UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION Securities Exchange Act of 1934 Release No. 55725 / May 8, 2007 Accounting and Auditing Enforcement Release No. 2607 / May 8, 2007 Administrative Proceeding File No. 3-12630 : ORDER INSTITUTING CEASE-AND- In the Matter of : DESIST PROCEEDINGS, MAKING : FINDINGS, AND IMPOSING A CEASE- MOTOROLA, INC., : AND-DESIST ORDER PURSUANT TO : SECTION 21C OF THE SECURITIES Respondent. : EXCHANGE ACT OF 1934 : : I. The Securities and Exchange Commission (“Commission”) deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”) against Motorola, Inc. (“Motorola” or “Respondent”). II. In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (“Offer”) which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission’s jurisdiction over Respondent and the subject matter of these proceedings, which are admitted, Respondent consents to the entry of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934 (“Order”), as set forth below. 2 III. On the basis of this Order and Respondent’s Offer, the Commission finds1 that: A. Summary 1. This case involves a round-trip of cash between Motorola and Adelphia Communications Corporation (“Adelphia”). Pursuant to a purported marketing support agreement entered into in 2001, Adelphia paid money to Motorola which was immediately returned to Adelphia in the form of marketing support payments. No marketing was specified in the agreement and no marketing was done pursuant to the agreement. Adelphia used Motorola’s marketing support payments to falsify its earnings in 2000 and 2001. 2. In the Fall of 2000, Adelphia, a cable television system owner and operator, asked Motorola, a vendor that provided digital cable television set-top boxes used by Adelphia, to enter into a marketing support agreement for the stated purpose of helping Adelphia fund its roll-out of digital cable television service. Adelphia proposed to pre-fund Motorola’s marketing support payment obligation through a retroactive and offsetting price increase applied to digital cable television set-top boxes Motorola had supplied Adelphia in the past and was to supply Adelphia in the future pursuant to a pre-existing purchase contract. 3. The marketing support agreement, which was not finalized until March 2001, was backdated to the prior fiscal year and applied retroactively to set-top boxes that had already been sold to Adelphia. The agreement also contained a false reason for the retroactive price increase. 4. The transaction had no economic substance, amounting to a round-trip of cash, and was designed by Adelphia to increase artificially its Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”) by reducing operating costs by the amount of the marketing support payments from Motorola. In this manner, Adelphia was able to use the transaction to reduce improperly its operating costs and increase its earnings by approximately $18.3 million in 2000 and $28 million in 2001. 5. Motorola knew or should have known that Adelphia was misusing the marketing support agreement. The marketing support agreement was backdated to a prior fiscal year, it applied retroactively to set-top boxes that had already been sold to Adelphia, and it contained a false reason for the price increase. Motorola executives also knew that (i) the marketing support agreement did not identify any marketing to be done by Adelphia and Motorola did not require that any marketing be done pursuant to the agreement; (ii) the transaction was a round-trip transfer of cash; and (iii) Motorola accounted for the transaction as economically neutral to Motorola. 1 The findings herein are made pursuant to Respondent’s Offer and are not binding on any other person or entity in this or any other proceeding. 3 B. Respondent 6. Motorola is a Delaware corporation, with corporate headquarters in Schaumburg, Illinois. Motorola is a global manufacturer and seller of wireless, broadband, and automotive communications technologies. At all relevant times, Motorola’s common stock was registered with the Commission pursuant to Section 12(b) of the Exchange Act and was publicly traded on the New York Stock Exchange. C. Relevant Entity 7. Adelphia is a Delaware corporation, headquartered in Greenwood Village, Colorado. During the relevant period, Adelphia was headquartered in Coudersport, Pennsylvania. Adelphia owns, operates, and manages cable television systems and other related telecommunications businesses. On March 27, 2002, Adelphia announced that it was liable for approximately $2.3 billion in debt that it had previously failed to disclose. In May 2002, certain members of the Rigas family, who controlled and held officer and director positions with Adelphia, resigned and Adelphia disclosed that it expected to restate its financial statements for fiscal years 2000 and 2001. On July 18, 2002, the Commission filed SEC v. Adelphia Communications Corporation, et al., 02 Civ. 5776 (PKC) (S.D.N.Y.), alleging that widespread, multifaceted financial fraud occurred at Adelphia. On May 31, 2005, the U.S. District Court for the Southern District of New York entered a consent order enjoining Adelphia from violating Section 17(a) of the Securities Act of 1933, Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, and 13a-13 under the Exchange Act. D. Facts Background 8. In January 2000, Motorola acquired General Instrument Corporation (“General Instrument”) for $17 billion in stock. General Instrument was integrated into Motorola as its broadband communications sector and was a major supplier of digital cable television set-top boxes to Adelphia both prior to and after its integration into Motorola. In fiscal year 2000, the sector’s earnings accounted for approximately 43% of the combined earnings reported by all of Motorola’s profitable sectors in that year. 9. In May 2000, Adelphia and Motorola entered into a purchase agreement that governed the pricing of digital cable television set-top boxes through December 2001 based upon the contemplated purchase by Adelphia of 1.6 million set-top boxes over the life of the contract. The purchase agreement did not require Adelphia to purchase any set-top boxes and it did not provide for a penalty if Adelphia purchased less than the 1.6 million set-top boxes contemplated by the agreement. 10. In June 2000, Adelphia realized that its second quarter reported EBITDA would fall below analysts’ expectations. Adelphia executives devised a plan to inflate artificially EBITDA by reducing operating costs through the purported marketing support agreement with Motorola. 4 11. In late August 2000, Adelphia approached Motorola with the idea of entering into the marketing support agreement. Key Factors That Should Have Put Motorola On Notice That Adelphia Was Not Using The Marketing Support Agreement For Its Intended Purpose 12. Between August 2000 and March 2001, when the marketing support agreement documents were signed, the executives who reviewed, or were told the substance of, the proposed transaction, were confronted with the following unusual facts unique to this transaction: • Adelphia’s request was the first time any customer had asked the Motorola executives to increase the price of Motorola’s products; • The marketing support agreement, which Adelphia provided to Motorola, contained a false reason for the price increase; • Motorola executives insisted as a condition to entering into the transaction that Adelphia provide a letter from its counsel that Adelphia would not use the transaction in contravention of federal regulations governing cable television rates. Instead, an Adelphia finance executive who was later implicated in Adelphia’s fraud sent a short confirmatory letter to Motorola without advising Motorola whether its counsel had been consulted; • The marketing support agreement did not contain any details of marketing to be done by Adelphia and required no input from Motorola’s marketing department; • The marketing support agreement was backdated and the price increase and marketing support payment obligation were made retroactive to the beginning of the prior fiscal year and applied to products that had already been sold to and paid for by Adelphia; • The transaction was a “wash” transaction with no economic impact on Motorola; and • Motorola did not treat the transaction as a marketing transaction for accounting purposes. Motorola Asked Adelphia To Purchase More Set-Top Boxes Than Adelphia Needed In Exchange For Signing The Marketing Support Agreement 13. Shortly before the marketing support agreement was due to be signed in March 2001, Adelphia’s orders for set-top boxes declined below the number called for under the May 2000 purchase agreement. Motorola knew that Adelphia did not need any additional set-top boxes at that time, but told Adelphia that it wanted Adelphia to purchase 100,000 additional set-top boxes. Adelphia agreed to make the purchase before the marketing support agreement was signed and before the close of Motorola’s first quarter for fiscal year 2001. 5 Motorola Signed The Backdated Marketing Support Agreement And Made A Retroactive Marketing Support Payment 14. On or about March 21, 2001, Motorola signed the marketing support agreement documents that were backdated to the prior fiscal year. The marketing support agreement did not specify any marketing to be done by Adelphia and it contained a false reason for the price increase. In the document memorializing the price increase, Motorola stated falsely that the purpose of the price increase was to secure “incremental component volumes and factory capacity” to meet Adelphia’s needs. In fact, Motorola executives knew that the true purpose of the price increase was to pre-fund Motorola’s marketing support payment obligation to Adelphia. 15. In May 2001, Motorola made the first $18.3 million marketing support payment for marketing purportedly done in 2000. The payment was funded by Adelphia three days earlier when it paid Motorola the retroactive price increase on set-top boxes previously purchased by Adelphia in 2000. Motorola Again Asked Adelphia To Purchase More Set-Top Boxes Than It Needed And Defrayed The Costs Of Warehousing The Boxes In A Third-Party Warehouse In Exchange For Maintaining The Marketing Support Agreement 16. In early June 2001, Adelphia told Motorola that it would be reducing its orders of set-top boxes due to decreased demand. Motorola knew that Adelphia had excess inventory that would carry it to the middle of the following year. Nevertheless, Motorola insisted that Adelphia purchase an additional 150,000 set-top boxes. Motorola proposed to finance the purchase through Motorola Credit Corporation, so that Adelphia would be able to pay for the additional set-top boxes in two installments over a period of one year and Motorola would be able to record the sales before the close of its second fiscal quarter. 17. To implement the deal and protect Motorola, Motorola insured the Adelphia receivable. Motorola knew or should have known that Adelphia did not actually need any additional set-top boxes, so it offered Adelphia credits that could be used for other Motorola services, including marketing, to offset the cost of warehousing the 150,000 set-top boxes in a third-party warehouse. Adelphia agreed to purchase the additional set-top boxes before the close of Motorola’s second quarter for fiscal year 2001. Motorola Agreed To Increase Its Marketing Support Payment Obligation In Exchange For Adelphia’s Agreement To Purchase More Set-Top Boxes In 2002 18. In mid-December 2001, at the end of Adelphia’s fiscal year, Adelphia asked Motorola to amend the marketing support agreement to require that Motorola make an additional $10 million marketing support payment for 2001 funded by an another retroactive price increase on set-top boxes previously delivered to Adelphia. Motorola agreed to the amendment after Adelphia agreed to purchase 200,000 set-top boxes in 2002. The amended marketing support agreement contained the same false reason for the price increase that the original agreement contained. 6 Adelphia Used The Marketing Support Agreement To Artificially Decrease Marketing Expenses And Increase EBITDA 19. Adelphia recorded the marketing support payments as a contra-expense to marketing costs. This accounting treatment lowered the amount of recorded marketing expenses and, in turn, artificially inflated Adelphia’s EBITDA. Adelphia recorded the price increases paid to Motorola as capital expenditures, which are depreciated over time and, therefore, have no impact on EBITDA and a minimal impact on earnings. 20. In total, from April 2000 through December 2001, Adelphia recorded improperly approximately $46.3 million in marketing support payments as reductions in current operating expenses, with the intended effect of inflating its reported EBITDA by $46.3 million over that period. Adelphia’s accounting treatment violated Generally Accepted Accounting Principles (“GAAP”) because it reflected the round-trip transaction as decreasing its reported expenses and increasing its reported earnings when it did not have that effect. Legal Analysis 21. The Exchange Act and Exchange Act rules require every issuer of registered securities to file reports with the Commission that accurately reflect the issuer’s financial performance and provide other true and accurate information to the public. 22. Adelphia violated Section 13(a) and Rules 13a-1, 13a-13, and 12b-20 by filing with the Commission reports from April 2000 through December 2001, each containing materially false and misleading earnings in the financial statements for each reporting period. 23. Adelphia violated Section 13(b)(2)(A) by improperly recording the marketing support payments as a contra-expense to Adelphia’s marketing costs, and by recording as capital expenditures the artificial price increase on the set-top boxes. Certain officers of Adelphia knowingly falsified, and caused others to falsify, Adelphia’s books, records and accounts, including the fraudulent journal entries of the price increases and marketing support payments. 24. Section 21C of the Exchange Act provides that the Commission may issue a cease-and-desist order against a person who is “a cause of [another person’s] violation, due to an act or omission the person knew or should have known would contribute to such violation.”2 Based on the conduct described above, Respondent was a cause of Adelphia’s violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 of the Exchange Act. 2 Where the primary violations underlying a finding that a person is “a cause of” violations do not themselves require a finding of scienter, the standard of liability for being “a cause of” such violations under Section 21C of the Exchange Act is negligence. See KPMG LLP v. SEC, 289 F. 3d 109, 112 (DC Cir. 2002). 7 IV. In view of the foregoing, the Commission deems it appropriate to impose the sanction agreed to in Respondent’s Offer. Accordingly, pursuant to Section 21C of the Exchange Act, it is hereby ORDERED that: A. Respondent cease and desist from committing or causing any violations and any future violations of Sections 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder. B. Respondent is herby ordered pursuant to Section 21C(e) of the Exchange Act to pay disgorgement in the amount of $18 million and prejudgment interest in the amount of $7 million, for a total payment of $25,000,000. Within 10 days of entry of this Order, Motorola shall deliver this payment into the Registry of the Court for the United States District Court for the Southern District of New York in the case captioned Securities and Exchange Commission v. Adelphia Communications Corp., et al., 02 Civ. 5776 (PKC). Simultaneously, Motorola shall transmit by hand delivery to the Clerk of the Court, United States District Court for the Southern District of New York, a letter specifying that the payment is made in connection with the Commission’s administrative proceeding and a copy of the letter shall be simultaneously transmitted by facsimile to Alistaire Bambach, Assistant Regional Director, Division of Enforcement, Securities and Exchange Commission, Northeast Regional Office, 3 World Financial Center, New York, NY 10281 (212) 336-1324 (facsimile). In accordance with Rule 1102 of the Commission’s Rules of Practice [17 C.F.R. 201.1102], the procedures set forth herein shall govern the distribution of any funds paid pursuant to this Order. By the Commission. Nancy M. Morris Secretary
34-55712 May 7, 2007 Citigroup Global Markets, Inc., successor by merger to Legg Mason Wood Walker Inc. Note: See also the Orders granting waiver: 33-8800 33-8799 http://www.sec.gov/litigation/admin/2007/34-55712.pdf
UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 55712 / May 7, 2007 ADMINISTRATIVE PROCEEDING File No. 3-12629 In the Matter of Citigroup Global Markets, Inc., successor by merger to Legg Mason Wood Walker Inc., Respondent. ORDER INSTITUTING ADMINISTRATIVE PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS PURSUANT TO SECTION 15(b) OF THE SECURITIES EXCHANGE ACT OF 1934 I. The Securities and Exchange Commission (“Commission”) deems it appropriate and in the public interest that public administrative proceedings be, and hereby are, instituted pursuant to Section 15(b) of the Securities Exchange Act of 1934 (“Exchange Act”) against Citigroup Global Markets, Inc., successor by merger to Legg Mason Wood Walker Inc. (“Respondent”). II. In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (“Offer”) which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission’s jurisdiction over it and the subject matter of these proceedings, Respondent consents to the entry of this Order Instituting Administrative Proceedings, Making Findings, and Imposing Remedial Sanctions Pursuant to Section 15(b) of the Securities Exchange Act of 1934 (“Order”), as set forth below. 2 III. On the basis of this Order and Respondent’s Offer, the Commission finds that:1 A. RESPONDENT Citigroup Global Markets, Inc., a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act, is the successor by merger to Legg Mason Wood Walker Inc. (“LMWW”). LMWW was a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act during the relevant period. Thereafter, on December 1, 2005, Citigroup Inc. acquired LMWW and then merged LMWW into its subsidiary, Citigroup Global Markets Inc. Subsequently, a Form BDW was filed with respect to the registration of LMWW, and it was accepted by the Commission on June 6, 2006. Prior to Citigroup Inc.’s acquiring it, LMWW engaged in the conduct described in this Order. B. SUMMARY As part of its broker-dealer business, LMWW underwrote and managed a limited number of auctions for auction rate securities. From at least January 1, 2003 through June 30, 2004, in connection with certain auctions, LMWW engaged in the practice, described in Section III.C.2 below, that violates Section 17(a)(2) of the Securities Act of 1933 (“Securities Act”). Accordingly, Respondent violated that provision. C. FACTS 1. The Auction Rate Securities Market Auction rate securities are municipal bonds, corporate bonds, and preferred stocks with interest rates or dividend yields that are periodically re-set through auctions, typically every 7, 14, 28, or 35 days. Auction rate bonds are usually issued with maturities of 30 years, but the maturities can range from 5 years to perpetuity. Auction rate securities are often marketed to issuers as an alternative variable rate financing vehicle, and to investors as an alternative to money market funds. Auction rate securities were first developed in 1984, and the auction rate securities market has grown to well over $200 billion. Mostly institutional investors participate in the auction rate securities markets, although recently smaller investors also have begun participating in the market. Typically, the minimum investment is $25,000. 1 The findings herein are made pursuant to Respondent’s Offer of Settlement and are not binding on any other person or entity in this or any other proceeding. 3 a. Auction Mechanics. Auction rate securities are auctioned at par so the return on the investment to the investor and the cost of financing to the issuer between auction dates is determined by the interest rate or dividend yield set through the auctions.2 According to the disclosure documents (the prospectus or official statement) for each security, the interest rate or dividend yield is set through an auction (commonly referred to as a “Dutch” auction) in which bids with successively higher rates are accepted until all of the securities in the auction are sold. Investors can only submit the following types of orders: 1) a “hold” order, which is the default order for current investors (i.e., the order that is entered for a current holder if the holder takes no action), where a current investor will keep the securities at the rate at which the auction clears; 2) a “hold-at-rate” bid, where a current investor will only keep the securities if the clearing rate is at or above the specified rate; 3) a “sell” order, where a current investor will sell the securities regardless of the clearing rate; or 4) a “buy” bid, where a prospective investor, or a current investor who wants more securities, will buy securities if the clearing rate is at or above the specified rate. Disclosure documents often state that an investor’s order is an irrevocable offer. The final rate at which all of the securities are sold is the “clearing rate” that applies to all of the securities in the auction until the next auction. Bids with the lowest rate and then successively higher rates are accepted until all of the sell orders are filled. The clearing rate is the lowest rate bid sufficient to cover all of the securities for sale in the auction.3 If there are not enough bids to cover the securities for sale, then the auction fails, the issuer pays an above-market rate set by a pre-determined formula described in the disclosure documents, and all of the current holders continue to hold the securities, with minor exceptions. If all of the current holders of the security elect to hold their positions without bidding a particular rate, then the clearing rate is the all-hold rate, a below-market rate set by a formula described in the disclosure documents. b. Broker-Dealers’ Role in Auctions. The issuer of each security selects one or more broker-dealers to underwrite the offering and/or manage the auction process. Investors can only submit orders through the selected broker-dealers. The issuer pays an annualized fee to each broker-dealer engaged to manage an auction (typically 25 basis points for the par value of the securities that it manages). The issuer also selects an auction agent to collect the orders and determine the clearing rate for the auction. Investors must submit orders for an auction to the broker-dealer by a specified time. Many broker-dealers have an internal deadline by which investors must submit their orders to the broker- 2 Between auctions, investors might be able to buy or sell auction rate securities in the secondary market at prices greater than, equal to, or less than par. 3 For example, suppose $100,000 of securities were for sale and the auction received four buy bids. Bid A was for $50,000 at 1.10%, Bid B was for $50,000 at 1.15%, Bid C was for $50,000 at 1.15%, and Bid D was for $25,000 at 1.20%. Under these circumstances, the “clearing rate” would be 1.15%, meaning all of the securities in the auction would pay interest at a rate of 1.15% until the next auction. Bid A would be allocated $50,000, Bids B and C would receive pro-rata allocations ($25,000 each), and Bid D would receive no allocation. 4 dealer. This internal deadline allows the broker-dealer sufficient time to process and submit the orders to the auction agent. Other broker-dealers allow investors to submit orders up until the submission deadline, i.e., the deadline for broker-dealers to submit orders to the auction agent. The broker-dealers must submit the orders to the auction agent before the submission deadline, and usually must identify each separate order. c. Auction Agents’ Role in Auctions. After receiving the orders from the broker-dealers, the auction agent calculates the clearing rate that will apply until the next auction. In practice, however, if there is only one broker-dealer, the broker-dealer can discern the clearing rate before submitting the orders to the auction agent. The auction agent allocates the securities to the broker-dealers based on the orders they submitted. The auction procedures generally state that orders are filled in the following order: hold orders, hold-at-rate and buy bids with a rate below the clearing rate, hold-at-rate orders with a rate at the clearing rate, and buy bids with a rate at the clearing rate. When there are more bids for securities at the clearing rate than securities remaining for sale, the securities are allocated on a pro rata basis first to the hold-at-rate bidders and then to the buy bidders. Generally, the auction procedures require broker-dealers to follow the same hierarchy in allocating the securities to their customers. d. Disclosures Regarding Broker-Dealer Bidding. During the relevant period, the disclosure documents for different securities varied as to what, if anything, they disclosed about broker-dealers bidding in auctions that they were managing. Some disclosure documents did not disclose anything about bidding by broker-dealers. Other disclosure documents disclosed that broker-dealers may bid in auctions with language similar to the following: “[a] broker-dealer may submit orders in Auctions for its own accounts.” Still other disclosure documents disclosed that broker-dealers may bid in auctions and may have an information advantage with language similar to the following: “[a] Broker-Dealer may submit orders in Auctions for its own accounts. Any Broker-Dealer submitting an order for its own account in any Auction might have an advantage over other bidders in that it would have knowledge of other orders placed through it for that Auction (but it would not have knowledge of orders submitted by other Broker-Dealers, if any).” 2. LMWW’s Conduct LMWW intervened in auctions by bidding for its proprietary account to prevent failed auctions without adequate disclosure. Failed auctions occur when there are more securities for sale than there are bids for securities and result in an above-market rate described in the disclosure documents. LMWW submitted bids to ensure that all of the securities would be purchased to avoid failed auctions and thereby, in certain instances, affected the clearing rate.4 4 The clearing rate determines the interest rate or yield the issuer must pay to investors until the next auction. In those instances when this practice lowered the clearing rate, investors received a lower rate of return on their investments. To the extent that this practice affected the clearing 5 D. LEGAL SECTION Section 17(a)(2) of the Securities Act prohibits material misstatements and omissions in any offer or sale of securities. Negligent conduct can violate Section 17(a)(2). See, e.g., SEC v. Hughes Capital Corp., 124 F.3d 449, 453 (3d Cir. 1997). As a result of LMWW’s conduct, Respondent willfully5 violated Section 17(a)(2) of the Securities Act. E. THE PENALTY AMOUNT The Commission aims to promote voluntary disclosures in industry-wide investigations and to encourage firms to provide comprehensive information to the staff in such investigations. See In the Matter of Bear, Stearns & Co. Inc. et al., Securities Act Release No. 8684 (May, 31, 2006) (“Previous Settlement”). In determining the size of the penalty in this matter, the Commission considered LMWW’s cooperation afforded the Commission staff and LMWW’s relatively small share of the auction rate securities markets. The Commission, however, also considered that LMWW reported the practice described in Section III.C.2 later than the broker-dealers in the Previous Settlement reported their practices. IV. In view of the foregoing, the Commission deems it appropriate, and in the public interest, to impose the sanctions agreed to in Respondent’s Offer. In determining not to seek or order that the Respondent cease and desist from committing or causing any violation and any future violations of Section 17(a)(2) of the Securities Act, the Commission considered that the Respondent already is subject to such an order concerning the same type of misconduct described in this Order. See In the Matter of Bear, Stearns & Co., Inc., Securities Act Release 8684 (May 31, 2006). Accordingly, pursuant to Section 15(b) of the Exchange Act, it is hereby ORDERED that Respondent: A. Be, and hereby is, censured, and B. Shall, within 10 days of the entry of this Order, pay a civil money penalty of $200,000 to the United States Treasury. Such payment shall be: (A) made by United States postal money order, certified check, bank cashier's check or bank rate, investors may not have been aware of the liquidity and credit risks associated with certain securities. 5 “Willfully” as used in this Order means intentionally committing the act which constitutes the violation, see Wonsover v. SEC, 205 F.3d 408, 414 (D.C. Cir. 2000); Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965). There is no requirement that the actor also be aware that he is violating one of the Rules or Acts. 6 money order; (B) made payable to the Securities and Exchange Commission; (C) hand-delivered or mailed to the Office of Financial Management, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312; and (D) submitted under cover letter that identifies the Respondent in these proceedings, the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Kenneth R. Lench, Division of Enforcement, Securities and Exchange Commission, 100 F Street N.E., Washington, D.C. 20549-6041. By the Commission. Nancy M. Morris Secretary
UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 55711 / May 7, 2007 INVESTMENT COMPANY ACT OF 1940 Release No. 27819 / May 7, 2007 ADMINISTRATIVE PROCEEDING File No. 3-12628 In the Matter of ZURICH CAPITAL MARKETS INC., Respondent. ORDER INSTITUTING ADMINISTRATIVE AND CEASE-ANDDESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS AND A CEASE-ANDDESIST ORDER PURSUANT TO SECTIONS 15(b) AND 21C OF THE SECURITIES EXCHANGE ACT OF 1934, AND SECTION 9(b) OF THE INVESTMENT COMPANY ACT OF 1940 I. The Securities and Exchange Commission (“Commission”) deems it appropriate and in the public interest that public administrative and cease-and-desist proceedings be, and hereby are, instituted pursuant to Sections 15(b) and 21C of the Securities Exchange Act of 1934 (the “Exchange Act”) and Section 9(b) of the Investment Company Act of 1940 (“Investment Company Act”) against Zurich Capital Markets Inc. (“ZCM” and “Respondent”). II. In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the “Offer”), which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission’s jurisdiction over it and the subject matter of these proceedings, which are admitted, Respondent consents to the entry of this Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order Pursuant to Sections 15(b) and 21C of the Securities - 2 - Exchange Act of 1934 and Section 9(b) of the Investment Company Act of 1940 (“Order”), as set forth below. III. On the basis of this Order and Respondent’s Offer, the Commission finds that: A. Summary 1. ZCM, an entity that provided financing, aided and abetted four hedge funds that were carrying out schemes to defraud mutual funds that prohibited market timing. Specifically, ZCM provided financing to four market-timing hedge funds that employed various deceptive tactics to invest in mutual funds. ZCM and these hedge funds knew that many mutual funds in which they invested imposed restrictions on market timing activity. In order to buy, exchange and redeem shares in these mutual funds, these hedge funds employed deceptive techniques designed to avoid detection by these mutual funds. ZCM came to learn that the hedge funds were utilizing deceptive practices to market time mutual funds, and nonetheless ZCM provided financing to them and took administrative steps that substantially assisted them. By providing assistance to the hedge funds, ZCM aided and abetted the hedge funds’ violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. B. Respondent 2. ZCM is a New York-based company, incorporated in Delaware, that is not registered with the Commission as a broker-dealer. During the relevant period, ZCM was an affiliate of Zurich Global Assets LLC (subsequently reorganized and re-named Crown Management Services Limited), and an indirect subsidiary of Zurich Financial Services (“ZFS”), a Swiss holding company. At all relevant times, ZCM wholly owned Zurich Capital Markets Securities Inc. (“ZCMSI”), a registered broker-dealer. As such, ZCM was a “person… directly controlling… [a] broker-dealer,” making it “at the time of the alleged misconduct, . . . a person associated with a broker-dealer’ subject to the Commission’s jurisdiction under Section 15(b)(6) of the Exchange Act.” See Section 3(a)(18) of the Exchange Act. ZCM was in the business of providing financing to hedge funds and funds of funds. Since mid-2003, ZCM effectively ceased its business operations, having sold its major assets to a third-party and shifted its remaining operations into wind-down mode. C. Facts Market Timing 3. Market timing of mutual funds includes (a) frequent buying and selling of shares of the same mutual fund or (b) buying or selling mutual fund shares in order to exploit inefficiencies in mutual fund pricing. Market timing, while not illegal per se, can harm other mutual fund shareholders because it can dilute the value of their shares. Market timing can also disrupt the management of the mutual fund’s investment portfolio, and frequent buying and selling of shares by market timers can cause the targeted mutual fund to incur costs it would not incur in the absence of the market timing. - 3 - 4. Some hedge funds trade through variable annuities to market time the underlying mutual funds. Variable annuities are securities that are insurance contracts that provide for tax-deferred accumulation of investment proceeds during the accumulation period and various payout options, including a series of payments to be made to a person named as the “annuitant” in the contract or another beneficiary whom the owner of the policy designates. The payments typically are scheduled to support the annuitant’s retirement. Hedge funds and others that engage in market timing through variable annuities, however, do not purchase the products in order to obtain the retirement income for themselves or family members or others dependent upon them. Rather, they purchase variable annuities to be able to market time the underlying mutual fund portfolios. Because issuers of variable annuities typically aggregate trades in their contracted fund complexes and transmit the trades on a net basis, trading through variable annuity contracts can make it more difficult for mutual funds that prohibit market timing to detect market timing activity or identify investors who are known market timers. ZCM Aided and Abetted its Hedge Fund Clients’ Violations of Federal Securities Laws 5. From 1999-2003, ZCM provided financing to various hedge funds, including some that utilized a market timing strategy. ZCM provided this financing through derivative structures known originally as “call options” and subsequently as “accreting strike basket transactions.” They were structured and operated in a manner similar to total return swaps. 6. With respect to the financing arrangements, ZCM generally placed the “leverage” it contributed as well as the “premium” or “principal” that its hedge-fund client contributed in accounts at one or more broker-dealers (“the managed accounts”). The financing arrangements permitted the hedge fund to contribute additional premium and increase the leverage provided by ZCM subject to a total dollar cap for the transaction and a maximum ZCM contribution of 75% (in one instance 80%) of the total assets in the managed accounts. ZCM opened managed accounts at brokerage firms in the names of special purpose vehicles (“SPVs”) that ZCM formed. Pursuant to a limited power of attorney, ZCM granted trading authority within the accounts to its hedge-fund client or the client’s investment adviser. The hedge fund or its adviser made all trading decisions with respect to purchases and sales of shares of mutual funds in the managed accounts. The hedge fund or its adviser communicated those decisions directly to the brokers. ZCM, as the owner of the managed accounts, routinely received account statements. ZCM would then track the leverage ratio of the financing arrangement to ensure that it did not exceed the maximum percentage allowed under the applicable derivative agreements. To ensure against diversion or dissipation of the premium and leverage in the managed accounts, ZCM also retained authority over all transfers of funds into and out of these brokerage accounts. To transfer funds among SPVs or accounts, the hedge funds would need to request that ZCM’s employees authorize wire transfers or journaling of funds between brokerage accounts. 7. The hedge-fund client was entitled to receive all gains, if any, resulting from its trading in the managed accounts, and bore any losses, while ZCM received only a financing charge on the leverage it provided of LIBOR plus a fixed amount ranging from 115 to 169 basis points, depending on the deal. - 4 - 8. ZCM’s hedge-fund clients knew that numerous mutual funds did not like market timing and that many of these mutual funds prohibited market timing. In an effort to avoid being detected and potentially blocked from making market-timing trades in these funds, each of these hedge funds submitted trades in ways designed to avoid detection by disguising their and ZCM’s identities or masking the trades in omnibus transactions. 9. For example, ZCM and the hedge funds used SPVs to mask their identities and execute market timing trades. ZCM first used SPVs in connection with its market timing business in May 2000 when it opened eight SPVs for one hedge fund client (“Hedge Fund A”). 10. In or around October, 2000, another hedge fund client (“Hedge Fund B”) requested that ZCM create an SPV owned by ZCM but under a different name. In an email, a former ZCM managing director noted that Hedge Fund B had advised him that it would “cause problems if ZCM is viewed as being the direct investor.” The managing director wrote that Hedge Fund B suggested setting up an SPV under a different name because a different name was needed to “intermediate” the purchase of mutual funds. When asked what would be problematic about ZCM being viewed as the direct investor, the ZCM managing director wrote that “[t]his is the familiar problem that mutual funds dislike mutual fund timers that arb their redemption policies.” Another former ZCM managing director responded that ZCM had previously “set up subsidiaries of [ZCM] (with non-ZCM) names” in connection with its financing arrangement with Hedge Fund A and asked whether that would “solve the problem.” ZCM proceeded to create for Hedge Fund B an SPV, to which it assigned a name not recognizable as connected to ZCM. 11. In addition, ZCM set up SPVs for use by two other hedge fund clients at the time the financing transactions were initiated in 2000 and 2001. 12. Further, in 1999, Hedge Fund B requested that ZCM purchase annuity policies with ZCM as owner and one of several ZCM employees named as annuitant on each policy. In December, 2000, a ZCM managing director wrote in an e-mail that Hedge Fund B was doing so because mutual funds were “constantly prohibiting” it from trading, and the variable annuity structure provided a “screen” that made it harder for the underlying mutual funds to detect its market timing activity. From 1999 to 2001, at the request of this counterparty, ZCM purchased at least nine variable annuity contracts. The annuitants named on these policies were ZCM employees, though ZCM was designated as the owner and beneficiary of the policies. Any profits or losses accrued for the benefit of Hedge Fund B. Hedge Fund B then engaged in market timing in the underlying mutual fund portfolios with financing provided by ZCM. 13. In or around February, 2002, a ZCM risk management employee cautioned ZCM’s senior management by email that ZCM’s hedge funds clients’ market timing transactions exposed the company to potential “reputational” risk because some might view the practice of market timing as harmful to other mutual fund shareholders. ZCM management imposed a freeze on any new financing transactions with mutual fund market timers pending ZCM’s review of and further inquiry into the business. In addition, internal auditors at Zurich Global Assets, acting at the request and direction of in-house counsel, were conducting a review of operational deficiencies with regard to ZCM’s financing of Hedge - 5 - Fund B that had come to light in the fall of 2001, after Hedge Fund B’s election to terminate its financing arrangement with ZCM. In March 2002, the auditors made a number of comments and recommendations, including the suggestion, with regard to potential reputational risks, that ZCM assess ZCM’s continued participation in market timing deals given the prohibitions by some mutual fund companies. A new management team that was installed in April 2002 maintained the freeze on any new financing transactions with hedge funds engaged in market timing of mutual funds, and ZCM did not thereafter enter into such financing transactions. However, while the financing transaction with Hedge Fund B had already been terminated in August 2001, ZCM continued to finance its three other existing market timing clients until the fall of 2003. ZCM Profited While Its Clients’ Short-Term Trading Harmed Mutual Funds and Their Shareholders 14. ZCM profited from the fees it received from the business of providing derivative financing to hedge funds engaging in a mutual-fund market timing strategy. From 1999 through September, 2003, ZCM’s revenue from providing financing to the four hedge fund clients was approximately $11 million. Numerous mutual funds and their shareholders suffered dilutive harm caused by short-term market timing trading done by these hedge funds with financing provided by ZCM. D. ZCM Aided and Abetted and Caused Violations of Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder 15. As a result of the conduct described above, ZCM willfully aided and abetted and caused violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, which prohibit, in connection with the purchase or sale of securities, the use of any manipulative or deceptive device, including any device, scheme or artifice to defraud; making any untrue statement of material fact or omitting to state a material fact when doing so makes the statement made misleading; or engaging in any act, practice or course of business which operates or would operate as a fraud. ZCM’s market timing hedge fund clients engaged in a scheme to defraud mutual funds. Specifically, these clients utilized numerous deceptive practices to market time mutual funds. ZCM knowingly provided substantial assistance to these hedge funds. For example, ZCM created seemingly unaffiliated SPVs in whose name multiple brokerage accounts were opened, and this enabled its hedge fund clients to disguise their identities (and ZCM’s identity) to market time mutual funds. Accordingly, ZCM willfully aided and abetted and caused violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. E. Respondent’s Remedial Efforts 16. In determining to accept the Offer, the Commission considered remedial acts promptly undertaken by Respondent and cooperation afforded the Commission staff by Respondent during its investigation. - 6 - F. Undertakings 17. Ongoing Cooperation. Respondent shall cooperate fully with the Commission in any and all investigations, litigations or other proceedings relating to or arising from the matters described in this Order. In connection with such cooperation, Respondent has undertaken: a. To use its best efforts to cause employees to be interviewed by the Commission’s staff at such times as the staff reasonably may direct; b. To use its best efforts to cause employees to appear and testify truthfully and completely without service of a notice or subpoena in such investigations, depositions, hearings or trials as may be requested by the Commission’s Staff; and c. To use its best efforts to facilitate access to its former employees. 18. Respondent undertakes pursuant to Rule 1101 of the Commission’s Rules on Fair Fund and Disgorgement Plans [17 C.F.R. § 201.1101], and in consultation with the Staff of the Commission, to develop, with the assistance of an expert consultant, a plan to distribute the $16,809,354.42 in disgorgement, civil penalties, and interest as provided for in the Order (“Distribution Plan”), which will be submitted to the Commission within 180 days for notice in accordance with Rule 1103 [17 C.F.R. § 201.1103]. Following a Commission order approving a Distribution Plan, as provided in Rule 1104 [17 C.F.R. § 201.1104], Respondent shall take all necessary and appropriate steps to assist the Commission-appointed Administrator of the final Distribution Plan. Respondents shall bear the costs of administering and implementing the final Distribution Plan. IV. In view of the foregoing, the Commission deems it appropriate and in the public interest to impose the sanctions agreed to in Respondent’s Offer. Accordingly, pursuant to Section 15(b) and Section 21C of the Exchange Act and Section 9(b) of the Investment Company Act, it is hereby ORDERED that: A. Respondent shall pay disgorgement in the amount of $11 million, pre-judgment interest in the amount of $1,809,354.42, and a civil money penalty in the amount of $4 million, for a total payment of $16,809,354.42. B. Respondent shall cease and desist from committing or causing any violations and any future violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; C. Respondent is hereby censured; and D. Respondent shall, within 30 days of the entry of this Order, pay disgorgement of $11 million, pre-judgment interest in the amount of $1,809,354.42, and a civil money penalty in the amount of $4 million to the Securities and Exchange Commission: Such payment shall be: (A) made by wire transfer, United States postal money order, certified check, bank cashier’s check or - 7 - bank money order; (B) made payable to the Securities and Exchange Commission; (C) wired, hand-delivered or mailed to the Office of Financial Management, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Alexandria, Stop 0-3, VA 22312; and (D) submitted under cover letter that identifies ZCM as Respondent in these proceedings, the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Kay L. Lackey, Assistant Regional Director, Division of Enforcement, Securities and Exchange Commission, Northeast Regional Office, 3 World Financial Center, New York, NY, 10281. E. There shall be, pursuant to Section 308(a) of the Sarbanes-Oxley Act of 2002, a Fair Fund established for the funds described in Section IV.A and D (“Fair Fund Distribution”), which shall be distributed to the affected mutual funds. Regardless of whether any such Fair Fund distribution is made, amounts ordered to be paid as civil money penalties pursuant to this Order shall be treated as penalties paid to the government for all purposes, including all tax purposes. To preserve the deterrent effect of the civil penalty, Respondent agrees that it shall not, after offset or reduction in any Related Investor Action based on Respondent’s payment of disgorgement in this action, argue that it is entitled to, nor shall it further benefit by offset or reduction of any part of ZCM’s payment of a civil penalty in this action (“Penalty Offset”). If the court in any Related Investor Action grants such a Penalty Offset, Respondent agrees that it shall, within 30 days after entry of a final order granting the Penalty Offset, notify the Commission’s counsel in this action and pay the amount of the Penalty Offset to the United States Treasury or to a Fair Fund, as the Commission directs. Such a payment shall not be deemed an additional civil penalty and shall not be deemed to change the amount of the civil penalty imposed in this proceeding. For purposes of this paragraph, a “Related Investor Action” means a private damages action brought against Respondent by or on behalf of one or more investors or mutual funds based on substantially the same facts as alleged in this Order instituted by the Commission in this proceeding. F. Respondents shall comply with the undertakings enumerated in Section III.F.18. By the Commission. Nancy M. Morris Secretary
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