Petition — Arthur Lipper Corp. v. Securities & Exchange Commission

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Supreme Court, U. S,

™ FILEQ ..

| AUG 18 1977,

MICHAEL RODAK, JR., CLERK ]

IN THE

preme Court of the United States

OctToBER TERM, 1976

No. a0 «2735

ARTHUR LIPPER CORPORATION AND ARTHUR Lipper III,

Petitioners,

SECURITIES AND ExcHance CoMmMiIssION, Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

JoHN A. DUDLEY

SuLLIVAN & WORCESTER

1025 Connecticut Avenue, N.W.

Washington, D.C. 20036

Attorney for Petitioners

Passs or Brnon S. ADAMS PRINTING, Inc., Wasnineton, D. C.

eta. ek ee

INDEX TO PETITION

Page

CD cs Be ceed wane y es 2

gE ed ER Oe ee Ce ee ee 2

ssc cec ceeenbineetnnepans 2

STaTuTE aND Ruue INVOLVED ......... cc cc ccccccees 3

STATEMENT OF THE CASE ...............002. eet eens 3

SuMMARY OF ARGUMENT .......... ee : aed See 8

REaSoNS FOR GRANTING THE WRIT ................--- 9

Ce eee ee es 22

TABLE OF AUTHORITIES

CasEs:

Gordon v. New York Stock Exchange, 422 U.S. 659

DD ~c\ sh gn can gc aun dhbe Che eaeeeeneaenaees 4

Santa Fe v. Green, —— U.S. —— No. 75-1753, 97 S.Ct.

fo Rr rrr rere 9, 16

Ernst € Ernst v. Hochfelder, 425 U.S. 185 (1976) .. 9,12,

14, 15

Sanders v. John Nuveen & Co., —— F.2d —— No.

75-1260 (C.A. 7, April 22, 1977) ............ 9, 15, 19

In re Steadman, [1977-78 Transfer Binder] Fep. Szc.

+ << 5 ¢ eA ree 12

IN THE

Supreme Court of the United States

OcToBER TERM, 1976

No.

ARTHUR LIPPER CORPORATION AND ARTHUR Lipper III,

Petitioners,

SECURITIES AND EXCHANGE CoMMISSION, Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

Petitioners, Arthur Lipper Corporation, an invest-

ment banker and a securities brokerage firm which was

a member of the New York and other national securi-

ties and commodities exchanges, and Arthur Lipper

III, its president and principal stockholder, respect-

fully pray that a writ of certiorari issue to review a

judgment and opinion of the United States Court of

Appeals for the Second Circuit. The Court of Appeals

(1) affirmed an order of the Securities and Exchange

Commission (‘‘SEC’’) that found Petitioners had

aided and abetted IOS Ltd., a non-United States in-

vestment manager of a group of non-United States

investment companies, in arranging brokerage prac-

tices which violated Section 10(b) of the Securities

Exchange Act of 1934, 15 U.S.C. 78(j), and Rule 10b-5

thereunder, 17 C.F.R. 240.10b-5, and (2) modified the

SEC’s sanction by reducing Petitioners’ permanent

expulsion from the securities business to a retroactive

12-month suspension. Petitioners seek a writ of cer-

tiorari solely to review (1)—the SEC’s determination

that Petitioners aided and abetted violations of Rule

10b-5.

OPINIONS BELOW

The opinion of the Court of Appeals (App 1a) °* is

reported at 547 F.2d 171. The opinion of the SEC

(App 29a) is unreported.

JURISDICTION

The judgment of the Court of Appeals was entered

on December 10, 1976, a timely petition for rehearing

filed by the SEC was denied on March 22, 1977. The

jurisdiction of this Court is invoked under 28 U.S.C.

1254(1).

QUESTIONS PRESENTED

1. Whether a securities broker can be found by

the SEC to be an aider and abettor in a deception vio-

lative of the SEC’s Rule 10b-5 where the broker, in

good faith and upon advice of qualified counsel, exe-

cuted securities transactions in compliance with in-

structions of the broker’s institutional customers (such

*“* App-——’”’ refers to pages of the appendix of Petitioners.

instructions being customary and in accord with pre-

vailing securities industry practices) without deter-

mining whether the institutional customers and their

investment manager had abided by their fiduciary

responsibilities.

2. Whether the SEC can export to and impose in

foreign lands its interpretation of American legal

concepts of a “gross breach of fiduciary duty” (App

41a) so that Rule 10b-5 duties are imposed upon rela-

tionships between foreign investment managers and

foreign investment companies and their shareholders.

3. Whether due process is denied where the SEC

is not required to shoulder the burden of introducing

evidence in an administrative proceeding charging Pe-

titioners with manipulative and deceptive practices.

STATUTE AND RULE INVOLVED

Section 10(b) of the Securities Exchange Act of

1934, 15 U.S.C. 78(j), and Rule 10b-5 thereunder, 17

C.F.R. 240.10b-5, are set forth in the Appendix, p. 74a.

STATEMENT OF THE CASE

This case is a further chapter in the SEC’s continu-

ous attempts, with the support of the Second Circuit

courts, to expand a rule of law of the SEC’s own crea-

tion, namely Rule 10b-5. The expansion of Rule 10b-5

in this case is twofold: (1) for the first time a securi-

ties broker is required (at the risk of being found an

aider and abettor) to determine whether its unaffili-

ated institutional customers and the customers’ invest-

ment manager are engaging in a breach of trust and

(2) novel American concepts of fiduciary duties are

imposed wholesale to corporations incorporated and

conducting business outside the United States.

Petitioners were found to have been secondarily lia-

ble as “aiders and abettors”’. The primary violator was

said to have breached its fiduciary duty. The fiduciary

was IOS Ltd., a Swiss-based, Panama incorporated

investment manager of a group of foreign mutual

funds, namely The Fund of Funds Ltd., and Regent

Fund Ltd., two Canadian investment companies, and

IIT, an investment company organized as a Luxem-

bourg Trust. The cestui que are the shareholders of

those foreign funds.

The breach of trus. involved brokerage arrange-

ments existing between the foreign investment com-

panies and Petitioner Arthur Lipper Corporaticn, an

American securities firm which was a member of the

New York Stock Exchange (“NYSE”’), other national

stock exchanges and the National Association of Se-

curities Dealers (“NASD”).* Arthur Lipper Corpora-

tion was conducting an institutional brokerage busi-

s during a period of extended controversy among

the NYSE. institutional investors and the SEC. The

controversy involved such fundamental questions as

justification for the very existence of the NYSE and,

of particular relevance here, the amount and manner

in which its members were compensated.’

The institutional brokerage practices challenged

here by the SEC were the methods whereby members

of the NYSE, who were acting as brokers in executing

2 The NASD is the self-regulatory association organized under

Section 15A(a) of the Securities Exchange Act of 1934, 15 U.S.C.

780-3.

* See Gordon v. New York Stock Exchange, 422 U.S. 659 (1975).

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transactions, were permitted to share, at their cus-

tomers’ direction, commissions with other members of

the brokerage community, provided none of the com-

mission dollars were shared with members’ customers,

t.e., so-called give-up practices. During the period in

question, 1967-1968, it is uncontested that give-up ar-

rangements pervaded the entire securities industry.

These years as the court below noted:

- . . were years of considerable uncertainty as to

the climate concerning give-ups; the Commission

was torn between its desire to move away from

uniform fixed commission rates, a movement

which would eliminate the economic basis for cus-

tomer-directed give-ups, and its belief that exist-

ing give-up opportunities should be utilized by

investment advisers for the benefit of shareholders

in mutual funds. (App 24a)

The salient facts are few and, for the most part,

never in dispute. Arthur Lipper Corporation was or-

ganized by Arthur Lipper III to engage in an institu-

tional securities brokerage business. As a result of a

1967 settlement negotiated with the SEC, the IOS for-

eign investment companies were required to execute

transactions either through a foreign broker or

through a U.S. broker with a foreign branch office.

Arthur Lipper Corporation was organized with its

principal office in New York City, became a member

of the NYSE, other national securities exchanges and

the NASD and opened branch offices in London and

Geneva. An elaborate communications network was

installed between the branch offices and New York.

The IOS foreign investment companies became cus-

tomers of Arthur Lipper Corporation. They were able

to execute efficiently transactions in the United States

securities markets through the communications net-

work. This communications network was also used by

the IOS group to issue and receive instructions

through Arthur Lipper Corporation to numerous

other brokerage firms executing transactions at IOS’

direction.

In accordance with the customary securities indus-

try practices at the time, the foreign investment com-

panies issued written instructions ordering Arthur

Lipper Corporation and the other brokers to share

commissions on transactions both executed on the na-

tional securities exchanges and in the over-the-counter

market. As is the custom for NYSE member firms exe-

cuting agency transactions in the over-the-counter

market, Arthur Lipper Corporation at all times

charged only the NYSE mandated minimum commis-

sion rate.

Pursuant to the written instructions of the foreign

investment companies Arthur Lipper Corporation

shared over-the-counter commissions with Investors

Planning Corporation (“IPC’’), a broker which was

an 80% owned subsidiary of IOS. IPC was registered

with the SEC and was a member of the NASD. The

record shows that other brokers which were members

of the NYSE received the same instructions from the

foreign investment companies as those received by

Arthur Lipper Corporation and shared commissions

on over-the-counter transactions with IPC.‘ Arthur

*The record demonstrates that the following brokers followed in-

structions of the IOS related funds and ,like Arthur Lipper Corpo-

ration, shared commissions with IPC on over-the-counter transac-

tions: Ladenberg, Thalmann & Company; Glore, Forgan & Staats,

Inc; Adams & Peck; Bear, Stearns; Emmanuel Deetjen & Co;

Jessup & Lamont; Drexel, Harriman & Ripley ; George Robinson &

Co; Baker, Weeks & Co.; Hertz, Warner & Co; Hertzfeld & Stern;

and White, Weld & Co. The NYSE was aware of the practice fol-

fined. Write stern snisrcacnre Ces Ge Te en

Lipper Corporation and the other brokers were per-

mitted to share over-the-counter commissions with

IPC because IPC and the firms executing the transac-

tions were all members of the NASD. During the

period in question approximately $2.6 million in com-

missions were shared between Arthur Lipper Corpora-

tion and IPC, with the latter firm receiving approxi-

mately $1.4 million.

The SEC charged that IOS breached its fiduciary

duty to the foreign investment companies by causing

those foreign investment companies to direct Arthur

Lipper Corporation to share over-the-counter commis-

sions with a subsidiary of IOS. In its opinion the SEC

found that IOS and Petitioners should have negoti-

ated a 50% reduction in the customary NYSE com-

mission rate charged by Arthur Lipper Corporation.

Failure to negotiate this 50% reduction was a “‘gross

breach of fiduciary duty” by IOS which Petitioners

aided and abetted. (App 41a) The SEC expelled Pe-

titioners permanently from the securities industry.

(App 72a)°

The Court of Appeals ignored the SEC’s theory that

Arthur Lipper Corporation and IOS were required to

negotiate a 50% reduction in NYSE commission rates.

Judge Friendly, writing for the Court of Appeals, re-

jected the SEC’s conclusion that over-the-counter com-

mission sharing was per se fraudulent. However,

relying on precedents in several Second Circuit de-

lowsd by its members of sharing over-the-counter commissions with

NASD members, and did not disapprove of the practice. There is

no evidence in the record that any firm, exchange or self-regulatory

body considered the practice improper.

*The Administrative Law Judge had suspended Arthur Lipper

Corporation only from over-the-counter trading for twelve months

and Mr. Lipper from the securities industry for the same period.

cisions which have superimposed the common law of

fiduciaries upon the SEC’s Rule 10b-5, Judge

Friendly opined that IOS should have returned the

shared commissions to the foreign investment compan-

ies or reduced the advisory fee IOS charged the for-

eign investment companies by the amount of broker-

age commissions that IOS was able to recapture

through its subsidiary, IPC. Since the SEC had pro-

ceeded under another theory, no evidence was intro-

duced in the administrative proceeding to establish

whether or not the shareholders benefited from the

commission sharing with IPC.

In December 1976 the Court of Appeals reduced the

permanent sanctions imposed by the SEC to twelve

month suspensions of Petitioners from the securities

business; the suspensions ran from the date of the

SEC’s order, October 24, 1975. (App 72a)

SUMMARY OF ARGUMENT

The SEC instituted these proceedings in September

1969; its decision over six years later concluded that

Petitioners should have negotiated a 50% reduced

commission.’ The Court of Appeals disagreed and con-

cluded that Petitioners made the proper commission

charge but since IOS did not reduce its advisory fee,

Petitioners aided and abetted IOS in its wrongdoing.

On the other hand, if IOS had reduced its advisory

fee, Petitioners conduct, which was exactly the same

* Three of the six years involved an unexplainable lapse between

the date oral argument was held before the SEC Commissioners and

the date on which the decision was entered. The length of time dur-

ing which the SEC Commissioners had the matter under advisement

suggests that the issues, which were wholly legal in nature, were not

readily ascertainable, even for the most sophisticated legal minds

knowledgeable and trained in securities law.

;

in either event, would have been laudable. It seems

apparent that Petitioners should not be placed in peril

contingent upon the actions of IOS, over which Peti-

tioners had neither control nor influence. This is the

issue which neither the SEC nor the court below faced.

The Court of Appeals sought to “soften the blow”

by reducing the SEC’s sanction and making the sus-

pension retroactive. However, Petitioners are indelibly

stained with a finding that they participated in a

fraud—a finding which has an irrevocable effect on

Petitioners’ reputation in an industry where reputa-

tion is crucial.

REASONS FOR GRANTING THE WRIT

I. The Decision Below Is In Conflict With The Decisions Of This

Court In Sania Fe v. Green, —— U.S. —— No. 75-1753, 97 S.Ct.

1293 (March 23, 1977), and Ernst & Ernst v. Hochfelder, 425

U.S. 185 (1976): It Aiso Conflicts With The Holding Of Sanders

v. John Nuveen & Co., —— F.2d —— No. 75-1260 (C.A. 7,

April 22, 1977).

A. Santa Fe v. Green

The decision below failed to consider the express

language in Section 10(b) of the Securities Exchange

Act of 1934 (“Act”) and, instead, relied on the Second

Circuit’s ‘‘gloss” coated on Rule 10b-5 over the years.

Section 10(b) of the Act authorizes the SEC to adopt

rules outlawing manipulative or deceptive practices.

The Court of Appeals simply accepted the SEC’s as-

sumption that any breach of fiduciary duty constitutes

fraudulent conduct in violation of Rule 10b-5. This

Court, however, in the Santa Fe case held that conduct

must be manipulative or deceptive to violate Rule

10b-5. This Court said (— U.S. —, slip op. at 10):

The language of §10(b) gives no indication

that Congress meant to prohibit any conduct not

involving manipulation or deception. Nor have we

been cited to any evidence in the legislative his-

tory that would support a departure from the lan-

guage of the statute. ... Thus the claim of fraud

and fiduciary breach in this complaint states a

cause of «ction under any part of Rule 10b-5 only

if the conduct allegead can be fairly viewed as

‘manipulative or deceptive’ within the meaning of

the statute.

The Petitioners’ conduct which the Court of Appeals

found fraudulent was Arthur Lipper Corporation’s

following written instructions from its customers to

share over-the-counter commissions. But there was

nothing unusual about such instructions. At that time

institutional customers issued similar instructions to

brokers executing their transactions in all markets. As

long as the instructions provided for commission shar-

ing with another bona fide member of the brokerage

community, the executing broker was not acting in-

consistent with the various rules of the NYSE and the

NASD, the securities self-regulatery agencies. There

was no rule of law which required executing brokers

to determine whether investment managers and insti-

tutional customers were living up to whatever fidu-

ciary resposibilities they may have assumed towards

shareholders of the institutional customers, particu-

larly one, as is the case here, which is unaffiliated with

the institutional customer and its investment manager.

The gist of the breach of fiduciary duty is Judge

Friendly’s belief that LOSS deceived the shareholders

of tie foreign investment companies. Thus, it is im-

plicit in the decision of the court below that if 10S

had made arrangements to disclose in the prospectuses

of the foreign investment companies that IOS was

receiving compensation in addition to that received

for its services in furnishing investment advisory serv-

ices, no deception would have existed.’ Although the

prospectuses did not contain such disclosure, there is

absolutely no evidence that Petitioners in any way

joined in or ‘‘aided and abetted”’ the alleged deception.

Even under United States fiduciary law, Arthur Lip-

per Corporation, as an unaffiliated broker acting as

agent for an investment company in executing transac-

tions in the securities markets, has no obligation to

police its customers’ activities to ascertain whether its

customers and their fiduciaries have abided by their

responsibilities.

It is vitally important to understand, as conceded

by the court below, that the give-up instructions were

not fraudulent per se. This finding is, of course, at

odds with the decision of the SEC. However, the Court

of Appeals was faced with an evidentiary record, con-

veniently ignored by the SEC, establishing that

Arthur Lipper Corporation did precisely what was

done by all other members of the NYSE. Accordingly,

the Court of Appeals found unacceptable the SEC’s

theory that Arthur Lipper Corporation and IOS could

have negotiated a 50% reduction in the commission

rate. There simply was no evidence that such negotia-

tion could or ever did occur in the securities industry.

Since IOS’ conduct was not fraudulent per se and

since the only possible deception involved relationships

between IOS, its foreign investment companies and

their shareholders, Petitioners’ conduct cannot be vio-

’ This is wholly apart from the question discussed, infra, whether

the SEC may expand Rule 10b-5 to apply to fiduciary relationships

outside the United States.

lative of Rule 10b-5—clearly Petitioners played no ac-

tive part in any alleged “deception’’. To the extent

that the court below snared Petitioners in this Rule

10b-5 web, the decision conflicts with this Court’s hold-

ing in Santa Fe.

B. Ernst & Ernst v. Hochfelder

In the recent Hochfelder case this Court held that

scienter i.e., an intent to deceive, manipulate or de-

fraud, was a necessary element in a violation of Sec-

tion 10(b) and Rule 10b-5. Following a comprehensive

review of the legislative and administra.ive history of

the section and rule this Court stated (425 U.S. at

206) that “there is no indication that Congress in-

tended anyone to be made liable for such [illicit] prac-

tices unless he acted other than in good faith”. Hoch-

felder involved a suit for damages under Rule 10b-5

in which this Court refused to hold an accounting firm

liable in the absence of evidence of a fraudulent intent

or at least reckless conduct.

The court below indicated (App 15a) that it was

assuming that the same element of scienter, which this

Court found in Hochfelder was necessary to create

liabilities for damages under Rule 10b-5, governs SEC

administrative proceedings to revoke a broker’s li-

eense.® The court below concluded, however, that in

® However, the validity of this assumption has been questioned

by a recent decision of the SEC, In Re Steadman, [1977-78 Trans-

fer Binder] FED. SEC. L. REP. (CCH) { 81,243. In that case,

the SEC indicated that the scienter requirement of Hochfelder was

inapplicable to SEC administrative proceedings involving Rule

10b-5, SEAR No. 13695, p. 17. In Hochfelder this Court left open

the question of the necessity of the scienter requirement under

Rule 10b-5 in actions other than an action for damages, 425 U.S.

charging the full NYSE commission rates on over-the-

counter transactions and in rebating half of the com-

missions to a subsidiary of IOS which retained the

commissions paid to it, Petitioners’ conduct consti-

tuted a “cunning device”. (App 19a) This was so,

Judge Friendly wrote, because these commission pay-

ments ‘“‘should have been turned over to the funds

directly or applied to reduce the advisory fee”. (App

19a) No citation of authority accompanies these state-

ments; for there is no rule of law, even United States

fiduciary law, which necessarily required this result.

No evidentiary record supports this finding. In fact,

the IOS foreign investment companies experienced

higher operating expenses than U.S. investment com-

panies, although the fees charged were comparable. In

any event, the executing broker’s responsibility to his

customers ended when the broker carried out the cus-

tomer’s instructions to share the commission with an-

other broker. The apparent requirement by the Court

of Appeals, that the executing broker second-guess his

customer’s instructions, is unprecedented.

Indeed, it is ironic that the Court of Appeals failed

to discuss a proposed rule which the SEC had circu-

lated for comment in early 1968.° The SEC’s proposed

Rule 10b-10 would have been adopted under Section

10(b) of the Securities Exchange Act and would have

achieved precisely the result suggested by the court

below, t.e., an investment adviser which recaptures

193, N. 12. As evidenced by the Steadman decision, whether the

SEC is bound by Hochfelder in its administrative proceedings, in-

volves an important, current question of federal law, present in

this case, which should be resolved by this Court.

* Proposed Rule 10b-10, Securities Exchange Act of 1934 Release

No. 34-8239, 33 Fed. Reg. 2393 (1968).

commissions through give-up practices would have been

required under proposed Rule 10b-10 to offset the

amount of commissions recaptured against the advi-

sory fee charged. Nothing in the release which accom-

panied the proposed rule, however, even suggests that

the executing broker over whom the SEC has broad

regulatory power, owed a responsibility to make cer-

tain that the recipient of the shared commission did,

in fact, return it indirectly to the customer. Moreover,

Rule 10b-10 was not adopted. The NYSE banned all

forms of give-up practices in December 1968. Obvi-

ously, the SEC did not then believe that Rule 10b-5

banned give-up practices that did not result in the

investment advisory fee offset; otherwise, the SEC

would not have felt the need to propose a rule such as

Rule 10b-10.

In a real sense, the court below has promulgated the

long-departed proposed Rule 10b-10 under an expan-

sive “interpretation’’ of Rule 10b-5 and applied it ez

post facto to Petitioners.

In addition, in considering this Court’s decision in

Hochfelder, the Court of Appeals concluded that ad-

vice of counsel was not relevant in determining whether

a violation of Rule 10b-5 occurred; advice of counsel

was only relevant to the question of penalty. We dis-

agree and contend that such a result runs counter to

Hochfelder. Where a broker seeks out competent

counsel to advise it concerning an extremely in-

tricate area of the securities law, and such counsel

determines that the broker may follow the prevailing

industry practice until such time as the SEC makes it

unlawful by rule, such conduct is highly relevant to

whether the broker intended to engage in fraudulent

conduct. In faet, the Court of Appeals ultimately

agreed that the advice rendered by counsel was cor-

rect, at least to the extent that the SEC was wrong in

saying that over-the-counter give-ups were fraudulent

per se. Even though the SEC did not reach the ques-

tion of counsel’s independence, the Court of Appeals

rejected Petitioners’ reliance on advice of counsel on

the grounds that this same counsel had represented

IOS in other matters. The court never explains, how-

ever, why this element should redound to the detri-

ment of Petitioners or why their reliance on the ad-

vice is evidence of a fraudulent intent on their part.

A review of the evidentiary record establishes that

Petitioners acted in good faith on the advice of well-

qualified ** counsel and in accordance with then existing

securities industry practices. The record shows, there-

fore, that Petitioners did not intend to deceive, manip-

ulate or defraud and the decision below conflicts with

Hochfelder in this regard.

C. Sanders v. John Nuveen & Co.

John Nuveen involved a Rule 10b-5 class action suit

by purchasers of short term commercial paper against

a brokerage firm acting as underwriter of the commer-

cial paper. This Court granted the broker’s petition

for certiorari, vacated the order of the Court of Ap-

peals affirming judgment against the broker and re-

manded the case in the light of Hochfelder, 425 U.S.

185 (1976). On remand, the Court of Appeals for the

Seventh Circuit found “the record is barren of any

showing of actual intent to deceive, manipulate or de-

fraud” (slip op. at 3); therefore the Court of Appeals

*° Petitioners’ counsel! had served as a director of the SEC s divi-

sion charged with the regulation of investment companies, as well as

serving as the SEC’s Genera] Counsel.

held that the judgment could not rest on a violation of

Rule 10b-5. The trial court had found that the broker’s

investigation of the issuer was deficient and that an

appropriate investigation would have revealed the is-

suer’s fraud. The Court of Appeals held that, never-

theless, the broker’s conduct was not reckless; at least

to the extent such conduct rose to the level of ‘‘a lesser

form of intent” (slip op. at 4) and hence the equiv-

alent of scienter required for a Rule 10b-5 violation.

The decisior. of the Court of Appeals for the Second

Cireuit conflicts with this holding. The standard ap-

plied by the court below was that Petitioners knew

what they were doing 1.e., they knew they were sharing

commissions with a broker who performed no services

in return for those commissions. But the industry

practice at that time was exactly that—executing

brokers always followed their customer’s instructions

to share commissions with other brokers. No one ever

suggested that it was the executing broker’s duty to

determine whether the broker receiving the shared

commissions could lawfully receive them. The SEC

never suggested that an unaffiliated executing broker

had such a duty. Because of the N YSE’s fixed commis-

sion rate structure (which Petitioners deplored, but to

which they were irrevocably bound), it certainly was

not negligent or reckless on Petitioners part to follow

their customers’ instructions.

Il. The Decision Below Expands Rule 10b-5 Fiduciary Concepts

To Persons Operating Outside The United States.

The Court of Appeals found that Petitioners’ juris-

dictional arguments ignored the fact “that the fraud

charged by the SEC was perpetrated in the United

States by payments from one registered broker-dealer

—

(Lipper Corp.) to another (IPC) in connection with

the purchase and sale of securities in the United

States over-the-counter market”. (App 13a) Peti-

tioners did not ignore this; the Court of Appeals sim-

ply engaged in the expediency of misstating a liti-

gant’s argument. Keeping in mind that Section 10(b)

of the Act requires a deception as a necessary element

in a violation,” it is quite clear that the only persons

who could possibly have been deceived were the share-

holders of the foreign investment companies. The give-

up instructions, it is recalled, were issued by author-

ized representatives of the foreign investment com-

panies. Therefore, Arthur Lipper Corporation’s cus-

tomers were not deceived.

Petitioners have been unable to discover the origin

of the rule of law relied on by the Court of Appeals

which imposes an obligation on the part of the mana-

ger of foreign investment companies to tell sharehold-

ers that additional compensation was being paid to it

through shared brokerage commissions.

First, one would assume that shareholders in a Ca-

nadian investment company and a Luxembourg trust

would not be governed by the common law fiduciary

standards engrafted upon Rule 10b-5 by the SEC, with

the aid and assistance of the Second Circuit. We cer-

tainly believe that a citizen of Hong Kong who bought

shares in the Luxembourg trust would be surprised to

discover that the United States federal securities laws

were applicable to his purchase of interests in the

trust. Second, and most important, Petitioners’ juris-

dictional argument, which the Court of Appeals mis-

stated and hence avoided, is as follows: any deception

'' See Santa Fe, supra.

in this factual context had to be related to the pur-

chase of the securities issued by the foreign invest-

ment companies. In other words, the real charge,

which neither the SEC nor the court below articulated,

is that the prospectuses of the foreign investment com-

panies did not disclose tc prospective investors resid-

ing outside the United States (and ultimately to the

shareholders of the investment companies) that IOS

was receiving compensation in addition to the com-

pensation received in its capacity as investment adviser.

Once this concept is accepted, it becomes readily clear

that a necessary element is missing for a violation of

Section 10(b) and Rule 10b-5. In connection with the

purchase or sale of the securities of the foreign invest-

ment companies there was no “use of any means or

instrumentality of interstate commerce or of the mails,

or of any facility of any national securities exchange”

as is required by the express language of the Section

and Rule.

The U.S. jurisdictional means were not used in con-

nection with the sale of the shares of the foreign in-

vestment companies. The fact that the U.S. jurisdic-

tional means were used in the purchase and sale of the

portfolio securities of the foreign investment compan-

ies is immaterial since no ‘‘deception” occurred with

respect to the purchase and sale of the portfolio secur-

ities. The alleged ‘‘deception’’ could only have oc-

curred outside the United States in the offer and sale

of the shares of the foreign investment companies; as

the record of this case makes clear, a necessary ele-

ment for a Rule 10b-5 violation is missing with respect

to the shares issued by the foreign investment com-

panies to their shareholders, namely use of U.S. juris-

dictional means.

Both the SEC and the court below refused to ad-

dress Petitioners’ contention ; and in avoiding it, were

able to expand Rule 10b-5 to foreign jurisdictions.

Moreover, as the evidentiary record shows, it was

the acceptable and customary practice in Europe for

an investment manager or banker, such as IOS, to

charge an additional commission for the placing of

orders with United States brokerage firms. Hence,

consistent with this established practice, IOS would

have been justified in charging a commission in addi-

tion to the compensation it received as investment

adviser. While this institutional practice may not be

either customary or even permitted in the United

States under national securities exchange regulations

or the federal securities laws, such evidence demon-

strates that IOS may not have engaged in a “decep-

tion” of its shareholders.

Ill. Petitioners Were Denied Due Process By The SEC

Although it rejected the SEC’s “fraud per se” rule,

the court below compounded the SEC’s denial of due

process: it too ignored the evidentiary record. Because

the SEC was convinced that commission sharing in the

over-the-counter markets was inherently fraudulent

in violation of Rule 10b-5, the SEC did not require its

staff to develop an administrative evidentiary record

which included any evidence that Petitioners had an

intent to defraud. Indeed, the evidence clearly estab-

lished that Petitioners did not intend to deceive any-

one. Proof of scienter, a prerequisite for a violation of

Rule 10b-5, (See Sanders v. John Nuveen & Co. supra,

slip op. at 9) is absent from the record of this case.

Petitioners introduced convincing evidence, com-

pletely ignored by the SEC, that Arthur Lipper Cor-

poration did precisely what was done by all other

members of the NYSE, that is:

(1) members charged the NYSE commission rates

in executing agency transactions in the over-

the-counter market ;

(2) this practice was in fact a requirement of the

NYSE in order to prevent commission rate-cut-

ting in the over-the-counter market for the same

customer with whom the member was doing

NYSE business ;

(3) members readily shared commissions at a cus-

tomer’s direction both on NYSE and over-the-

counter transactions ;

(4) the sharing of commissions on over-the-counter

transactions was permissible with other mem-

bers of the NASD and

(5) the foreign investment companies received best

execution of securities transactions through

Arthur Lipper Corporation.

The SEC had hoped that statements it had made in

various studies and in a SEC staff letter would be

acceptable proof of fraud. The statements announced

simply that give-ups in the over-the-counter market

were fraudulent because the commission rates in that

market were negotiable. Although the court below re-

jected such “proof”, Judge Friendly simply formu-

lated a new theory: IOS should have returned the

commissions to the foreign investment companies.

Since this was not the SEC’s theory at the administra-

tive trial, no evidence supports Judge Friendly’s

speculation.

A fatal blow to Judge Friendly’s theory would be

evidence that during this period the NYSE would

have sought to revoke Petitioners’ membership in the

NYSE for participating in a rebate arrangement to

the customers of the brokerage firm—the foreign in-

vestment companies. While neither Judge Friendly

nor the SEC were overly concerned with the NYSE

rules and regulations, Petitioners were in a different

boat. However convoluted the NYSE interpretations

may seem in hindsight (and Petitioners agree the

whole commission rate structure of the NYSE was an

odious relic of bygone days), nevertheless it is clear

that: (1) Arthur Lipper III was a businessman de-

pendent for his livelihood on adhering to those rules

and interpretations of the NYSE which governed his

brokerage arrangements and (2) IOS’ return of the

commission dollars to the foreign investment com-

panies would have been an unquestioned rebate

Secondly, IOS did perform research and sales serv-

ices for the foreign investment companies. The court

below specifically stated that shared commissions could

be used to pay for these services. (App 10a)

Thirdly, Petitioners sought out the advice of an

experienced and competent securities counsel—hardly

the course of action of one bent on participating in a

‘cunning device”.

Fourthly, the commission sharing payments were re-

corded methodically and openly on the books and rec-

ords of Arthur Lipper Corporation—books and rec-

ords which are readily available for inspection at any-

time without the necessity for a subpoena by the SEC,

the NYSE and the NASD. One would suspect that a

knowing participant in a “cunning device” would be

less circumspect.

It has shocked the SEC to learn that “scienter” is

to be a requirement of its own creation—Rule 10b-5.

To require the SEC to actually introduce evidence that

someone trapped in its administrative web intended to

deceive the other party to the transaction will un-

doubtedly precipitate the predictable anguished cries

of budgetary shortcomings and a lessening of investor

protections. The irony here, of course, is the inordi-

nate amount of SEC time and money spent on protect-

ing shareholders of foreign lands. In any event, Peti-

tioners are U.S. citizens and, as such, are entitled to

the constitutional protections of due process contained

within Amendment V of the U.S. Constitution. The

SEC has simply not met its burden of proof by intro-

ducing evidence of deception and, by its failure, has

denied Petitioners due process of law.

CONCLUSION

A businessman who follows in good faith the advice

of well-qualified counsel and adheres to industry prae-

tice should not be accused of aiding and abetting viola-

tions of Rule 10b-5. It took the SEC and the court

below seven years to define IOS’ wrongdoing and they

disagreed. Petitioners’ involvement was completely in

accordance with then existing business practices.

The conduct attacked by the SEC was prevalent in

the securities industry for a long period of time. Then,

early in 1968, the SEC circulated for comment pro-

posed Rule 10b-10 to require investment managers to

return give-ups to their customers. The proposed rule

was withdrawn when the NYSE banned all forms of

give-ups. This was done because the NYSE did not

want to see the development of a practice of invest-

ment managers offsetting their advisory fees by the

amount of shared commission dollars; such arrange-

ments would have been authorized rebates, an unac-

ceptable gap in the NYSE fixed minimum commission

rate structure. The banning of give-ups was seen by

the NYSE as the election of the lesser of two evils.

Although give-ups were banned in December 1968,

the holding of the court below has far-reaching conse-

quences for the brokerage community; the court below

has placed undue burdens on relationships between

brokers and their unaffiliated institutional customers.

Despite the fact that the court’s decision, in effect,

permits Petitioners to re-enter the securities business,

it did not erase the stain of a Rule 10b-5 violation and

the resulting irreparable harm to Petitioners’ reputa-

tions in an industry where one’s business reputation is

all important. In addition, the debris from the SEC’s

action spreads far—even to the extent that the Internal

Revenue Service has asserted that the commissions

which Arthur Lipper Corporation shared with IPC

are not deductible because the payments were illegal

rebates. This visits a possible $761,195 tax claim upon

Petitioners. This IRS position has immediate and “ar-

reaching impact on the numerous highly-publicized

eases the SEC is currently conducting against U.S.

corporations and their officers who have engaged in

allegedly ‘‘illegal’’ commercial and political payments,

both domestic and foreign. Accordingly, Petitioners

request that the writ of certiorari issue so that Peti-

tioners may have an opportunity to be vindicated and

the unjustified expansion of SEC Rule 10b-5 doctrine

may be contained.

Respectfully submitted,

JOHN A. DUDLEY

SULLIVAN & WORCESTER

1025 Connecticut Avenue, N.W.

Washington, D.C. 20036

Attorney for Petitioners

August 1977

a Sa am hd Mt me

eee awit

APPENDIX

UNITED STATES COURT OF APPEALS

SECOND CIRCUIT

Artuur Lipper Corporation and Arthur Lipper If,

Petitioners,

SEcuRITIES AND Excnance Commission, Respondent.

No. 165, Docket 76-4067

Argued Oct. 21, 1976

Decided Dec. 10, 1976

Before Frrenpiy, Hays and Mutuiean, Circuit Judges.

FRIENDLY, Circuit Judge:

This petition to review a disciplinary order of the Se-

curities and Exchange Commission (SEC), Securities Ex-

change Act Release No. 11773 (Oct. 24, 1975), is the latest

chapter in the extensive litigation resulting from the finan-

cial debacle of IOS, Ltd., S.A. (IOS) and the off-shore

funds for which it was investment adviser and distributor.

See Bersch v. Drexel Firestone, Inc., 519 F.2d 974 (2 Cir.),

cert. denied, 423 U.S. 1018, 96 S.Ct. 453, 46 L.Ed.2d 389

(1975); 1JT v. Vencap, Ltd., 519 F.2d 1001 (2 Cir, 1975).

We deal here with an order under §15 of the Securities

and Exchange Act, 15 U.S.C. §780, which revoked the

broker-dealer registration of Arthur Lipper Corporation

(Lipper Corp.) and barred Arthur Lipper III (Lipper),

its principa! owner, from association with any broker or

dealer. The order, dated October 24, 1975, was predicated

on violations of § 10(b) of the Securities Exchange Act of

1934, 15 U.S.C. § 78}(b), and the Commission’s Rule 10b-5,

17 C.F.R. 240.10b-5, during 1967 and 1968. We confirm the

decision that a violation occurred but modify the penalty

to suspension for a period of 12 months from the effective

date of the SEC’s order.

I. The Facts and Proceedings Before the SEC

The complaint concerns transactions whereby at the di-

rection of Edward M. Cowett, executive vice-president and

director of IOS, Lipper Corp. turned over to IOS’s 80%-

owned subsidiary Investors Planning Corporation (IPC), a

registered broker-dealer and a member of the National

Association of Securities Dealers, Inc. (NASD), a total of

$1,450,000, out of the commissions earned by Lipper Corp.

on over-the-counter (OTC) transactions for the account of

three off-shore funds for which IOS or one of its affiliates

was investment adviser. These were Fund of Funds, Ltd.

(FOF), a Canadian corporation which invested chiefly in

United States mutual funds and also was the sole owner

of another investment company, FOF Proprietary Fund,

Ltd. (FOF Prop.) ; International Investment Trust (IIT),

organized under the laws of Luxemburg, which invested in

companies throughout the world; and Regent Fund Ltd.

(Regent), a Canadian investment company with invest-

ments in both Canada and the United States. ITT and Re-

gent had no American shareholders; FOF had some 3,000

of a total of over 100,000, although the shares so owned had

been acquired without any registration of FOF shares

under §6 of the Securities Act of 1933, 15 U.S.C. §77f.

IOS had itself been a registered broker-dealer with its

principal place of business in Geneva, Switzerland. In 1965,

it acquired IPC, based in New York, apparently with a

view to building up IPC, which had been operating at a

loss, as a vehicle of IOS’s American securities business.

This plan was shattered and a revamping of IOS’ method

of doing business was compelled by a SEC order of May

23, 1967, accepting an offer of settlement of a proceeding

it had brought on February 3, 1966 against IOS, Bernard

Cornfeld (its organizer), Cowett and others. This order

provided, so far as here pertinent, that IOS would with-

draw its broker-dealer registration; that IOS, FOF, IIT

and any investment company affiliated with any of them

bo Pesan. Need an estates? BL EO Mek OR RE RE Al, be LONE ok i At ge SE SO DS

nad

should conduct no activity subject to the SEC’s jurisdiction

except as provided in the order; and, save for qualifica-

tions not here material, that within 16 months IOS should

dispose of its entire interest in IPC. The effect of the order

was to require IOS to devise some method whereby orders

for transactions on United States stock exchanges or in the

OTC market would have to be placed with exchange or

NASD members having offices abroad’ or with foreign

broker-dealers who in turn would refer the orders to Amer-

ican broker-dealers able to execute them. The order also

furnished IOS an incentive to build up the value of its

equity in IPC in order to increase the price it could obtain

upon the required sale.

Anticipating the settlement, Cowett approached Lipper,

a partner in the New York Stock Exchange (NYSE) firm

of Zuckerman, Smith & Co., to ascertain whether the firm

would be interested in opening branch offices in Geneva and

London, together with the extensive communications net-

work that would be needed for the purpose of serving as

coordinating agent for the flow of IOS brokerage trans-

actions. The caer partners in Zuckerman, Smith & Co. de-

clined the proposal although they were willing to have the

firm act as clearing agent if Lipper decided to withdraw

and form his own company, which would become a regis-

tered broker-dealer and member of NYSE and NASD for

the purpose desired by IOS. Lipper indicated his interest

to Cowett, and proceeded to make the necessary arrange-

ments. His compensation was to be in commissions earned

on IOS generated transactions both on and off the ex-

changes, as to which his company was to be in a favored

position.

The Constitution of the New York Stock Exchange re-

quired Lipper Corp. to charge the three off-shore funds

the fixed commissions then in effect on transactions exe-

1 Petitioners assert and the SEC does not dispute that all such

offices were operated by members of the New York Stock Exchange.

cuted on that exchange and forbade any rebates to them.

Until December 5, 1968, NYSE allowed customer-directed

give-ups on NYSE transactions to other NYSE members.

The record is silent how far IOS directed Lipper Corp. to

make such give-ups; in any event the SEC makes no com-

plaint against Lipper Corp. with respect to NYSE trans-

actions. The conduct of which it does complain relates to

OTC transactions for the three off-shore funds. As to these

also Lipper Corp. charged the commissions provided by

the NYSE minimum rate schedule. However, as Lipper

anticipated, directions were received from Cowett to give

up 50% of these commissions to IPC.? Pursuant to these

instructions Lipper Corp., duriug the period from July 10,

1967, to August 5, 1968 remitted to IPC approximately

$1,275,000, about 50% of the commissions paid it by FOF

Prop., ITT and Regent Fund on OTC transactions.’ In

addition, because cash was required for IPC before Sep-

tember 30, 1968, in order to meet warranties in a subse-

quently aborted contract for the sale of IPC, Cowett, as

president of FOF Prop., by letter dated August 14, 1968,

requested that, over and above the ‘‘reguiar’’ 50% give-

* By letter dated June 29, 1967, Cowett, as president of FOF

Prop., directed Lipper Corp. to give up to IPC ‘‘the maximum give-

up (50%)’’ on commissions earned on OTC transactions for the

account of FOF Prop. On July 11, 1967, as a representative of IIT

Management Co., (S.A.), an IOS affiliate, Cowett gave similar writ-

ten instructions with respect to OTC transactions for the account of

IIT. By letter dated March 15, 1968, Cowett, as vice president of

Canadian Fund Management Company Limited, also an IOS affili-

ate, confirmed an earlier request for similar give-ups on OTC trans-

actions effected on behalf of Regent Fund, Ltd.

* The details were:

Gross Commissions Give-Ups

FOF Prop. $1,974,064 $ 950,821

IIT 636,423 312,175

Regent Fund 28,670 12,521

Total: $2,639,157 $1,275,517

SO ee RO Crs IE

Weta iittiniainternitata tintin hb nace 8 a ri ree eee e © Pew ete ene ieee re eer nT ee aa

up, Lipper Corp. should make additional give-ups to IPC

of $175,000 on or before August 30, 1968, and another

$175,000 on or before September 30, 1968. Lipper demurred

to the size of the request, telling Cowett that no more than

an extra $175,000 should be paid. On August 28, Lipper

Corp. sent this extra sum, bringing the total give-ups to

IPC to some $1,450,000. The Commission found that neither

IOS nor IPC rendered services to the funds in return for

these give-ups.

No disclosure of the Lipper Corp.-IPC give-ups was

made to the shareholders of FOF (the sole owner of FOF

Prop.), of IIT or of Regent Fund. No such disclosure was

made directly to the directors of IIT or of Regent Fund.

Apparently the most nearly complete disclosure occurred

at a meeting of the board of directors of FOF held in

Acapulco, Mexico, in April 1968, at which Lipper was pres-

ent, when Allan F. Conwill, Esq., a director of FOF and

counsel for it, IOS, Lipper Corp. and Lipper, informed

the FOF directors of the arrangements outlined above;

he also advised that Lipper Corp. was in effect required

to charge the minimum NYSE commissions for OTC trans-

actions; that there was no legal way for Lipper Corp. to

refund any part of such commissions to FOF; that the

SEC staff took the position that any give-up on OTC

business was a fraud per se since there was no fixed rate

commission structure on OTC transactions and willingness

to give-up a part of the commission showed that the broker

would have been willing to take less; but that he considered

this position to be unfounded in law. There is no evidence

that anyone suggested exploration by outsice counsel of

the validity of Mr. Conwill’s view that Lipper Corp. had

to charge the minimum NYSE commission on OTC trans-

actions or that no way could be found whereby the share-

holders of FOF would benefit from give-ups to IPC.

Upon these facts and others that will be stated in our

discussion, Chief Hearing Examiner, now Administrative

Law Judge (ALJ), Blair found on June 11, 1971 that Lip-

per Corp. and Lipper had willfully violated and willfully

aided and abetted violations of §10(b) of the 1934 Act

and Rule i0b-5. Overruling both the assertion of the peti-

tioners that no sanctions should be imposed and the staff’s

contention that the registration of Lipper Corp. should be

cancelled and Lipper should be permanently barred from

the securities business, he determined that a suspension of

one year from the effective date of the order would be the

proper sanction as to both. Lipper and Lipper Corp. and

the staff filed petitions for review by the Commission, which

heard argument on August 28, 1972. By a decision filed

on October 24, 1975, the SEC sustained the ALJ’s con-

clusion with respect to violations but directed the drastic

remedies of cancellation of Lipper Corp.’s registration

and the permanent barring of Lipper from the securities

business urged by the staff. Petitioners sought rehearing

on the sole basis that three of the four Commissioners

who participated in the decision had not been members

at the time of argument. The petition for rehearing was

denied on January 6, 1976. Securities Exchange Act Re-

lease No. 11980. This petition for review followed.

II. Liability

Sections 15(a)(4) and (6) of the Securities Exchange

Act authorize the SEC to suspend for a period not exceed-

ing twelve months or to revoke the registration of any

broker or dealer or to bar or suspend for a period not

exceeding twelve months any person from being associated

with a broker or dealer on various grounds. One is willful

violation of any provision of the Act or any rule or regu-

lation thereunder; another is willful aiding, abetting, coun-

seling, commanding, inducing or procuring any such vio-

lation. The familiar Rule 10b-5 reads as follows:

It shall be unlawful for any person, directly or in-

directly, by the use of any means or instrumentality

of interstate commerce, or of the mails or of any fa-

cility of any national securities exchange,

atts tn

Paitin Jam areed M0) vb

eS oO Te

ES eS |e ee ee

(a) To employ any device, scheme, or artifice to

defraud,

(b) Te make any untrue statement of a material

fact or to omit to state a material fact necessary in

order to make the statements made, in the light of the

circumstances under which they were made, not mis-

leading, or

business which operates or would operate as a fraud

or deceit upon any person, in connection with the pur-

chase or sale of any security.

There is some initial surprise in seeing Rule 10b-5 in-

voked where the fraud relates not, as in the usual case, to

a particular securities transaction but to a course of deal-

ing in securities regardless of their identity. However,

the language of the Rule is broad enough to include the

latter type of case and petitioners do not urge that the

Rule has no application to a course of dealing where the

fraud concerns the overall relation of broker and customer

rather than the overvaluation or undervaluation of a se-

curity sold or purchased. We see nothing in Blue Chip

Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S.Ct. 1917,

44 L.Ed.2d 539 (1975), that would militate against appli-

eation of the Rule in a situation like that here before us,

though ‘‘the terms ‘purchase’ and ‘sale’ are relevant ve

to the question of statutory coverage’’ even in other than

private actions, SEC v. National Securities, Inc., 393 U.S.

453, 467 n.9, 89 S.Ct. 564, 572, 21 L.Ed.2d 668 (1969).

Portions of the Commission’s decision seem to take the

view, which had been the staff’s principal reliance at the

hearing and was also stressed in the oral argument of

counsel before us, that any give-up of a commission on an

OTC transaction is per se a ‘‘device, scheme, or artifice to

defraud.’’ In support of this the C.mmission points parti-

cularly to two passages in its report of December 2, 1966,

on the Public Policy Implications of Investment Company

Growth (hereafter PPI), H.R.Rep.No.2337, 89th Cong., 2d

Sess. These are:

A directed give-up of a portion of the commission

charged for handling a transaction for a fund in the

over-the-counter market would be a patent waste of

investment company assets. Since the over-the-counter

market in both listed and unlisted securities is a nego-

tiated market, which is not governed by fixed prices

or minimum commission rate schedules, any willing-

ness of the executing broker or dealer to allow his

customer to direct a give-up of a portion of his com-

mission or markup to dealers in fund shares in and of

itself shows that a lower price or commission could

have been negotiated.

and

In the over-the-counter markets, where brokerage costs

are subject to negotiation, give-ups of commissions to

brokers who perform no necessary function in con-

nection with a transaction have long been recognized

as improper and illegal. Give-up practices have been

tolerated in the exchange markets only because bro-

kerage costs are fixed by the exchange minimum com-

mission rate schedules.

Id. at 178, 185 (footnote omitted).*

* The Commission relies also on a July 18, 1966 letter from Irving

M. Pollack, then Director of the Division of Trading and Markets,

to the presidents of various stock exchanges and of the NASD. One

sentence in the three and one-half pages of single spaced text of the

letter, which expressed concern about the give-up problem gen-

erally, said:

In this connection, we consider it significant that ‘*give-ups’’

in the over-the-counter market have long been recognized to be

improper and illegal.

Pn anaes Mee 5: Radi bee tag os

ARs Menard A dion es

Se el eee One es ee er

ee See

Pe ee. ee ee eee betwee sro ln

‘

Insofar as the Commission would attribute legal force

to these statements in PPI, we must disagree. While the

Report was transmitted to Congress by the Chairman of

the Commission pursuant to §14(b) cf the Investment

Company Act, it constituted informatio for the legisla-

ture, not a rule having the force of law for the indus-

try, as would a regulation adopted pursuant to 5 U.S.C.

§ 553. Indeed, we doubt whether these two passages from

a 346 page report would qualify even as an ‘‘interpreta-

tive rule’’ or a ‘‘general statement of policy.’’ In saying

this we are quite aware of the importance attached to

other portions of PPI in Moses v. Burgin, 445 F.2d 369,

383-84 (1 Cir.), cert. denied, 404 U.S. 994, 92 S.Ct. 532,

30 L.Ed.2d 547 (1971), and in Fogel v. Chestnutt, 533

F.2d 731, 734-37, 749 (2 Cir. 1975), cert. denied, —— U.S.

—., 97 S.Ct. 77, 50 L.Ed.2d 86 (1976). However, those

eases cited PPI as placing the mutual fund industry on

notice that the SEC believed there were opportunities for

advantaging stockholders that ought to be explored and

explained to the disinterested directors, not as having in-

dependent legal force. So here we regard the quoted

statements from PPI as doing no more than warning the

industry what position the Commission would be likely

to take with respect to customer-directed give-ups in the

OTC market.

We are not persuaded that any such all encompassing

across-the-board per se principle as stated in PPI would

be sustainable in the absence of a Commission rule. It

is true that the source of the practice whereby the man-

agers of investment companies directed executing brokers

Apart from the fact that the letter came from a staff member (albeit

a high one) rather than from the Commission, we can hardly regard

such an incidental statement, for which no explanation was given,

as putting the entire industry on sufficient notice of the Commis-

sion’s views.

10a

to give »» a part of their commissions to other brokers

who furnished services in selling investment company

shares and in providing research lay in the inordinate

profits a few executing brokers would receive under the

fixed commission rate structure prevailing on the ex-

changes. See Fogel v. Chestnutt, supra, 533 F.2d at 735-

36. We are not certain, however, that even after PPI,

if the manager of an investment company determined

that the interests of the company would be served by

paying fixed commission rates on OTC business, with

customer-directed give-ups to brokers who had furnished

sales or research service, and disinterested directors, on

full disclosure, had joined with others in a good faith

determination that this was in the fund’s best interest,

this would have violated Rule 10b-5. At least we would

find it difficult to reach such a conclusion on this record,

which contains no evidence that commissions on OTC

agency business were in fact the subject of negotiation

in 1967 or 1968; rather, as the Commission seemingly

concedes in its opinion, a purchaser or seller unwilling

to pay the fixed commissions generally charged on OTC

business, because of the size of the transaction or for

other reasons, would deal with a market-maker as a prin-

cipal—a course which the 1967 settlement precluded IOS

from following unless an American firm with an office

outside the United States happened to be a market-maker

in the particular issue in which IOS was interested.

However, we find it unnecessary to decide whether the

extreme position thus far discussed is sustainable. The

Commission based its decision primarily on the ground

that IOS and its affiliates committed a fraud on the funds

by diverting to themselves, through IPC, rebates which

belonged to the funds while IPC was doing nothing in

return, and that Lipper and his company willfully aided

and abetted this. The proposition that it is a fraud on

the fund for a manager simply to pocket give-ups which

ent Qe ie?

hed PE ie Ie

lla

he has diverted to himself is almost too clear for argu-

ment. While there has been controversy, illustrated by

the Moses and Fogel decisions, how far an investment

adviser was bound to secure give-ups when these were

attainable, there has been and could be no question that

if these were obtained, they must be applied for the bene-

fit of the fund, either by direct payment or as a reduction

in the advisory fees. See statement of then General Coun-

sel Loomis, Securities Exchange Act Release No. 8746

(Nov. 10, 1969); Provident Management Corp., 44 SEC

442, 447 (1970). We recognize that both statements came

after cessation of the conduct here complained of, but

the proposition needed no elucidation. See also Moses v.

Burgin, supra, 445 F.2d at 376 n.11. It is no answer for

petitioners to contend that they were in no position to

police IOS’ exercise of its fiduciary responsibilities; they

still were under no obligation to engage in conduct aiding

IOS’ fraud on the funds.

Starting from this position, we shall consider peti-

tioners’ various attacks on the Commission’s conclusions.

(1) Petitioners say that, as a practical matter, they

were compelled to apply the NYSE minimum rate com-

mission schedule on OTC transactions. Conceding that

Article XV of the NYSE Constitution applied and legally

could apply only to transactions on that exchange, they

contend that NYSE looked with suspicion on the charg-

ing of lower rates on OTC transactions since such rates,

at least if below cost, might operate in practical effect

as a rebate of a portion of the commissions charged the

same customer on NYSE business. They point to evidence

that in fact NYSE would require a member that charged

less than NYSE minimum commissions on OTC business

to provide cost justification and contend that, as a new

member operating a complex and costly trans-Atlantic

communications network, it could not have satisfied NYSE

12a

that lower commissions on IOS generated OTC transac-

tions were cost justified.

We need not debate the solidity of the factual basis for

the argument. Whatever force petitioners’ contention

might or might not have if Lipper Corp. had retained the

full commissions on OTC business and the complaint was

that this amounted to a gouging of the funds, this was

not what occurred. In fact Lipper Corp. did just what it

claims NYSE prevented it from doing, namely, conduct

OTC business at less than NYSE commission rates. Give-

ups to the manager of an investment company on OTC

transactions infringed the NYSE policy that members

should not compete for business on a price basis as much

—or as little—as the charging of lower commissions or

give-ups to the investment company itself would have

done. As the Commission said:

The Lipper respondents claim to have been in fear

of disciplinary action by the New York Stock Ex-

change. But they have never explained why this fear

did not restrain them from giving up to IPC. If the

New York Stock Exchange’s rules had been appli-

cable to these transactions, they would have prohib-

ited commission-splitting with IPC as well as with

the funds that paid those commissions.

Putting the matter in another way, petitioners’ conduct

either violated the spirit of the NYSE Constitution or it

did not. If it did, they can derive no comfort from the

argument that their acts were compelled by the NYSE

Constitution; if it did not, they likewise gain no pro-

tection.

In any event, no NYSE practice could immunize con-

duct assisting investment company managers effectively

to pocket give-ups when the funds receive nothing in

return.

“=

13a

(2) Petitioners argue that even though their conduct

might have violated Rule 10b-5 if the three funds had

been registered investment companies, a different con-

clusion is compelled because here the payment of give-

ups to the manager was at the expense of off-shore funds,

only one of which had American shareholders. The ar-

gument ignores that the fraud charged by the SEC was

perpetrated in the United States by payments from one

registered broker-dealer (Lipper Corp.) to another (IPC)

in connection with the purchase and sale of securities

in the United States over-the-connter market. We said

in IIT v. Vencap, Ltd., supra, 519 F.2d 1017:

We do not think Congress intended to allow the

United States to be used as a base for manufacturing

fraudulent security devices for export, even when

these are peddled only to foreigners.

Petitioners thus derive no support from so much of the

decision in Bersch v. Drexel Firestone, Inc., supra, 519

F.2d at 992, as held that merely preparatory activity or

non-feasance in the United States was not sufficient to

trigger application of the securities laws in a class action

for damages in the absence of effect on Americans. Also,

in light of its language and our previous decisions, no-

tably Schoenbaum v. Firstbrook, 405 F.2d 200, 207-08 (2

Cir. 1968), modified in other respects, 405 F.2d 215 (en

banc), cert. denied, 395 U.S. 906, 89 S.Ct. 1747, 23 L.Ed.

2d 219 (1969), no discussion is needed to demonstrate the

inapplicability of 4 30(b) of the Securities Exchange Act,

15 U.S.C. § 78dd(b), which exempts ‘‘any person insofar

as he transacts a business in securities without the juris-

diction of the United States.’’ Petitioners argue that char-

acterizing the transaction as a fraud on the funds may

displace otherwise applicable foreign law, since certain

countries in which IOS and its affiliates operate would

allow the manager of an investment company to receive

l4a

a commission for placing an order, in addition to the

commission payable to the broker executing it. We do not

think the result should differ on this account. Presumably

the receipt of such commissions would have had to be

reported by IOS and would thus have been known to

existing shareholders of the funds and to persons soli-

cited to buy their shares. Here IOS, through IPC, secretly

pocketed the money. Moreover, we see no reason why

the United States may not prescribe a rule for conduct

within its borders even if another country having an

interest might be less rigorous. See Bersch v. Drexel Fire-

stone, Inc., supra, 519 F.2d at 985; Restatement of the

Foreign Relations Law of the United States $17 (1965).

(3) Little need be said in regard to petitioners’ con-

tention that the arrangements for the payment of re-

bates to IPC were adequately disclosed. Admittedly no

disclosure was made directly to the boards of directors

of IIT and Regent; the disclosure to the board of FOF

was only that the arrangements were proper, with no

attempt by independent directors to check this. Petition-

ers contend they could not compel disclosure; perhaps

not, but here again they were under no obligation to en-

gage in conduct that would be fraudulent without it.

Moreover, it is not within the competence of a board of

directors of an investment company to sanction the per-

petration of a fraud by the manager. Cf. Schoenbaum v.

Firstbrook, supra, 405 F.2d at 219-20; Drachman v. Har-

vey, 453 F.2d 722, 736-38 (2 Cir. 1972) (en banc). Indeed,

it would seem that only a unanimous shareholder vote

could ratify a fraud of this type even if approved by di-

rectors. See Ballantine on Corporations § 71, at 177 (rev.

ed. 1946); Cary, Cases and Materials on Corporations

591-92 (1969); Lattin, Jennings & Buxbaum, Corporations

821 (1968 ed.); Kennan v. Eshelman, 23 Del.Ch. 234, 2

A.2d 904 (Sup.Ct.1938); Continental Securities Co. v.

Belmont, 206 N.Y. 7, 99 N.E. 138 (1912). An arrangement

ec ee i a ee

15a

like that here at issue, which was a bald diversion to the

manager of sums belonging to the investment company, is

quite different from the situation in Moses v. Burgin and

Fogel v. Chestnutt, where there were some arguable

reasons against seeking recapture so that a negative de-

cision by the board of directors, after full disclosure to

the independent directors and approval by them and their

colleagues, might protect an adviser from liability, un-

der the business judgment rule. See Fogel v. Chestnutt,

supra, 533 F.2d at 750.

(4) We find it convenient to treat together petitioners

arguments on the scores of scienter, willfulness and re-

liance on the advice of counsel.

It would seem at first blush that since the relevant

provisions of §15 of the Securities Exchange Act require

a showing of willful violation or willful aiding and abet-

ting, little would have been added by the recent holding

in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct.

1375, 47 L.Ed.2d 668 (1976), that ‘‘scienter’’ is a neces-

sary element to establish liability in an action for damages

under Rule 10b-5. However, ‘‘the Commission has con-

sistently held under §15(b) that the term [‘willfully’’ in

§15] does not require proof of evil motive, or intent to

violate the law, or knowledge that the law was being

violated. ... All that is required is proof that the broker-

dealer acted intentionally in the sense that he was aware

of what he was doing.’’ 2 Loss, Securities Regulation 1309

(1961). This view has been accorded judicial acceptance.

As this court said in Tager v. SEC, 344 F.2d 5, 8 (2 Cir.

1965) :

It has been uniformly held that ‘‘willfully’’ in this

context means intentionally committing the act which

constitutes the violation. There is no requirement that

l6a

the actor also be aware that he is violating one of the

Rules or Acts.*

Petitioners are thus right in contending that it is im-

portant to determine what standard of culpability Hoch-

felder imposes for a violation of Rule 10b-5 such as that

here alleged, and specifically what the proper standard

is in a disciplinary proceeding.

The Hochfelder plaintiffs sought to hold Ernst & Ernst,

an international accounting firm, liable as an aider or

abettor of one Leston B. Nay, president of First Se-

eurities Company of Chicago, a small broker. Nay had

induced the plaintiffs to invest in allegedly high-paying

‘‘eserow accounts’? which he immediately converted to

his own use. The accounts did not appear in First Se-

curities’ books and records, payment having been made

by personal checks payable to Nay or to a designated

bank for his account. In urging that Ernst & Ernst was

liable as an aider and abettor, plaintiffs ‘‘specifically dis-

claimed the existence of fraud or intentional misconduct,’’

425 U.S. at 190, 96 S.Ct. at 1380. The claim was that

Nay had imposed a ‘‘mail rule’’ that no mail addressed

to him or to First Securities to his attention could be

opened by anyone other than Nay, even if it arrived in

his absence; that if Ernst & Ernst had conducted a proper

audit, they would have discovered the existence of this

rule; that Ernst & Ernst should then have disclosed the

rule, in reports to the SEC, as an irregular procedure

that prevented an effective audit; and that this would

have led the SEC to make an investigation of Nay that

would have revealed his fraudulent scheme. The Supreme

Court held that a mere claim of negligence did not suffice

* The court cited, in addition to the Loss treatise, Gilligan, Will &

Co. v. SEC, 267 F.2d 461, 468 (2 Cir.), cert. denied, 361 U.S, 896,

80 S.Ct. 200, 4 L.Ed.2d 152 (1959), and Hughes v. SEC, 85 US.

App. D.C. 56, 174 F.2d 969, 977 (1949).

17a

to support an action for damages under Rule 10b-5 but that

scienter’’ must be alleged and proved.* Since plaintiffs

had claimed ncthing more than negligence, the Court had

no occasion to refine its definition of scienter beyond saying

that the term ‘‘refers to a mental state embracing intent

to deceive, manipulate, or defraud’’ and leaving open the

question whether reckless behavior would suffice to meet

that test, 425 U.S. at 194 fn. 12, 96 S.Ct. at 1381.

Putting aside for the moment the defense of reliance

on the advice of counsel, we do not regard Hochfelder

decision as carrying the day for petitioners. The Court

held that in order to create liability for damages under

Rule 10b—5 and we assume in petitioners’ favor

that the same standard governs proceedings under § 15

see fn. 6—there must be proof of intention ‘‘to deceive,

manipulate, or defraud’’—not an intention to do this in

knowing violation of the law. The Court reasoned that

the language of 410 suggested that the section ‘“‘was in-

tended to proscribe knowing or intentional misconduct,’’

* The Court left open ‘‘the question whether scienter is a neces-

sary element in an action for injunctive relief under § 10(b) and

Rule 10b-5.’’ 425 U.S. at 194 n.12, 96 S.Ct. at 1381. The Court said

nothing about whether scienter is a necessary element in discipli-

nary actions under § 15. These actions share with damage suits the

quality of visiting serious consequences on past conduct, even

though they also have a remedial effect. They thus differ from in-

junctive proceedings, the objective of which is solely to prevent

threatened future harm, although unlawful conduct is necessary—

if not always sufficient—to demonstrate the reality of this threat.

We therefore assume, arguendo, without deciding, that the Hoch-

felder culpability standard applies in disciplinary proceedings. Cf.

Jaffe, J udicial Control of Administrative Action 267-68 (1965)

(“‘Revoeation, indeed, seems often to be used as a sanction not 80

much to control the respondent as to warn others, and thus it has

significant penal’ components, even though the courts may choose to

— its character by calling it a ‘civil’ remedy.’’) (footnote omit-

18a

425 U.S. at 197, 96 S.Ct. at 1383.’ It thought that use of

such words as ‘‘manipulative’’ ‘‘device,’’ and ‘‘contri-

vance’’ made ‘‘unmistakable a congressional intent to

proscribe a type of conduct quite different from negli-

gence,’’ 425 U.S. at 199, 96 S.Ct. at 1384. And it referred,

425 U.S. at 202, 96 S.Ct. at 1385 to the oft-cited testi-

mony of a sponsor of the Act before the House Com-

mittee on Interstate and Foreign Commerce that what be-

came §10(b) says ‘Thou shall not devise any other cun-

ning devices.’’ While that phrase could not be regarded

as including negligence, it reads precisely on what peti-

tioners did here—charging the full NYSE commission

rates on IOS generated OTC transactions of rebating

half of these to IPC, a subsidiary of IOS, knowing that

* Indeed, even in the criminal context neither knowledge of the

law violated nor the intention to act in violation of the law is gen-

erally necessary for conviction. The first proposition seems implied

by the rule ignorantia juris non excusat. Hall, Criminal Law 288

(2d ed. 1961). And the second, of course, follows from the first.

Perkins, Criminal Law 745 (2d ed. 1969). See ALI, Model Penal

Code §§ 1.13(12), 2.02(2)(a) & (b); Ellis v. United States, 206

U.S. 246, 257, 27 S.Ct. 600, 602, 51 L.Ed. 1047 (1907), where, in

rejecting a claim that knowledge of the law was required for con-

viction under a statute that included the word ‘‘intentionally’’,

Justice Holmes said, ‘‘If a man intentionally adopts certain conduct

in certain circumstances known to him, and that conduct is for-

bidden by the law unmler those circumstances, he intentionally

breaks the law in the only sense in which the law ever considers

intent.’’ And see Tager v. SEC, supra, 344 F.2d at 8:

We have recently held that a finding of actual knowledge is not

necessary for finding criminal liability under § 24 of the Secu-

rities Act, 15 U.S.C. § 77x for ‘‘willful’’ violations of §§ 5(a)

and (c) and 17(a), 15 U.S.C. §§77e(a), (e), and 77q(a).

United States v. Benjamin, 328 F.2d 854, 863 (2 Cir.), cert.

denied, 377 U.S. 953, 84 S.Ct. 1631, 12 L.Ed. 497 (1964). As

Professor Loss reminds us, ‘‘It is conceivable, therefore, that

‘willfully’ means something less in § 15(b) than it does in the

penal provisions of the SEC acts.’’ 2 Loss [Securities Regula-

tion] 1309. It is inconceivable that it means something more.

OED A RENE tN ba te Ee la

19a

IPC would retain the sums paid to it although these

should have been turned over to the funds directly or ap-

plied to reduce the advisory fee. It is no answer that pe-

titioners may not have realized that this ‘‘cunning de-

vice’’ was a fraud.

We likewise reject petitioners’ argument that there was

no violation of Rule 10b—5 because they acted on the

advice of their counsel, Mr. Conwill. We are not re-

quired to consider the Commission’s arguments that the

conduct was so flagrant a fraud that advice of counsel

could never be a defense or that such advice must be

disregarded because Mr. Conwill informed petitioners

that his advice ran counter to a position as to the illegal-

ity of give-ups on OTC transactions taken by the Com-

mission’s staff and indeed by the Commission in PPI.

It is a sufficient answer that, with all respect for Mr.

Conwill’s knowledge and experience, he was not in a

position to give petitioners wholly disinterested advice

and petitioners could not have reasonably have thought

he was. Although Cowett of IOS apparently was the

architect of the plan here attacked, Conwill was counsel

for IOS and his primary concern lay, as petitioners must

have known, in promoting its interests by assisting

Cowett. Petitioners say it was natural for them to turn

to him, since he was so familiar with IOS’ settlement

with the SEC. But this familiarity could have been at

the disposal of independent counsel retained by peti-

tioners; alternatively petitioners could have retained Mr.

Conwill and then had independent outside counsel check

his advice. Petitioners also note that, in addition to

being counsel for IOS, Conwill was a director of FOF

so that they were justified in believing that he was Riv-

ing proper heed to the interests of the funds. We cannot

regard the wearing of this additional hat as relieving

Conwill of the interest he had as IOS’ counsel in giving

his sanction to an arrangement so advantageous to it. Pe-

20a

titioners’ reliance on his advice goes not to the violation,

but to the penalty.

(5) The points that initially gave us most concern were

petitioners’ claims that many other NYSE firms, includ-

ine some of high reputation, made give-ups or conferred

other benefits on IPC in connection with OTC transac-

tions initiated by IOS and that the only other firms dis-

ciplined in connection with IPC’s receipt of give-ups,

Hertz, Warner & Co. and Dishy, Easton & Co., together

with certain principals, were only suspended from cer-

tain activities for short periods pursuant to set-

tlement offers. Securities Exchange Act Releases No.

8874 and No. 8702. Petitioners’ argument is not simply

a protest against selective enforcement. They claim that

the prevalence of the practice of customer-directed give-

ups on OTC transactions weighs heavily against the

SEC’s contention that it was a violation of law.

Examination of the record indicates that both the se-

lective enforcement claim, to which in any event Oyler

v. Boles, 368 U.S. 448, 454-57 (1962), would be a formid-

able obstacle, and the prevailing practice argument are

considerably overstated. The record does demonstrate

that other firms gave up to IPC in connection with OTC

transactions. However, the exhibits prepared from IPC’s

books showing the corporation’s receipt of reciprocal and

directed income were not confined to OTC give-ups, and

it seems indisputable that the activity of Lipper Corp.

in this regard was far greater than that of these other

firms. More important, in the view we take of the case,

namely, that the SEC was not obligated to predicate

liability on the broad basis that any OTC give-up was

a per se fraud but could and did rely on the fact that

petitioners made give-ups to IPC, knowing that this was

an 80%-owned subsidiary of IOS and that no sales or

research service was furnished in return, the evidence

is much less significant. For nothing in the record

2la

shows that the other brokers who made OTC give-ups

or conferred other benefits on IPC were aware of the

latter facts. The evidence thus does not establish wide-

spread belief in the legality of what petitioners did—for

whatever bearing that might or might not have. The

effect of the evidence of widespread give-ups and other

benefits to IPC on OTC business, like the advice of coun-

sel defense, goes rather to the penalty.*®

IV. The Penalty

As stated, the ALJ rejected the staff’s recommenda-

tion that Lipper Corp.’s certificate of registration should

be cancelled and that Lipper should be barred and instead

proposed a 12 month suspension, a period which ex-

pired in late October, 1976. The Commission adopted the

staff recommendation.

Wright v. SEC, 112 F.2d 89 (2 Cir. 1940), might ap-

pear to be an obstacle to our altering the penalty chosen

by the Commission. In Wright, review was sought of an

SEC order expelling the petitioner from several national

security exchanges and the court held that only one of

* Petitioners raise the point, made in their unsuccessful petition

to the SEC for rehearing, that they were denied due process because

although three of the four commissioners then in office heard oral

argument on August 28, 1972, only one of these, Commissioner

Loomis, joined in the decision of October 1975—the other three

participants in the decision not having been members of the Com-

mission in August 1972; petitioners, however, do not urge that we

remand for additional oral argument because of this. Rule 21(f) of

the Commission’s Rules of Practice, 17 C.F.R. 201,21(f), allows a

member who was not present at oral argument to participate in the

decision on condition that he review the transcript of the argument

and it is not contended that this was not done. There is no general

constitutional right to oral argument before an administrative agen-

cy, FCC v. WJR, 337 U.S. 265, 274-77, 69 S.Ct. 1097, 93 L.Ed. 1353

(1949), and the Commission’s rule represents a reasonable accom-

modation of the interest—one almost essential in these days when

many agency members serve so briefly. See Gearhart & Otis, Inc. v.

SEC, 121 U.S.App.D.C. 186, 348 F.2d 798 (1965).

22a

the two findings of violation was justified. Still, a ma-

jority of the panel apparently thought that a reviewing

court was ‘‘without power to supervise’ the Commis-

sion’s choice of sanction, although Judge Swan, the au-

thor of the opinion, disagreed :

The petitioner urges that the order of expulsion is

unduly harsh; that an order of suspension would

have accorded investors all the protection they need.

So far as appears this was Wright’s first infraction

of the statute. For many years he has been operat-

ing in Wall Street and his transactions in Kinner

stock are the only blemish upon his reputation. There

is nothing to indicate that he is an habitual manipu-

lator or would be likely to try to manipulate the

market in the future. To deprive him for all time of

an opportunity to pursue his calling in a lawful

manner does seem severe. But a majority of the

court hold the view that we are without power to

supervise the Commission’s discretionary determina-

tion that expulsion of the petitioner is necessary and

appropriate for the protection of investors. The

writer of this opinion does not share that view, be-

lieving that under the power conferred upon this

court to ‘‘modify’’, as well as to affirm or to set

aside an order in whole or in part, we may reduce

the relief accorded investors. My own opinion is

that the Commission should be directed to reduce

it.

112 F.2d at 95-96.°

° The court then remanded to the Commission for its reconsidera-

tion of the penalty in view of the holding that one of the alleged

violations was insufficiently shown. See 112 F.2d at 96. On re-

mand, the Commission adhered to its determination of expulsion,

In the Matter of Charles C. Wright, 12 SEC 100 (1942), and this

was upheld on further review, Wright v. SEC, 134 F.2d 733 (2

Cir. 1943).

eee ee

23a

Numerous cases in this circuit since Wright, however,

while not expressly repudiating that decision, have as-

sumed that Commission-ordered penalties are reviewable

as to severity although none apparently considered the

sanction under review so harsh as to require that it be

set aside. See e. g., Berko v. SEC, 316 F.2d 137, 141-42

(1963); Tager v. SEC, 344 F.2d 5, 9 (1965); Hanly v.

SEC, 415 F.2d 589, 598 (1969); Fink v. SEC, 417 F.2d

1058, 1060 (1969); Gross v. SEC, 418 F.2d 103, 107

(1969); Sinclair v. SEC, 444 F.2d 399, 402 (1971). See

also Boruski v. SEC, 289 F.2d 738 (1961); Nassau Se-

curities Service v. SEC, 348 F.2d 133, 136 (1965).*° Com-

pare Jacob Siegal Co. v. FTC, 327 U.S. 608, 612, 66 S.Ct.

728, 90 L.Ed. 888 (1946). Reviewability of sanctions

would seem to be authorized by application of the Ad-

ministrative Procedure Act, see 5 U.S.C. §§551(10) &

(13), 702, 706, the enactment of which adequately explains

why Wright’s suggestion that an agency’s discretionary

choice of sanctions cannot be altered has not been fol-

lowed." See also Jaffe, Judicial Control of Administra-

*° Courts in other circuits similarly have reviewed SEC sanctions

on an abuse of discretion or arbitrary or capricious standard. See

e.g., Nees v. SEC, 414 F.2d 211, 217 (9 Cir. 1969) ; O’Leary v. SEC.

424 F.2d 908, 912 (D.C.Cir. 1970) ; Beck v. SEC, 430 F.2d 673 ( 6

Cir. 1970) (setting aside four month suspension as a ** gross abuse

of diseretion’’) ; Quinn & Co. v. SEC, 452 F.2d 943, 947 (10 Cir.

1971), cert. denied, 406 U.S. 957, 92 S.Ct. 2059, 32 L.Ed.2a 344

(1972). See also American Power Co. v. SEC, 329 U.S. 90, 112-13

67 S.Ct. 133, 146, 91 L.Ed. 103 (1946), where the Court stated that

an SEC remedial action would be set aside ‘‘only if the remedy

chosen is unwarranted in law or is without justification in fact,’’ a

standard more recently applied to the review of an administrative

sanction in Butz v. Glover Livestock Comm’n Co., Inc., 411 U.S

182, 93 S.Ct. 1455, 36 L.Ed.2d 142 (1973). sei

. 7 Indeed, the Commission does not contend here that the order

18 IN any sense unreviewable, urging instead that judicial disturb-

ance of such orders is limited to cases of abuse of discretion. Re-

spondent’s Br. at 63. )

24a

tive Action 270-71 (1965)(‘‘It is not in accord with cur-

rent concepts of justice that the exercise of such drastic

powers [to revoke or suspend a license] should be total-

ly beyond revision, particularly where exercised by our

monolithic, policy-oriented agencies.’’); Schwartz &

Wade, Legal Control of Government 270 (1972) (‘‘One

of the limitations of the administrative expert is his

tendency to single-mindedness and excessive zeal. The

judges can stand apart from the tensions of the immedi-

ate case and mitigate the enthusiasm of the expert by

the community’s sense of justice.’’). Given our power

to review SEC penalty determinations, our authority to

limit such sanctions in appropriate cases seems neces-

sarily to follow.

Coming then to the question of the appropriateness

of the Commission’s sanction, we think it was too se-

vere.” Clearly it is unnecessary to prevent petitioners

from again doing what they did, since all customer-di-

rected give-ups have been abolished since December 5,

1968. The purpose of such severe sanctions must be to

demonstrate not only to petitioners but to others that the

Commission will deal harshly with egregious cases.

Viewed in bald outline and in the light of hindsight, pe-

titioners’ conduct may indeed seem egregious. But, as

conceded by the Commission in an amicus brief filed in

this court in Tannenbaum v. Zeller, No. 75-7503, the years

1967 and 1968 in which petitioners engaged in unlaw-

ful give-ups were years of considerable uncertainty as

to the regulatory climate concerning give-ups; the Com-

*? Under the circumstances of this case we give little weight to

the Commission’s protestations that persons once barred might be

readmitted to the securities business under proper supervision. See

Tager v. SEC, supra, 344 F.2d at 9. Whatever the force of this in

the case of a registered representative, Lipper is hardly interested

in returning to the business as a minor salesman in a large broker-

age firm. Moreover, eight years have already elapsed since the con-

duct of which the SEC complains.

25a

mission was torn between its desire to move away from

uniform fixed commission rates, a movement which would

eliminate the economic basis for customer-directed give-

ups, and its belief that existing give-up opportunities

should be utilized by investment advisers for the bene-

fit of shareholders in mutual funds. True, there was

nothing in all this that should have induced a belief that

give-ups could be utilized for the benefit of the adviser

rather than of the fund. Still petitioners were living in

a world of customer-directed give-ups, which many other

competing brokers were directing to IPC. Moreover,

they did act under the supervision of experienced al-

though in our view not disinterested counsel and, while

they knew exactly what they were doing, there is no

evidence that they had any thought they were violating

the law—unless, of course, it were the law that any give-

up on OTC business was fraudulent, which they had

been advised, perhaps correctly, was not true. We are

moved also by the inordinately long time in which this

proceeding has been pending, particularly the unexplained

lapse of over three years from the argument to the de-

cision of the Commission, the cloud that has hung over

petitioners’ heads during this period and the tremendous

disparity between the sanctions invoked against peti-

tioners and that imposed on two other brokers whose

violations were perhaps more clear. Finally, although

the Commission is in no way bound by the views of the

ALJ, FCC v. Allentown Broadcasting Corp., 349 U.S.

358, 75 S.Ct. 855, 99 L.Ed. 1147 (1955); Hiller v. SEC,

429 F.2d 856, 858 (2 Cir. 1970), some weight may prop-

erly be given to his opportunity to observe Lipper and

others who played a part in the acts here in question

and in fashioning a remedy in light of that observation.

Universal Camera Corp. v. NLRB, 340 U.S. 474, 492-97,

71 S.Ct. 456, 95 L.Ed. 456 (1951). If this statute author-

ized suspension for a period longer than twelve months,

and the Commission had exercised such authority to sus-

26a

pend for say another twelve months, we surely would not

interfere. But with the choices limited to a suspension of

not more than twelve months or a revocation or bar, we

consider that under the special circumstances of this case,

selection of the latter was an abuse of discretion.

The petition to review is therefore denied except that

the sanctions shall be limited to suspension of Lipper

Corp.’s registration for 12 months from the date of the

Commission’s order and the barring of Lipper from as-

sociation with any broker or dealer for the same period.

ee — vie

27a

UNITED STATES COURT OF APPEALS

SECOND CIRCUIT

At a Stated Term of the United States Court of Ap-

peals, in and for the Second Circuit, held at the United

States Court House, in the City of New York, on the

twenty-second day of March, one thousand nine hundred

and seventy-seven.

Present: HonorasLe Henry J. FRIENDLY

Honorasce Paut R. Hays

HonorasBLe Wititiam H. MuLiican

Circuit Judges.

76-4067

ArtTHuR Lipper CorporaTion and ArtHur Lipper, III,

Petitioners,

Securities aND Excaance Commission,

Respondent.

A petition for a rehearing having been filed herein by

counsel for the respondent (Securities and Exchange

Commission)

Upon consideration thereof, it is

Ordered that said petition be and hereby is Denied.

/8/ A. Dante, Fvusaro,

A. Daniel Fusaro,

Clerk

28a

UNITED STATES COURT OF APPEALS

SECOND CIRCUIT

At a stated term of the United States Court of Appeals,

in and for the Second Circuit, held at the United States

Court House, in the City of New York, on the twenty-

second day of March, one thousand nine hundred and

seventy-seven.

Docket No. 76-4067

ArTHUR LipPeR CORPORATION and

ArtTHurR Lipper, III, Petitioners

Vv.

Securities anp Excuance Commission, Respondent

A petition for rehearing containing a suggestion that

the action be reheard en banc having been filed herein by

counsel for the respondent, and a poll of the judges in

regular active service having been taken and there being

no majority in favor thereof,

Upon consideration thereof, it is Ordered that said

petition be and it hereby is DENIED.

Judge Oakes dissents.

/s/ Irvine R. Kaurman

Irving R. Kaufman,

Chief Judge

29a

UNITED STATES COURT OF APPEALS, SECOND CIRCUIT

ARTHUR Lipper Corporation and Arthur Lipper, ITI,

Petitioners,

SEecuRITIES AND ExcHance Commission, Respondent.

No. 165, Docket 76-4067

Petition for Rehearing Dec. 27, 1976.

Order Denying Petition for Rehearing March 22, 1977

DissENTING Opinion Apriz 1, 1977

A petition for rehearing containing a suggestion that

the action be reheard en banc having been filed herein by

counsel for the respondent, and a poll of the judges in reg-

ular active service having been taken and there being no

majority in favor thereof,

Upon consideration thereof, it is

Ordered that said petition be and it hereby is Dentep.

Oakes, Circuit Judge (with whom Judge Mesk1LL con-

curs):

I dissent from the denial of rehearing en banc. Express-

ing no opinion on the merits, it seems to me that this case

raises sufficiently important questions of administrative

law and the role of the courts therein, of general applica-

bility, to warrant our careful consideration sitting en banc.

Even assuming, as the panel opinion persuasively argues,

that American Power & Light Co. v. SEC, 329 U.S. 90, 112,

67 S.Ct. 133, 91 L.Ed. 103 (1946), and Butz v. Glover Live-

stock Commission Co., 411 U.S. 182, 93 S.Ct. 1455, 36 L.Ed.

2d 142 (1973), permit the reviewing court to vacate an ad-

ministrative sanction, which is ‘‘ ‘peculiarly a matter for

30a

administrative competence,’ ’’ 329 U.S. at 112, 67 S.Ct. at

146, it is difficult to see how the reviewing court may prop-

erly substitute its judgment for that of the agency on such

a matter. O’Leary v. SEC, 137 U.S.App.D.C. 420, 424 F.2d

908, 911-12 (1970); see K. G. Davis, Administrative Law

Treatise § 30.10, at 250-52 (1958). Underlying precepts of

administrative law would seem to require a remand for

further agency consideration of the sanction if it has pre-

viously abused its discretion. I am as intolerant of the

agency’s delays in this case, and other agencies’ in other

cases, as the distinguished author of the majority opinion,

but I question seriously whether those delays justify taking

a leap which has, except for one ‘‘sport,’’ Beck v. SEC, 430

F.2d 673 (6th Cir. 1970) (entire sanction set aside), not

heretofore been taken, that is, the reviewing court’s sub-

stituting its own judgment of what the sanction should be

for that of the agency. See, e. g. Hanly v. SEC, 415 F.2d

589, 598 (2d Cir. 1969) ; Marketlines, Inc. v. SEC, 384 F.2d

264, 267 (2d Cir. 1967), cert. denied, 390 U.S. 947, 88 S.Ct.

1033, 19 L.Ed.2d 1137 (1968). If this is the unique case the

panel opinion pictures it as—where the SEC had abso-

lutely no choice under the statute, Section 15(b) (4), (6) of

the Securities Exchange Act, 15 U.S.C. § 780(b)(4), (6),

between a year’s suspension and a permanent bar—it would

be one thing, but it seems to me it was entirely open to the

Commission to impose a bar with leave to reapply, just as

this court recommended to the Drug Enforcement Admin-

istration in Sokoloff v. Saxbe, 501 F.2d 571, 576-77 (2d

Cir. 1974). I fail to see any Commission rule or require-

ment that readmission to the business be under supervision

or, if it were, that this would be so terribly unfair to some-

one who ignored his fiduciary obligations and violated the

Securities Exchange Act and Rules thereunder.

3la

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.

Securities Excuance Act or 1934

Rel. No. 11773/October 24, 1975

Admin. Proc. File Nos. 3-2156 and 3-2157

Tn the Matters of

ArtHurR Lipper CorPorRaTION

140 Broadway

New York, New York (8-13182)

ArtTHuR Lipper, IIT

108, LTD, (S.A.)

Geneva, Switzerland

Investors PLaNNING CoRPORATION OF AMERICA

(now known as CIP, Inc.)

New York, New York (8-12374)

Opinion of the Commission

Broker-DEaLER PROCEEDINGS

Grounds for Remedial Sanctions

Recapture by Affiliate of Commissions on Investment

Company Portfolio Transactions Through Give-Ups from

and Reciprocal Arrangements with Unaffiliated Broker-

Dealers

Receipt of Money in Connection with Investment Company

Portfolio Transactions

Over-the-Counter Give-Ups

Conflict of Laws—International Law

Where manager of unregistered off-shore investment com-

panies selected to execute companies’ over-the-counter

portfolio transactions broker who paid portion of commis-

sions on such business to manager’s subsidiary, held,

32a

manager, aided and abetted by broker, violated Section

10(b) of the Securities Exchange Act and Rule 10b-5

thereunder; and gravity of misconduct required that reg-

istration of broker be revoked and that manager be

barred.

Where Securities Exchange Act’s antifraud provisions

were violated in connection with portfolio transactions of

unregistered off-shore investment companies executed in

the United States, and where violators were registered

broker-dealers, held, United States has jurisdiction to take

remedial action.

Receipt by Affiliate of Compensation in Connection with

Purchase and Sale of Investment Company Property

Deficient Investment Advisory Contract

Misstatements in Prospectuses, Proxy Material

and Other Documents

Where registered broker-dealer who was mutual fund’s

principal underwriter and investment adviser procured

for itself rebates of fund’s brokerage commissions from

unaffiliated brokers without rendering any brokerage serv-

ices in return therefor, held, such broker-dealer and its

unregistered corporate parent violated or aided and

abetted violations of Securities Exchange Act’s antifraud

provisions and of Sections 17(e)(1), 15(a)(1), 20(a),

and 34(b) of the Investment Company Act and also of

Rule 20a-1 under the Investment Company Act.

APPEARANCES:

Allan F. Conwill, of Willkie, Farr & Gallagher, John A.

Dudley, of Sullivan & Worcester, and Howard 8S. Klotz,

for Arthur Lipper Corporation and Arthur Lipper, III.

33a

Calvin H. Cobb, Jr., Robert M. Goolrick, Edmund B.

Frost, and W. John Amerling, of Steptoe & Johnston, for

IOS, Ltd. (S.A.) and Investors Planning Corporation of

America.

Stanley Sporkin, Marvin E. Jacob, Robert M. LaPrade,

Joanne Leveque and Robert L. Anthony, for the Division

of Enforcement of the Commission.

I. INTRODUCTION

This case is about the once vast international financial

complex controlled by IOS, Ltd. (S.A.) (‘‘TOS’’).? More

specifically, it is about IOS’s handling of the large volume

of brokerage business generated by the enormous pools of

other people’s money under its management and about the

way in which IOS used that brokerage business to serve

its own interests rather than those of the investors who

had entrusted their savings to it. The transactions in

question were executed in the over-the-counter market and

on the New York Stock Exchange.

In 1967 and 1968, the period involved in this case, brok-

ers executed all stock exchange orders at fixed rates. These

rates varied with the price per share of the security. But

the commission was calculated on a per share basis. The

commission on an order for 10,000 shares of a given stock

was exactly 100 times that on an order for 100 shares of

the same stock. Brokers found it profitable and were eager

to handle transactions for investment companies and other

institutional customers because the cost of handling large

orders did not increase proportionately with the commis-

sions they were obligated to charge. This was so much the

case that brokers were willing and anxious to execute

large institutional orders for substantially less than the

fixed minimum commission rate. Since the commission

could not be reduced, brokers were willing, at the custom-

* The initials stand for Investors Overseas Services.

34a

er’s direction, to pay over part of the commission to other

brokers within the rules of the stock exchange. Thus, large

institutional investors had substantial amounts of so-called

‘fexcess brokerage’’ (i.e., that portion of the commission

that the executing broker was willing to give up) at their

disposal.’

Il. THE ADMINISTRATIVE LAW JUDGE’S

INITIAL DECISIONS

The administrative law judge before whom the hearings

were held concluded that:

1. Brokers who executed transactions for, and who

therefore received commissions from, members of the

complex of mutual funds managed by IOS®* surren-

dered portions of those commissions to an IOS sub-

sidiary known as Investors Planning Corporation of

America (‘‘IPC’’).* This was done at IOS’s direction.

2. Neither IOS nor IPC* rendered any brokerage

services to the funds in whose commission disburse-

ments they shared.

*In theory, only the minimum rate of commissions was fixed.

Brokers were free to go higher if they wished. And, in fact, broker-

age houses sometimes charged more than the minimum on small

transactions or even refused to handle them at all. By and large,

however, the minimum was also the maximum.

* A group of mutual funds under common management is called

a ‘‘fund complex.’’ See Report of the 8.E.C. on Public Policy Im-

plications of Investment Company Growth, H.R. Rep. No. 2337,

89th Cong., 2d Sess., 45-47 (1966) [hereinafter cited as Public Pol-

icy}. See also Glazer, A Study of Mutual Fund Complezes, 119 U.

Pa. L. Rev. 205 (1970).

*IOS owned eighty percent of the outstanding IPC stock. After

the events dealt with in this opinion, IPC changed its name to CIP,

Ine.

* Hereinafter sometimes referred to collectively as ‘‘the IOS re-

spondents.”’

35a

3. The money surrendered by the executing brokers to

the IOS respondents belonged in equity and good con-

science to the funds out of whose commissions it came.

When the IOS respondents appropriated that money

for themselves, they breached their fiduciary duties to

the funds under their management. This breach of

duty and the failure to disclose it to actual and pros-

pective investors in those funds were in willful viola.

tion of Section 10(b) of the Securities Exchange Act

and Rule 10b-5 thereunder.

4. Fund of America, Inc. (‘‘FOA’’) was registered

with us as an investment company under the Invest-

ment Company Act. When the IOS respondents took

a portion of that fund’s excess brokerage, they vio-

lated various provisions of the Investment Company

Act.

5. The IOS respondents’ violations were serious. It is

in the public interest to bar IOS itself from association

with a broker or dealer. But IPC’s situation is differ-

ent. It is no longer controlled by or affiliated with

IOS. Since its wrongdoing stemmed from its former

relationship to IOS, a nine-month suspension of

IPC’s broker-dealer registration is enough to satisfy

the public interest.

6. Arthur Lipper Corporation (‘‘Lipper Corp.’’), a

New York City broker-dealer, and during the relevant

period, a New York Stock Exchange member firm and

also a member firm of other domestic securities ex-

changes registered with this Commission under the

Securities Exchange Act, was organized to handle the

large brokerage business for [OS-managed funds.

Substantial portions of the commissions received from

such business were surrendered to IPC. Thus, the

Lipper firm was a knowing participant in the IOS

36a

respondents’ fraudulent scheme. And so was its foun-

der, president and controlling stockholder, Arthur

Lipper, III. Lipper and his firm’ willfully aided

and abetted some of the IOS respondents’ violations

of Section 10(b) of the Exchange Act and Rule 10b-5

thereunder.

7. It would be in the public interest to suspend the

Lipper firm from effecting transactions in the over-

the-counter market for twelve months. During that

period, Lipper himself should be suspended from as-

sociation with any broker or dealer.

An independent review of the record leads us to agree

with the administrative law judge’s analysis.’ We are also

in accord with his view that it is in the public interest to

preclude IOS from associating itself with brokers or deal-

ers in the future. But we see no need at this juncture for

remedial action against IPC. And we also disagree with

the administrative law judge about the nature of the sanc-

tions against the Lipper respondents called for by the

public interest. As to that, we agree with our staff that

suspension is not enough and that the Lipper respondents

ought to be barred from the securities business.

Our reasons for so holding are stated below.

Ill. THE 10S COMPLEX

During the 1950’s and the 1960’s the basic trend in the

American equity securities markets was upward. In those

* Hereinafter sometimes referred to collectively as ‘‘the Lipper

respondents. ’’

* The respondents petitioned for review of the administrative law

judge’s decision. Our Division of Enforcement also sought review

with respect to what it considers the gross inadequacy of the sanc-

tions imposed on the Lipper respondents. After granting all of the

petitions for review, we received briefs from all parties and heard

oral argument.

37a

years, the American mutual fund industry grew dra-

matically." These developments led foreign investors to

take a favorable view of American mutual funds, and fa-

cilitated the sale of their shares abroad.

IOS capitalized on this market.’ It did so by means of

the so-called ‘‘off-shore fund.’’ That involved the forma-

tion by IOS of investment companies in countries other

than the United States.*° Those entities sold their shares

outside the United States. But they invested the proceeds

largely or wholly in United States securities, using our

securities markets to do so. 1OS created off-shore funds,

managed them after their creation, and sold their shares

in many countries.

During the period of concern to us here, IOS, a Pana-

manian corporation that maintained its principal offices in

Switzerland, controlled IPC, a large New York City-based

United States broker-dealer registered as such under the

Exchange Act. IPC had little or no general securities

business. Its primary activity was the retail sale of mutual

fund shares to Americans here in the United States. Like

many other mutual fund retailers, IPC sold the public

shares in many different mutual funds. But it had nothing

whatever to do with the management of those funds.

® This theme was expounded at length in Public Policy.

*IOS’s first idea was the fund holding company, The Fund of

Funds (‘‘FOF’’) formed for the purpose of investing in American

mutual funds registered and regulated under the Investment Com-

pany Act and in publicly-held mutual fund management companies.

See Public Policy 311-324. But by the time dealt with in this opin-

ion the original concept had been broadened so that it included

direct investment in the stocks and bonds of United States compa-

nies engaged in industry and trade.

the funds were set up on the islands off the shores of the United

States. Note, United States Taxation and Regulation of Off-Shore

Mutual Funds, 83 Harv. L. Rev. 404, 405 n.10 (1969).

38a

IPC, however, was more than a mere retailer of shares

in mutual funds that were managed by others. It also had

its own ‘‘in-house’’ fund for which IPC acted as invest-

ment adviser and principal underwriter. This fund was

FOA, a corporation organized under New Yor! law. There

was nothing ‘‘off-shore’’ about FOA. It was just another

domestic mutual fund. Like hundreds of similar funds, it

was subject to the Investment Company Act and regis-

tered with us under that statute as an open-end investment

company.

IPC’s domestic mutual fund retailing operation was

much older than IOS. In April 1965, IOS bought a con-

trolling interest in IPC’s going (albeit then unprofitable)

retail mutual fund business." After that, IOS naturally

wanted to make IPC profitable. One way of doing this was

to build up IPC’s captive fund, FOA.

As a mere merchandiser of shares in mutual funds con-

trolled by others, IPC could expect only the retail dealer’s

share of the sales charge plus some excess brokerage in-

come funneled to it by the managers of the funds whose

shares it was selling. But when IPC sold shares in FOA,

it:

“IOS attributed the losses to IPC’s ‘‘unimaginative’’ manage-

ment. An IOS official testified that IPC was acquired because it

‘represented an opportunity for IOS to come into the United

States market, building from a base of a reasonably large and well-

established broker-dealer.’’ IPC had a 5,000-man sales force at the

time of its acquisition by IOS. It appears that this sales force con-

sisted for the most part of what a study by the staff of our Office of

Economic Research described as ‘‘armies of salesmen who are be-

lieved to be worthwhile even if they only sell themselves, their close

friends, and their relatives.’’ S.E.C. Staff Report On the Potential

Economic Impact of a Repeal of Section 22(d) of the Investment

Company Act of 1940, p. A-49 (November 1972). See also id. at pp.

A-63 - A-64 (referring to ‘‘legions of unproductive low-income

salesmen’’).

39a

1. Kept the total sales charge since there was no un-

affiliated wholesaler or principal underwriter with

whom that charge had to be divided; and

2. Enhanced its advisory fee income because the sale

of new shares increased the volume of assets on which

the fee paid to IPC by FOA was based."

So IOS made FOA grow.” It did that in two ways.

First, it caused IPC’s sales force to push FOA and to

deemphasize what had theretofore been that sales force’s

primary pursuit, the sale of shares in mutual funds un-

affiliated with IPC. Second, IOS put money from one of its

own off-shore funds into FOA. IOS’s foreign mutual fund

holding company, FOF," bought into FOA in a big way.

From July 1965 to August 1966, FOF invested approxi-

72 Mutual fund sales charges tended to cluster around the 8.5

percent level. Thus, when an investor wrote a check for a thousand

dollars to pay for a purchase of ‘‘load’’ fund shares, only $915 of

that sum actually went to the fund for investment. The other $85

was consumed by the sales charge, which went to those who made

the sale. During the relevant period, it was usual for principal un-

derwriters to retain two percent of the investor’s total payment (or

about 25 percent of the aggregate sales charge) for themselves. The

balance went to the retail dealers and the salesmen who did the

actual selling. Publie Policy 207-209.

** Over the long-run, this was much more important than sales

charge revenues. Generally, the advisory fees that the adviser-un-

derwriters receive for their managerial services are based on the

size of the asset pools under management. Since the size of a mutual

fund does not fluctuate nearly as much as the sale of new shares,

the advisory fee provides a stable source of income.

* FOA had only about $5 million in assets when IOS came into

the picture. A year and a half later (on November 30, 1966) FOA’s

assets were around $44 million.

*® See n.9 on p. 5, supra.

40a

mately $22 million in FOA. By mid-1966, FO! owned

about 46 percent of FOA’s outstanding shares.”

FOF’s investment in FOA was a highly-remunerative

proposition for IOS. The benefits to FOF itself or its

shareholders were more obscure, to say the least. By hav-

ing one of its funds, FOF, invest in FOA, another IOS-

managed fund, IOS:

1. Collected a sales charge on a sales charge—because

the investor who bought FOF shares and who paid a

sales charge to IOS at that time also bore the burden

of the sales charge later paid by FOF to IPC (but in-

uring, of course, to the benefit of IPC’s parent, IOS)

when FOF purchased FOA shares from IPC, the ex-

clusive distributor of those shares;’’ and

2. Received two advisory fees out of what was in eco-

nomic reality a single pool of capital—IOS took an

advisory fee from FOF in exchange for its services in

putting FOF’s money into FOA, and through IPC it

then took a second advisory fee from FOA for manag-

ing FOA’s investments.”

IV. THE 1956 PROCEEDING AND ITS AFTERMATH

Soon after IOS’s acquisition of IPC, members of the

Commission’s staff reported to the Commission that infor-

Public Policy 313, Table VIII-1. The record shows that in

January 1968 FOF still owned approximately 40 percent of FOA’s

shares.

** There were so many entities in the IOS complex that the above

text simplifies the corporate relationships involved. FOA’s under-

writer was IPC, and FOA’s adviser was IPC’s wholly-owned sub-

sidiary, Fund of America Management Corporation.

** As we said in Public Policy: Inherent in the fund holding

company structure is a layering of costs including advisory fees,

administrative expenses, sales loads, and brokerage fees, all of which

serve to make a fund on funds a particularly expensive investment

vehicle.’’ Public Policy at 318.

4la

mation had come to their attention indicating that IOS’s

assertedly off-shore funds were not wholly off-shore. Our

staff believed that shares in those funds had been offered

and sold to an appreciable number of Americans fraudu-

lently and in violation of the Securities Act’s registration

requirements.** To determine whether this was actually so

and what remedial action, if any, was needed, this Com-

mission, in February 1966, instituted an administrative

proceeding against IOS and some of its affiliates.*” After

the failure of its strenuous efforts to enjoin that proceed-

ing on the ground that we had no power to conduct it,”

IOS decided to settle.

During settlement negotiations with our staff, IOS

learned that settlement would require a material reduc-

tion in the scope of its United States activities. IOS made

an offer of settlement in which it undertook, among other

things, to:

1. Divest itself of IPC within a specified time;

2. Cease selling securities to United States citizens

and nationals wherever located, except, inter alia, for

sales by IPC during its continued ownership of that

entity ;

3. Make a rescission offer to Americans who held in-

terests in FOF;

4. Withdraw its own broker-dealer registration and

the registrations of those of its affiliates that were

then registered with us as brokers and dealers; and

1° Our staff also believed that violations of the Investment Com-

pany Act had been committed.

*° Administrative Proceeding No. 3-497 instituted by order of

February 3, 1966. This proceeding is referred to as ‘‘the 1966 pro-

ceeding.’’

™ See Fontaine v. 8.E.C., 259 F. Supp. 880 (D.P.R., 1966).

42a

5. Conduct all of its securities activities outside the

United States.

We accepted IOS’s offer on May 23, 1967, thus termi-

nating the 1966 proceeding.”

Before that time, IOS began to prepare for the day

when it would have to dispose of IPC and place all orders

for United States securities abroad through an independ-

ent foreign brokerage firm or through an independent

United States brokerage firm with a foreign branch office.

IOS chose Lipper as a broker for the funds managed by

it. At IOS’s instance, in March 1967 Lipper organized

Lipper Corp., headquartered in New York, with branch of-

fices in London and Geneva. He did so for the primary

purpose of acting as a broker for the funds managed by

IOS and after assurances from it of sufficient business

from ‘‘IOS generated sources to cover the kind of invest-

ment involved.’’ * The ‘‘investment involved’’ was needed

to establish an elaborate communications network for

transmitting the orders that the IOS-managed funds

placed with Lipper Corp’s foreign branches to its .uain

office in New York. Through this network those foreign

funds continued to buy and sell United States securities

in this country’s markets rather than those abroad.

As for IPC, the settlement agreement granted IOS a

period of time before it had to sell its shares of IPC, and

this was ultimately accomplished in the fall of 1968. Of

course, the price that IOS could expect to obtain for its

IPC shares obviously depended on the latter’s earning

power. IOS, therefore, had an especially strong incentive

*2 IOS, Ltd. (8.A.), Securities Exchange Act Release No. 8083.

** From April 1967 through June 1968, Lipper Corp. received

gross commissions of $11,372,000, $8,014,000 of which came from

IOS-related business.

43a

to improve IPC’s performance prior to the sale. The Lip-

per respondents helped IOS to attain that objective.

V. REBATES OF OVER-THE-COUNTER

BROKERAGE COMMISSION

A. The Facts and Their Legal Consequences

Lipper Corp. handled the foreign funds’ over-the-coun-

ter business on an agency business. For its services in this

regard, Lipper Corp. charged the stock exchange commis-

sion rate. But it kept less than half of the resulting gross

commissions. The rest of them were paid over—‘‘given

up’”’ in the jargon of the trade—to IPC. These give-ups

by Lipper Corp. to IPC totaled about $1,450,000 from

July 1967 to August 1968. In view of IOS’s relationship

to IPC, that money was for all practical purposes given

up to IOS.

Since neither of the IOS respondents performed any

brokerage function in connection with the over-the-coun-

ter transactions handled by Lipper Corp., it is apparent

that they did nothing in return for the income that they

derived from those transactions. They simply caused the

funds to divert $1,450,000 to them. Lipper Corp. was a

mere conduit for the diversion. No extended discussion is

required to demonstrate that this was a gross breach of

fiduciary duty by the IOS respondents.”

* It is true, of course, that IOS managed the funds and that this

involved work. But IOS was getting a management fee for these

services.

25 Investment advisers are fiduciaries. S.E.C. v. Capital Gains

Research Bureau, 375 U.S. 180, 191 (1963); Arleen W. Hughes, 27

S.E.C. 629, 635-638 (1948), aff’d sub. nom. Hughes v. 8.E.C. 174

F. 2d 969 (C.A.D.C., 1949). And investment advisers to invest-

ment companies are on the same footing. Rosenfeld v. Black, 445

F. 2d 1337 (C.A. 2, 1971), petition for cert. dismissed 409 U.S. 802

(1972) ; Brown v. Bullock, 194 F. Supp. 207, 229 (S.D.N.Y. 1961),

44a

Such ‘‘disregard of trust relationships by those whom

the law should regard as fiduciaries’’ was one of the evils

that the Exchange Act sought to eliminate.** We therefore

find, as did the administrative law judge, that the IOS

respondents’ over-the-counter commission-splitting ar-

rangements were a fraud on the foreign funds and on

their shareholders.*’ It follows that the IOS respondents

aff’d 294 F. 2d 415 (C.A. 2, 1961). See Provident Management.

Corp., 44 S.E.C. 442, 447 (1970): ‘‘ Porteous and Lautsbaugh, as

officers of Fund and as persons responsible for directing the execu-

tion of its portfolio transactions, and Management by virtue of its

position as investment adviser, were fiduciaries of Fund. As such,

they were under a duty to act solely in the best interest of Fund

and its shareholders. . . . While there is no proof that Fund did

not receive the best caecution on its transactions, or that the exist-

ence of the arrangement described resulted in additional] costs to

Fund, once the reciprocal arrangements were made, it was improper

for Porteous & Co. to keep for itself rather than confer on Fund the

benefits attributable to Fund’s assets.’’; Consumer-Investor Plan-

ning Corp., 43 S.E.C. 1096, 1100-1101 (1969) : It is clear that [re-

spondents] .. . placed the purchase and sale of the Fund’s portfolio

securities with those brokers who would pay over to them the largest

extractable portions of the brokerage commissions thus yenerated

and the most substantial other benefits. The payments and benefits

received by them did not represent compensation for any services

rendered to or benefits conferred upon the Fund, but rather consti-

tuted a form of personal enrichment derived from the Fund’s port-

folio transactions. By such blatant trafficking of the Fund’s busi-

ness, respondents simply used their fiduciary positions in relation to

the Fund to cause monetary and other benefits to inure to them-

selves without regard to what was best for the fund... . The abuse

of position aud conflict of interests inherent in the making of these

arrangements was clearly inimical to the Fund and its sharehold-

ers.’’ Delaware Management Co., 43 S.E.C. 392 (1967).

*° H.R. Rep. 1383, 73d Cong., 2d Sess. 6 (1934).

** Respondents contend that their over-the-counter commission

arrangements were disclosed to the directors of the foreign funds.

Like the administrative law judge, we find this contention unsup-

ported by the record. Three foreign funds were involved. The Lip-

45a

willfully violated Section 10(b) of the Exchange Act and

Rule 10b-5 thereunder.

Since the Lipper respondents knew about IOS’s rela-

tionship to the foreign funds, and since their active assist-

ance was an essential element of the scheme, they were

clearly participants in the IOS respondents’ breach of

trust. It follows that the Lipper respondents willfully

aided and abetted the IOS respondents’ violations.”

Respondents advance various arguments, based upon

then existing rules and practices in the securities markets

per-IPC give-up arrangements are claimed to have been discussed

at a meeting of one of the three boards. But what about the boards

of the other funds? No disclosures are expressly claimed to have

been made to them. As to the disclosures made to the one fund, we

agree with the administrative law judge that they cannot be deemed

to have been adequate. But even if they had been adequate so far

as the directors were concerned, it seems to use that in view of IOS’s

controlling influence over these entities, the disclosure required in

this situation was disclosure to the shareholders actual and prospec-

tive. Moreover, the administrative law judge pointed out that the

person making the purported disclosures was a principal in the

scheme to defraud the foreign funds. Cf. Schoenbaum v. Firstbrook,

405 F. 2d 200, 211-212, reversed in part on other grounds en banc

405 F.2d 215 (C.A. 2, 1968), cert. denied sub nom. Manley v.

Schoenbaum, 395 U.S. 906 (1969) :

“In general, if the corporation’s agents have not been deceived,

neither has the corporation. However, as in other situations gov-

erned by agency principles, knowledge of the corporation’s officers

and agents is not imputed to it when there is a conflict between the

interests of the officers and agents and the interests of the corporate

principal. [Citations omitted.] Therefore, a corporation may be de-

frauded in a stock transaction even when all of its directors know

all of the material facts, if the conflict between the interests of one

or more of the directors and the interests of the corporation pre-

vents effective transmission of material information to the corpora-

tion, in violation of Rule 10b-5(2).’’ See also Pappas v. Moss, 393

F. 2d 865 (C.A. 3, 1968).

** See Provident Management Corp., 44 S.E.C. 442, 448 (1970).

46a

which, they claim, justify their activities. To these we now

turn.

Respondents claim that the rules of the New York

Stock Exchange required the funds to bear over-the-coun-

ter brokerage costs that are conceded to have been high.

They argue that:

1. As a New York Stock Exchange member, Lipper

Corp. was bound to adhere to that organization’s

minimum commission rate schedule.

9. The anti-rebate rules that the exchange adopted

for the purpose of preventing its members from

cutting rates in underhanded ways precluded Lipper

from returning any excess brokerage to the funds

themselves.

3. There were only two choices. One was for Lipper

to retain for himself all of the brokerage that the

New York Stock Exchange had thrust into his unwill-

ing hands. The other was to divide it with IOS. In

no event could the funds’ over-the-counter brokerage

costs have been any lower than they actually were.

This argument, although perhaps superficially appeal-

ing, is, upon analysis, unavailing. The New York Stock

Exchange had no jurisdiction over commission rates in

over-the-counter transactions. The over-the-counter mar-

ket during the relevant period was, and it still is, ‘‘a ne-

gotiated market . . . not governed by fixed prices or mini-

mum commision rate schedules.’’** Therefore, ‘‘any will-

2® Public Policy 178. Although the practice was to charge the New

York Stock Exchange minimum rate on over-the-counter transac-

tions executed on an agency basis, no rules legally binding on

Lipper required this. A violation of the National Association of

Securities Dealers’ Rules of Fair Practice might have been involved,

however, if the commission charged was in excess of the New York

Stock Exchange minimum.

47a

ingness of the executing broker . . . to allow his customer

to direct a give-up of a portion of his commission... in

and of itself shows that a lower . . . commission could

have been negotiated.’’ *°

The New York Stock Exchange’s anti-rebate policies

are clearly not relevant here. Those policies applied only

to transactions on that exchange. What they prohibited

was the division of commissions paid for such transac-

tions with those who were not themselves members of the

New York Stock Exchange." The transactions involved

herein were not New York Stock Exchange transactions.”

Nor was IPC a New York Stock Exchange member. The

Lipper respondents claim to have been in fear of discipli-

nary action by the New York Stock Exchange." But they

*° Public Policy 178.

** Public Policy 170.

* The New York Stock Exchange’s vice president in charge of

member firms testified that ‘‘The New York Stock Exchange mini-

mum commissions applied to New York Stock Exchange trades, not

over-the-counter trades.’’ The following colloquy then ensued:

““Q To what extent does the New York Stock Exchange feel

it has the authority to establish rates in the over-the-coun-

ter market?

A We der’t feel that we have any authority to establish rates

in the over-the-counter market.’’

is The New York Stock Exchange official previously referred to

did testify that very low over-the-counter charges might in certain

circumstances be deemed impermissible rebates. But he made it

clear that he was talking about over-the-counter commissions that

were below the cost of doing business. He further testified as follows

on redirect examination by Division counsel :

“*Q Now Mr. Bishop, is it a requirement of the New York

Stock Exchange [sic] be charged by member firms in exe-

cuting over-the-counter transactions, even though the mini-

mum New York Stock Exchange Commission exceeds the

cost of executing the transaction?

A No.’’

48a

have never explained why this fear did not restrain them

from giving up to IPC.* If the New York Stock Ex-

change’s rules had been applicable to these transactions,

they would have prohibited commission-splitting with

IPC as well as with the funds that paid those commis-

sions.

Moreover, the New York Stock Exchange had no juris-

diction over IPC. There is nothing in the record to show

that the exchange would have been disconcerted had IPC

returned Lipper’s give-up money™ to the funds.” Hence

the administrative law judge was clearly correct when he

held that:

‘‘There was no requirement of the NYSE that its

members charge NYSE rates on over-the-counter

transactions and Cowett [IOS’s executive vice presi-

** Lipper testified :

‘*Q Weren't you concerned that the New York Stock Exchange

might consider the payment of commissions earned in the

over-the-counter market, for Fund of Funds portfolio

transactions, to IPC, as violative of their anti-rebate rules?

A No sir, I was not concerned.’’

** During the relevant period, the New York Stock Exchange

permitted one of its members to manage a large investment com-

pany complex without receiving any management fee. The partners

in that firm viewed the brokerage income that they derived from

the complex’s portfolio transactions as sufficient in itself to com-

pensate them for their services. There is no indication that the Ex-

change considered this arrangement an impermissible rebate. See

Public Policy 106-109.

3¢ Whatever the New York Stock Exchange’s sentiments might or

might not have been, the money having come from the funds in the

first place, aud IPC having done nothing to earn it, there was no

way in which the IOS respondents could lawfully keep it. Moses v.

Burgin, 445 F.2d 369, 376 n. 11 (C.A. 1, 1971), cert. denied 404

U.S. 994 (1971). .

49a

dent and the principal architect of the give-up

scheme] and Lipper, both highly sophisticated in the

financial world, knew or should have known the limi-

tations of the NYSE rules. It was permissible for

Lipper Corporation to charge less on the funds’ over-

the-connter transactions and, contrary to respond-

ents’ position, the record evidences a willingness by

Lipper Corporation to be content with 50% of the

amounts actually charged the funds on such transac-

tions. In this connection, it is also clear from the

record that Cowett was not interested in negotiating

for a lower rate but in having Lipper Corporation

give up 50% of the funds’ commission payments to

IPC so that the latter would obtain additional reve-

nues.”’

Respondents say that customer-directed give-ups were

widespread and generally regarded as legitimate in 1967

and 1968. They are right about that. But their conclusion

that this justifies the activities here involved, however, is

unfounded because the customer-directed give-ups_ re-

ferred to, which were in the exchange market, differed

from the present case in two critical respects. First, they

did not involve fiduciaries diverting their beneficiary’s

funds into their own pockets. Secondly, they represented

a form of competition for lucrative institutional business

that prevailed under the rigid fixed commission rate sys-

tem which existed in the exchange markets only.

Exchange rules fixed minimum commissions at a rate

which often exceeded the amount for a which a broker was

willing to execute a transaction. Exchange rules also pro-

hibited any rebates of commissions to the customer. Under

this regime, brokers sought to attract lucrative institution-

al business by offering various inducements to institutional

customers. These included, particularly in the case of mu-

tual funds, a willingness to give-up a portion of the com-

mission to broker-dealers designated by the fund manage-

50a

ment, who were engaged in selling fund shares. Such give-

ups represented additional compensation to these dealers

for their selling activities. The exchanges chose not to re-

gard this as a rebate. While this practice was questionable

and was abolished by the exchanges in December 1968, it

was permitted prior to that time as a means by which fund

managers could obtain something of value for their excess

commissions.

In the over-the-counter market, no fixed commission rate

was imposed. The National Association of Securities Deal-

ers, Inc., the self-regulatory body for the over-the-counter

market, was and is prohibited by law from maintaining

fixed commission rates. The customer-directed give-up was

not prevalent in that market and was, indeed, regarded

as improper, if not illegal. As the Commission noted in

December 1966

‘*A directed give-up of a portion of the commission

charged for handling a transaction for a fund in the

over-the-counter market would be a patent waste of

investment company assets.’’ *’

Respondents point to the fact that it was the usual prac-

tice in agency transactions in the over-the-counter market

to charge the New York Stock Exchange commission rates.

This appears to be correct.** The conclusion which respond-

ents derive from this, that price competition for execution

services did not exist in the over-the-counter market any

more than in the exchange market, does not follow. Nor does

it further follow that because give-ups were accepted in

exchange transactions, they were therefore also acceptable

in over-the-counter transactions.

*? Publie Policy 178.

** See Report of Special Study of Securities Markets of the 8.E.C.,

H.R. Doe. No. 95, pt. 2, 88th Cong., Ist Sess. 624 (1963) (herein-

after cited as Special Study).

5la

Although on smal] over-the-counter brokerage transac-

tions the New York Stock Exchange commission was uti-

lized as a familiar measure of a proper charge for the serv-

ice, institutions were not required to, and usually did not,

pay the high exchange commissions on large over-the-coun-

ter transactions. They simply dealt directly with over-the-

counter market makers and were charged a mark-up sub-

stantially less than the applicable exchange commission.”

Consequently, on institutional transactions in the over-the-

counter market there were no excess commissions to be dis-

posed of by using customer-directed give-ups, and customer-

directed give-ups were not utilized in that market,

Respondents argue that because the Commission’s 1967

consent order precluded IOS from dealing directly with

market makers, the IOS-managed funds had to pay exces-

sive commissions and IOS had to divert the excess into

its own pocket. The Commission, of course, did not intend

such a result, and the order clearly does not provide for

such. Nothing in the 1967 order required the funds to

pay, or Lipper to charge, excessive commissions.* If for

any reason an institution wished to execute an over-the-

counter trade with a broker-dealer firm as agent rather

than as principal, this could be done, and the commission

could be negotiated, as IOS and Lipper might have done

here.

* Id. at 627. But on the exchange, the transaction could not, of

course, be executed for less than the minimum commission.

“ Respondents appear to suggest that the practice of charging

the stock exchange commission on over-the-counter transactions was

not merely a practice, resorted to for convenience where appropri-

ate, but rather reflected some type of agreement or conspiracy

among broker-dealers to charge that rate under all circumstances.

We can hardly assume the existence of such an agreement, particu-

larly in view of the fact that, if practiced in the over-the-counter

market where no statute affords the slightest justification for rate

fixing, it would have been a flagrant violation of the antitrust laws.

52a

Respondents claim to have relied on the advice of

counsel, and they did have opinions of counsel which sup-

ported their course of conduct. Although neither ignor-

ance of the law nor reliance upon counsel’s opinions can

make unlawful conduct legal, advice of counsel is often

a weighty mitigating factor.“* This is particularly true

where the law is obscure or changing, or where the issues

are technical and specialized, and a layman, therefore,

requires the advice of counsel in order to chart a course.

But here the situation is different. The IOS respond-

ents sought to divert the funds’ money tc themselves, and

the Lipper respondents knowingly participated in this

effort. In doing so, they relied upon counsel's conclusion

that they had discovered a loophole in the law of fidu-

ciary responsibility. Counsel, in turn, relied upon the

fact that no contested decision or rule was precisely in

point and specifically prohibited respondents’ scheme.

This type of reliance is misplaced, particularly in the

area of fraud. Moreover, counsel actually knew (not

merely should have known) that this agency considered

give-ups by brokers in over-the-counter transactions to

be ‘‘improper and illegal.’’** Counsel apparently dis-

“1 An act done in reliance on the advice of counsel may never-

theless be ‘‘willful’’ within the meaning of that term as used in

Section 15(b) of the Exchange Act. This is so because for purposes

of that section ‘‘a violation is ‘willful’ whenever the actor inteads

to do the act that constitutes the violation without regard to wheth-

er he specifically intends to violate the law.’’ Gearhart & Otis, Inc.,

42 S.E.C. 1, 28 (1964), affirmed, 348 F. 2d 798 (C.A.D.C., 1965).

See also Tager v. S.E.C., 344 F. 2d 5, 8 (C.A. 2, 1965).

«2 Public Policy 185. Respondents dismiss Public Policy as a mere

essay that no one was obliged to heed. One part of that report dealt

with the economics and the organizational patterns of the invest-

ment company business, as it was in 1966. Since those descriptions

were based on exhaustive and protracted studies, we consider them

authoritative. Another part of Public Policy—and the one pertinent

here—contained a concise and carefully considered summary of this

53a

agreed with these views. That was their privilege. But

both counsel and their clients were aware of the risk, and

they czn hardly claim that they could not reasonably fore-

see that the loophole which they perceived might prove

to be illusory.

B. Jurisdictional Contentions

Respondents assert that their over-the-counter give-up

arrangements are outside the Exchange Act’s purview.

They advance two reasons to support their contention.

One is that the charges against them have no real con-

nection with the purchase or sale of securities, but are

matters involving internal corporate affairs. The other is

that what is involved here is so foreign as to make the

laws of the United States inapplicable.

It is true that nothing falls within the ambit of Section

10(b) of the Exchange Act or of Rule 10b-5 thereunder

unless it be ‘‘in connection with the purchase or sale of

any security.’’ It necessarily follows that there is an area

of internal corporate management untouched by the Ex-

change Act’s antifraud provisions.

These generalities, however, have no bearing on the

case before us. This case deals with nothing but securities

transactions and the securities business. The foreign

funds were investors and traders in securities. Indeed,

Commission’s understanding of the then existing law, the law as it

already was, with respect to investment companies. A lawyer who

told his clients that this was meaningless was counseling them to act.

at their peril. As the First Circuit said when it had, to consider

Publie Policy's impact on Moses v. Burgin, 445 F. 2d 369, 384 (C.A.

1, 1971), cert. denied, 404 U.S. 994 (1971) : ‘‘ Any contention that

the Commission’s views were offhand or . . . inconsequential . . .

is, to put it bluntly, little short of extraordinary. We may add

that . . . willingness to disregard the Commission itself casts some

doubt on the bona fides of a claim that the earlier expressed views

of the staff were ignored because of its inferior position.’’

d4a

that is all they ever did. The funds were constantly buying

and selling huge blocks of securities. And they were con-

tinuously offering and selling their own shares to inves-

tors. Moreover, their shares were redeemable. Hence they

were making continuing offers to repurchase their out-

standing shares. In these circumstances we find it difficult

to conceive of any significant aspect of their affairs that

was not intimately connected with the purchase and sale

of securities. We think it axiomatic that their expendi-

tures for the brokerage services incident to such transac-

tions were so connected.

Respondents support their contention that ‘‘foreign

law rather than United States securities law is applica-

ble’? so that ‘‘the Commission is without jurisdiction or

power over the allegations in this section of the order for

proceedings’’ by pointing to Section 30(b) of the Ex-

change Act, which provides as follows:

‘*The provisions of this title or of any rule or reg-

ulation thereunder shall not apply to any person

insofar as he transacts a business in securities with-

out the jurisdiction of the United States, unless he

transacts such business in contravention of such rules

and regulations as the Commission may prescribe as

necessary or appropriate to prevent the evasion of

this title.’’

We note at the outset that §30(b) does not speak of a

business in securities ‘‘without the United States,’’ but

rather ‘‘without the jurisdiction of the United States.’’

The Lipper respondents and IPC were conducting a sub-

stantial securities business in the United States. More-

over, the transactions of concern to us occurred in the

United States. The Court of Appeals for the Second Cir-

cuit, in considering the reach of Rule 10b-5, has stated

55a

that ‘the nation where the conduct occurred has jurisdic-

tion to displace foreign law and to... apply its own.’’“

Lipper Corp. and IPC chose to register with this Com-

mission as brokers and dealers. When they did that, they

voluntarily subjected themselves and their businesses to

the jurisdiction of the United States.** In view of their

controlling influence over Lipper Corp. and IPC, Lipper

himself and IOS were also transacting a securities busi-

ness within the jurisdiction of the United States. Accord-

ingly, this Commission concludes that it has jursdiction

over the persons and the subject matter before it in this

action.

C. Other Matters

The IOS respondents claim that the administrative law

judge was disqualified because he reached certain conclu-

** Leasco Data Processing Equip. Corp. v. Maxwell, 468 F. 2d

1326, 1339 (C.A. 2, 1972) (Substantial conduct within the United

States warrants application of Rule 10b-5 to transactions on the

London Stock Exchange in securities not traded on the American

markets.) In JIT v. Vencap, Ltd., 519 F.2d 1001, 1017 (C.A. 2,

1975) the Court of Appeals for the Second Circuit said: ‘‘We do

not think Congress intended to allow tne United States to be used

as a base for manufacturing fraudulent security devices for export,

even when these are peddled only to foreigners. This country would

surely look askance if one of our neighbors stood by silently and

permitted misrepresented securities to be poured into the United

States. By the same token it is hard to believe Congress meant to

prohibit the SEC from policing similar activities within this coun-

try. ...’’ And on that same day the court underscored this in the

companion case of Bersch v. Drexel Firestone, Inc., 519 F.2d 974,

987 (C.A. 2, 1975), where it said: ‘‘We are .. . holding . . . that

Congress did not mean the United States to be used as a base for

fraudulent securities schemes even when the victims are foreigners,

at least in the context of suits by the SEC or by named foreign

plaintiffs. ’’

‘Jurisdiction for purposes of Section 30(b) does not mean

territorial limits.’’ 8.2.C. v. United Financial Group, Inc., 474 F.

2d 354, 357-358 (C.A. 9, 1973).

56a

sions and made certain findings in his initial decision

dealing with the Lipper respondents before he issued his

initial decision about the IOS phase of the case. He issued

separate decisions to accommodate the exigencies of a

situation engendered by IOS aad IPC. On representations

that settlement with IOS and IPC was imminent, the

administrative law judge closed the record without preju-

dice to an application to reopen it if IOS and IPC did

not settle as anticipated. When no such settlement was

reached, he reopened the hearings on the issues relating

to IOS and IPC. Meanwhile, he issued an initial decision

dealing with the Lipper respondents. No showing of ac-

tual bias or prejudice stemming from an extrajudicial

source that would warrant disqualification was made: The

administrative law judge’s findings against Lipper and

Lipper Corp. were made in the course of his official du-

ties. And his initial decision in the Lipper case expressly

pointed out that its findings were not binding on IOS and

IPC. Hence he was not disqualified from subsequently

deciding common legal and factual issues against IOS

and IPC.*

VI. REBATES OF BROKERAGE COMMISSIONS DE-

RIVED FROM NEW YORK STOCK EXCHANGE

TRANSACTIONS

As previously noted, commissions on New York Stock

Exchange transactions were, during the relevant period,

divisible only among members of that exchange. Since

neither IOS nor IPC was a New York Stock Exchange

member, it would seem at first blush that there was no

“8 Transamerica Corporation, 10 S.E.C. 454, 473474 (1941);

Kennedy, Cabot & Co., Inc., 44 S.E.C. 216, 223 (1970). Cf. Federal

Trade Commission v. Cement Institute, 333 U.S. 683, 702-703

(1948); United States v. Grinnell Corp., 384 U.S. 563, 582-583

(1966); Lyons v. United States, 325 F.2d 370, 375-376 (C.A. 9,

1963).

57a

way in which they could derive direct pecuniary benefits

from the New York Stock Exchange brokerage business

placed by the IOS-managed funds. The IOS respondents,

however, engaged in a scheme to obtain rebates of broker-

age commissions paid on New York Stock Exchange

transactions.**

The New York Stock Exchange commissions here under

attack were paid by IPC’s domestic fund, FOA, an in-

vestment company registered with us as such under the

Investment Company Act.

The salient facts are these:

1. The IOS respondents gave some of FOA’s New

York Stock Exchange brokerage business to X Com-

pany, a New York Stock Exchange member firm.

They did so because X Company had devised a tech-

nique for transmitting substantial chunks of excess

institutional New York Stock Exchange brokerage

back to the managers who placed orders with it.

2. X Company did not share the institutional New

York Stock Exchange commission payments them-

selves with non-members. That would have been a

blatant and an easily-detected violation of the New

York Stock Exchange’s anti-rebate rules. X Com-

pany’s modus operandi involved the splitting of com-

missions generated by transactions in the over-the-

counter market and on the Boston Stock Exchange.“

** The Lipper respondents have no connection with thi of

the proceedings. cist

**X Company was a member of both the Boston and the New

York Stock Exchanges. Like most other regional exchanges, the

Boston Stock Exchange permitted its members to divide commis-

sions with other professionals in the securities business, whether or

not they belonged to it or any other exchange. See Public Policy

171; Moses v. Burgin, 445 F. 2d 369, 375-376 (C.A. 1, 1971) cert.

denied 404 U.S. 994 (1971).

58a

The institutional manager with whom those commis-

sions were divided had no connection with, and had

never even heard of, the over-the-counter and Boston

transactions in question. X Company’s clients in

these trades were generally not institutions. Yet X

Company was ready, willing, and able to send a

stream of money arising out of these transactions to

any institutional manager who placed New York

Stock Exchange business with it.

3. The amount of money that the institutional mana-

ger ¢ould expect to receive from X Company was

directly related to the amount of New York Stock

Exchange business he gave it. Thus, for example, an

FOA New York Stock Exchange trade that produced

a $5,000 commission for X Company would be fol-

lowed by a $2,500 check from it to IPC.

4. X Company, however, was not a large firm.

Neither its over-the-counter nor its Boston volume

was large enough to create a give-up pool sufficient

in size to satisfy the IOS respondents’ desire for

commission money.

5. At this point, Y Company, another brokerage

house, became involved. Y Company was not a New

York Stock Exchange member. But it had developed

an ingenious ‘‘new technique’”’ for arranging give-

ups. The key to the new technique was Y Company’s

membership on the American Stock Exchange. Now

the simple two-sided arrangement of old was dis-

placed by a triangular relationship among IPC, X,

and Y, involving:

(a) The continued placement of FOA’s New York

Stock Exchange business with X Company—accom-

panied now, however, by the notation that the

order had been placed with X Company, ‘‘courtesy

of Y Company’’;

59a

(b) X Company’s placement with Y Company of

enough American Stock Exchange business to pro-

duce net commissions for Y Company equal to the

amount of the New York Stock Exchange commis-

sions just paid by FOA to X Company;

percent of the commissions received from the

American Stock Exchange business that X Com-

pany had forwarded to it to two of Y Company’s

registered representatives ;

(d) The retention by those registered representa-

tives of two percent of the aforementioned com-

missions to compensate them for their services as

intermediaries; and

(e) The transmission of the 50 percent of these

commissions to IPC so that the upshot of this ser-

ies of maneuvers was the return to IPC of 50 per-

cent of the commissions its cestui que trust, FOA,

had paid X Company.

Since IOS and IPC were fiduciaries for the funds they

controlled, neither of them was free te appropriate bene-

fits derived from the execution of FOA’s portfolio trans-

actions for itself.“* Of course, an investment company’s

manager may also be its broker.** When the manager acts

as a broker, he is entitled to be paid for his work.” Here,

however, neither IOS nor IPC ever supplied any broker-

** See Provident Management Corp., 44 S.E.C. 442 (1970) ; Con-

sumer Investor Planning Corp., 43 S.E.C. 1096 (1969).

** See Public Policy 71, 188-190.

*° Section 17(e)(2)(A) of the Investment Company Act permits

persons affiliated with registered investment companies and persons

affiliated with such persons to receive ‘‘the usual and customary

broker’s commission if the sale is effected on a securities exchange.’’

60a

age services to FOA. Hence this is a twice-told tale. In

the New York Stock Exchange context with FOA ’s com-

missions, just as in the over-the-counter context with the

foreign funds’ commissions, the IOS respondents used

their strategic position in, and controlling influence over,

the funds to collect brokerage income from them without

supplying any brokerage services in return.

We find, as did the administrative law judge, that the

IOS respondents’ activities in connection with FOA’s

New York Stock Exchange transactions were in willful

violation of Section 10(b) of the Exchange Act and Rule

10b-5 thereunder. We affirm and adopt as our own his

holding that:

‘‘No legal impediment precluded FOA instead of

IPC from being the beneficiary of the arrangements.

_. . [T]he arrangements . . . constituted a fraud

upon FOA and its shareholders for which ITC, and

IOS as a participant in the scheme, must be held

accountable. It is also manifest from the record that

IOS and IPC withheld details regarding arrange-

ments that had been made for the benefit of IPC

from FOA and its shareholders. Full and complete

disclosure of that information was required of IOS

and IPC in order to meet the fiduciary responsibili-

ties that they had assumed by their active intervén-

tion in the management of FOA. The failure of the

respondents in this regard can only be viewed as

deliberate, and a deception that respondents felt nec-

essary to the success of their scheme.”’

The IOS respondents argue that their conduct was

justifiable under then existing industry practices and the

New York Stock Exchange’s rules. T:cy claim that:

1. New York Stock Exchange anti-rebate rules made

it impossible for FOA to benefit from the reciprocal

payments.

6la

2. Retail sellers of investmeat company shares com-

monly received reciprocal ‘ncome from the funds’

portfolio brokerage transactions.

3. The reciprocal income paid IPC, and through it

to IOS, was simply additional compensation for

IPC’s services as the principal retail distributor of

FOA’s shares.

4. Both IPC and FOA would have been at a com-

petitive disadvantage vis-a-vis other mutual funds

and other mutual fund managers, had they been pre-

cluded from paying and receiving reciprocal income.

These contentions are without merit.

We begin by assuming arguendo that what respondents

say about the impact of the New York Stock Exchange’s

anti-rebate rules is correct. On that assumption, no direct

pecuniary benefits could have been passed back to FOA.

Hence the IOS respondents had to choose between letting

New York Stock Exchange members keep all of the com-

missions or devising some plan by which they, the re-

spondents, could share in them.

Even if that had been the situation, respondents would

not have been privileged to do as they did. True, direct

price competition among exchange members was sup-

pressed. But it does not follow that there was no compe-

tition at all among exchange members. The sellers of New

York Stock Exchange brokerage services were, in fact, in

vigorous non-price competition with each other. In the

institutional sphere, that non-price competition took sev-

eral forms. One most significant form was a competition

in supplying services to the institutions. Investment re-

search was the principal form of such service."

* See Public Policy 163-164.

62a

In the circumstances of this case, the IOS respondents

were under a duty to deploy FOA’s excess brokerage or

‘brokerage power’’ for the fund’s benefit, not theirs. It

follows that, if they had the capacity to cause any part of

the commissions to leave the hands of the executing

broker, they were bound to use that part to buy research

and related services of value to FOA’s shareholders.

When respondents entered into their kickback arrange-

ments with X and Y, they breached that duty. Those ar-

rangements were of great benefit to respondents. But they

did nothing at all for FOA. To the extent respondents

chose to induce the executing broker to give up a portion

of the commissions, they could not cause it to benefit

themselves in preference to FOA.”

The rules of the New York Stock Exchange provide no

more justification for the IOS respondents’ retention of a

portion of the commissions on the New York Stock Ex-

change transactions than they did on the over-the-counter

transactions previously discussed. IOS and IPC were

neither members of the New York Stock Exchange nor

subject to its rules. And even if they had been, nothing in

those rules would have compelled them to keep this give-

up money for themselves. These are what we deem the

controlling considerations :

1. Complex reciprocal and give-up arrangements,

such as those that were entered into here, were de-

signed for the very purpose of avoiding the New

*? The peculiarities of the investment company context call for

standards higher, not lower, than those that prevail elsewhere. Cf.

Brown v. Bullock, 194 F. Supp. 207, 233 (S.D.N.Y., 1961), affirmed

294 F.2d 415 (C.A. 2, 1961): ‘‘In light of the distinctive character

of investment companies and their easy susceptibility to manage-

ment abuses (e.g., looting of the companies by insiders using means

both crude and subtle), one of the primary objectives of the 1940

Act was the protection of investment companies as well as investors

against the derelictions of investment companies’ directors, inves'-

ment advisers, other fiduciaries, and principal underwriters.’’

63a

York Stock Exchange’s anti-rebate rules. The over-

the-counter markets and the regional exchanges were

brought into the picture because the New York Stock

Exchange had no more than the most peripheral sort

of control, if that, over the economic aspects of its

members’ activities on those markets."

2. The New York Stock Exchange did not object to

arrangements under which excess brokerage stem-

ming from transactions on its floor was used to re-

duce an investment company’s advisory fee. Hence

it would have been quite easy to give FOA the benefit

of these give-ups. But respondents had no desire to

do that.

3. Unlike the New York Stock Exchange, six of the

seven regional exchanges permitted non-members who

were professionals in the securities business to share

in commissions arising out of transactions executed

on them.

Respondents’ argument that the give-ups in question

are analogous to those that were common in the invest-

** As of the 1963 Special Study pointed out: ‘‘Return by an

NYSE member of cash to his reciprocal correspondent for commis-

sion business would violate the anti-rebate rule . . ., but the return

of a cash equivalent in the form of profitable security commission

business which might have been transacted directly by the NYSE

member is permissible .... The Exchange’s published constitution

and rules have never officially recognized a need to regulate recipro-

cal commission arrangements. Its rule 369 outlaws 10 specific com-

mission practices either outright or under specified conditions, but

does not mention reciprocal arrangements with non-member profes-

sionals.’’ H.R. Doe. No. 95, pt. 2, 88th Cong., Ist Sess. 304.

* Public Policy 171-173. ‘‘It would not be inconsistent with

those rules for dealer-distributed funds to direct give-ups to their

adviser-underwriters, all of whom are NASD members, for the pur-

pose of applying these give-ups to reduce the advisory fees payable

by the funds.’’ Jd. at 173. See also Moses v. Burgin, 445 F. 2d 369,

375 (C.A. 1, 1971), cert. denied 404 U.S. 994 (1971).

64a

ment company industry during the relevant period is mis-

placed. As the owner of FOA’s investment adviser and

manager and as the principal underwriter of FOA’s

shares, IPC’s position was in no way comparable to that

of a mere retail seller of fund shares to whom the ad-

viser-underwriters of the various funds whose shares he

sold directed reciprocal brokerage income by way of give-

ups in order to provide an additional incentive to sell

their shares. IPC was a fiduciary for FOA and its share-

holders. The ordinary retail dealer is a merchant of mu-

tual funds shares; no fiduciary relationship exists between

him and his merchandise.

A mutual fund’s adviser-underwriter needs no special

incentive to promote the sale of shares in his own funds.

His advisory fee supplies him with sufficient motive. And

unlike the independent retail dealer, the adviser-under-

writer has the entire sales charge at his disposal. More-

over, he has voluntarily bound himself by contract to

exert his best efforts to promote the sale of the fund’s

shares.

To the independent retail dealer, on the other hand,

the hundreds of mutual funds promoted and managed by

the various competing adviser-underwriters present a

wide choice. Within a broad area, he has no special rea-

son to prefer to sell the shares of Fund Complex A rather

than Fund Complex B. Hence the adviser-underwriters

who sold through retail dealers were under strong com-

petitive pressure to reward those dealers with give-up

money. The sale of FOA shares was already attractive

to the IOS respondents. There was no need to make it

5° Public Policy 170: ‘‘The customer-directed give-up has been

used extensively by the funds. It permits them to entrust the execu-

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