==========================================START OF PAGE 1====== INITIAL DECISION RELEASE NO. 88 ADMINISTRATIVE PROCEEDING FILE NO. 3-8400 UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION ____________________________ In the Matter of : : THORN, ALVIS, WELCH, INC., : INITIAL DECISION JOHN E. THORN, JR., and : MAY 2, 1996 DERRYL W. PEDEN : ____________________________ APPEARANCES: William P. Hicks, Stephen L. Cole, and Cheryl C. Nichols for the Atlanta District Office, Division of Enforcement, Securities and Exchange Commission Michael C. Russ, M. Kristin Ramsey, and Jill M. Wood for Thorn, Alvis, Welch, Inc. and John E. Thorn, Jr. BEFORE: Brenda P. Murray, Chief Administrative Law Judge ==========================================START OF PAGE 2====== CONTENTS Respondents . . . . . . . . . . . . . . . . . . . . . . . . . 2 Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Findings of Fact . . . . . . . . . . . . . . . . . . . . . . 3 Findings of Law . . . . . . . . . . . . . . . . . . . . . . . 13 Antifraud Provisions of the Securities Statutes and Regulations . . . . . . . . . . . . . . . . . . . . 13 1. Bonds are not tax-exempt . . . . . . . . . . . . 15 2. Bond proceeds totalled $1.5 million . . . . . . 26 3. Application of funds: construction - $713,950 . 27 4. The project was a turnkey project . . . . . . . 27 5. Site value was $525,000 . . . . . . . . . . . . 28 6. Contractor's guaranty . . . . . . . . . . . . . 29 Municipal Securities Rulemaking Board Rule G-17 and Exchange Act Section 15B(c)(1) . . . . . . . . . . 30 Respondents' Arguments . . . . . . . . . . . . . . . . . 31 Sanctions . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Bar and Revocation . . . . . . . . . . . . . . . . . . . 34 Disgorgement . . . . . . . . . . . . . . . . . . . . . . 36 Civil Penalty . . . . . . . . . . . . . . . . . . . . . 37 Cease and desist . . . . . . . . . . . . . . . . . . . . 38 Order . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 ==========================================START OF PAGE 3====== The Securities and Exchange Commission (Commission) initiated this proceeding on June 23, 1994, pursuant to Section 8A of the Securities Act of 1933 (Securities Act), and Sections 15(b), 19(h), and 21C of the Securities Exchange Act of 1934 (Exchange Act). The Order Instituting Proceedings charges that, from about August 1992 through at least February 1994, the respondents willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and that Thorn, Alvis, Welch, Inc. (TAW) willfully violated, and Mr. Thorn willfully aided and abetted violations of, Section 15B(c)(1) of the Exchange Act and Rule G-17 of the Municipal Securities Rulemaking Board (MSRB). I held five days of hearing in Atlanta, Georgia, in January and February 1995 at which each side presented nine witnesses.-[1]- I allowed 157 exhibits into evidence: three from counsel, 87 exhibits by the Division of Enforcement (Division), and 67 by the respondents.-[2]- The parties filed consecutive briefs. I received the last brief on April 28, 1995. I deny respondents' single sentence request for oral argument received in April 1995 because they gave no reason why they needed another opportunity, in addition to briefs, to present arguments to me. ---------FOOTNOTES---------- -[1]- Three people testified twice. The transcript for January 2 through 5 is numbered 1 to 1002 and I will refer to it as Tr. __. The transcript of February 9 is numbered 1 to 210. I will refer to it as Tr. 2/9/95 at __. -[2]- The Division's exhibits are referred to by number as Div. Ex. ___; the respondents' exhibits are referred to by number as Resp. Ex. ___. Exhibits that were stipulated to by all parties are referred to by number as Counsel Ex. ___. ==========================================START OF PAGE 4====== Respondents TAW, a broker-dealer with a single office in Jackson, Mississippi, has been registered with the Commission, pursuant to Section 15(b) of the Exchange Act, since 1977. TAW specializes in municipal tax-exempt securities. Mr. Thorn has owned a 25 percent interest in TAW since it was founded. He is a director and has been president of the firm for 18 years. He has degrees from Mississippi College and New Orleans Baptist Theological Seminary. Mr. Thorn is a registered municipal securities principal. He did not take an exam but was grandfathered in when TAW joined the National Association of Securities Dealers. Tr. 51-52. In a 30-year career in the securities industry, Mr. Thorn's activities have consisted almost entirely of selling and underwriting tax-exempt securities. Tr. 53, 55-57. The Commission entered an Order Making Findings and Imposing a Cease and Desist Order Against Derryl W. Peden on December 2, 1994. 58 SEC Docket 0505 (1995). Issues Whether Respondents TAW and Mr. Thorn have willfully violated the antifraud provisions of the securities statutes, and either willfully violated or willfully aided and abetted violations of Rule G-17 of the MSRB, and Section 15B(c)(1) of the Exchange Act and, if they did so, (a) what remedial action is appropriate; (b) whether they should be ordered to cease and desist from committing or causing violations and future violations of the statute and rules thereunder; (c) whether they should be ordered to comply with the applicable laws and regulations in the future; (d) whether they should be ordered to disgorge amounts, including reasonable interest; and (e) whether civil penalties should be imposed. Findings of Fact-[3]- Reading this record is reminiscent of reading Alice in Wonderland in that things are not what they appear to be and, as Alice exclaimed, events get "Curiouser and curiouser!"-[4]- In the period August 1992 through October 1993, TAW was the underwriter on seven non-rated private activity urban renewal ---------FOOTNOTES---------- -[3]- My findings are based on the record and my observation of the witnesses' demeanor. I applied preponderance of the evidence as the applicable standard of proof. I have considered all proposed findings and conclusions and all contentions, and I accept those that are consistent with this decision. -[4]- Lewis Carroll, Alice's Adventures in Wonderland, Chap. II. ==========================================START OF PAGE 5====== revenue bond offerings totaling almost $19.5 million by two Mississippi counties - Warren or Hinds County.-[5]- Name of Project Face Value Date Sherwood Garden Apartments $ 1,375,000 August 27, 1992 Northwest Plaza Apartments 950,000 January 21, 1993 Eden Point Apartments 2,470,000 March 26, 1993 The Pines 1,865,000 April 30, 1993 Northpark Apartments 625,000 May 15, 1993 Glen Oaks Apartments 4,050,000 July 28, 1993 The Lodge Apartments 7,950,000 October 20, 1993 Counsel Ex. 1 at 1-2. These bonds were not registered with the Commission, pursuant to the exemption in Section 3(a)(2) of the Securities Act. The same parties participated in each of the seven offerings. As noted, TAW was the underwriter. The Mitchell Company (Mitchell) of Mobile, Alabama, was the contractor, and the project manager after development was completed. Attorney Derryl W. Peden (Attorney Peden), who at the time had been counsel on about 90 percent of the tax-exempt, multi-housing bonds issued in Mississippi, was bond counsel and underwriter's counsel in the first two issues by Warren County, and was bond counsel in the next five issues by Hinds County. Mitchell, which specialized in real estate development, is the largest of fourteen companies and partnerships known as the Mitchell Group which was run as one business enterprise.-[6]- Three officers of Mitchell - Mr. Saint the president, Mr. Kelly the senior executive president, and Mr. Stefan the executive vice president - owned 70 percent of the company, and the employee stock ownership plan owned the remaining 30 percent. In the period at issue here, these persons ran Mitchell under a contract to buy the company from the Resolution Trust Corporation (RTC). Tr. 387. The Mitchell Group is not a legal entity but a term used to refer to all the companies in which at least one of the three individual owners of Mitchell - Mr. Saint, Mr. Kelly, and Mr. Stefan - owns an interest. Tr. 351-52. ---------FOOTNOTES---------- -[5]- The term private activity bond indicates that a municipality or state government served in effect as a conduit for the private party to achieve tax-exempt financing. Tr. 635. A bond is a private activity bond if 10 percent or more of the bond issue proceeds are used for private business uses. Internal Revenue Code, 26 U.S.C.  141. -[6]- The record is confusing because witnesses used the term Mitchell when they meant individual officers or employees or one of several companies. ==========================================START OF PAGE 6====== The material facts on all seven bond issues are sufficiently similar so that a detailed description of the first one, Sherwood Garden Apartment Project (Sherwood Garden Project, Sherwood Garden, project), is applicable to all seven situations. Counsel Ex. 1. The Sherwood Garden Project is a ninety-eight unit, garden-type apartment project, located in Vicksburg, Mississippi. Id. Mitchell learned of the property from a real estate broker in 1992. The owner, a financially distressed savings and loan association, had foreclosed on the property which was in disrepair. Local authorities would only grant a building permit on ninety-eight of the original 150 units, and required that the fifty-two units which had been flooded three times be demolished. Mitchell or Mr. Stefan and Mr. Saint took an option to buy the property. Compare Tr. 496-97; Tr. 2/9/95 at 10-14. Each of the TAW offerings involved several legal documents. For Sherwood Garden, the legal documents are as follows: 1. The Official Statement for the bond issue dated August 27, 1992, was the disclosure document provided to prospective purchasers. Div. Ex. 1; Counsel Ex. 1 at 2. 2. The Agreement of Limited Partnership effective August 24, 1992, which created the limited partnership, Warren-Sherwood, Ltd., formed to own the Sherwood Garden Project, the subject of the bonds.-[7]- Div. Ex. 63C. 3. The Construction Management Contract between Warren-Sherwood, Ltd. and Mitchell dated August 23, 1992. Div. Ex. 63B. 4. The Memorandum of Agreement prepared by Attorney Peden to memorialize what occurred at the closing. Div. Ex. 63(a).-[8]- ---------FOOTNOTES---------- -[7]- Paul C. Wesch, Mitchell secretary, senior vice president, and legal counsel, prepared the documents. According to Attorney Wesch, the certificate of limited partnership executed July 22, 1992, is a perfunctory but statutorily required document. Tr. 728. The partnership agreement is a non-filed instrument prepared on or after July 22, 1992, but prior to its first execution on August 21, 1992. -[8]- The underwriter allowed a person with conflicting interests to sign documents for more than one party. For example, Mr. Stefan signed the construction contract between Mitchell and Warren-Sherwood, Ltd., on behalf of Warren-Sherwood, Ltd., of which he was a partial owner. Mr. Stefan was an executive vice president of Mitchell. (continued...) ==========================================START OF PAGE 7====== Attorney Peden, in his capacity as bond counsel, opined that the bonds were tax-exempt and, in his capacity as underwriter's counsel, prepared with Mr. Thorn the Official Statement which made this representation.-[9]- Tr. 69-75. TAW sold these bonds to the public as qualified tax-exempt private activity bonds, and in doing so it used the mails and other means of interstate commerce. The Official Statement for the Sherwood Garden bond issue, dated August 27, 1992, represented that: 1. Interest on the bonds is excludable from income for federal income tax purposes. 2. The bond proceeds are expected to be used primarily to provide the Issuer, Warren County, with funds to loan to the Developer to finance the acquisition, partial demolition, reconstruction, renovation, and expansion of an existing multifamily rental housing project located in an urban renewal area of the Issuer. 3. The Developer is Warren-Sherwood, Ltd., an Alabama limited partnership. The Developer's general partner is Disposition & Management, Inc., which is owned by Mitchell's President, John Saint, and Executive Vice-president, Chester J. Stefan. The Developer's limited partners include Mr. Stefan, Mr. Saint, Mr. Napper and Mr. Kelly, of Mitchell, and Mr. Thorn, Mr. Welch and Mr. Yelverton of TAW. 4. Mitchell, the Project Coordinator, General Contractor, and Property Manager, is a wholly-owned subsidiary of Altus Bank which has been placed under control of the RTC. ---------FOOTNOTES---------- -[8]-(...continued) Attorney Wesch acted as counsel for Warren-Sherwood, Ltd. when it was negotiating a construction contract with Mitchell, his employer. Moreover, Attorney Wesch opined on August 27, 1992, that Warren-Sherwood, Ltd., owned by some of the same people who owned his employer, had validly executed the documents regarding the bonds at issue. Resp. Ex. 84D. Mr. Thorn signed the Memorandum of Agreement for TAW and Warren-Sherwood, Ltd. Mr. Stefan signed the same document for Mitchell and Warren-Sherwood, Ltd. -[9]- I reject Mr. Thorn's denial that he prepared the Official Statement with underwriter's counsel. He admits to furnishing counsel with information, reviewing and providing comments on counsel's draft, and approving the final version which was furnished to investors. ==========================================START OF PAGE 8====== 5. The contractor will guaranty the payment of a portion of the principal and interest on the bonds. 6. The construction contract will be a turnkey contract in the total amount of $686,000.-[10]- 7. The source of funds are: Bond principal $ 1,375,000 Premium 27,500 Interest earned 3,500 Developer's contribution 95,450 Total $ 1,501,450 8. One application of funds is a construction expenditure of $713,950. 9. The fair market value of the site is $525,000. 10. Mitchell will manage the project for an annual fee of 5 percent of gross rental income. Div. Ex. 1. Mitchell typically did not share ownership in renovated projects with others, i.e., engage in joint ventures. It agreed to jointly own these renovated projects with Mr. Thorn and others from TAW because TAW offered to arrange 100 percent financing,-[11]- which was not available from any other source, and Mr. Thorn required that he and others receive ownership in the projects. Tr. 356-57, 518-20; Tr. 2/9/95 at 16- 17. As a result, certain owners and officers of TAW and Mitchell formed limited partnerships which became the owner/developer of each of the seven properties which were the subject of the bond offerings. Mr. Thorn signed the Agreement of Limited Partnership of Warren-Sherwood, Ltd. (limited partnership) on August 24, 1992. Div. Ex. 63(c). As noted, the limited partners of Warren-Sherwood, Ltd. were John B. Saint, Chester J. Stefan, Gordon K. Napper, and Donald P. Kelly, Jr., from Mitchell, and Lonnie Joe Welch, Mr. Thorn, and E. J. Yelverton, Jr., from TAW. A limited partner's share of the profits, to be paid in cash quarterly, was in the same proportion ---------FOOTNOTES---------- -[10]- A turnkey contract is where the contractor agrees, for a set fee, to turn over to the developer a completed project that is ready to rent. Tr. 113. -[11]- One hundred percent financing refers to a situation where the parties- developer, owner and/or construction company - do not have to contribute additional funds over what is raised from the offering. Tr. 517-19. ==========================================START OF PAGE 9====== as his ownership of the partnership. Div. Ex. 63C at 1-2. The limited partners' shares ranged from a low of 9.9 percent and a high of 19.8 percent. Mr. Thorn owned 19.8 percent of the project. Div. Ex. 1 at 8; 63C. The total capital contribution to the partnership was $2,000. The general partner paid $20. The limited partners contributed in a range between $198 and $396. Div. Ex. 63C, Schedule A. Each of the Official Statements for the seven bond offerings listed a developer's contribution as a source of funds. Developer's Percent of Project Contribution Offering Proceeds Sherwood Garden $ 95,450 6.81 Northwest Plaza 72,500 7.48 Eden Point 144,229 5.69 The Pines 105,143 5.49 Northpark 48,144 7.50 Glen Oaks 242,450 5.99 The Lodge 404,662 5.09 Counsel Ex. 1 at 7. The limited partnership agreement that created Warren- Sherwood, Ltd., dated August 24, 1992, directed the partnership to enter a construction contract with Mitchell for rehabilitation of the project for actual costs plus 10 percent. Tr. 729; Div. Ex. 63C at 12-13. This limited partnership agreement provided that Mitchell-[12]- would be paid property management fees not to exceed 5 percent of the gross collections from the project, and an incentive fee equal to 25 percent of the distributable cash for each quarter. Div. Ex. 63C at 13; Tr. 729. As I have noted, the Official Statement did not disclose that Mitchell would receive an incentive fee. Also on August 24, 1992, Warren-Sherwood, Ltd. entered into a two page Construction Management Contract (construction contract) with Mitchell. Mr. Stefan signed for Warren-Sherwood, Ltd., as the executive vice president of Disposition & Management, Inc., the general partner, and Duke W. Miller signed for Mitchell as the vice president of Armay Development Corp., a general partner of Mitchell. Div. Ex. 63B. This contract provided that Mitchell would repair and rehabilitate the project for costs plus 10 percent, and that Mitchell was not responsible for cost overruns, insuring the project, plan errors, or existing code violations. Id.; Tr. 363-64, 438-48. The Official Statement did not disclose this information or that Mitchell ---------FOOTNOTES---------- -[12]- The testimony was that the payment was to Mitchell; however, the limited partnership agreement provided for payment of the management fee and the incentive fee to "the General Partnership and its Affiliates." Div. Ex. 63C at 13. The partnership's general partner was Disposition & Management, owned by Mr. Saint and Mr. Stefan. ==========================================START OF PAGE 10====== would receive an incentive fee to manage the property of 25 percent of net revenues. The construction contract was just one part of the overall compensation received by Mitchell and some of its officers and employees. Tr. 362-384, 451, 453, 735; Tr. 2/9/95 at 180-96; Div. Ex 113. At least thirty days before the bond closing, Mr. Stefan, representing Mitchell, and Mr. Thorn, representing TAW, agreed that the transaction would be financed 100 percent, and that Mitchell would do the work for: 1. hard construction costs plus 10 percent; Mitchell agreed on the sum of $429,855, which included the 10 percent return on hard costs, on a best efforts basis.-[13]- Div. Ex. 113; Tr. 390-92, 416, 435- 47. Mitchell was not responsible for cost overruns, insuring the project, plan errors or code violations.-[14]- 2. cost of the contractor's guaranty for payment of principal and interest on the bonds, i.e., $211,000 to purchase zero coupon or stripped Treasury bonds. If these securities were not needed to pay debt service over the 25 years the bonds were outstanding, they would revert to Mitchell. Div. Ex. 113; Tr. 381. 3. ownership interest in the project for certain officers and employees of Mitchell. 4. five percent of gross rents as a management fee when the project is rehabilitated. 5. twenty-five percent supplemental management fee, i.e., percentage of distributable cash as defined in the partnership agreement. Div. Ex. 63C at 2. Tr. 361-68, 383. ---------FOOTNOTES---------- -[13]- Attorney Peden believed the Official Statement accurately described Sherwood Garden as a turnkey project even though the construction contract provided that Mitchell would do the work for actual costs plus 10 percent. Tr. 247-49, 929-33. Attorney Peden maintained that Mr. Thorn and Mr. Stefan were still negotiating Mitchell's compensation when they participated in a phone call shortly before August 27, 1992, even though Mr. Stefan and Mr. Thorn agreed on Mitchell's compensation well before that conversation. Tr. 246. -[14]- Mitchell paid small cost overruns on Sherwood Garden and some of the other projects of between five and ten thousand dollars. One project, Glen Oaks, had more serious problems and Mitchell put in approximately $86,000. Tr. 438-48. ==========================================START OF PAGE 11====== According to Mr. Stefan, Mitchell would not have agreed to just a construction contract for cost plus 10 percent. Mitchell viewed the various agreements as a compensation package. It expected to make a profit from each of the agreements. Tr. 453. Mr. Stefan learned that Mitchell was expected to make a $95,450 developer's contribution when he saw a draft of the Official Statement and the Memorandum of Agreement shortly before the bond closing. Tr. 393-95, 403-05. He called Mr. Thorn and Attorney Peden and reminded them that they had consistently represented that Sherwood Garden would be financed 100 percent. Tr. 396-97. Attorney Peden and Mr. Thorn assured Mr. Stefan that Mitchell would not have to bring a check to the closing.-[15]- Respondents represent that Mitchell, the construction company, made the developer's contribution in all seven offerings. At the closing on August 27, 1992, Attorney Peden directed that Batesville Security Bank, trustee for the bond proceeds, disburse the following sums from the construction fund to escrow accounts of First American Title Insurance Company (First American) at Sunburst Bank: $525,000 for Warren-Sherwood, Ltd.'s. account for site purchase; $3,500 for First American's account for title insurance premium; $1,000 for the State of Mississippi for bond allocation fee; and $95,450 for Mitchell's account representing the contractor's initial draw. Counsel Ex. 1 at 7-8. Additional disbursements from the construction fund were: $1,000 to Batesville Bank for trustee fee; $10,787 to Attorney Peden for bond counsel fee and expenses; $6,000 to Attorney Ken Harper for issuer's counsel fee; $10,263 to TAW for underwriter's fee; and $307,021 to Mitchell for the initial draw under the construction contract. Div. Ex. 46A. Attorney Peden directed First American to wire $83,237 of the $95,450 to TAW and the remaining $12,213 to Attorney Peden's law firm to pay issuance costs in excess of 2 percent of the offering. Tr. 410-420. Attorney Peden had TAW, Warren-Sherwood, Ltd., and Mitchell sign a Memorandum of Agreement at the closing on August 27, 1992.-[16]- Div. Ex. 63A. It stated that Mitchell agreed ---------FOOTNOTES---------- -[15]- The testimony is that Mr. Stefan was able to understand Attorney Peden's explanation when it was analogized to a Builders and Sponsors Profit and Risk Allowance (BSPRA), a device reportedly used in Federal Housing Act deals by the Department of Housing and Urban Development when the contractor leaves something of value in the project. Respondents' Counterstatement of Proposed Findings of Fact and Conclusions of Law at 25. There was no BSPRA in this situation. Tr. 399, 650, 788. -[16]- Attorney Peden prepared this because Mr. Thorn wanted to document the agreement with Mitchell. Attorney Peden believed (continued...) ==========================================START OF PAGE 12====== to pay miscellaneous business expenses and obligations of the owner, Warren-Sherwood, Ltd., in consideration of being awarded the construction contract of $713,950; that payment of the expenses shall be a cost of the contractor in performing under its construction contract; and that the contractor was required to pay these costs under the contract. Mr. Stefan considered the Memorandum Agreement just another closing document, and he did not notify Mitchell's attorney that he had signed such a document or that Mitchell received $95,450 and used it to pay closing costs in excess of 2 percent. Tr. 427. The Sherwood Garden offering raised $1,402,500.-[17]- Issuance costs of the offering totaled $124,500 or 8.88 percent of bond proceeds.-[18]- Div. Ex. 104. TAW received net underwriter's fees of $24,750. Counsel Ex. 1 at 12; Tr. 594. Attorney Peden and his law firm received $23,000 as bond counsel fees and expenses. Counsel Ex. 1 at 11; Div. Ex. 104. TAW retained $117,376 of the total underwriting fees of $350,635 it received from the seven offerings. Counsel Exhibit 1 at 15. It disbursed $116,432 to Mr. Thorn and $116,827 to another TAW principal. Id. Attorney Peden's law firm received a total of $152,161 from the TAW offerings. Id. Findings of Law Antifraud Provisions of the Securities Statutes and Regulations It is well established that broker-dealers are subject to the same high standards when underwriting and trading municipal securities as when they underwrite and trade corporate securities. Walston & Co., Inc., 43 S.E.C. 508, 512 (1967). As the underwriter, TAW was required: to have a reasonable basis for recommending any municipal securities and its responsibility, in fulfilling that obligation, to review in a professional manner the accuracy of the offering statements with which it is associated. An underwriter, whether of municipal or other securities, occupies a vital position in an offering. ---------FOOTNOTES---------- -[16]-(...continued) that TAW and Mitchell "were staffed with honorable men who would adhere to their word." Tr. 254-57. -[17]- Respondents and the Division stipulated that the offering proceeds totaled $1,402,500, but the disbursement sheet at closing puts the total at $1,410,693. Compare Counsel Ex. 1 at 7 with Div. Ex. 47. -[18]- In the other six offerings, issuance costs as a percentage of bond offerings were as follows: Northwest Plaza, 9.44%; Eden Point, 7.63%; The Pines, 7.57%; Northpark, 9.41%; Glen Oaks, 7.99%; and The Lodge, 6.96%. Tr. 560-74. ==========================================START OF PAGE 13====== The underwriter stands between the issuer and the public purchasers, assisting the issuer in pricing and, at times, in structuring the financing and preparing disclosure documents. Most importantly, its role is to place the offered securities with public investors. By participating in an offering, an underwriter makes an implied recommendation about the securities. Because the underwriter holds itself out as a securities professional, and especially in light of its position vis-a-vis the issuer, this recommendation itself implies that the underwriter has a reasonable basis for belief in the truthfulness and completeness of the key representations made in any disclosure documents used in the offerings. Release Requesting Comments on SEC Proposed Rule 15c2-12, 41 SEC Docket 1402, 1411 (1988). See Brown, Barton & Engel, 41 S.E.C. 59 (1962); The Richmond Corporation, 41 S.E.C. 398 (1963); Amos Treat & Co., Inc., 42 S.E.C. 99 (1964). The expert testimony affirmed TAW's duty as the underwriter to have a reasonable basis for the truthfulness and completeness of the factual representations in the Official Statement. Tr. 803-06. This duty included undertaking a reasonable investigation of the facts behind the disclosure documents to make sure they were not misleading. Tr. 2/9/95 at 97-102. Mr. Thorn and, through him, TAW willfully disseminated copies of the Official Statement, the disclosure document provided to prospective purchasers, which he knew or was reckless in not knowing contained material information that was false and misleading. Mr. Thorn acted with full knowledge of the facts and the responsibilities of an underwriter intending to deceive, manipulate and defraud investors. Aaron v. SEC, 446 U.S. 680, 686 n.5 (1980). Alternatively, if one accepted Mr. Thorn's claim that he did not know that certain material information was false, the evidence is overwhelming that he acted with extreme recklessness, i.e., a degree of negligence that was an extreme departure from ordinary care. SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992). The Official Statement for the Sherwood Garden Project, which was similar to the other six offerings, was false and misleading in material respects by representing that: 1. interest on these bonds was tax-exempt; 2. a total of $1,500,000 was coming into the transaction, Tr. 798, and the owner/developer, Warren- Sherwood, Ltd., contributed $95,450 to the project, Tr. 796-98; Tr. 2/9/95 at 102-03; 3. $713,950 would be spent on construction, Tr. 796; ==========================================START OF PAGE 14====== 4. the construction contract was for a turnkey project so that the contractor was responsible for any cost overruns, Tr. 799-801; 5. the fair market value of the property was approximately $525,000; and 6. the contractor would furnish a guaranty on the payment of interest while the bonds were outstanding. These representations were material because a reasonable person would consider the information important in deciding whether to invest in these securities. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 445 (1976); accord Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988). 1. Bonds are not tax-exempt Interest on these bonds is taxable because the transaction violated two provisions of the Internal Revenue Code which made them ineligible for tax-exempt status. Section 147(g) provides that "a private activity bond shall not be a qualified [tax exempt] bond if the issuance costs financed by the issue (of which such bond is a part) exceed 2 percent of the proceeds of the issue."-[19]- 26 U.S.C.  147(g). Issuance costs include the cost of lawyers, underwriters, printers, and others concerned with issuance. Tr. 637. Section 142(a) provides that "the term 'exempt facility bond' means any bond issued as part of an issue 95 percent or more of the net proceeds of which are to be used to provide" the financed facility. 26 U.S.C.  142(a).-[20]- The term "provide" means a cost chargeable to the capital account of the facility such as the purchase, construction or rehabilitation cost. Tr. 636-37, 777. Issuance costs are not costs of providing the facility within the meaning of Section 142(a). Tr. 777. As noted the developer was Warren-Sherwood, Ltd. There is not one shred of evidence that the parties ever considered that Warren-Sherwood, Ltd., which had a capitalization of $2,000, would make a developer's contribution of $95,450. To accept respondents' position, you have to accept first that it was reasonable for them to describe in the Official Statement a contribution from Mitchell, the contractor, as a developer's contribution. Attorney Peden claimed that Mitchell was the developer because by industry custom the developer can be ---------FOOTNOTES---------- -[19]- This provision was added to the Internal Revenue Code in 1986 when Congress made a policy decision that bond professionals were making too much money from their participation in tax-exempt offerings. Tr. 778. -[20]- These two provisions are applied independently. If either provision is not met, interest on the bonds is not tax- exempt. Tr. 636-38. ==========================================START OF PAGE 15====== a party who advises the owner or does the development work for the owner. Tr. 317-21. I disagree. Mitchell was not the developer in these seven offerings. The Official Statement which Attorney Peden drafted designated Warren-Sherwood, Ltd. as the owner/developer. Two experts, Attorney N. Jerold Cohen for the Division and Attorney Margaret Joslin for respondents, thought Warren-Sherwood, Ltd. to be the developer based on their reading of the Official Statement. The drafter of the limited partnership agreement, Attorney Paul C. Wesch, considered Warren- Sherwood, Ltd. to be the developer. Tr. 659-60, 727-28; Tr. 2/9/95 at 102, 162. Even if one excused as not misleading the Official Statement's misdescription of the developer, rather than the contractor, as the source of the contribution to pay issuance cost in excess of 2 percent,-[21]- the evidence leaves no doubt that Mitchell agreed to do all the work in connection with Sherwood Garden for consideration which did not include the $95,450 developer's contribution. Speaking on behalf of Mitchell, Mr. Stefan's position is unequivocal. The developer's contribution of $95,450 was of no economic consequences either to Mitchell or to Mr. Stefan. Tr. 418-23. I find the evidence persuasive that Mitchell did not earn the $95,450, and did not donate its funds to pay issuance costs over 2 percent. As an accommodation to Mr. Thorn and Attorney Peden who arranged the transaction, Mr. Stefan agreed to have it appear that Mitchell was making a contribution. As long as Mitchell and Mr. Stefan received all the economic benefits they had agreed to, Mr. Stefan was willing to do or sign whatever Attorney Peden and Mr. Thorn proposed at the closing. I reject the position of respondents' municipal bond expert, Attorney Theberge,-[22]- that: [i]n the hands of the contractor, once earned it is no longer proceeds from the bonds. . . . if it is a reasonable contract and the proceeds are disbursed to the contractor and they are earned, they lose their character as bond proceeds. What the contractor does with them is irrelevant for our purposes. Tr. 981. ---------FOOTNOTES---------- -[21]- The evidence is unanimous that issuance costs almost always exceed 2 percent of the offering proceeds in tax-exempt offerings. The two basic ways of raising funds to pay issuance costs over 2 percent of the offering are either a contribution from the developer or owner, or a taxable bond issue (taxable tail) for the amount of the additional costs. Tr. 2/9/95 at 81- 82. -[22]- Attorney Theberge is a partner in the law firm of Kutak, Rock in Washington, D.C. ==========================================START OF PAGE 16====== Attorney Theberge's belief is that: Effectively what happened here was The Mitchell Company's contract was cost plus 10% plus $95,450. That was the contract billing, and that was a reasonable contract. They then took $95,450 and gave it, in one form or another, to their employees and shareholders, who then made a contribution to pay the excess cost of issuance. That's what the transaction was. And that's really what Stefan and -- and that's what Derryl Peden gave his opinion on I think pretty clearly. That's what Stefan I think negotiated; that is, a cost plus 10% and no one paying out-of-pocket. And when they were out-of-pocket he said, "Well, I want to adjust -- adjust it to reflect that net-net, no one's out-of-pocket." So I think the adjustment of the $95,450 was clearly what Stefan -- it was consistent with what they had negotiated. Tr. 2/9/95 at 75. Attorney Theberge's position is unpersuasive for several reasons. He incorrectly assumed that Mitchell was donating $95,450 which it had earned and which was part of the fee it negotiated. He determined that Mitchell's compensation was reasonable believing that Mitchell's full compensation was cost plus 10 percent and $95,450. Tr. 2/9/95 at 54, 57-58, 77. He was unaware that Mitchell also received $211,571.25 to reimburse it for the contractor's guaranty it was required to post, and that these funds went to Mitchell if the project succeeded and the funds were not used. Tr. 2/9/95 at 59. He also failed to consider that Mitchell received the right to manage the project for an annual fee of 5 percent of gross rental income.-[23]- Div. Ex. 1 at 9. Finally, he claimed that cost plus 30 or 25 percent would have been a reasonable fee for Mitchell's services based on the testimony of others. He had no independent judgment on this issue. Tr. 2/9/95 at 58. Attorney Theberge also adopted certain false theories put forward by Attorney Peden: ú Mitchell lowered its fee from the reasonable level of cost plus 25 or 30 percent to cost plus 10 percent with no out-of-pocket expenses because its employees and shareholders were members of the limited partnership, Warren-Sherwood, Ltd., which owned the Sherwood Garden Project; ú Mitchell earned the $95,450 for reasonable services rendered and contributed it to the project to benefit some of its employees and shareholders; and ---------FOOTNOTES---------- -[23]- No expert has opined that these offerings were tax- exempt on the facts as I have found them. ==========================================START OF PAGE 17====== ú Mitchell's contract was adjusted upward by $95,450, within fair value, to cover an out-of-pocket expense (closing costs in excess of 2 percent of the proceeds) in keeping with the agreement that Mitchell would receive cost plus 10 percent without any out-of-pocket expenses, meaning 100 percent financing. Tr. 235, 315, 322, 896-900; Tr. 2/9/95 at 50-53, 55-56, 58, 64- 67, 70-71. It is well settled that the terms agreed to by independent parties in arms length negotiations are the best evidence of what is reasonable compensation for services rendered. Tr. 2/9/95 at 148, 187. Mitchell and TAW were independent parties, and Mitchell negotiated the best deal it could get for itself and related parties in all the agreements having to do with these projects. Mitchell bargained for and got a compensation package which did not include $95,450. Div. Ex. 113; Tr. 412-19; Tr. 2/9/95 at 159. The fact that Attorney Peden had to explain to Mr. Stefan why the Official Statement showed a developer's contribution of $95,450 undercuts his position that Mitchell earned this money. According to Attorney Peden: I was explaining to [Mr. Stefan] and was pointing out the fact that as project coordinator in this and for the functions that they were performing [Mitchell] were certainly entitled to reasonable compensation for this because they had done a great many very valuable things for this project. The project in no way could have gone forward without the Mitchell Company's activities. I told him that what we are doing here is you are going to be getting funds like this, in effect a developer's type fee, and it is going to be limited, though, to an amount sufficient to offset what you are going to be contributing to pay the developer's contribution. Tr. 898. There is no evidence that Mitchell left $95,450 on the table. I find it implausible that Mitchell had a claim for an additional $95,450 over the consideration to which it had agreed. Mr. Stefan was unaware that Mitchell was going to be asked to pay these costs prior to his conversation with Attorney Peden. He expected Mitchell would receive at the closing only $211,571.25 for the contractor's guaranty. Tr. 412. It was illogical and contrived for Mr. Thorn and Attorney Peden to inform the construction company that it had earned $95,450 more than it had bargained for, and that it would use the $95,450 to pay issuance costs, including part of their fee, which exceeded the 2 percent of bond proceeds allowed in a tax-exempt offering. Tr. 898-99. ==========================================START OF PAGE 18====== The Peden and Theberge position - that Mitchell and TAW were still negotiating a few days before the closing and agreed on terms, including a developer's contribution, on a phone call Attorney Peden held with Mr. Stefan and Mr. Thorn shortly before the closing - is false. Mitchell and TAW had agreed on terms, and contracts were in preparation or signed, when the phone conversation occurred. Tr. 375-83, 390-92, 416, 436-46. Both the partnership agreement, which directed a cost plus construction contract, and the construction contract itself were signed on August 24, 1992, a few days before the August 27 closing. The record is persuasive that Mr. Thorn had, from the beginning of negotiations with Mitchell, consistently represented that the project would be 100 percent financed. Therefore, he and Attorney Peden structured the offering so as not to appear to violate the Internal Revenue Code restrictions for tax-exempt offerings, and yet pay issuance costs in excess of 2 percent from bond proceeds. Tr. 357. To do this, Attorney Peden and Mr. Thorn carried out a scheme to artificially inflate Mitchell's construction contract by $95,450 for services it allegedly rendered, and directed Mitchell to contribute this amount to pay Attorney Peden and TAW for issuance costs over 2 percent of the offering. Tr. 268. Respondents emphasize all the work Mitchell did, including that of a project coordinator, to show that Mitchell earned the $95,450. Their evidence is unpersuasive. Mr. Stefan testified the term "project coordinator" was meaningless and was used because it was on the documents from a prior transaction. Tr. 495. Someone in Mitchell's role normally incurred the cost of a property appraisal. Mitchell did not order one for Sherwood Garden, however, and it did not do a formal written feasibility study. Tr. 2/9/95 at 10-11; Tr. 495. According to Mr. Stefan, all Mitchell needed was financing because they had the property under contract, had done a walk-through inspection and had budgeted needed repairs, and had spoken with building and county officials. Tr. 355-56. The evidence is that TAW's underwriting of this project as a tax-exempt offering allowed Mitchell to recoup funds that it could not recover by other means, and provided Mr. Thorn, TAW, Mitchell, and some of their officers and employees, substantial financial benefits. Mitchell had been looking for financing for Sherwood Garden for about two years. The Mitchell employee who located all seven projects, Mr. Griffen, testified that the Department of Housing and Urban Development had rejected Mitchell's financing proposal for Sherwood Garden. According to this Mitchell real estate broker, "Nobody was willing to do [conventional financing] because of the market at that time. And we had accumulated a good amount of cost involved in our efforts to try to do something with this complex." Tr. 2/9/95 at 12-13. According to Mr. Griffen, Mitchell recovered these costs in the reduced price ==========================================START OF PAGE 19====== it paid for the property.-[24]- Mr. Stefan and Mr. Saint appear to have purchased the project from the bank which was controlled by the RTC, paid a $50,000 commission, resold it to Warren-Sherwood, Ltd. for $525,000, and each pocketed $25,000. Tr. 428-30.-[25]- Respondents note that these projects are all successful in that interest is being paid on the bonds and the projects provide quality housing to low-income tenants. These facts are interesting but irrelevant to resolving the allegations in this proceeding. As support for his position, Attorney Peden relied on the use of a developer's contribution in a 1990 tax-exempt offering by Clarksdale, Mississippi, in which another law firm served as bond counsel. The Clarksdale situation does not support the legality of the developer's contribution in these seven offerings because here the source of the contribution was bond proceeds while in Clarksdale the project owners obtained a bank loan and used it to make the developer's contribution. Tr. 925. Because the only money available to pay the expenses of the offering was from the bond issue,-[26]- and because $95,450 was 6.81 percent of the offering proceeds, well above the 2 percent limit for tax-exempt offerings prescribed by Section 147(g), it follows that 95 percent of the offering was not used as required by Section 142(a) of the Internal Revenue Code.-[27]- Tr. 668-69. ---------FOOTNOTES---------- -[24]- The witness's references were to Mitchell, but the evidence is that Mr. Stefan and Mr. Saint each made a profit of $25,000 by buying the property for less than the $525,000 they charged the limited partnership. -[25]- Attorney Cohen calculated Mitchell's profits on the seven offerings applying respondents' position. The summary of 10 percent of construction costs, the developer's contribution, and the cost of the contractor's guaranty, would give Mitchell a profit of $371,926, or 26.52 percent of the bond offering, on the Sherwood Garden Project. Div. Ex. 117. Similar results occurred on each of the seven offerings. Attorney Cohen characterized these results as staggering in terms of total construction costs and outlandish in terms of hard construction costs. Tr. 2/9/95 at 156. -[26]- According to one expert, when, as here, no other money is brought to the table but the bond proceeds, it immediately raises questions as to whether issuance costs above the 2 percent limit are being financed from bond proceeds. Tr. 713. -[27]- This is also true for the other six offerings. Counsel Ex. 1 at 7. ==========================================START OF PAGE 20====== The expert opinions of Attorney N. Jerold Cohen, former chief counsel of the Internal Revenue Service,-[28]- and Attorney Earle R. Taylor-[29]- are persuasive that these bonds were not tax-exempt offerings under either a direct application of the Internal Revenue Code or application of three generally accepted and closely related tax doctrines: (a) substance-over-form;-[30]- (b) sham transaction; -[31]- and (c) step transaction.-[32]- Tr. 650-51, 653-59, 778-90, 807. For tax analysis purposes, the $95,450 developer's contribution, which Mitchell purportedly earned and contributed to pay issuance costs, was meaningless and should be ignored under the substance-over-form doctrine, was a sham transaction, and was meaningless because the transaction does not survive scrutiny under any of the three versions of the step transaction doctrine. The substance-over-form doctrine is applicable where the substance of the transaction is different than the form would suggest. In such a situation, the substance of the transaction governs for tax purposes. Tr. 639-40, 780-81, 784. Accordingly, the $95,450, which Attorney Peden characterized as a developer's contribution, is meaningless and should be ignored under the ---------FOOTNOTES---------- -[28]- Attorney Cohen is a partner in the firm of Sutherland, Asbill & Brennan in Atlanta. Attorney Cohen was qualified as a tax expert. Attorney Cohen believed, with close to 100 percent certainty, that these bonds were not tax-exempt. Tr. 659. In his opinion, it is doubtful that any reasonable, competent tax counsel could find these offerings to be tax- exempt. Tr. 2/9/95 at 208. -[29]- Attorney Taylor, a partner in the firm of Kilpatrick & Cody in Atlanta, is a member of the firm's public finance group. He was qualified as an expert on tax law, especially disclosure and materiality. Tr. 771-74. -[30]- Attorney Taylor believed this doctrine is the one that most clearly and easily destroys the tax-exempt status of these bonds. Tr. 786. -[31]- This is the most difficult of the three theories to satisfy. Tr. 651, 784. -[32]- Attorneys Cohen and Taylor believe that the Memorandum of Agreement, which the parties signed at the closing, described a situation which violated Internal Revenue Code Sections 142(a) and 147(g). Tr. 649-50, 779. Attorney Taylor was adamant that it showed a non-exempt transaction because Mitchell got a contract financed with bond proceeds by agreeing to pay costs that could not be paid with bond proceeds. Tr. 784- 88. ==========================================START OF PAGE 21====== substance-over-form doctrine because it was, in substance, a portion of the bond proceeds used to pay issuance costs. Tr. 653-55, 786-87. If a transaction has no business purpose or economic substance it is a sham and will be ignored for tax purposes. Mitchell was willing and ready to execute the contract without receiving $95,450. By receiving this amount and disbursing it as Attorney Peden directed, Mitchell was simply a conduit to get funds from the bond proceeds to pay issuance costs. Tr. 645-46, 648, 710. The developer's contribution was therefore a sham transaction and bond proceeds directly financed issuance costs over 2 percent. Tr. 783-86. Respondents' argument, that Mitchell's costs were reasonable and therefore it deserved the $95,450, is irrelevant. The fact is that Mitchell agreed to do all the work on this project for an amount that did not include the $95,450 that it received, or purportedly received, at the closing which the Official Statement designated as the developer's contribution. Tr. 648-49, 655, 788. I agree with Attorneys Cohen and Taylor that a finding that the transaction was a sham is supported by the fact that it is unreasonable to believe that (1) the RTC, which controlled the bank that owned Mitchell, would give away funds to pay issuance costs which were the responsibility of a third party, Warren- Sherwood, Ltd.; and (2) Mitchell would donate its funds when the beneficiaries included some Mitchell owners and others who had no connection to Mitchell.-[33]- Tr. 649, 663, 785. This transaction does not survive scrutiny under any of the three versions of the step transaction doctrine and is, therefore, meaningless. Under the step transaction doctrine, if the taxpayer designs the transaction to have several steps to avoid taxes, the steps are collapsed and taxability is determined from what actually occurred. Tr. 641-43, 655-59, 784, 787-88. In applying the step transaction doctrine, the closer in time the steps took place, the greater the likelihood the steps will be collapsed. Here, the steps - the transfer of bond proceeds to First American, then the transfer from First American to TAW and to Attorney Peden's law firm - happened on the day the offering closed. From a tax perspective, this would set off red flags that there is a potential step transaction problem. Tr. 656-57. Even if Mitchell received the $95,450, and I have found that it did not, Mitchell never had the ability to keep the money, because it was always obligated to use these funds to pay the issuance costs in excess of 2 percent of the offering. Tr. 254- 55, 656. Under the interdependence test, a generally accepted version of the step transaction doctrine, if the individual steps would not have been taken but for other steps, you would collapse the ---------FOOTNOTES---------- -[33]- Attorney Taylor believed the entire scenario contained all types of red flags. Tr. 784-85. ==========================================START OF PAGE 22====== steps and examine what actually happened. The tax consequences of the transaction are determined by ignoring the intermediate step or steps. Here the developer's contribution would not have been paid to Mitchell but for Mitchell's agreement to use the funds to pay the issuance costs in excess of 2 percent. The intermediate step - the payment to Mitchell - would be ignored and the $95,450 would be viewed as coming directly from bond proceeds. Tr. 642, 658-59. Two other versions of the step transaction doctrine yield the same result. Under the most limited version, the binding commitment test, because Mitchell was committed to pay issuance costs of $95,450 at the time it received that amount, one would, for tax purposes, collapse the steps and look at the end result. The $95,450 would, therefore, be considered as coming directly from the bond proceeds to pay issuance costs in excess of 2 percent. Tr. 642-43, 657. Under the end result test, the broadest application of the doctrine, the alleged payment to Mitchell and the developer's contribution in the same amount are ignored as steps taken to make it appear, for tax purposes, that bond proceeds were not used to pay issuance costs over 2 percent. Tr. 641-42. Since the only money coming in was from the bond offering, bond proceeds are considered to have been used to pay issuance costs. Tr. 657-58. For purposes of the above analysis, I assumed respondents were correct that Mitchell received $95,450 from the bond proceeds and disbursed it to TAW and Attorney Peden's law firm. However, this claim does not appear to be true. There is nothing to indicate that First American's function was to do more than the normal function of a title company, which is to accept that portion of the bond proceeds going to purchase the property.-[34]- Tr. 645. I find that Mitchell had no claim to the $95,450, and neither Mitchell nor anyone acting for it ever had custody of the $95,450. This finding is supported by the testimony of the examiners from the Commission's Division of Market Regulation. In their examination of TAW's books and records, the examiners could not reconcile the statement of receipts and disbursements at closing and the Official Statement's sources and uses of funds because the funds from the developer's contribution "were not there at the closing." Tr. 743; see also Tr. 177-78. 2. Bond proceeds totalled $1.5 million ---------FOOTNOTES---------- -[34]- Mr. Stefan selected First American and testified that it was "our agent." Tr. 474-75. However, considering the variety of roles Mr. Stefan played in the transaction, I am not sure if he was referring to Mitchell, he and Mr. Saint who held an option on the property, or Warren-Sherwood, Ltd. of which he was an owner. Since Warren-Sherwood, Ltd. was the owner/developer, it is logical that First American was its agent, not the agent of the construction company. ==========================================START OF PAGE 23====== Attorney Peden and at least two experts agreed that reasonable investors would believe that funds at the closing would total $1,501,450 based on information in the Official Statement. Div. Ex 1; Tr. 336, 798; Tr. 2/9/95 at 104. This material representation was false because the developer did not contribute $95,450 so that the offering raised $1,402,500. Counsel Ex. 1 at 7; Tr. 798-99. 3. Application of funds: construction - $713,950 The expert testimony is that an investor would interpret this representation to mean that $713,950 was spent on hard costs to improve the property. This was false material information. Tr. 796-97. The $713,000 included only about $425,000 for construction costs including the 10 percent.-[35]- The rest of the funds were spent on the $211,000 to reimburse Mitchell for the cost of the contractor's guaranty, and on the $95,450 for the developer's contribution. Tr. 376-77, 392, 796. 4. The project was a turnkey project There is no dispute that Mr. Thorn lied and caused Attorney Peden to believe that the construction contract for Sherwood Garden would be a turnkey contract. Mr. Thorn received a draft of the Official Statement, which stated that the project was a turnkey project, and discussed its contents with Attorney Peden and Mr. Stefan in a phone conversation a few days before August 27. TAW and Mr. Thorn issued an Official Statement which Mr. Thorn knew was materially erroneous because he knew his agreement with Mr. Stefan, the limited partnership agreement, and the construction contract which Mitchell had signed on August 24, all provided for a cost plus construction contract which absolved Mitchell from responsibility for cost overruns. I reject Mr. Thorn's excuse that he was confused and that the misrepresentation was immaterial because Mitchell had agreed to do the construction for a sum certain. Tr. 114. The expert evidence is that the terms of the construction contract, including liability for cost overruns, are materially significant especially on an offering such as this where the funds to pay interest on the bonds will be generated solely by the cash flows from the project.-[36]- Tr. 800-01, 822-23. ---------FOOTNOTES---------- -[35]- Mitchell agreed to do the work on a best efforts basis for $429,855 which included the 10 percent return. Tr. 417-19. Mr. Yelverton, who worked with Mr. Thorn at TAW, got a construction cost figure from Mitchell of about $400,000 plus. Tr. 950. Mr. Yelverton accepted the hard costs that Mitchell gave him as true, and made no attempt to verify beyond talking to persons at Mitchell. Tr. 950-53. -[36]- Expert Attorney Taylor testified: So economically there is a big difference between the contractor eating the cost overruns and the partnership (continued...) ==========================================START OF PAGE 24====== 5. Site value was $525,000 The Official Statement's Application of Funds showed $525,000 as the amount to be paid for the site purchase. Div. Ex. 63C at 11; Div. Ex. 1 at 7. Based on this representation, an investor would reasonably expect that the property was worth about one half million dollars. This was not true. It appears from the record that Mr. Stefan and Mr. Saint exercised an option and acquired the property for approximately $425,000 and resold it to Warren-Sherwood, Ltd. for $525,000. Mr. Stefan admits to negotiating a reduced price. He claimed to have paid a $25,000 commission to a real estate agent and acknowledged splitting $50,000 with Mr. Saint. Tr. 428-29; Tr. 2/9/95 at 12-14. Mr. Stefan claimed to have told Mr. Thorn before the closing that he and Mr. Saint had purchased the site for less than $525,000. Tr. 428-29, 481-89, 525-26. Mr. Thorn's credibility is highly suspect based on the evidence in this record. Even if you accept Mr. Thorn's position that he did not know that Mr. Stefan paid less than $525,000, he did not fulfill an underwriter's obligation to assure the accuracy of this material information in the Official Statement. Mr. Thorn devoted little time to the responsibilities of an underwriter on these offerings. Tr. 87-88. In the five months from the initial contact in April, until the August 27 closing, Mr. Stefan and Mr. Thorn only spoke five or six times for about 15 minutes each time. Tr. 358. He met with Mr. Stefan and Mr. Saint once briefly. Mr. Thorn did not verify the price Mr. Stefan actually paid for the property he resold to Warren- Sherwood, Ltd., and he failed to get an appraisal supporting the $525,000 purchase price. In 1988, the property was appraised at $1,750,000 in "as-is" condition. Tr. 2/9/95 at 11. The record does not show whether this appraisal occurred before or after 52 units had been flooded three times, and whether it considered the asbestos and other possible problems with hazardous waste caused by the required removal of the flooded units. Tr. 2/9/95 at 12. The unrefuted expert testimony is that while the amounts are small, the fact that the property was purchased from related parties made this misrepresentation and omission material. Tr. 801-02. 6. Contractor's guaranty The Official Statement provided that the contractor would guaranty payment of principal and interest on the bonds pursuant to a limited guaranty agreement issued by Mitchell, and that ---------FOOTNOTES---------- -[36]-(...continued) eating the cost overruns. . . . To the extent the partnership has to pay cost overruns, there is less cash available to pay my bonds if I were an investor. So on that basis I say there is a material misstatement. Tr. 800-01. ==========================================START OF PAGE 25====== Mitchell intended to buy government zero based bonds or strips to meet this obligation. Div. Ex. 1 at iii.-[37]- The Official Statement did not reveal that Mitchell received the cost of the contractor's guaranty, $211,571.25, from bond proceeds. Tr. 2/9/95 at 187-93. According to Mr. Thorn, this money was part of the $713,950 described as "Construction" in the Application of Funds section of the Official Statement. Tr. 83- 84; Div. Ex. 1 at 7. Attorney Cohen's opinion that the Official Statement permitted Mitchell to get out of its obligation to provide a guaranty by buying the strips and depositing them with the trustee is unrefuted on this record. This is not clear from the document. Tr. 2/9/95 at 187-93. Q. But isn't part of what the contractor's being paid, the $713,000, for providing this guarantee? A. No, there's no guarantee. The minute this transaction closed there's no guarantee, Mr. Russ. The minute the transaction closed, the strips are purchased, they're deposited, there's no further guarantee. Contractor never had a guarantee. Tr. 2/9/95 at 192. The expert's position is affirmed by evidence that Mr. Yelverton at TAW told Attorney Peden that Mitchell would find it difficult to furnish the guaranty because it was under RTC control, and Attorney Peden indicated he was willing for Mitchell to do the work without a bond. Tr. 953. Municipal Securities Rulemaking Board Rule G-17 and Exchange Act Section 15B(c)(1) On these facts, TAW violated Municipal Securities Rulemaking Board (MSRB) Rule G-17, which specifies that a broker-dealer shall deal fairly with all persons and shall not engage in any deceptive, dishonest or unfair practice, and Section 15B(c)(1) of the Exchange Act, which prohibits a broker-dealer from using the mails or any means of interstate commerce to effect any transaction which violates an MSRB rule. The MSRB has interpreted Rule G-17 as prohibiting conduct which violates the antifraud provisions of the securities statutes. MSRB Manual (CCH) at 4864, 4867. Mr. Thorn willfully aided and abetted TAW's violations because there were independent or primary securities law ---------FOOTNOTES---------- -[37]- Both Division experts opined that payment of $211,571.25 to Mitchell from bond proceeds for the zero interest bonds or strips violated the Internal Revenue Code provisions for a non-taxable bond offering and made the interest on these bonds taxable. Tr. 651, 779-80; Tr. 2/9/95 at 154-55. I sustained objections to this testimony because the Order Instituting Proceedings did not challenge the legitimacy of this use of bond proceeds. ==========================================START OF PAGE 26====== violations, he knew that his activities were part of an overall activity that was illegal, and he knowingly gave substantial assistance in effecting the primary violations. Woods v. Barnett Bank of Fort Lauderdale, 765 F.2d 1004, 1009 (11th Cir. 1985); IIT, an International Investment Trust v. Cornfeld, 619 F.2d 909, 922 (2d Cir. 1980). Respondents' Arguments Respondents argue: (1) reliance on advice of counsel is an absolute defense to securities fraud charges; (2) the Internal Revenue Service has exclusive jurisdiction on the tax-exempt status of the offerings; and (3) Attorney Peden's tax analysis was correct. Reliance on counsel's advice is not an absolute defense, and a person asserting reliance on counsel as a defense must show that he/she: (1) made a complete disclosure to counsel; (2) sought and received advice that the proposed conduct was legal; and (3) relied on that advice in good faith. Markowski v. SEC, 34 F.3d 99, 105 (2d Cir. 1994); SEC v. Goldfield Deep Mines Co. of Nevada, 758 F.2d 459, 467 (9th Cir. 1985); SEC v. Mechoir, [1992-1993 Transfer Binder] Fed Sec. L. Rep. (CCH) 97,356 at 95,838 (D. Utah, Jan. 14, 1993). This defense is inapplicable to Mr. Thorn because he lied and withheld several pieces of material information from underwriter's counsel. Mr. Thorn did not tell Attorney Peden that Mitchell had agreed to do all the work for compensation which did not include the $95,450; that Mitchell and Warren-Sherwood, Ltd. had entered a cost plus 10 percent construction contract before the Sherwood Garden offering closed on August 27; and that Mitchell would receive a 25 percent incentive fee for managing the property. Because he lied to counsel and withheld material information from him, and because he knew that information he distributed to investors was false and misleading, Mr. Thorn did not act in good faith in reliance on counsel's advice. Mr. Thorn claimed he directed Attorney Peden to structure a tax-exempt offering and then merely followed his instructions. According to Mr. Thorn, I said Derryl, are we going to do a taxable tail for this excess of two percent, or are we just going to put in the cash like we did in Clarksdale, which we went to the bank and borrowed the money and put it in. It was paid from the contractor's profits. He said well, let me get back to you. I don't remember exactly. He got back to me. He said John, you're working with [the] Mitchell Company, which are honorable people. He said they're going to be entitled to certain fees at the closing. They can take these fees, and what we're going to do is we're going to make these fees where they are going to exceed what we need in order to help make the project better because they were really entitled to more money. There's no doubt about that. ==========================================START OF PAGE 27====== Tr. 85. Contrary to his testimony given under oath, Mr. Thorn was not a naive client depending on legal counsel for advice in a difficult legal area in which he was unfamiliar. He is a college graduate with many years of specialized experience in this subject matter. In addition, there is testimony from Attorney Peden that perhaps Mr. Thorn was the one who came up with the structure for the seven offerings. Tr. 268. The evidence is persuasive that Mr. Thorn willingly and willfully participated as underwriter in these seven bond offerings and his participation was part of a scheme to defraud public investors. Mr. Thorn's college and theological education and his thirty years experience specializing in tax-exempt securities caused him to know that the material information he provided to the public was false, and that he omitted to disclose material information which was necessary to make statements he made not misleading. There are many points in the record where Mr. Thorn lied or where he could not remember information.-[38]- For example, Mr. Thorn lied in the investigative phase of this proceeding when he stated he was unaware that the bond's tax- exempt status depended on compliance with the 2 percent rule. Tr. 77-79. Contrary to his assertions, the evidence is persuasive that Mr. Thorn knew that: (1) issuance costs paid from the bond proceeds could not exceed 2 percent for the bonds to be tax-exempt; (2) Mitchell agreed to compensation that did not include $95,450; (3) the owner/developer would not be contributing funds; and (4) the Official Statement falsely represented that the developer was contributing funds to pay issuance costs over 2 percent. Tr. 76. Mr. Thorn assured Mitchell that the deal would be 100 percent financed and thus acquired for himself and others an equity interest in the projects. I reject respondents' defense that the Internal Revenue Service has exclusive jurisdiction in this area.-[39]- I ---------FOOTNOTES---------- -[38]- According to Mr. Stefan and Mr. Griffen, Mr. Thorn consistently stated that the deal would be 100 percent financed. Tr. 357. Mr. Thorn denied ever telling Mr. Stefan that the transaction would be financed 100 percent. Tr. 133-35, 144-45, 162. Mr. Thorn's position is that the offering was not 100 percent financed. Tr. 141-43. Mr. Thorn did not recall that the Official Statements represented that all but the last project were turnkey projects. Tr. 164. After the Commission began its investigation, Mr. Thorn tried to understand how the developer's contribution was handled at the closings. Tr. 165. -[39]- It is obvious that I deny respondents' defense that Attorney Peden's tax analysis was correct. ==========================================START OF PAGE 28====== denied the same argument on October 12, 1994, when respondents advanced it as an affirmative defense. Ruling On Motion to Strike Affirmative Defenses, 57 SEC Docket 2421 (1994). I find that TAW and Mr. Thorn willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and that TAW willfully violated, and Mr. Thorn willfully aided and abetted violations of, Section 15B(c)(1) of the Exchange Act and MSRB Rule G-17, by offering and selling the seven private activity bond offerings described herein to the public using Offering Statements that were false and misleading in material respects. Sanctions Bar and Revocation I find that revoking TAW's broker-dealer registration and barring Mr. Thorn from association with any broker or dealer and from dealing in municipal securities are necessary to protect public investors. As a substantial equity owner, firm president, and registered municipal securities principal, Mr. Thorn controlled TAW's involvement in these seven offerings. I therefore impute his knowledge and actions to TAW. SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1097 n.18 (2d Cir. 1972).-[40]- Mr. Thorn is a tax professional, with 30 years of specialization in tax-exempt offerings, who knew all the material facts. Acting with a high level of scienter, he committed egregious violations of the securities statutes and regulations. The illegalities were not isolated events but occurred in seven bond offerings during a 15 month period that totaled almost $19.5 million. The likelihood of future violations is high since the respondents do not acknowledge any wrongdoing or gddassurance that the violations will not reoccur. Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd, 450 U.S. 91 (1981). In addition to the Steadman criteria, other factors that persuade me that this sanction is necessary are Mr. Thorn's lack of candor, TAW's abysmal failure to carry out its underwriter's due diligence responsibilities, and the fact that TAW's primary concern was the personal financial benefit of persons in the firm with no concern for their responsibilities as securities professionals. Mr. Thorn's due diligence activities on the Sherwood Garden offering consisted of coordinating and talking with the construction company,-[41]- visiting the project, checking on the need for rental units by talking to people, and checking on rents in the area. Tr. 58-59, 71. Personally, Mr. Thorn only ---------FOOTNOTES---------- -[40]- See also Gotham Securities Corp., 46 S.E.C. 723, 727 n.19 (1976). -[41]- Mr. Thorn thought Mitchell was responsible for construction cost overruns even though the construction contract provided otherwise. Tr. 115. ==========================================START OF PAGE 29====== made sure the figures on the closing sheet added up. He let others check that disbursements occurred as represented.-[42]- Tr. 161-62. Mr. Yelverton, a TAW owner and director, acted in Mr. Thorn's absence. In doing due diligence on Sherwood Gardens, Mr. Yelverton relied on Mitchell for rental information and vacancy rates because "that is their business, and you have to rely on them for that." Tr. 949. Mr. Yelverton only read that part of the partnership agreement for Warren-Sherwood, Ltd. to make sure TAW got its agreed percentage. Tr. 954. TAW did not have a copy of the construction contract in its file. Tr. 956-57. Mr. Yelverton described the underwriter's responsibilities at the closing, "All I was assured of is that out of the closing we received the compensation that was coming to us. At that point I was satisfied." Tr. 969. Disgorgement Sections 8A of the Securities Act and 21C of the Exchange Act authorize the Commission to order an accounting and disgorgement, including reasonable interest, in cease and desist proceedings when, as here, respondents have violated the securities statutes and regulations. Disgorgement is an equitable remedy "uniquely suited to redress or cancel unfairness and promote investor confidence in securities transactions." SEC v. World Gambling Corp., 555 F.Supp. 930, 934 (S.D.N.Y. 1983). The deterrent effect of the Commission's enforcement efforts will be diminished if securities violators were not required to disgorge their illicit profits. Manor Nursing Centers, 458 F.2d at 1104. The rationale cited in the above cases is applicable to this situation. I find, therefore, that TAW and Mr. Thorn should disgorge the net underwriting fee they received on these seven offerings, plus pre-judgment interest; TAW received $117,376 and $116,827, and Mr. Thorn received $116,432. Counsel Ex. 1 at 15. I find further that Mr. Thorn should disgorge his equity interest in the seven partnerships that own the housing projects that were the subject of the offerings.-[43]- Counsel Ex. 1. Disgorgement wrests ill-gotten gains from the hands of the wrongdoer, and is meant to prevent the wrongdoer from enriching himself by his wrongs. SEC v. Huffman, 996 F.2d 800, 802 (5th Cir. 1993). ---------FOOTNOTES---------- -[42]- In his investigative testimony, Mr. Thorn said he made sure that disbursements were done according to the Sources and Applications of Funds in the Official Statement. Tr. 148-50. -[43]- The Division's position would allow Mr. Thorn to retain what he acquired by fraud. Division's Post-Hearing Brief at 31-32, n.32. ==========================================START OF PAGE 30====== Civil Penalty Section 21B of the Exchange Act provides for three tiers of monetary penalties in an administrative action where the respondents have willfully violated the securities statutes, regulations thereunder, or MSRB rules, and the penalty is in the public interest. The statute does not specify characteristics for the first tier. Tier two is applicable where the violations "involved fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement." Tier three is applicable where, in addition to the characteristics present at tier two, the violations caused substantial losses or the risk of such, or substantial pecuniary gain to the person who committed the violations.-[44]- I find it in the public interest to assess civil penalties at the highest level, $100,000 against Mr. Thorn and $500,000 against TAW. Mr. Thorn's unblemished record in the securities industry is outweighed by the following considerations: (1) his actions involved fraud, deceit, and deliberate or reckless disregard of the applicable laws and regulations; (2) his actions caused him to be unjustly enriched by partial ownership of seven housing projects which are valuable as real estate investments and as operating businesses: ---------FOOTNOTES---------- -[44]- The Division has recommended the application of penalties at the second tier of $50,000 against Mr. Thorn and $250,000 against TAW. Post Hearing Brief at 32; Reply Brief at 22. ==========================================START OF PAGE 31====== Mr. Thorn's Ownership Property Acquisition Record Property Interest Cost Before RehabCitation Sherwood Gardens 19.8% $ 525,000 Counsel Ex. 1 Northwest Plaza 13.2 315,000 Div. Ex.46 at 11 Eden Point 19.8 1,400,000 Div. Ex 70 The Pines 13.2 1,100,000 Div.Ex. 88 at 11-2 Northpark 19.8 670,000 Div. Ex. 82 at 12 Glen Oaks 14.9 2,030,000 Div. Ex. 39 at 11 The Lodge 19.8 1,100,000 Div. Ex. 66 at 11; (3) his actions could cause financial harm to persons who purchased these bonds relying on the false representation that the interest was tax-exempt; and (4) the securities industry presents many opportunities for fraud so that these strong penalties are necessary to deter others. Cease and desist A cease and desist order is applicable when, as here, the respondents violated the statutes and regulations.-[45]- Order Pursuant to Section 8A of the Securities Act, and Sections 15(b), 19(h), and 21C of the Exchange Act, I ORDER that the broker-dealer registration of Thorn, Welch & Co., Inc.,-[46]- be, and it hereby is, revoked, and that John E. Thorn, Jr., be, and he hereby is, barred from association with any broker or dealer and from dealing in municipal securities;-[47]- I FURTHER ORDER that Thorn, Welch & Co., Inc., disgorge $234,203, and that Mr. Thorn disgorge $116,432 and his equity interest in the seven limited partnerships that own the seven projects which were the subject of these bond offerings, plus prejudgment interest from November 1, 1993 through the last day of the month preceding which payment is made at the rate of interest established under Section 6621(a)(2) of the Internal ---------FOOTNOTES---------- -[45]- The Order Instituting Proceedings raises the possibility of an order requiring future compliance or steps to effect future compliance. In view of the other sanctions that I have ordered, it does not seem necessary. -[46]- The firm has changed its name to Thorn, Welch & Co., Inc. -[47]- The Division recommended that I bar Mr. Thorn from association with any investment adviser, investment company, and municipal securities dealer. I deny this request because the sections of the statutes which are the basis for this proceeding do not, in my opinion, provide for such broad sanctions. This issue is before the Commission. ==========================================START OF PAGE 32====== Revenue Code, compounded quarterly.-[48]- A copy of the letter transmitting the payment should be sent to the Atlanta District Office, Division of Enforcement, Securities and Exchange Commission. If and when the respondents pay 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. I FURTHER ORDER that Mr. Thorn and Thorn, Welch & Co., Inc. pay penalties of $100,000 and $500,000, respectively.-[49]- I FURTHER ORDER that John E. Thorn, Jr. and Thorn, Welch & Co., Inc., cease and desist from committing or causing any present or future violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, and that Thorn, Welch & Co., Inc. cease and desist from committing or causing, and Mr. Thorn cease and desist from aiding and abetting, any present or future violations of Section 15B(c)(1) of the Exchange Act and MSRB Rule G-17. 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 (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. ______________________________ Brenda P. Murray Chief Administrative Law Judge ---------FOOTNOTES---------- -[48]- I have used November 1, 1993, the first day of the month following the closing of the last bond offering at issue as the date to begin assessing interest. Payment should be made by certified check payable to the Securities and Exchange Commission, bearing on its face the caption John E. Thorn and Thorn, Alvis, Welch, Inc., Administrative Proceeding No. 3-8400. The check should be sent to the Office of the Comptroller, Room 2067, Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, on the first day after this decision becomes final. -[49]- Payment should be made in accordance with procedures outlined in n.48. ==========================================START OF PAGE 33====== Washington, D.C. May 2, 1996