Securities and Exchange Commission
Washington, D.C.

Securities Exchange Act of 1934
Rel. No. 48146 / July 9, 2003

Admin. Proc. File No. 3-8327-EAJ

OPINION OF THE COMMISSION

EQUAL ACCESS TO JUSTICE ACT PROCEEDINGS

Applicant, who had prevailed in Commission broker-dealer proceedings, sought an award of fees and expenses under the Equal Access to Justice Act. Held, the application is denied since the Division of Enforcement's position in the underlying action was substantially justified.

APPEARANCES:

Marc B. Dorfman, of Foley & Lardner, and Arthur M. Schwartzstein, of Arthur M. Schwartzstein, P.C. (of counsel), for Richard J. Adams.

David M. Becker, Richard M. Humes, Samuel M. Forstein, and Michele R. Vollmer, for the Division of Enforcement.

Appeal filed: December 21, 2000.
Last brief received: March 29, 2001.
Case remanded: April 19, 2002.

I.

The Division of Enforcement appeals from the decision of an administrative law judge awarding Richard J. Adams fees and expenses under the Equal Access to Justice Act ("EAJA")¹ The Commission action underlying Adams' claim charged that Adams, who was a vice president and financial and operations principal of Graystone Nash, Incorporated ("Graystone" or "the firm"), formerly a registered broker-dealer,² participated in a manipulative scheme involving Graystone initial public offerings and their aftermarkets.

The law judge dismissed the proceedings against Adams on two separate grounds. She found that the evidence did not establish that Adams had committed any violations, and, citing Johnson v. SEC³ (decided just prior to her decision), that the proceedings against Adams were barred by the statute of limitations contained in 28 U.S.C. § 2462 since all of the conduct at issue had occurred more than five years prior to the institution of proceedings.

On review, noting that, in light of Johnson, the Division had determined not to seek reversal of the law judge's decision, we dismissed the proceedings against Adams, citing the age of the case and the fact that the Division did not oppose dismissal.⁴ Thereafter, Adams filed the EAJA claim that is now before us. We initially concluded that Adams' claim was untimely, and denied his application.⁵ However, the Court of Appeals reversed that decision, and remanded the case for a determination of Adams' EAJA claim on the merits.⁶

The EAJA provides that a respondent who has prevailed against the government in an adversary adjudication may recover the fees and expenses that were incurred unless "the position of the agency was substantially justified."⁷ The Division contends that its position in the underlying case was substantially justified. Our findings are based on an independent review of the record.

II.

Based in New Jersey, Graystone, at its height, had about 35 franchised branch offices employing about 1100 salespersons at locations throughout the United States. In 1987 and 1988, the firm underwrote about a dozen initial public offerings ("IPOs") of speculative securities. These registered offerings consisted of units comprising shares of common stock and warrants to purchase such shares. Most of Graystone's business consisted of transactions in "house stocks," securities it had underwritten and in which it was making a market.

The charges in the underlying proceeding detail a manipulative scheme that may be summarized as follows. Graystone's customers were required to pay for units in the IPO offerings prior to the effective dates of the registration statements, and Graystone pressured the firm's brokers to obtain the units' quick resale to Graystone at prices set by the firm. Once Graystone repurchased the units, it stripped the common stock from the warrants, and sold it to retail customers at predetermined, successively higher prices known as "ticks." Branch offices were allocated increasing amounts of common stock as tick prices increased, creating the false impression that normal market forces were driving prices higher on increasing volume.

Graystone also took steps to support aftermarket prices by preventing customers from selling house common stocks once they had purchased them. Brokers were required to discourage such sales. In addition, the firm instituted a "buy-sell formula" under which branch office commissions were reduced if customers of the office were not net purchasers of house stocks. Graystone often refused to accept customer sell tickets or delayed them until they could be matched with buy orders, and it denied salesmen commissions on sell orders.

On the basis of his alleged participation in this scheme, Adams was charged with violating antifraud, anti-manipulative, and registration provisions of the securities acts.⁸

III.

As detailed below, several witnesses testified with respect to Adams' activities at Graystone.

1. Stephen E. Ware was operations manager of Graystone's Newport Beach, California branch office. He testified that he had had at least 100 telephone conversations with Adams. Ware stated that, when he had a question about trading, Adams was the one making the decisions and issuing orders, and Ware was told by his superiors to do what Adams said.

According to Ware, Adams and Thomas V. Ackerly, Graystone's president,⁹ determined how many units of an IPO a branch office would receive. It was standard policy that IPO units could not be sold to a customer unless there were "good funds" in the customer's account prior to the IPO offering. "Good funds" meant a cashier's check, cash, or a check that had already cleared. Usually, the amount of money raised in advance of an IPO was at least ten times the total amount of the offering, and Adams instructed Ware to tell brokers to put the extra money into the aftermarket for the common stock component of the IPO, or into other Graystone house stocks. If an IPO client failed to have "good funds" in his account prior to the offering, Adams, who was in charge of making sure that such funds were present, would call Ware and "scream" at him that the client was not going to get any IPO units or common stock in the aftermarket.

Adams told Ware that all IPO units had to be repurchased from the customers and resold to Graystone so that the common stock could be stripped away and sold in the aftermarket. If all of the units were not resold to Graystone, Ware would get a call from Adams "berating and screaming and yelling in a tirade." Adams threatened that, if all of the units were not repurchased, the branch office would not be allocated any aftermarket common stock at lower tick prices, and would not be allowed to participate in future Graystone IPOs. He warned that there would be "dire consequences" both to the office and to offending brokers who could not persuade their customers to sell their units back to Graystone.

Adams or Ackerly would call Ware to advise him of the office's allocation of aftermarket common stock. In a single phone call, Adams would notify Ware of the multiple increasing price levels or "ticks" at which the office was to sell such stock. In the same phone call, Adams would also notify Ware of the number of shares that were to be sold at each price level.

Ware stated that Adams appeared to be in charge of enforcing Graystone's "buy-sell formula." Under that formula, sales of house stocks to customers had to exceed customer resales by 25% or the branch office as well as the individual broker would receive lower commissions.¹⁰ Moreover, any customer sale of a house stock was strongly discouraged. Ware testified that, if he put in a sell ticket on a house stock, it was usually met with "a tirade of abuse" from Adams "because sell tickets were not allowed by Graystone Nash." Such tickets were not handled routinely but were usually routed to Adams. Adams would then call Ware and "yell at [him] to make sure that the broker controlled his clients so that we don't get any more of these sell tickets coming through." Graystone not only refused to pay commissions on customer sell orders but also charged brokers a fee on such orders. These charges were netted against the brokers' commissions, and served as a further deterrent to customer sales.

2. Jose Gallego was operations manager of Graystone's Boca Raton, Florida branch office, and later became office manager of Graystone's Chicago office. He testified that he had numerous conversations with Adams. According to Gallego, Adams was second-in-command at Graystone, and ran the firm in Ackerly's absence.

Gallego testified that Adams told him that he (Adams) expected to get the IPO units sold to customers back, and named the price that Graystone would pay. Adams further stated that the larger the number of units that were resold to Graystone, the larger the allocation of common stock the branch office would receive in the aftermarket. Adams threatened that, if IPO units were not returned "when it was required," the branch office would be excluded from participating in future IPOs.

Adams informed the branch office of its allocation of aftermarket stock. He would call Gallego and, in a single telephone conversation, give him the various "tick" price levels and the amounts of stock Graystone was allotting at each level. The ticks were at premium prices, and each level was higher than the level preceding it. Once the office received its aftermarket allocation, brokers would write up sales tickets and, on Adams' instructions, a sales blotter would be prepared for each tick level and sent to New Jersey for execution. Adams told Gallego when to submit each blotter. In the aftermarket for the common stock of one IPO, Gallego was instructed by Adams to complete the first blotter in 15 minutes,¹¹ the second within half an hour, and the third within 45 minutes after the first.¹²

3. David Torrey and a partner owned a Graystone branch office in Jacksonville, Florida. Torrey testified that, after the sale of Graystone IPO units, the office's first objective was to repurchase them from the customers. Adams instructed him more than once to "get the units back." Thereafter, Adams or another Graystone official would call with directions for tiered pricing in the aftermarket. Two or three ticks would be given in the first phone call, as well as the amount of aftermarket stock that could be sold at each tick price. The amount of stock allotted always increased with each increasing tick level.

Torrey stated that Adams enforced Graystone's buy-sell formula for house stocks. Adams kept track of each office's performance under the formula and, if that performance was unsatisfactory, Torrey would hear from Adams. In fact, Torrey's office lost "tens of thousands" in commissions as a result of the formula. Adams strongly discouraged customer sales of house stocks in an "angry, . . . threatening, [and] overpowering" manner, stating that any such sales would "hurt the price of the stocks," "hurt the firm," and "have an adverse effect" on Torrey's branch office. Torrey understood that this could mean anything from curtailing the office's participation in Graystone IPOs to affecting Graystone's monthly payment of branch office commissions.

4. John F. Mather was compliance manager in Graystone's Boca Raton office. Mather stated that customers would call him complaining that their sell orders in house stocks had not been executed. He would then call Adams and warn him that Graystone was "asking for all kinds of trouble," and that Adams must "sell this individual's stock." This happened several times. However, Adams would always reply, "It's none of your (expletive deleted) business . . . I run trading. You mind your own (expletive deleted) business," after which Adams would slam down the phone. Mather stated that, as a general rule, sell orders in house stocks were not executed until there was a corresponding buy of 1 1/4 times the amount of the sell. Some sell orders were probably held for a week or longer, and salesmen were not paid any commission on customer sell orders in house stocks. Mather testified that Adams was the enforcer of Graystone's buy-sell formula.

The Division subpoenaed Graystone's trading records in various securities from the service bureau that maintained the required books and records of Graystone's clearing firm, Outwater & Wells, Inc. From those records, a Division expert prepared charts summarizing Graystone's trading in four representative IPO offerings. The charts show that Graystone sold all of the units in each IPO at the price listed in the prospectus, repurchased most of them at a premium within days of the offering, and quickly sold the common stock component of the units at successively higher price levels.

In her initial decision in the underlying proceeding, the law judge refused to credit the documentary evidence introduced by the Division and the testimony of the witnesses described above. The law judge stated that, "[t]he quality of the testimony of [Ware, Gallego and Torrey] does not rise to the level of substantial evidence of wrongdoing or recklessness by Adams, mainly because the conversations they describe are not detailed, are not dated, and are not corroborated by any memoranda or notes." She also noted that, although Ware testified that he had had about 100 telephone conversations with "a person who identified himself as 'Mr. Adams'," he had never met Adams and thus "had little basis for concluding that the Respondent was actually the person who talked with him on the telephone." The law judge also noted that Mather did not supply dates or corroborating notes for his conversations with Adams, and concluded that his testimony did not show that Adams had engaged in any wrongdoing.

IV.

An agency position can be substantially justified even if the trier of fact finds the evidence insufficient to prove the violations alleged. It is sufficient if the position is justified to a degree that could satisfy a reasonable person, i.e., if it has a reasonable basis in law and in fact.¹³ Because the standard applied under the EAJA differs from the standard applied in the underlying action, the conclusions reached in the initial proceeding are not dispositive. Instead, an "independent evaluation [must be conducted] through an EAJA perspective."¹⁴ Making the outcome of the underlying case dispositive would "virtually eliminate the 'substantially justified' standard from the statute."¹⁵

That is exactly what the law judge did here. While acknowledging her obligation to conduct an independent evaluation, she based her conclusion that the Division's position was not substantially justified on her findings in the underlying proceeding. That conclusion was at odds with a significant determination that she made in that proceeding. After the Division had completed the presentation of its evidence, the law judge denied Adams' motion to dismiss, finding that the Division had established a prima facie case. Adams renewed his motion to dismiss after he completed his defense but, once again, the law judge denied his motion.

1. The Division's evidence provides substantial justification for its position that Adams participated in a fraudulent and manipulative scheme in violation of the above-cited antifraud provisions. A determination of substantial justification may properly be premised on testimony and other evidence that was rejected by the trier of fact.¹⁶ Thus, notwithstanding the law judge's adverse evidentiary rulings, we consider that the evidence adduced by the Division fully supports a finding of substantial justification under the EAJA.¹⁷

The price leadership that results from control over the supply of a security empowers an underwriter to set prices arbitrarily. If that power is abused, the result is a manipulation.¹⁸ Here Graystone exercised its control by setting arbitrary aftermarket prices for the common stock components of the IPO units it had underwritten. The firm deliberately created the false impression that the prices of those stocks were rapidly rising on increasing volume. This was a striking example of turning the markets for those securities into "a stage-managed performance."¹⁹ It is clear from the testimony noted above that Adams was the chief enforcer of Graystone's manipulative scheme. There was also reasonable justification for concluding that Adams committed further antifraud violations by impeding and delaying the execution of customer sell orders.²⁰

2. During the relevant period, Securities Exchange Act Rule 10b-6 prohibited any person engaged in the distribution of a security to bid for or purchase that security until that person had completed his participation in the distributions.²¹ It is evident that Graystone's unit offerings were merely intermediate steps in distributions that were completed only when Graystone sold the common stock components of the units to investors. Thus Graystone violated Rule 10b-6 by bidding for and repurchasing the units before its distributions were completed.²² Adams had a leading role in Graystone's unit repurchases. Thus there was substantial justification for charging him with violations of Rule 10b-6.

3. The Division was also substantially justified in charging Adams with violations of registration provisions. Adams enforced Graystone's requirement that customers pay for IPO units in advance, before the registration statements for those units became effective. Those sales violated registration provisions.²³ In addition, Section 6(a) of the Securities Act provides that "[a] registration statement shall be deemed effective only as to the securities specified therein as proposed to be offered." Graystone's IPO registration statements described offerings of units at a specified price. In fact, those offerings were a sham. The real offerings were common stocks derived from the breakup of the units that were sold at escalating prices set by Graystone. The registration statements did not describe those offerings, and thus did not cover them. Accordingly, the common stocks sold in those offerings were not registered, and their sale violated registration provisions.²⁴ Adams was instrumental in directing those sales.

V.

The law judge held, and Adams argues, that this proceeding was not substantially justified because it was time-barred, having been instituted in 1994 after the Court of Appeals decision in 3M Company v. Browner,²⁵ which held that the five-year statute of limitations in 28 U.S.C. § 2462²⁶ applied to administrative proceedings. In 1996, the Court of Appeals, in Johnson v. SEC,²⁷ held that Section 2462 was applicable to Commission proceedings.

Prior to Johnson, the Commission took a contrary position. We believed that 3M held that Section 2462 applied to administrative actions that sought to assess civil penalties, and did not apply to proceedings instituted to determine whether prospective, non-monetary, remedial sanctions should be imposed.²⁸ In order to assess whether the Division of Enforcement was substantially justified in bringing this proceeding, it is necessary to examine whether this distinction between monetary penalties and non-monetary sanctions was appropriate after 3M and prior to Johnson.

The Division's belief that 3M did not apply to this administrative proceeding was grounded on the assumptions that Section 2462 applied only to a proceeding "for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise," and that a proceeding that did not seek to impose a money penalty could not be considered a proceeding covered by the language of Section 2462.

The meaning of "civil fine, penalty or forfeiture" was not an issue in 3M, as that case involved an action by the Environmental Protection Agency seeking to impose a monetary penalty. In Johnson, the Court of Appeals acknowledged that the term "penalty" was not defined in the statute. In crafting a definition of that term, the Court recognized that remedies that are truly remedial are not penalties, but it nonetheless went on to find that the sanctions imposed in that case (a supervisory suspension and censure) were not remedial but punitive since they affected the respondent's ability to earn a living, triggered future affirmative disclosure obligations that could affect future income, and were not based on any finding of the respondent's present unfitness as a supervisor or any showing of the risk the respondent posed to the public. That analysis was not based on the analysis made by the Court in 3M.

Because the Court's opinion in 3M dealt with an administrative proceeding that sought to impose a money penalty, it did not address the breadth of the phrase "civil fine, penalty or forfeiture," and therefore gave no indication of the Court's future reasoning in Johnson. In fact, in reversing our determination that Adams' EAJA claim was untimely, the Court stated that "[o]ur decision in 3M Co. v. Browner (citation omitted) is not dispositive on the issue of whether the Division's position was 'substantially justified'...."²⁹

The administrative proceeding against Adams was instituted pursuant to Section 15(b)(6) of the Exchange Act. Under that provision, the remedies that could have been imposed on Adams included a censure, limitations on his activities or functions, a suspension of up to twelve months, or a bar. Each of these possible sanctions is designed to protect the public from future harm by unfit persons, and may be imposed only after this Commission finds that the sanction is "in the public interest." At that time, more than two years prior to the Johnson decision, the Commission considered it "well settled that such administrative proceedings were not punitive but remedial"³⁰ and thus not governed by Section 2462, a belief that was based on longstanding legal precedent.³¹

In order to assess a civil money penalty against Adams, it would have been necessary to institute the underlying proceeding under Section 21B of the Exchange Act.³² The fact that the underlying action was not brought under that section, in addition to Section 15, is another indication that the Division reasonably believed that the proceeding against Adams was remedial in nature rather than punitive, and thus not governed by Section 2462.

Because the court in 3M did not address the applicability of Section 2462 to administrative proceedings in which monetary penalties were not sought, this Commission continued at that time to take the position that proceedings that did not seek to impose such penalties were remedial and not governed by Section 2462. Under these circumstances, we believe that the Division of Enforcement's legal position was substantially justified.

Adams also complains that the Division sought review of the law judge's initial decision in the underlying proceeding even after the Court's decision in Johnson. That complaint is without merit. In its petition for review of that decision, the Division noted that, at that time, the Commission was considering whether to appeal the Johnson decision. The Division stated that it was seeking review pending the Commission's determination of its course of action. In fact, the Commission subsequently filed a petition for rehearing in Johnson. The Division's petition for review also took exception to the law judge's findings of fact. In support of its petition, the Division acknowledged that the Johnson decision applied to this proceeding. However, it argued that, in any event, the law judge's erroneous factual findings must be vacated since, if the law judge's decision became final, her findings of fact could be dispositive in a pending Commission injunctive action against Adams.³³ In dismissing the proceeding against Adams, we noted that our grant of the Division's petition for review effectively vitiated those findings.³⁴ We find that the Division was substantially justified in appealing the initial decision both because of the probable appeal of Johnson, and the collateral estoppel effect the initial decision's factual findings may have had in the pending federal court action.

* * * *

We are satisfied that there was a reasonable basis in law and fact for bringing proceedings against Adams. We shall accordingly deny his claim under the EAJA for attorneys' fees and costs.

An appropriate order will issue.³⁵

By the Commission (Chairman DONALDSON and Commissioners GLASSMAN, GOLDSCHMID, ATKINS, and CAMPOS).

Jonathan G. Katz
Secretary

Securities and Exchange Commission
Washington, D.C.

Securities Exchange Act of 1934
Rel. No. 48146 / July 9, 2003

Admin. Proc. File No. 3-8327-EAJ

ORDER DENYING APPLICATION UNDER THE EQUAL ACCESS TO JUSTICE ACT

On the basis of the Commission's opinion issued this day, it is

ORDERED that the application of Richard J. Adams for an award of fees and expenses under the Equal Access to Justice Act be, and it hereby is, denied.

By the Commission.

Jonathan G. Katz
Secretary

http://www.sec.gov/litigation/opinions/34-48146.htm