly know the accounting behind it (Tr. 58). I conclude that the payments were unauthorized because TP was not in fact generating monthly net income.
TP's private placement memorandum also authorized Storm Peak, Inc. (Storm Peak), to receive a "set up fee" of 3% of the amount raised by TP, up to a maximum of $150,000 (RX 1). Respondent Melton controlled Storm Peak (Tr. 15, 85), and used these "set up fee" payments from TP to reimburse individuals who had lost money with him in the past on unrelated ventures (Tr. 229-30). Since TP raised just over $2 million of the anticipated $5 million offering, TP owed Storm Peak a fee of no more than $61,245. However, TP paid Storm Peak $139,968, or $78,715 more than the amount authorized.4
Trading Partners II, L.C. (TP II), is a Florida limited liability company, formed on May 31, 1995. At all relevant times, its principal place of business was also in Greensboro. TP II was organized to engage in covered call writing and intermediate term securities investments. Kenneth Melton was the managing member of TP II. Through ARM and Falcon Financial Management Group, Respondent Melton controlled TP II (Tr. 14, 55, 91-93). Ownership interests in TP II were offered under a private placement memorandum dated May 31, 1995, and relied on the same exemption from registration as TP did (RX 4). The offering was for a maximum of $10 million, but only $995,735 was raised (Tr. 51; DX 2 at 18). Like Westview Capital and TP, TP II has been in receivership since March 31, 1997.
The private placement memorandum disclosed that TP II would pay Storm Peak II, Inc. (Storm Peak II), a set up and consulting fee of up to $300,000, which represented up to 3% of the funds raised by the offering. The fee was payable at the rate of $50,000 for each $1 million of the offering sold (RX 4 at 2, 13). Respondent Melton controlled Storm Peak II (Tr. 15).
On August 24, 1995, TP II wired $200,000 to the personal brokerage account of Sydney Melton (Tr. 96-97; DX 2 at 20). The transfer was not authorized by the terms of the private placement memorandum, and there was no evidence on the face of the transaction that Storm Peak II had been involved.
Mr. Melton testified that the funds wired to his wife's brokerage account represented an advance payment of funds owed by TP II to Storm Peak II. Mr. Melton stated that the advance had been approved by his brother Ken and by an unidentified attorney for TP II (Tr. 223-25). Mr. Melton and his wife needed the funds in a hurry, and they were unable to wait seven to fourteen days for checks to clear (Tr. 52-54). As with the $104,373 Rug Crafters' wire transfer described above, the urgency was related to construction of their house (Tr. 223-25).
I reject Mr. Melton's explanation that the payment was authorized. He testified that Storm Peak II was entitled to $300,000 because he had already done all the work he said he was going to do for TP II (Tr. 223). That testimony cannot be squared with the wording of the private placement memorandum, which called for incremental payments tied to the sums that had actually been raised. Because the TP II offering had raised only $995,735, Storm Peak II was not entitled to receive any funds whatsoever.
The hearing record contains other examples of Mr. Melton's mishandling of investor funds, but the illustrations above are sufficient for purposes of this decision.
Litigation
On October 6, 1996, a group of eighteen investors filed suit against Mr. Melton, AMR, and others in Wake County, N.C., General Court of Justice, Superior Court Division. The suit alleged securities fraud, common law fraud, breach of fiduciary duty, breach of contract, breach of fair dealing, and negligence in violation of state law (Tr. 64-67). The plaintiffs sought $2.1 million in actual damages and $10 million in punitive damages. See generally Abe v. Westview Capital, L.C., 502 S.E.2d 879 (N.C. Ct. App. 1998).
On February 24, 1997, the Commission filed its complaint against Mr. Melton, AMR, Westview Capital, TP, and TP II in the U. S. District Court for the Middle District of North Carolina (Tr. 19; DX 1). The complaint alleged violations of the antifraud provisions of the federal securities laws between 1994 and 1996. It sought preliminary and permanent injunctions against all five defendants. As ancillary relief, the complaint sought disgorgement of all ill-gotten gains, prejudgment interest, civil penalties, a freeze of all assets held by Mr. Melton and the defendant companies, and the appointment of a receiver for Westview Capital, TP, and TP II. The defendants' answer to the complaint admitted some allegations and denied others.
On March 31, 1997, and April 30, 1997, Judge William L. O'Steen, Sr., entered orders of preliminary injunction against all defendants (Tr. 24). By separate order dated March 31, 1997, Judge O'Steen appointed Mr. Pettit as receiver to oversee the estates of Westview Capital, TP, and TP II.
On April 21, 1997, Mr. Melton was indicted in Guilford County, N.C., for eight felony violations of the North Carolina securities laws (Tr. 63-64, 227, 235). The criminal case has not yet gone to trial.
On June 18, 1997, the receiver filed a thirty-one page preliminary report with Judge O' Steen (DX 2). Mr. Pettit concluded that, "at a minimum, Mr. Melton and his affiliates acted with gross recklessness in handling investors' funds." He noted that many of the facts and circumstances demonstrated "more than mere recklessness and indifference on the part of Mr. Melton and his affiliates," and that many of the transactions had been unauthorized and constituted "an improper, if not fraudulent, use of investor funds." The receivership remains open, and Mr. Pettit has yet to file his final report with the district court.
On May 4, 1998, Judge O'Steen entered an order of permanent injunction and ancillary relief as to Mr. Melton and AMR (DX 5). The district court ordered Mr. Melton to disgorge $352,021 and AMR to disgorge $188,243. These sums represented the income, fees, and gains they received from the sale of interests in the limited liability companies, plus prejudgment interest. However, payment of disgorgement and prejudgment interest was waived, based upon the defendants' financial circumstances.
On September 24, 1999, following a lengthy trial, a state court jury returned a mixed verdict in Abe (Tr. 64-67). Mr. Melton was found liable for damages to certain investors in Westview Capital, but he was found not liable to other investors in TP and TP II. The jury also rejected the plaintiffs' request for punitive damages (Tr. 204-06). At the time of the hearing in this case, post-trial motions in Abe were still pending, and the trial court had not entered judgment (Tr. 65).
Witness Credibility
Mr. Pettit was a fully credible witness. When he had information that was favorable to Mr. Melton, such as acknowledging Mr. Melton's cooperation with his investigation, he did not hesitate to say so (Tr. 106). Mr. Pettit conceded that certain statements in his preliminary report might have been inaccurate (Tr. 99, 102, 119, 126). He testified that he would correct these statements when he submits his final report.
Mr. Melton attempted to put his own spin on several events, and his credibility suffered as a result. As to Westview Capital's payment of $200,000 to Messrs. Fagg and Jewell for debts owed by an unrelated company, Mr. Melton explained that he simply wanted these individuals to be able to participate in his own good fortune, without his having to pay income taxes on the money. "It was good will" (Tr. 230). With respect to TP's trading losses of $1 million in July 1996, Mr. Melton stated that the traders were self-sufficient and did not really report to anybody, even though he controlled ARM (Tr. 188-89). Moreover, Mr. Melton sought to distance himself from the liquidation by noting that it occurred while he was out of town. He also observed that technology stocks were at an all time low when the positions were liquidated. "From that point forward, the market has just gone crazy. Who knows what they would've been worth today, if they'd been left alone" (Tr. 190). Mr. Melton rationalized the October 1996 lawsuit by eighteen investors as just a group of investors, meeting in someone's home, talking back and forth, taking erroneous pieces of information, and spreading it among themselves (Tr. 201). As for press accounts of the Meltons' custom built house, with the fireplace next to the sunken bathtub, Mr. Melton lamented that "negative newspaper articles hurt us publicly" (Tr. 9-11, 159) and he sarcastically observed that "everyone we had fired seemed to have all this nice stuff to say about us" (Tr. 201). Most disturbing was Mr. Melton's analysis of the September 1999 state court jury verdict, awarding actual damages to certain defrauded investors. According to Mr. Melton, there was actually a silver lining to this storm cloud. No punitive damages were awarded against him and the jury only found that he "probably" should have updated the financial statements provided to investors in Westview Capital (Tr. 204-06). I have accorded little weight to such testimony in this decision.
CONCLUSIONS OF LAW
Section 15(b)(6)(A)(iii) of the Exchange Act authorizes the Commission to censure, limit the activities of, suspend for up to twelve months, or bar any person from association with a broker or dealer after finding that it is in the public interest to do so and that such person is enjoined from any action, conduct, or practice specified in Section 15(b)(4)(C). As here relevant, Section 15(b)(4)(C) covers activity in connection with the purchase or sale of any security.
Section 19(h)(3) of the Exchange Act authorizes the Commission to suspend for up to twelve months or bar any person from association with a member of a national securities exchange or registered securities association if that person is subject to a Commission order pursuant to Exchange Act Section 15(b)(6) if in its opinion such action is necessary or appropriate in the public interest. The term "person[] associated with a member" is defined by Section 3(21) of the Exchange Act to include any partner, officer, or director of a member of a national securities exchange or registered securities association, or any person directly or indirectly controlling such a member.
Section 203(f) of the Advisers Act requires the Commission to censure, limit the activities of, suspend for up to twelve months, or bar any person from being associated with an investment adviser after finding that such a sanction is in the public interest and that such person is enjoined from engaging in any conduct or practice specified in Section 203(e)(4). Section 202(a)(17) of the Advisers Act defines a "person associated with an investment adviser" as any officer or person directly or indirectly controlling an investment adviser.
Section 203(e)(4) of the Advisers Act requires the Commission to censure, limit the activities of, suspend for up to twelve months, or revoke the registration of any investment adviser after finding that such sanction is in the public interest and that the investment adviser or person associated with the investment adviser has, among other things, been permanently enjoined by order of any court of competent jurisdiction from engaging in any conduct or practice in connection with the purchase or sale of any security.
At all relevant times, Mr. Melton qualified as a person associated with a broker or dealer and a member of a registered securities association (Tr. 19; DXs 7-10). AMR was registered with the Commission as an investment adviser and Mr. Melton was its owner and president (Tr. 17; DXs 11, 17, 18, 23).
On May 4, 1998, the U.S. District Court for the Middle District of North Carolina, entered a permanent injunction against Mr. Melton and AMR by consent, enjoining both from future violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5. The court also enjoined AMR, aided and abetted by Mr. Melton, from future violations of Section 206 of the Advisers Act (DX 5). It is not significant that the injunction was entered by consent and without findings of fact. The applicable statutes focus on the fact of the injunction, with no exception made in the case of a consent injunction.
Since a court of competent jurisdiction has enjoined both Respondents, the only issue remaining in this proceeding is what administrative sanctions, if any, are appropriate in the public interest. The Division seeks to bar Mr. Melton from association with a broker, dealer, investment adviser, member of a national securities exchange, and a registered securities association. It also seeks to revoke AMR's registration as an investment adviser. Because these are the most drastic sanctions at the Commission's disposal, Respondent argues that the Commission has a duty to explain why lesser sanctions will not suffice to protect investors. But see Rizek v. SEC, ___ F.3d ___ (1st Cir. 2000), 2000 U.S. App. LEXIS 14067. The factors to be considered in determining the public interest are set out in Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981):
[t]he 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 the defendant's occupation will present opportunities for future violations.
Respondents acknowledge that their conduct was "troubling" and "left much to be desired," but they maintain that it was not egregious (Resp. Prop. I.D. at 29, 31). Mr. Melton caused the limited liability companies to pay debts they did not incur, to replace his wife as note holder on a risky loan to a start-up company, and to pay fees when none were due, or when lesser amounts were due. The district court's order that Mr. Melton disgorge $352,021 and that AMR disgorge $188,243 confirms the magnitude of the misconduct. I conclude that Respondents' repeated misuse of investor funds was extremely serious.
Respondents' illicit conduct involved a course of business that was ongoing from May 1994 through late 1996. Several related corporations and limited liability companies were involved, and Mr. Melton and his family operated all of them from the same Greensboro offices (Tr. 11-16, 241-42). In addition to the behavior leading to the injunction, the State of North Carolina also delayed Mr. Melton's securities licensing for several months because he had failed to report various liens and judgments (Tr. 236). I cannot conclude that the misconduct established on this record was isolated, or that it was the result of a unique misstep that is unlikely to recur.
In his preliminary report to the district court, the receiver determined that Mr. Melton had acted with "gross recklessness in handling investors' funds" (DX 2 at 29). He also opined that many of the facts and circumstances demonstrated "more than mere recklessness and indifference" and that many of the transactions had been unauthorized and constituted "an improper, if not fraudulent, use of investor funds" (DX 2 at 30). These preliminary conclusions were fully supported by the hearing testimony and exhibits in the present proceeding, and I embrace them as my own.
I did not really hear any persuasive assurances against future violations. As explained above in my adverse credibility determination, Mr. Melton repeatedly portrayed himself and his companies as the victims of hard luck, bad timing, disgruntled former employees, misguided state regulators, investors who would not listen to reason, and adverse newspaper publicity. It did not instill confidence to learn that Mr. Melton could not even remember the name of his "compliance guy" (Tr. 189).
Much confusion surrounds the parties' arguments about the fifth Steadman factor, the recognition of wrongful conduct. Citing Russell G. Koch, 52 S.E.C. 1330, 1335 n.17 (1997), vacated, 177 F.3d 784 (9th Cir. 1999), the Division argues that formal findings of wrongdoing are not required before applying the Steadman factors in a public interest determination. It then faults Mr. Melton for failing to offer any serious recognition of his wrongdoing (Div. Prop. I.D. at 16-17). As Mr. Melton notes, there is a certain lack of symmetry in the Division's position: the notion that he should be faulted because he failed to apologize for that which the Division did not, and need not, prove (Resp. Prop. I.D. at 32).
The parties have focused on the wrong issue. Expressions of contrition following detection only deserve significant weight if the wrongful nature of the conduct was unclear at the time it occurred. If the wrongful nature of the conduct was clear at the time it occurred, such expressions warrant only limited weight. Cf. Ryan v. CFTC, 145 F.3d 910, 921 (7th Cir. 1998); In re Horn, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) &#para; 24,836 at 36,940 & n.18 (CFTC Apr. 18, 1990).
Mr. Melton acknowledged mistakes and admitted he could have been a better manager (Tr. 234-35). He also expressed sorrow that investors lost money and stated that he never intended to violate the law. But the impropriety in Mr. Melton's handling of investor funds is hardly debatable now, and was not debatable at the time it occurred. Thus, even a full expression of contrition at the hearing would have availed Mr. Melton only marginally. Moreover, by disavowing his involvement only in "knowing and intentional" misconduct, Mr. Melton specifically failed to address the issues identified by the Division and the receiver: repeatedly reckless and indifferent conduct.
Mr. Melton expressed no interest in an "immediate" return to the securities industry (Tr. 233-34). However, given his relative youth (age forty-three) and his high degree of success in the sales field, the prospect of a return to the securities industry at a later date cannot be ignored. Cf. Laurie Jones Canady, 69 SEC Docket 1468, 1489 n.40 (Apr. 5, 1999). The Commission should control the timing.
Viewing the Steadman factors in their entirety, the public interest plainly warrants the relief sought by the Division.
RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission Rules of Practice, I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on May 30, 2000, as amended on June 13, 2000. I decline to order the additional change proposed by the Respondents in their pleading dated June 13, 2000.
ORDER
Based on the findings and conclusions set forth above, I order:
(1) pursuant to Section 15(b) of the Exchange Act, that Marshall E. Melton is barred from association with any broker or dealer;
(2) pursuant to Section 19(h) of the Exchange Act, and based on the order concerning Section 15(b) of the Exchange Act above, that Marshall E. Melton is barred from association with any member of a national securities exchange or registered securities association;
(3) pursuant to Section 203(f) of the Advisers Act, that Marshall E. Melton is barred from association with any investment adviser; and
(4) pursuant to Section 203(e) of the Advisers Act, that the registration of Asset Management & Research, Inc., as an investment adviser is revoked.
This Order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice. Pursuant to that Rule, a petition for review of this initial decision may be filed within twenty-one days after service of the initial decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision upon that party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to that party. If a party timely files a petition for review, or the Commission acts to review on its own motion, the initial decision shall not become final as to that party.
_____________________________
James T. Kelly
Administrative Law Judge
Footnotes
| 1 | References to the hearing transcript in this decision are "Tr. ___." References to the Division's exhibits are "DX ___" and to Respondents' exhibits are "RX ___." References to the Division's posthearing pleading are "Div. Prop. I.D. at ___" and to Respondents' posthearing pleading are "Resp. Prop. I.D. at ___." Because of cost considerations, Respondents did not purchase a hearing transcript. Their request for relief from Rule 340(b) of the Commission's Rules of Practice, which requires citations to specific parts of the record, is granted. |
| 2 | Attached to Mr. Melton's answer to the OIP was a copy of the defendants' joint answer to the district court complaint. I find that, by offering this attachment, Mr. Melton incorporated by reference in this proceeding all his answers to the district court complaint and that matters he admitted in his district court answer should be deemed admitted here. I further find that Mr. Melton has waived any argument he might have had that matters he admitted in his district court answer were for purposes of that proceeding only and should not be used against him here. Cf. Fed. R. Civ. P. 36(b). However, AMR made no such incorporation by reference in its separate answer to the OIP. Whatever economy has resulted from utilizing admissions in the joint answer against Mr. Melton here, it is still necessary to look elsewhere for evidence to satisfy the public interest standard as to AMR. |
| 3 | A verified complaint is quite different from the unverified complaint at issue here (DX 1). See Fed. R. Civ. P. 11(a) ("Except when otherwise specifically provided by rule or statute, pleadings need not be verified or accompanied by affidavit."). Cf. Martinez v. Rosado, 614 F.2d 829, 830 n.1 (2d Cir. 1980) (collecting cases) (a verified complaint can, in certain circumstances, be treated as an affidavit in determining a motion for summary judgment). Of course, the Division may well have supported the injunctive complaint by submitting affidavits and other documents to the district court. It just elected not to provide copies of such evidence for the record here. |
| 4 | The receiver was unable to determine what the "set up fee" was and what value TP received for paying it (Tr. 86, 139). Mr. Melton explained that the fee compensated him for getting TP "street ready"-putting people in place, as well as working with brokerage firms, attorneys, and accountants (Tr. 191-92, 230-31). For purposes of this decision, it is not necessary to determine if TP received fair value or if the amount of the fee was reasonable. The unexplained overpayment of $78,715 is quite enough. Mr. Melton's attorney suggested that Storm Peak was entitled to the full $150,000 (3% of the offering), and not just 3% of the amount raised (Tr. 128-29). However, the wording of the private placement memorandum itself contradicts that argument (RX 1 at 13). |
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