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Securities and Exchange Commission
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In the Matter of MONETTA FINANCIAL SERVICES, INC., |
OPINION OF THE COMMISSION
INVESTMENT ADVISER PROCEEDING
INVESTMENT COMPANY PROCEEDING
CEASE-AND-DESIST PROCEEDING
Grounds for Remedial Action
Fraud
Aiding and Abetting Fraud
Alleged Material Misrepresentations
Registered investment adviser and its president, who was also president of registered investment companies, failed to disclose that investment adviser was allocating shares of initial public offerings to accounts of certain investment company directors and trustees. Held, it is in the public interest to censure investment adviser; suspend the president from association with any investment adviser and registered investment company for 90 days; to order investment adviser and president to cease and desist from committing or causing any violations and any future violations of the provisions that they were found to have violated; to impose civil money penalties of $200,000 oninvestment adviser and $100,000 on president; and to dismiss proceeding against trustee of investment company.
APPEARANCES:
Steven S. Scholes and Douglas G. Edelschick, of McDermott, Will & Emery, for Monetta Financial Services, Inc. and Robert S. Bacarella.
Peter B. Shaeffer, for Richard D. Russo.
Jane E. Jarcho, David S. Kempers, and Wendy D. Fox, for the Division of Enforcement.
Appeal filed: April 18, 2000
Last Brief received: September 26, 2000
Oral Argument: April 11, 2003
Monetta Financial Services, Inc., a Delaware corporation ("MFS"); Robert S. Bacarella, MFS' president, president and a director of the Monetta Fund, Inc. ("Monetta Fund"), and president and a trustee of the Monetta Trust, each investment companies; and Richard D. Russo, a trustee of the Monetta Trust (collectively, "Respondents"), appeal from the decision of an administrative law judge. The law judge found that MFS, Bacarella, and Russo willfully violated Section 17(a) of the Securities Act of 1933, 1 Section 10(b) of the Securities Exchange Act of 1934, 2 and Exchange Act Rule 10b-5. 3 The law judge also found that MFS willfully violated Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 and that Bacarella aided and abetted and was a cause of those violations. 4
The law judge ordered MFS, Bacarella, and Russo to cease and desist from committing or causing any violations and any future violations of those provisions. The law judge further:
We base our findings on an independent review of the record, except for those findings not challenged on appeal. 6
Bacarella formed MFS, a registered investment adviser, in June 1984. MFS is based in Wheaton, Illinois. Bacarella is the president and a director of MFS, and owns 71.1% of MFS' stock. 7
In May 1986, Bacarella formed the Monetta Fund, Inc. ("Monetta Fund"). The Monetta Fund is a Maryland corporation and an open-end diversified management investment company offering a single class of capital stock. In 1993, Bacarella was president, a director, and portfolio manager of the Monetta Fund. 8 TheMonetta Fund's assets increased dramatically in the early 1990s from approximately $7 million to $408 million on December 31, 1992. 9 By the end of 1993, the Monetta Fund's assets had increased to $524 million. In 1992, the Monetta Fund paid advisory fees to MFS in the amount of $2.25 million, which more than doubled to $5.11 million in 1993.
In January 1993, Bacarella organized the Monetta Trust, a Massachusetts business trust and an open-end diversified management investment company. The Monetta Trust began operations in March 1993. Bacarella was the president and a trustee of Monetta Trust. 10 The Monetta Trust offered shares in three series in 1993: the Mid-Cap Equity Fund ("Mid-Cap Fund"), the Intermediate Bond Fund ("Bond Fund"), and the Government Money Market Fund. In 1993, the Mid-Cap Fund had capital of approximately $10 million, and the Bond Fund was smaller. 11
On December 31, 1993, MFS had almost $620 million under management, including the Monetta Fund, the Monetta Trust, and350-500 individual advisory accounts. 12 MFS was the sole investment adviser to the Fund Clients, and the Fund Clients were MFS' only clients that were investment companies. Neither the Monetta Fund nor the Monetta Trust had any employees in 1993.
During the early 1990s MFS received shares of initial public offerings ("IPOs") from various broker-dealers. Richard Smith, an investment banker with NationsBank Montgomery Securities, testified that, at the end of 1992 or beginning of 1993, MFS' asset base was growing rapidly. In an effort to encourage MFS to do more business with Montgomery and thereby increase Montgomery's commissions, Montgomery agreed to offer MFS 10,000 shares of each new issue for which Montgomery was an underwriter. Bacarella proved astute at being able to distinguish which IPOs, on average, would be successful. 13
In accordance with their investment policies, the Monetta Fund, the Mid-Cap Fund, and the Bond Fund were permitted to invest in shares of IPOs. Because the majority of MFS' individual accounts were so-called "wrap accounts," MFS determined that these accounts would not receive IPOs. 14
However, MFS permitted at least twenty individuals to receive allocations of IPO shares. In order to receive allocations, MFS required an individual client who wished to receive IPO allocations to open an account at the Old Kent Bank ("Old Kent") with sufficient funds. 15 The Old Kent accounts were used exclusively for transactions in IPO shares. Although Russo, Valiant, and Henry formally granted MFS full discretion over their accounts, they each testified that Bacarella had exclusive control over the Old Kent accounts. Bacarella often "flipped" the IPO shares, i.e., sold them within a day or two.
Bacarella testified that MFS had general guidelines to ensure that IPOs were equitably distributed among both the Fund Clients and the individual accounts. 16 Bacarella admitted, however, that he did not adhere strictly to the guidelines. 17 Bacarella further testified that he purchased IPO shares for individual Old Kent accounts on a rotating basis. According to Bacarella, when MFS received an IPO allocation, he asked Tim Cekal, then president of Monetta Brokerage and an MFS trader, to provide a list of Old Kent accounts that had not recently received an IPO allocation and that had sufficient funds to purchase the particular IPO. Bacarella testified that he never allocated an IPO to an individual client that was not on Cekal's list. Bacarella did not retain any of these lists. 18
Between January and September 1993, MFS participated in over fifty IPOs. 19 Two trustees of the Monetta Trust — Richard Russo and William Valiant — and Paul Henry, a director of the Monetta Fund (collectively the "Director-Clients"), participated in a total of thirteen of these IPOs. Neither Bacarella nor any of these Directors-Clients disclosed the fact of the IPO allocations to any of the remaining members of the Fund Clients' boards or to the shareholders of the Fund Clients. 20
Russo is an attorney and a personal friend of Bacarella. 21 In 1988, Russo and his wife opened a jointaccount with Monetta Brokerage, and in 1989 gave Bacarella discretion to manage the account. Near the end of 1991, Russo opened a custodial account to effect IPO transactions at Old Kent with a deposit of approximately $87,000. As noted above, Bacarella exercised full discretion to manage Russo's Old Kent account. Between December 1991 and January 1993, Bacarella allocated shares in six IPOs to Russo's Old Kent account. The sale of these shares earned Russo approximately $31,000.
At Bacarella's request, Russo became an independent trustee for Monetta Trust when it was formed in January 1993. 22 Between January 1993, when Russo became a trustee, and September 1993, Bacarella allocated shares in nine IPOs to Russo's account. 23 Bacarella's sale of these shares earned Russoapproximately $28,000. Russo did not disclose his IPO transactions to the remaining Monetta Trust trustees. 24
William M. Valiant was Vice President and Treasurer of Borg-Warner Corporation from 1976 to 1990. Valiant met Bacarella in the 1970s when Bacarella also worked for Borg-Warner. In 1988, Valiant became a director of MFS and opened an account with Monetta Brokerage. 25
In August 1992, Valiant deposited $50,000 in an Old Kent account for investment in IPOs. As with Russo, MFS nominally had complete discretion over Valiant's account, but Bacarella controlled trading in the account. Valiant received three IPO allocations in late 1992 that Bacarella then sold for profits of over $33,000.
Valiant became an interested trustee of the Monetta Trust when it was established in January 1993, and continued to receive IPO allocations. After he became a trustee, Valiant received four IPO allocations that Bacarella sold for a profit of approximately $12,000. 26 While Valiant did not personallydisclose his IPO trades to the other trustees of the Monetta Trust, he did disclose them on reports pursuant to IC Act 17j-1 that he filed with the Monetta Trust in June and September 1993.
Paul W. Henry met Bacarella at Borg-Warner in the 1970s, where Henry was manager of financial systems. Henry joined the Monetta Fund at its inception. In 1986, Bacarella appointed Henry a director and vice president of the Monetta Fund. 27
Unlike Russo and Valiant, Henry was already an interested director of the Monetta Fund at the time that he opened his Old Kent account. Henry deposited $50,000 in an Old Kent account in February 1993 and gave complete discretion over the account to MFS, discretion that Bacarella exclusively exercised. During 1993, Henry received four IPO allocations that Bacarella sold for approximately $10,000 in profits. 28 Unlike Valiant, Henry did not disclose any of his IPO trades on the reports he filed he filed with the Monetta Fund pursuant to IC Act Rule 17j-1 in March, June, and September 1993.
* * *
Bacarella stopped allocating shares in IPOs to Valiant and Henry in July 1993. From the record, it appears that Bacarellabecame concerned that these allocations contravened the National Association of Securities Dealers, Inc. ("NASD") Free-Riding and Withholding Interpretation. 29 Bacarella stopped allocating IPOs to Russo in September 1993 after he became aware of adverse publicity about investment company insiders trading in the same securities as their funds.
The Division alleges that MFS willfully violated and Bacarella willfully aided and abetted and was a cause of MFS's violations of Advisers Act Section 206. Advisers Act Section 206(2) makes it unlawful for any investment adviser "to engage in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client." A person is liable as an aider and abettor of a securities law violation if (1) another person commits a primary violation; (2) the aider and abettor generally was aware or knew that his or her actions were part of an overall course of conduct that was improper or illegal; and (3) the aider and abettor substantially assisted the primary violation. 30
In SEC v. Capital Gains Research Bureau, Inc., 31 the Supreme Court observed that the Advisers Act "reflects a congressional recognition <of the delicate fiduciary nature of an investment advisory relationship,' as well as a congressionalintent to eliminate, or at least to expose, all conflicts of interest. . . ." 32 The Court cited a Commission report 33 that led to the enactment of the Advisers Act, which concluded:
that investment advisers could not "completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed." 34
The Court held that an investment adviser has "an affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' his clients." 35 An investment adviser must disclose, and, if possible, eliminate all conflicts of interest.
MFS, through Bacarella, allocated IPOs to a director and trustees of its Fund Clients. MFS and Bacarella argue that MFS had an equal fiduciary obligation to all its clients, whether Fund Client or individual, to provide them access to investment opportunities, including IPOs. 36 Bacarella admitted that IPOs were limited valuable assets that he wanted to acquire for hisclients, including the Fund Clients. 37 However, when Bacarella invited Valiant and Russo, who were existing MFS clients, to becomes trustees of MFS, and subsequently permitted Henry, already a Monetta Fund director, to open an Old Kent account, he placed the Director-Clients in the role of competing with the Fund Clients for IPOs. 38 Bacarella did not disclose the fact of any of the allocations to either the Monetta Fund's Board of Directors or the Monetta Trust's Board of Trustees. 39
The significance of the conflict in the allocation was exacerbated by the important role played by directors of investment companies. Investment company directors, and particularly the independent directors, are responsible, amongother things, for evaluating an investment company's adviser. The Fund Clients, like many investment companies, were organized and operated by their adviser, MFS. The Fund Clients depended on MFS for advice and their day-to-day operations. We have stated that an investment company must be operated for the benefit of its shareholders even though the adviser has a responsibility and loyalty to its own shareholders. 40 Thus, the Investment Company Act relies on fund boards of directors to police the conflicts of interest between funds and their investment advisers 41 and gives independent directors a particularly important role in fund governance.
Bacarella's allocation of IPOs to the Director-Clients, and particularly to Russo, who Monetta Trust identified in its public filings as an independent director, created the potential that the Director-Clients would favor MFS' interests over those of the Fund Clients. Among other things, IC Act Section 15(c) requires that a majority of the directors, including a separate majority of the independent directors, must vote to approve the contracts between the investment company and the adviser. 42
Bacarella argues that there was no review by the directors or trustees of MFS' advisory contracts between February and October of 1993, and that there is no other evidence that any director was influenced by the allocations. As the Court in Capital Gains recognized, the occurrence of "actual inequitable conduct" is irrelevant. The failure to disclose conflicts is the practice:
with its potential for abuse, which "operates as a fraud or deceit" within the meaning of the [Advisers] Act when relevant information is suppressed. The Investment Advisers Act of 1940 was "directed not only at dishonor, but also at conduct that tempts dishonor." 43
Bacarella had scienter. He exercised complete discretion over the Old Kent accounts and determined which of the FundClients and Old Kent accounts received IPO allocations. 44 He invited Valiant and Russo to become trustees and permitted Henry, an existing director, to receive IPOs. He did not disclose these transactions to the remaining members of the Board. 45
Bacarella asserts that he relied upon the advice of counsel. 46 Bacarella contends that, after the January 19, 1993 organizational meeting of the Monetta Trust, he discussed with Janet Olsen, outside counsel to MFS and the Fund Clients, the legality of allocating shares of IPOs to Valiant and Russo. He testified that he told Olsen that Valiant and Russo were MFS clients, and asked whether there would be a problem with them continuing to receive IPOs from MFS now that they were trustees of Monetta Trust. Bacarella contended that Olsen advised that, as long as Valiant and Russo were not employees of the Monetta Trust, she saw no conflict at all. Olsen testified that she had no recollection of this conversation and did not believe it occurred.
The law judge, who observed the demeanor of the witnesses, credited Olsen's testimony and did not credit Bacarella's testimony. The law judge noted that Bacarella did not explain why he waited to ask such a critical question until the meeting was over and the remaining directors, including Valiant and Russo had left. The law judge further cited Olsen's testimony that, if she had been asked whether allocations to Valiant or Russo were proper, she would have needed additional information before she could have responded. 47 The credibility determinations of the fact finder are entitled to considerable weight unless contradicted by substantial evidence. 48 There is no suchevidence in this case. Moreover, Bacarella never sought a formal written legal opinion from Olsen or any other outside counsel. He also never raised the subject for discussion at quarterly board meetings where legal counsel was present.
Bacarella further exhibited a lack of candor with Commission examiners. In a November 1993 interview, the examiners asked Bacarella about how Valiant had obtained the IPO allocations reported pursuant to IC Act Rule 17j-1. Bacarella stated that did not know why Valiant was in a position to receive these allocations, but suggested that it might be due to Valiant's contacts as an executive with Borg-Warner. Bacarella did not disclose that he had effected these transactions on Valiant's behalf. Nor did Bacarella inform the examiners that he had made allocations to Russo or Henry. 49
* * *
For these reasons, we conclude that MFS, acting through Bacarella, willfully violated, and Bacarella willfully aided and abetted and was a cause of MFS' violations of Advisers Act Section 206(2). 50
MFS, Bacarella, and Russo each are charged with violations of Securities Act Section 17(a), Exchange Act Section 10(b), and Exchange Act Rule 10b-5. The Division argues that Respondents improperly failed to disclose MFS' allocations of "hot" IPOs to the Director-Clients. As we describe below, we are dismissing the charges against MFS, Bacarella, and Russo under Securities Act Section 17(a), Exchange Act Section 10(b) of the Exchange Act, and Exchange Act Rule 10b-5. 51
We wish to make clear that we dismiss these disclosure allegations for evidentiary reasons. If an independent fund director maintains an account with a fund's investment adviser in order to receive allocations of securities of limited availability, such as IPOs, that may be available to the fund, a conflict of interest exists where the independent director's judgment may be compromised. Therefore, the existence of the account and the trading in the account should initially be disclosed and approved by the fund's independent directors. When Congress amended the Investment Company Act in 1970, it recognized that directors may engage in retail transactions with investment advisers to their fund so long as the directors do not receive "special treatment." We believe that, at a minimum, special treatment would include granting a director or trustee access to a transaction with the adviser because of that person's status as a fund's director or trustee. We also believe that allocation of a security of limited availability, particularly an IPO, constitutes a "red flag" that would strongly indicate special treatment. If such special treatment is accorded to a fund's director or trustee, we believe that a fund would face ahigh burden to justify why disclosure to investors of that transaction is not appropriate. 52
Here, there is insufficient evidence on the record before us to make a determination as to whether the Director-Clients received treatment that was any different from MFS' other individual adviser clients. One of the factors that we consider is whether the director or trustee participated in the transaction on the same terms as any person not affiliated with the fund could have obtained in an arm's-length transaction. As noted, at least 17 other MFS clients had Old Kent accounts managed by Bacarella that received IPO allocations. Several of these 17 accounts received more IPO shares than either Valiant or Henry and at least two other clients received more shares than Russo. We cannot discern from the record what criteria were used to open Old Kent accounts for these seventeen clients; what, if any, pre-existing relationship they had with MFS or Bacarella; and whether other clients were offered the opportunity to open Old Kent accounts. This information would have substantially aided our analysis. On this record, we cannot find by a preponderance of the evidence that the Division has met its burden. 53
The Division further asserts that Bacarella consistently allocated "hotter" or better performing IPOs to the Director-Clients while the Fund Clients received IPOs that were less hot or even cold. MFS and Bacarella argue that they could not know which IPOs would be hot and which cold until secondary trading in the particular offering began. The expert testimony, however, demonstrates that an experienced professional can predict when the opening trading price of an IPO in the secondary market likely will be greater than the offering price, i.e., be considered hot. The Respondents' expert testified that her research showed that some IPOs will have better than average initial returns based upon the increase of the offering price in the prospectus amendments before the opening of secondarytrading. Another strong indicator of the "hotness" of an IPO offering, according to the Division's experts, is the ratio of indications of interest to the size of the offering. 54 Generally, an offer that is four to five times oversubscribed is in the range to be considered hot. 55 Bacarella was aware of the over-subscription ratios of the IPOs offered to MFS. The record demonstrates that broker-dealers disclosed these ratios to their customers.
In its briefs, the Division cites the statistical analysis of one of its expert witnesses to show that the Director-Clients received "hotter" IPOs than did the Fund Clients. The expert reported that the IPOs allocated to the Director-Clientsincreased from the offering price to the first public trade an average of 34.2% while those allocated to the Fund Clients increased 24%. He characterized this difference in performance as "significant." However, the expert did not present the results of any test for the level of statistical significance, such as standard deviation. Without that evidence, we cannot conclude whether the difference in performance of the transactions effected by the Director-Clients and those effected by the Fund Clients is attributable to Bacarella's allocations or a result of simple random variation.
The expert also performed a "bootstrap" analysis. 56 The expert took fifty IPOs received by MFS, and calculated the likelihood that thirteen of those fifty IPOs could be allocated that would generate returns at least as good as those received by the Director-Clients. The expert concluded that it was unlikely that the particular thirteen IPOs assigned to the Director-Clients were chosen at random. However, this analysis makes certain assumptions that are not supported by the record. For example, the analysis assumes that all the allocations occurred simultaneously. Here, the IPOs were not all available simultaneously, and the allocations occurred over an eight-month period.
The expert used the actual percentages of increase in the IPOs from offer to the beginning of secondary trading. Respondents argue that the precise amount of increase can only be known after the fact. We agree. While, as discussed above, an experienced securities professional can discern with reasonable accuracy whether an IPO is likely to be hot, the record also demonstrated that it is difficult to discern the precise degree of "hotness." Thus, while we believe a skilled professional could identify a potentially hot IPO, we do not find that the professional could predict whether that IPO would increase, for example, by 15% rather than 25% at the opening.
Bootstrapping also leaves open the possibility that some outside factor might have caused the particular allocation. Bacarella testified that one of the criteria for allocating IPOs to an Old Kent account was whether the account had money to pay for the particular allocation on the day that it was available. While Bacarella's testimony is the only evidence that this was a criterion for allocating IPOs to a particular individual account, his assertion is consistent with business practice in the securities industry. 57
We thus are unable to conclude by a preponderance of the evidence that Bacarella gave the Director-Clients preferred access to IPOs, allocated "hotter" IPOs to the Director-Clients than he allocated to the Fund Clients, or otherwise gave the Director-Clients preferred treatment. 58
Agencies have substantial discretion in assessing administrative sanctions. 59 In determining whether administrative sanctions serve the public interest, we are guided by the following factors: the egregiousness of a respondent's actions, the isolated or recurrent nature of the violation, the degree of scienter, the sincerity of a respondent's assurances against future violations, the respondent's recognition that the conduct was wrongful, and the likelihood of recurring violations. 60 Advisers Act Section 203(k) further authorizes the Commission to impose a cease-and-desist order if it finds that any person has violated or caused violations of the Act. 61 We have stated that, in determining whether a cease-and-desist order is appropriate, we will consider, along with the risk of future violations, the factors listed above. 62
MFS, through Bacarella, ignored its fiduciary duty to disclose material information to those entitled to its utmost loyalty and good faith. Bacarella acted with scienter. Bacarella made no effort to disclose these transactions to the remaining directors and trustees and was not candid with the Commission's examiners. Bacarella's actions and his testimony at the hearing evince a lack of understanding of his fiduciary obligations. MFS' and Bacarella's insistence that, since no actual conflict existed, they had no duty to disclose the information to the Fund Clients' boards shows a lack of appreciation for MFS' obligations as an adviser to an investment company.
In light of these circumstances, we conclude that MFS' and Bacarella's violations pose a sufficient risk of futureviolations to warrant cease-and-desist relief. We censure MFS. We also find that it is in the public interest to suspend Bacarella from associating with an investment adviser for a period of 90 days, and to impose civil monetary penalties on MFS in the amount of $200,000, and on Bacarella, in the amount of $100,000.
An appropriate order will issue. 63
By the Commission (Chairman DONALDSON and Commissioners GLASSMAN, GOLDSCHMID, ATKINS, and CAMPOS).
Jonathan G. Katz
Secretary
In the Matter of MONETTA FINANCIAL SERVICES, INC., |
ORDER IMPOSING REMEDIAL SANCTIONS
On the basis of the Commission's opinion issued this day, it is
ORDERED that Monetta Financial Services, Inc. and Robert S. Bacarella shall cease and desist from committing or causing any violations or any future violations of Section 206(2) of the Investment Advisers Act of 1940; and it is further
ORDERED that respondent Monetta Financial Services, Inc. be, and hereby is, censured; and it is further
ORDERED that Robert S. Bacarella be, and hereby is, suspended from associating with any investment adviser and from associating with any investment company for 90 days effective at the opening of business on June 23, 2003; and it is further
ORDERED that Monetta Financial Services, Inc. and Robert S. Bacarella be, and hereby are, assessed civil money penalties of$200,000 and $100,000, respectively. Each respondent's payment of the civil money penalty shall be: (a) made by United States postal money order, certified check, bank cashier's check, or bank money order; (b) made payable to the Securities and Exchange Commission; (c) delivered by hand or courier to the Comptroller, Securities and Exchange Commission, 6432 General Green Way, Alexandria VA 22312; and submitted under cover letter that identifies the particular respondent in this proceeding, as well as the Commission's administrative proceeding file number. A copy of this cover letter and money order or check shall be sent to Wendy D. Fox, Securities and Exchange Commission, Midwest Regional Office, 175 West Jackson Boulevard, Suite 900, Chicago, Illinois 60604; and it is further
ORDERED that this proceeding is dismissed with respect to Richard D. Russo.
By the Commission.
Jonathan G. Katz
Secretary
1 15 U.S.C. § 77q.
2 15 U.S.C. § 78j.
3 17 C.F.R. § 240.10b-5.
4 15 U.S.C. § 80b-6.
5Paul W. Henry, a director of the Monetta Fund, and William M. Valiant, a trustee of the Monetta Trust, were also respondents below. The law judge found that Henry willfully violated Securities Act Section 17(a), Exchange Act Section 10(b), Exchange Act Rule 10b-5, Section 17(j) of the Investment Company Act of 1940 ("IC Act"), and IC Act Rule 17j-1. The law judge suspended Henry from association with a registered investment company for 30 days, imposed a $10,000 civil money penalty on him, and ordered him to disgorge $10,187.50, plus prejudgment interest. The law judge dismissed the proceedings as to Valiant.
Neither Henry nor the Division appealed the initial decision. See Monetta Financial Services, Inc., Initial Decision Rel. No. 162 (Mar. 27, 2000), 72 SEC Docket 72. The Commission gave notice that the law judge's decision was final as to Henry and Valiant. Exchange Act Rel. No. 42768 (May 9, 2000), 72 SEC Docket 1120.
6 Rule of Practice 451(d), 17 C.F.R. §201.451(d), permits a member of the Commission who was not present at oral argument to participate in the decision of the proceeding if that member has reviewed the oral argument transcript prior to such proceeding. Commissioners Atkins and Campos have reviewed the transcript of the oral argument.
7 In 1987, Bacarella also formed Monetta Brokerage, Inc. ("Monetta Brokerage"), a registered broker-dealer affiliated with MFS. In 1993, Bacarella was the secretary, treasurer, a director, and a shareholder of Monetta Brokerage.
8 In 1993, there were five directors of the Monetta Fund: Bacarella; Paul W. Henry (a director and former vice president of the Monetta Fund, a director of MFS, and shareholder in Monetta Brokerage); John W. Bakos (a director of MFS, former vice president of the Monetta Fund, and a shareholder in the Monetta Brokerage); John Rozinsky (compliance director for MFS, Monetta Fund, and Monetta Trust, a director of MFS, vice president, trustee, and treasurer of the Monetta Trust, and vice president, director, and a shareholder in Monetta Brokerage); and Mark F. Ogan.
IC Act Section 2(a)(19)(A) defines an "interested person" of an investment company to include, among others, any affiliated person of the investment company or any interested person of any investment adviser of the investment company. IC Act Section 2(a)(3) includes within the definition of an "affiliated person" any officer of director or owner of 5% or more of the entity's voting securities. A director who is an "interested" person of an investment company is disqualified from being considered a "disinterested" or "independent" director. See, e.g., Role of Independent Directors of Investment Companies, Investment Company Act Rel. No. 24082 (Oct. 14, 1999), 70 SEC Docket 2529 ("Proposing Release") at n.21 and accompanying text.
All of the directors, except Ogan, were "interested persons," as defined by the IC Act, of the Monetta Fund. Bacarella was an officer of the Monetta Fund and a 71% shareholder, officer, and director of MFS, the Monetta Fund's adviser. Henry was an officer of the Monetta Trustand a director of MFS. Bakos was a director of MFS. Rozinsky was an officer of the Monetta Fund and an officer and director of MFS.
9 At year-end 1991, the Monetta Fund had net assets of $57 million.
10 There were seven Trustees of the Monetta Trust: Bacarella, Rozinsky, James Boves (vice president, trustee, and portfolio manager of the Monetta Trust), William Valiant, Russo, Ogan, and John L. Guy, Jr. Four of the trustees were "interested persons" of the Monetta Trust: Bacarella, Rozinsky, and Boves were officers of the Monetta Trust and officers and directors of MFS. Valiant was a director of MFS. The Monetta Trust designated Russo as one of three independent trustees, along with Ogan and Guy.
11 We will refer to the Monetta Fund, Mid-Cap Fund and the Bond Fund collectively as the "Fund Clients."
The Government Money Market Fund did not receive allocations of shares in initial public offerings. This fund is a money market fund that invested only in U.S. Government securities maturing in less than 13 months. Its activities are not at issue in this proceeding.
12 These accounts were maintained by natural persons, individual retirement accounts, and individual companies.
13 In 1993, the average increase from offering price to opening day trading price for all IPOs was 11.6%. For the IPOs Bacarella selected for the Fund Clients, the average increase was 24.9%, and for the accounts of Valiant, Henry, and Russo, which are at issue here, the average increase was 34.2%.
14 According to its Form ADV, MFS was retained under a so-called "wrap fee" arrangement offered through broker-dealers. Various broker-dealers would recommend retention of MFS as investment adviser, pay MFS' advisory fee on behalf of the client, monitor and evaluate MFS' performance, execute the client's portfolio transactions without commission charge, and provide custodial services for the client's assets, all for a single fee paid by the client to the broker-dealer.
According to Bacarella, the members of an underwriting syndicate would refuse to deliver shares of an IPO to a broker-dealer that was not a member of the syndicate. Since the assets of the wrap accounts were held at a particular broker-dealer, which might not be a member of the syndicate,MFS did not allocate IPOs to its "wrap account" customers.
15 Beyond the requirement that a client maintain an Old Kent account, we cannot determine from the record why each of these clients received IPO allocations. Aside from Valliant, Henry, and Russo, the only information we have about the remaining accounts is the account names and the amounts of the IPO allocations to each account. We cannot determine the scope of their pre-existing advisory dealings with MFS, whether they had any relationship with MFS or Bacarella beyond that of adviser-client, and whether any other of MFS' individual clients were offered the opportunity to open an Old Kent account and declined.
16 Bacarella claimed that, as a general rule, if MFS were offered more than 10,000 shares of a particular IPO, Bacarella would give the Monetta Fund preference in allocation of the IPO shares. If MFS were offered less than 10,000 shares, Bacarella would normally give preference to MFS' smaller eligible accounts, although, if the portfolio manager expressed interest, a fund might obtain shares from such an allocation.
17 Allocations made to the Fund Clients during 1993 demonstrate that the guidelines were not always followed. The Monetta Fund received 10,000 or more shares in only fourteen out of twenty-nine IPOs allocated to it during this period. In seventeen allocations, the Mid-Cap Fund received 10,000 or more shares on two occasions, and the Bond Fund received three allocations, all for 1,000 or fewer shares. In threeinstances when MFS received 10,000 or more shares in an IPO, none of the shares were allocated to the Fund Clients.
18 Between 1993 and the hearing Tim Cekal died. He did not testify during the Division's investigation.
19 There is some confusion as to the number of IPOs in which MFS participated between January and September 1993. Our review of the record identifies fifty-three IPOs received by MFS, although there is little or no data for three of those allocations. The Initial Decision stated that MFS participated in fifty-one IPOs, a number used in one expert's report. That number (fifty-one), however, appears to include one IPO that was allocated to another adviser affiliated with MFS. The Division's expert based his bootstrap analysis on fifty IPOs. See discussion following note 51 infra.
20 But see text following note 25 infra.
21 Russo maintained a solo general practice concentrating in residential real estate, criminal defense, personal injury,estate planning, general civil litigation, and organization of small corporations. He testified that he never practiced securities law.
22 Russo was also a member of the Monetta Trust audit committee. Russo received compensation of $100 for every meeting he attended. From January, 1993 through September, 1993, Russo received $300 in compensation for his service as a trustee.
23 Between February 1993 and September 1993, Russo received allocations in the following IPOs:
| Company | Shares | Transaction Dates | Fund Shares* |
|---|---|---|---|
| Powersoft | 200 | 2/93 | n/a |
| Wall Data | 100 | 3/93 | M Fund 48,000 |
| Parallan Computer | 1,000 | 3/93 | M Fund 10,000 |
| BHC Financial | 1,000 | 4/93 | M-Cap 4,000/Bond 700 |
| Catalyst Semiconductor | 1,000 | 5/93 | n/a |
| Papa Johns Int'l | 1,000 | 6/93 | M Fund 4,000 |
| Wonderware | 1,000 | 7/93 | M Fund 6,000 |
| Cyrix Corp. | 2,500 | 7/93 | n/a |
| Netmanage, Inc. | 500 | 9/93 | M Fund 10,000 |
* M Fund = Monetta Fund; M-Cap = Mid-Cap Fund; Bond = Bond Fund.
John Alogna, who made the investment decisions for the Mid-Cap Fund, testified that, he did not express interest inpurchasing shares for the Mid-Cap Fund in the Powersoft, Wall Data, Parallan, Catalyst, Papa Johns, Wonderware, Cyrix, or Netmanage IPOs. Russo was not a director of the Monetta Fund.
24 IC Act Rule 17j-1 requires "interested persons" (within the meaning of IC Act Section 2(a)(19)) of a fund to make certain initial, quarterly, and annual transaction and holdings reports to their funds. These reports detail the title, number of shares, and principal amount of the securities held, and the name of any broker-dealer or bank with whom the "interested person" maintained an account in which any securities were held. Because Russo was an independent trustee, he was not an "interested person" required to file a 17j-1 report.
25 Valiant also owned shares in Monetta Brokerage.
26 Valiant received allocations in the following IPOs:
| Company | Shares | Transaction Dates | Fund Shares |
|---|---|---|---|
| 3 Do Co | 1,000 | 5/93 | n/a |
| Papa Johns Int'l | 500 | 6/93 | M Fund 4,000 |
| Sunglass Hut | 500 | 6/93 | M Fund 3,000 |
| Broadband Technology | 500 | 6/93 | M Fund 5,000/M Cap 5,000 |
27 Henry owned 2.22% of the voting shares of MFS and 2.55% of the voting shares of Monetta Brokerage. He was a brokerage client of Monetta Brokerage.
28 In 1993, Henry received shares in the following IPOs:
| Company | Shares | Transaction Dates | Fund Shares |
|---|---|---|---|
| BHC Financial | 1,000 | 4/93 | M-Cap 4,000/Bond 700 |
| Auspex | 500 | 5/93 | n/a |
| Papa Johns Int'l | 500 | 6/93 | M Fund 4,000 |
| Sunglass Hut | 500 | 6/93 | M Fund 4,000 |
29 The NASD's Free-Riding and Withholding interpretation requires every participating broker-dealer in a public offering to make a "bona fide" distribution to the public. In 1993, this interpretation prohibited the sale of any "hot" security to, among others, any senior officer or employee or other person who might influence a registered investment company or registered investment advisory firm. NASD Manual (July 1994), ¶ 2151.06 at p. 2032.
30 Graham v. SEC, 222 F.3d 994, 100 (D.C. Cir. 2000); Donald T. Sheldon, 51 S.E.C. 59, 62 (1992), aff'd 45 F.3d 1515 (11th Cir. 1995).
31 375 U.S. 180 (1963).
32 Id. at 191.
33 Investment Trusts and Investment Companies, Report of the Securities and Exchange Commission, Pursuant to Section 30 of the Public Utility Holding Company Act of 1935, on Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services, H.R. Doc. No. 76-477 (1939) ("SEC Report").
34375 U.S. at 187, citing SEC Report at 28.
35 Id. at 194.
36 Respondents' argument that their actions were in furtherance of their ongoing duty to their individual clients is undercut by Bacarella's allocation of IPOs to Henry. Henry opened his Old Kent account only after he became a director of the Monetta Fund. Henry had learned of the opportunity to receive these IPO allocations because of his status as an MFS and Monetta Fund affiliate.
37 MFS' and Bacarella's argument that they had a duty to allocate IPO shares equitably among both the Fund Clients and individual accounts necessarily concedes that IPOs are limited and valuable opportunities, which could not be offered to every client. In any given IPO allocation, one client likely would have to be preferred over another.
38 MFS and Bacarella argue that the fact that MFS would allocate shares of IPOs was disclosed in public filings. However, MFS' Forms ADV, which address the purchase of securities by affiliates of MFS, does not disclose that Fund Client directors or trustees might compete for securities with the Fund Clients.
The Fund Clients filed Forms N-1A that state that MFS may purchase or sell the same class of securities for the Fund Client and other advisory clients and that if it does so on the same day, MFS will "allocate [the securities] in a manner considered equitable." This statement does not reveal that the Director-Clients were among MFS' "other advisory clients."
Only Valiant reported his transactions pursuant to IC Act Rule 17j-1. Russo was not required to make such a filing, and Henry failed to disclose his IPO transactions.
39 Both Boves and Rozinsky testified that Bacarella did not inform them of any of the IPO allocations to Valiant, Henry, or Russo before October 1993. Rozinsky stated that he had seen Valiant's IC Act Rule 17j-1 reports and that he knew what IPOs were. Rozinsky further stated that he did not realize that Valiant was receiving IPOs from MFS because Rozinsky was aware that Valiant had "brokerage relationships" outside of the Monetta companies.
40 Proposing Release, 70 SEC Docket at 2530.
41 Id. at 2530-31.
42 15 U.S.C. § 80a-15(c).
43375 U.S. at 200, quoting U.S. v. Mississippi Valley Generating Co., 364 U.S. 520, 549 (1961).
44 Bacarella claims that John Alogna, Portfolio Manager for The Mid-Cap Fund and James Boves, Portfolio Manager for the Intermediate Bond Fund and a trustee of the Monetta Trust, allocated two IPOs in 1993 while he was on vacation. Nothing in the record confirms this claim. In fact, although Bacarella met with Alogna and Boves daily, Boves testified that Bacarella never informed him that Russo, Valiant, or Henry were receiving IPOs.
45 Bacarella testified that he allocated IPOs in accordance with certain internal guidelines. However, he admittedly did not always follow these guidelines. It appears that no records were kept to show how determinations were made concerning the allocations. Because Bacarella failed to inform the remaining directors or trustees about allocations to the Director-Clients, the Fund Clients' Boards could not monitor Bacarella's determinations or seek improvements in IPO allocations.
46 The essential elements for an effective reliance on advice of counsel defense are that a person: (1) made a disclosure to counsel of the intended action; (2) requested counsel's advice as to the legality of the intended action; (3) received counsel's advice that the conduct would be legal; and (4) relied in good faith on that advice. Markowski v. SEC, 34 F.3d 99, 104-05 (2d Cir. 1994).
47 Olsen testified that she would have wanted to know, among other things, the basis for any allocation and the nature of the underlying client relationship.
48 See Anthony Tricarico, 51 S.E.C. 457, 460 (1993).
To bolster his claim, Bacarella elicited the testimony of three MFS employees, Rozinsky, Valerie Lefevre, and Maria DeNicolo. Rozinsky gave what the law judge described as contradictory testimony at the hearing. She found more reliable his investigatory testimony in which Rozinsky stated that he had no clear recollection of even being aware that any Fund Client director or trustee had received shares of IPOs until after October 31, 1993. We find no reason to disturb the law judge's assessment. See Michael J. Fee, 50 S.E.C. 1124, 1125 (1992)(investigatory testimony can be favored over live testimony).
Lefevre testified that Rozinsky told her that the Fund Clients' attorney had stated that it was proper for Valiant to receive allocations of IPO shares. However, Lefevre could not recall when the conversation occurred or what particular transaction she was discussing. In any event, since Rozinsky was not aware of the allocations until October, his conversation with Lefevre could not have occurred before that date.
The law judge also found DeNicolo's testimony to be suspect. DeNicolo claimed that, while she was cleaning up the room following the January 1993 meeting of the trustees of the Monetta Trust, she overheard Bacarella ask Olsen whether, since Valiant was now a director, it would be a problem for him to continue to receive IPOs. DeNicolo stated that Olsen told Bacarella that, as long as Valiant was not an officeror employee, it would not be a problem. The law judge discounted DeNicolo's testimony, noting that she appeared to be fiercely loyal to Bacarella, and that her livelihood was tied directly to Bacarella's continued success. We further note that DeNicolo's description of the conversation with Olsen differed from Bacarella's testimony that he asked Olsen about both Valiant and Russo.
49 Bacarella's failure to inform the examiners about the allocations further undercuts his insistence that he had an opinion of counsel that the allocations were permissible. If he had had such an opinion, it would be reasonable immediately to bring it to the attention of the examiners.
50 As noted, the law judge also found that Bacarella aided and abetted and was a cause of MFS' violations of Advisers Act Section 206(1). It appears that these findings are based on her conclusions that Respondents violated Securities Act Section 17(a), Exchange Act Section 10(b), and Exchange Act Rule 10b-5. Because we dismiss those violations for the reasons set forth below, we also dismiss the alleged violations of Advisers Act Section 206(1).
51 The Commission has the authority to bring an action in district court against, among others, a fund's adviser or a director if that person has engaged or is about to engage in a breach of fiduciary duty involving personal misconduct in respect of any registered investment company. IC Act Section 36(a), 15 U.S.C. §80a-35. Because this case was brought as an administrative proceeding, rather than in district court, the issue of whether Respondents violated their fiduciary duties under the Investment Company Act is not before us.
52 In 2001, the Commission adopted rules making clear the requirements that investment companies disclose in various investment company filings material transactions and relationships with the companies' independent directors. Role of Independent Directors of Investment Companies, Exchange Act Rel. No. 43786 (Jan. 2, 2001), 74 SEC Docket 3.
53 The Division also notes that MFS waived fees for the Director-Clients accounts. MFS responds that it waived advisory fees for all advisory accounts under $100,000 and, in 1993, also waived fees for the Bond Fund and Money Market Fund.
54 Once a registration statement is filed, underwriters may begin soliciting "indications of interest" from investors. These indications are non-binding requests from investors for allocations of shares in the offering.
55 Respondents complain that the law judge determined that Bacarella knew which IPOs were hot and preferentially allocated them with that knowledge before evidence on that issue was produced. They further claim that the law judge improperly placed the burden upon them to prove that Bacarella could not know which IPO was likely to be hot.
Statements by a presiding officer based on prior proceedings or information do not evidence bias. Liteky v. United States, 510 U.S. 540, 555 (1994); SEC v. First City Fin. Corp., 890 F.2d 1215, 1222 (D.C. Cir. 1989) ("We presume that a judge will set aside personal views — which given human nature are always present — and find the relevant facts solely on the evidence presented. An appellant therefore must show that a judge's mind was <irrevocably closed' on the issue before the court."). Moreover, we have performed an independent review of the record and come to the same conclusion: an experienced professional can discern when a particular IPO is more likely than not to open at a premium once secondary trading begins.
Respondents also claim that the law judge was biased against them because their pre-hearing motions were denied. These claims are baseless. Denials of pre-hearing motions are not by themselves evidence of bias, and Respondents do not identify what in the denials were improper. Moreover, the law judge who conducted the hearing was different from the law judge who decided the pre-hearing motions.
56 Bootstrapping takes a series of occurrences that are not normally distributed, and creates a distribution for the data. It then uses statistical measures, such as standard deviation, to generate statistical analyses. MFS and Bacarella claim that "bootstrapping" is "junk science." However, bootstrapping is a reputable and useful statistical method. See, e.g., Michael R. Chernick, Bootstrap Methods: A practitioner's guide, at 161-244 (1999); Bradley Efron and Robert Tibshirani, An Introduction to the Bootstrap (1993).
57 We find that Respondents' statistical analysis was equally flawed. Respondents' expert performed a series of statistical tests that purported to test the difference in means among different groups of allocations. However, the difference-in-means test assumes that the sample is normally distributed. Even that expert's own analysis demonstrates clearly that her data were not normally distributed. Furthermore, the expert performed her tests on extremely small samples (including one sample composed of a single IPO). The difference in means test is more effective on larger samples.
58 The Division further argues that, by receiving IPO allocations, the Director-Clients usurped corporate opportunities owed to the Fund Clients. The Division asserts that this usurpation is evidenced by the fact that Respondents received "hotter" or better IPOs, and that the Fund Clients received less hot, or even cold IPOs. For the reasons stated above, we disagree.
The record on this point is otherwise incomplete. For example, as discussed above, we cannot determine whether the Director-Clients received treatment that was any different from MFS' other individual adviser clients, see text following n.50 supra. We also do not have evidence of any relationship between MFS and other firms that allocated IPOs to MFS. See text accompanying n.12, supra. We thus are unable to make a further determination as to whether Director-Clients usurped that opportunity. We note that the Fund Clients received 83% of the IPO shares received by MFS, while the Director-Clients received only 1.6 percent andthat the Mid-Cap Fund's portfolio manager testified that he did not express interest in 8 of the 9 IPOs allocated to Russo.
In 1999, we stated that allocation of IPOs presented the potential for conflicts of interest between an individual and the fund, including whether the possibility that the individual is misappropriating an opportunity that should have been offered to the fund. See Personal Investment Activities of Investment Company Personnel, Securities Act Rel. No. 7728 (Aug. 27, 1999), 70 SEC Docket 1191, 1196 (requiring investment personnel obtain prior approval from their fund or adviser before directly or indirectly acquiring any beneficial ownership in an IPO).
59 See Butz v. Glover Livestock Comm'n Co., 411 U.S. 182, 185 (1973) (holding that an agency's choice of sanction is "peculiarly a matter of administrative competence") (internal quotations omitted).
60 Donald T. Sheldon, 51 SEC at 86, quoting Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd, 450 U.S. 91 (1981).
61 15 U.S.C. Section 80b-3(k).
62 KPMG Peat Marwick LLP, Exchange Act Rel. No. 43862 (Jan. 19, 2001), 74 SEC Docket 384, 436, petition denied, 289 F.3d 109 (D.C. Cir. 2002).
63 We have considered all of the contentions advanced by the parties. We reject or sustain them to the extent that they are inconsistent or in accord with the views we express here.
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