Petition — Steadman v. Securities & Exchange Commission

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Supreme Court. US

a ie aes

FEB 15 1980

79-1266 sian alas al

-No oie

IN THE

Supreme Court of the United States

OCTOBER TERM, 1979

CHARLES W. STEADMAN,

Petitioner,

¥.

SECURITIES AND EXCHANGE COMMISSION,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR THE

FIFTH CIRCUIT

PETER J. NICKL&S

ALEX KOZINSKI

GREGG H. LEvy

Covington & Burling

888 Sixteenth Street, N.W.

Washington, D.C. 20006

Attorneys for Petitioner

Fekruary 1980

TABLE OF CONTENTS

OPINIONS BELOW o..0..00000--cc-ccccccccccscccccesvcesvesssvssse

BUPUIITI an ccinccocccc scsccceeccccresctectsesse

QUESTION PRESENTED... ooooooooocoseeecsesee

STATUTE INVOLVED ........cccccccccccscssssscssssssssssssssseee

t,t a a Ter

THE QUESTION PRESENTED INVOLVES A

CONFLICT AMONG THE COURTS OF

SRE SREB eh rane a eden pod aarti

TABLE OF AUTHORITIES

Page

CASES:

Addington v. Texas, 441 U.S. 418 (1979) .......... 8

Collins Securities Corp. v. Securities & Ex-

change Commission, 562 F.2d 820 (D.C. Cir.

i, alisssucdosnncesnsieeseies 6,7,8,9

In re Fisher, 179 F.2d 361 (7th Cir.), cert.

denied, 340 U.S. 825 (1950).......... 0 8

In re Ryder, 263 F. Supp. 360 (E.D. Va.),

aff'd, 381 F.2d 713 (4th Cir. 1967) ................. 8

Sea Island Broadcasting Corp. v. Federal

Communications Commission, No. 76-1735

(D.C. Cir., Jan. 14, 1980)... 9

Whitney v. Securities & Exchange Commis-

sion, 604 F.2d 676 (D.C. Cir. 1979) ..000000000..... 6,7,8,9

STATUTES:

Investment Advisers Act of 1940

Section 203(f), 15 U.S.C. § 80b-3(f)......... 7

Section 206, 15 U.S.C. § 80b-6 2000... 4

Securities Act of 1933

Section 17(a), 15 U.S.C. § 77q(a).............. 4,6

Section 9, 15 U.S.C. § VTi...

Securities Exchange Act of 1934

Section 10(b), 15 U.S.C. § 78j(b) 00... 4,6

Section 25, 15 U.S.C. § T8y on.

IN THE

Supreme Court of the United States

OCTOBER TERM, 1979

No.

CHARLES W. STEADMAN,

Petitioner,

Vie

SECURITIES AND EXCHANGE COMMISSION,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR THE

FIFTH CIRCUIT

Petitioner, Charles W. Steadman, prays that a

writ of certiorari issue to review the judgment of the

United States Court of Appeals for the Fifth Circuit.

OPINIONS BELOW

The opinion of the United States Court of Ap-

peals for the Fifth Circuit, reported at 603 F.2d 1126,

is reproduced at pages 1-34 of the Appendix. The

opinion of the Securities and Exchange Commission

is reported unofficially at Fed. Sec. L. Rep. (CCH)

{ 81,243 (1977).

JURISDICTION

The judgment of the Court of Appeals was en-

tered October 4, 1979. App. 35. Respondent’s peti-

tion for rehearing, filed October 17, 1979, was denied

by the court on November 27, 1979. App. 36. The

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

§ 1254(1).

QUESTION PRESENTED

Whether, in SEC disciplinary proceedings, viola-

tions of the anti-fraud provisions of the securities

laws must be proved by clear and convincing evi-

dence, rather than by a preponderance of the evi-

dence.

STATUTE INVOLVED

Section 203(f) of the Investment Advisers Act of

1940, 15 U.S.C. § 80b-3(f), provides as follows:

“The Commission may, after appropriate no-

tice and opportunity for hearing, by order cen-

sure any person or bar or suspend for a period not

exceeding twelve months any person from being

associated with an investment adviser, if the

Commission finds that such censure, barring, or

suspension is in the public interest and that such

person has committed or omitted any act or

omission enumerated in paragraph (1), (4), or

(5) of subsection (e) of this section, or has been

convicted of any offense specified in paragraph

(2) of subsection (e) of this section within ten

years of the commencement of the proceedings

under this subsection, or is enjoined from any

action, conduct, or practice specified in para-

graph (3) of subsection (e) of this section. It

shall be unlawful for any person as to whom such

an order barring or suspending him from being

associated with an investment adviser is’ in

effect, willfully to become, or to be, associated

with an investment adviser, without the consent

of the Commission, and it shall be unlawful for

any investment adviser to permit such a person

to become, or remain, a person associated with

such investment adviser without the consent of

the Commission, if such investment adviser

knew, or in the exercise of reasonable care should

have known of such order.”

STATEMENT

Petitioner is president, chairman of the board

and owner of all the voting stock of Steadman

Security Corporation (“SSC’’), an investment adviser

registered with the Securities and Exchange Com-

mission. SSC advises and manages several mutual

funds known as the Steadman Funds.

The SEC found by a preponderance of the evi-

dence that from 1965 until 1972 Steadman and SSC

had borrowed funds from several banks at which

some of the Steadman Funds maintained custodial

accounts. Using the same standard of proof, the SEC

also found that these loans had not been fully re-

vealed to the funds’ directors nor mentioned in the

prospectuses. App. 3-5. The Commission did not find

that the mutual funds had been harmed by the loans

or the banking relationships; on the contrary, the

evidence showed that the funds had benefited from

the location of the custodial accounts. Moreover, the

Commission specifically refused to find that the banks

had granted the loans as a quid pro quo for the

mutual fund accounts, or that SSC or Steadman had

compromised the funds’ interests in managing the

accounts. App. 6.

Nevertheless, the Commission held that the exis-

tence of the loan “relationships” was material infor-

mation that SSC had a duty to reveal and that

petitioner had aided and abetted SSC in violating

Section 17(a) of the Securities Act of 1933 (“Section

17(a)”), Section 10(b) of the Securities Exchange

Act of 1934 (“Section 10(b)’’), and Subsections (1)

and (2) of Section 206 of the Investment Advisers

Act of 1940. On the basis of these and other minor

violations! the Commission (1) permanently barred

petitioner from associating with any investment ad-

viser, (2) prohibited petitioner from affiliating with

any registered investment company, and (3) sus-

pended petitioner for one year from associating with

any broker or dealer in securities.” This order, causing

the total and permanent disqualification of petitioner

‘The Commission also found by a preponderance of the

evidence that petitioner had violated the securities laws by

aiding and abetting (a) SSC’s collection of advisory fees in

excess of those specified in the management contract, (b) SSC’s

subsidiary’s collection of tender solicitation fees to which it was

not entitled, and (c) SSC’s failure to comply with certain

reporting provisions. App. 2 n.1.

? No sanctions were ordered against SSC or its subsidiaries;

they did not join in the petition below.

from the investment industry and forced divestiture

of his interest in SSC, constitutes the most serious

sanction that the Commission could have imposed.

App. 28-34.

Although petitioner argued below that the SEC

was required to prove the alleged violations by clear

and convincing evidence, the United States Court of

Appeals for the Fifth Circuit affirmed the SEC as to

standard of proof, holding that the violations require

proof only by a preponderance of the evidence. Not-

ing, however, that the Commission had imposed the

most serious sanctions at its disposal—total and per-

manent exclusion of petitioner from the investment

advisory industry—the Court remanded with direc-

tions that the Commission “articulate a sufficient

justification” for ordering petitioner’s expulsion from

the industry. App. 30.

The SEC’s petition for rehearing was denied by

the court on November 27, 1979. App. 36.

THE QUESTION PRESENTED INVOLVES

A CONFLICT AMONG THE COURTS

OF APPEALS

Petitioner argued below that in a disciplinary

proceeding the SEC must prove violations of the

anti-fraud provisions of the securities laws by clear

and convincing evidence. The court ruled against

petitioner, holding that proof by a mere pre-

ponderance of the evidence was sufficient. This hold-

ing is squarely and irreconcilably in conflict with the

decisions of the Court of Appeals for the District of

Columbia Circuit in Collins Securities Corp. v. Secu-

rities & Exchange Commission, 562 F.2d 820 (D.C. Cir.

1977), and Whitney v. Securities & Exchange Commis-

sion, 604 F.2d 676 (D.C. Cir. 1979).

Like this case, Collins involved an SEC dis-

ciplinary proceeding. Applying the preponderance of

the evidence standard of proof, the SEC found viola-

tions vf the anti-fraud provisions of the securities

laws, including Sections 10(b) and 17(a). See 562 F.

2d at 821. The court of appeals unanimously reversed,

holding that the more stringent clear and convincing

standard of proof was required in a disciplinary

proceeding involving allegations of fraud and the

potential of serious sanctions.

The Collins court recognized that the pre-

ponderance of the evidence standard is normally used

in administrative proceedings. Nevertheless, it held

that two elements typical of SEC disciplinary pro-

ceedings require application of a higher standard of

proof: ‘(1) the type of case (fraud); (2) the heavy

sanction (deprivation of livelihood).” 562 F.2d at 824.

Analogizing SEC disciplinary proceedings to those

for disbarment or suspension of attorneys, the court

ruled that serious sanctions for fraud could be predi-

cated only upon clear and convincing evidence:

“Given those elements, typical of many SEC

cases, and given the type of circumstantial proof

on which the SEC most often must rely, it ap-

pears to us that the ‘clear and convincing evi-

dence’ standard is the proper standard here; it

will require the SEC to reach a degree of per-

suasion much higher than ‘mere preponderance

of the evidence’... .” 562 F.2d at 824.

The Fifth Circuit rejected the Collins approach,

holding that the preponderance of the evidence stan-

dard was sufficient. The court remanded, however,

directing the SEC to articulate its reasons for impos-

ing upon petitioner the ultimate sanction of total and

permanent expulsion from the profession.

This approach cannot be squared with that taken

by the D.C. Circuit. Under Collins no expulsion or

lengthy suspension may be imposed, regardless of

justification, unless the violation is proved by clear

and convincing evidence. Thus, in Whitney v. Secu-

rities & Exchange Commission, 604 F.2d 676 (D.C. Cir.

1979), the D.C. Circuit, reaffirming Collins, held that

a nine-month suspension by the SEC was sufficiently

serious to require proof by clear and convincing

evidence. 604 F.2d at 680-81. In contrast, the court

below approved the imposition of the most severe

sanctions available to the SEC, including total and

permanent professional disqualification and forced

divestiture, based on a mere preponderance of the

evidence.

The Fifth Circuit premised its rejection of Collins

on the fact that the SEC can impose disciplinary

sanctions less severe than permanent debarment. See

15 U.S.C. § 80b-3(f). Explicitly mentioning suspen-

sion for twelve months, the court argued that these

milder sanctions would be appropriate for those

whose violations had been proved by a mere pre-

ponderance of the evidence. App. 26. This rationale is

at war with the approach taken by the D.C. Circuit

which, in Whitney, held that even a nine-month

suspension is a sufficiently serious sanction to require

proof by clear and convincing evidence.®

The court below also rejected the second basis for

the Collins opinion. The D.C. Circuit had reasoned

that because fraud must generally be established by

circumstantial evidence, clear and convincing proof is

required to safeguard against an erroneous determi-

nation. 562 F.2d at 824-25 & n.32. This Court recently

confirmed that the clear and convincing standard of

proof is appropriate in proceedings involving allega-

tions of fraud because a finding of fraud tarnishes

the reputation of the accused:

“One typical use of the [clear and convincing ]

standard is in civil cases involving allegations of

fraud or some other quasi-criminal wrongdoing

by the defendant. The interests at stake in those

cases are deemed to be more substantial than

mere loss of money and some jurisdictions ac-

cordingly reduce the risk to the defendant of

having his reputation tarnished erroneously by

increasing the plaintiff’s burden of proof.”

Addington v. Texas, 441 U.S. 418, 424 (1979).

Reaffirming this aspect of Collins, the D.C. Circuit in

Whitney placed specific reliance upon this passage

from this Court’s opinion in Addington. 604 F.2d at

680 n.14.

*The approach of the court below is also inconsistent with

the rule, adopted by many courts, that the standard of proof ina

disciplinary proceeding must be more stringent than the min-

imal preponderance of the evidence standard. See, e.g., In re

Fisher, 179 F.2d 361, 369-70 (7th Cir.), cert. denied, 340 U.S. 825

(1950); In re Ryder, 263 F. Supp. 360, 361 (E.D. Va.), aff'd, 381

F.2d 713 (4th Cir. 1967).

The fundamental conflict between the court be-

low and the D.C. Circuit cannot be disputed. Collins

and Whitney prohibit the SEC from imposing any

serious sanctions, regardless of justification, unless

the violation is proved by clear and convincing evi-

dence.‘ The court below refused to follow Collins and

squarely approved the weaker preponderance of the

evidence standard, requiring only that the SEC give

an explanation whenever it chooses to impose the

most serious sanction. It is thus certain that the

outcome of any review of an SEC disciplinary order

imposing serious sanctions will depend upon whether

it is brought in the Fifth or the District of Columbia

Circuit. This will defeat the Congressional mandate

that SEC respondents have the choice of their home

Circuit in addition to the D.C. Circuit for review of

SEC disciplinary orders. See, e.g., 15 U.S.C. § 77i, 78y.

-The conflict between the circuits cannot be

reconciled. The cases give inconsistent directives on

the proper standard for adjudication, a fundamental

aspect of the administrative process. Because a large

portion of SEC disciplinary proceedings involve al-

leged violations of the anti-fraud provisions, the

question presented by this petition is crucial to the

orderly administration of the securities laws and

must be resolved quickly.

‘ Subsequent to the Fifth Circuit’s decision in this case, the

vitality of Collins was reaffirmed by the D.C. Circuit. Placing

specific reliance upon Collins, the court held the requirement of

clear and convincing proof applicable in Federal Commu-

nications Commission hearings involving the possibility of

serious sanctions. Sea Island Broadcasting Corp. v. Federal

Communications Commission, No. 76-1735 (D.C. Cir., Jan. 14,

1980), slip op. at 6-1€

CONCLUSION r

The petition for a writ of certiorari should be

granted.

Respectfully submitted,

PETER J. NICKLES

ALEX KOZINSKI

GREGG H. LEVY

Covington & Burling

888 Sixteenth Street, N.W.

Washington, D.C. 20006

Attorneys for Petitioner

February 1980

UNITED STATES COURT OF APPEALS

For THE FIFTH CIRCUIT.

No. 77-2415.

CHARLES W. STEADMAN,

Petitioner,

SECURITIES AND EXCHANGE COMMISSION,

Respondent.

Oct. 4, 1979.

On Petition For Review of an Order of the Securities

and Exchange Commission.

Before WISDOM, GODBOLD and TJOFLAT, Circuit

Judges.

TJOFLAT, Circuit Judge:

The petitioner in this case, Charles W. Steadman, is

the president, chairman of the board, and sole beneficial

owner of all the voting stock in Steadman Security Corpo-

ration (SSC), an investment adviser registered with the

Securities and Exchange Commission (SEC or the Com-

mission). SSC, either directly or through wholly-owned

subsidiaries, is the adviser to and manager of several

mutual! funds known collectively as the Steadman Funds.

Steadman petitions for review of the SEC’s decision of

June 29, 1977, In re Steadman Security Corp., __— S.E.C.

, [1977-1978 Transfer Binder] Fed.Sec.L.Rep. (CCH)

781,243 (1977), which found Steadman, SSC, and the

subsidiaries in violation of several provisions of the secu-

rities laws.' Because of these violations, the Commission

entered an order that would (1) bar Steadman per-

manently from associating with any investment adviser,

‘The Commission found the following violations:

1. Steadman, SSC, and SSC’s wholly-owned broker-

dealer subsidiary, Republic Securities Corp. (RSC), violated

or aided and abetted violations of section 17(a) of the

Securities Act of 1933 (Securities Act), section 10(b) of the

Securities Exchange Act of 1934 (Exchange Act) and rule

10b-5 thereunder, and sections 206(1) and (2) of the

Investment Advisers Act of 1940 (IAA) by failing to

disclose that Steadman and SSC had borrowed money from

the banks that maintained the custodian accounts for the

Steadman Funds;

2. Steadman and SSC violated or aided and abetted

violations of sections 20(a), 30, and 34 of the Investment

Company Act of 1940 (ICA) by failing to disclose the bank

loans in proxy solicitation materials and annual and quar-

terly reports;

3. Steadman and SSC violated or aided and abetted

violations of section 17(a) of the Securities Act, section

10(b) of the Exchange Act, and rule 10b-5 thereunder,

sections 206(1) and (2) of the IAA, and subsection 15(a) (1)

of the ICA by failing to disclose that SSC had received

compensation from the mutual funds not precisely de-

scribed in its management contracts;

4. Steadman and RSC violated or aided and abetted

violations of section 17(e) of the ICA by receiving tender

solicitation fees in connection with the tender of shares held

by the funds and not remitting the fees to the funds;

5. Steadman, SSC, and its subsidiaries violated and

aided and abetted violations of sections 30(a) of the ICA

and rules 30a-1 and 30a-2 thereunder, and section 17(a) of

the Exchange Act and rule 17a-5 thereunder by failing to

file annual reports of three mutual funds and four broker-

age firms on time; and

6. Steadman and SSC aided and abetted technical

violations of section 17(a) of the ICA by causing one fund

under their control to buy and sell securities directly from

other funds to which SSC was the adviser.

(2) prohibit his affiliation with any registered investment

company, and (3) suspend him for one year from associ-

ating with any broker or dealer. No sanctions were or-

dered against the corporate respondents, and they do not

join in this appeal. Steadman raises several points of error

in his petition, most of which we find to be without merit.

We grant the petition in part, however, and remand the

case to the Commission for reconsideration of the sanc-

tions.

The violations found by the Commission relate to

several different aspects of Steadman’s management of

the mutual funds through the corporations he controlled.

See note 1 supra. The violations we shall discuss concern

Steadman and SSC’s loan relationships with the banks

used by the funds, the method of repayment to the funds

of advisory fee overcharges, the retention by a broker-

dealer subsidiary of tender solicitation fees paid for the

tender of shares held by the funds, and the failure of

Steadman and SSC to file timely reports with the Com-

mission. We shall also examine the burden of proof to be

applied in SEC disciplinary proceedings and the factual

showing necessary to support the harsh sanctions in this

case. As we review each of these areas, the relevant facts

will be presented.

I. THE BANKING RELATIONSHIPS

Between 1965 and 1968, Steadman and SSC borrowed

substantial amounts of money from the Riggs Bank of

Washington, D.C.,? the same bank where the Steadman

*The Commission’s opinion does not specify any of the

banks involved in these dealings, but the Administrative Law

Judge’s Initial Decision identifies them and their names are not

in dispute.

Funds kept their checking accounts.’ In 1968, SSC began

an expansion program to acquire the management rights

to additional mutual funds. To finance these acquisitions,

SSC applied to the Riggs Bank for a $2 million unsecured

loan. The bank turned down the request, finding that the

additional debt load on SSC, whose operations had not

been profitable, would be too large. Steadman then

retained two prominent investment bankers to aid his

quest for capital; one of them successfully arranged a $3

million loan to SSC from the Chase Manhattan Bank in

New York.

At about the time the Chase loan was negotiated,

Steadman and SSC recommended to the directors of

several of the mutual funds that the funds transfer their

bank accounts to Chase. The directors were told that the

New York bank’s custodial fees were lower, that it would

be advantageous to be closer to the New York securities

market, and that there had been problems with the Riggs

Bank. They were not told about the loan to SSC. The

transfer of accounts was approved.

Riggs called its personal loans to Steadman when the

accounts were transferred (SSC had no loans outstanding

from this bank at the time). Steadman obtained a

collateralized loan from the First National Bank of

Washington to repay the Riggs loans. The First National

loan was called in 1970 when the value of the collateral

declined, but Steadman received a 90-day extension. Two

days later, one of the funds purchased a 90-day certificate

of deposit from First National in an amount in excess of

’The Riggs Bank was the custodian for the securities and

other investments owned by the funds and it also kept the

fund’s cash assets on deposit. Cash assets of a fund include

proceeds from the sale of portfolio securities and any judgments

realized by the fund. Checking accounts are used by the funds

principally to pay dividend distributions and redemptions to

fund shareholders.

the loan. To repay his First National loan, Steadman

obtained a loan from yet another bank, the National Bank

of Washington. Soon afterwards, the custodial accounts

for one of the Steadman funds were transferred from St.

Louis to the National Bank. The fund’s directors were not

told about the loan to Steadman when they approved the

transfer.

Neither Steadman’s nor SSC’s loans were disclosed in

the mutual funds’ prospectuses. The Commission found

that this was material information that Steadman had a

duty to reveal. His failure to do so was in willful violation

of section 17(a) of the Securities Act of 1933 (Securities

Act), 15 U.S.C. §77q(a) (1976), section 10(b) of the

Securities Exchange Act of 1934 (Exchange Act), 15

U.S.C. § 78j(b) (1976), rule 10b-5, 17 C.F.R. § 240.10b-5

(1978), and sections 206(1) and (2) of the Investment

Advisers Act of 1940 (IAA), 15 U.S.C. § 80b-6(1), (2)

(1976). Steadman contends that the Commission erred in

finding the omitted information material, and that even

if it were material, he cannot be held in violation of these

statutes absent a finding that he acted with scienter, 7.e.,

an intent to deceive or defraud.

A. Materiality

Steadman agrees that TSC Industries, Inc. v. North-

way, Inc., 426 U.S. 488, 96 S.Ct. 2126, 48 L.Ed.2d 757

(1976), defines the applicable standard of materiality but

argues that the Commission misapplied that standard in

this case. The TSC case states: “An omitted fact is material

if there is a substantial likelihood that a reasonable

shareholder would consider it important in deciding [the

matter before him]” Jd. at 449, 96 S.Ct. at 2132. The

Commission concluded that Steadman’s practice of

borrowing heavily, for himself and SSC, from the same

banks where the funds had accounts created a potential

for subordinating the funds’ interests to his own. Deposits

are the source of money that banks lend out for interest.

Steadman needed large loans. His self-interest in

currying the good favor of the banks might have led him,

the Commission speculated, to keep unduly large amounts

idle in the funds’ non-interest-bearing accounts to the

benefit of the banks but the detriment of the funds’

shareholders. The SEC made no finding that this had in

fact occurred and specifically declined to find that the

funds’ custodial accounts were a quid pro quo for the loans.

Regardless of whether there was a connection between

the loans and the accounts, the Commission decided that

“Steadman had disabled himself from looking at the

funds’ checking account balances in a wholly disinterested

way, with an eye single to the funds’ best interest.

Investors had a right to know this.” ___ S.E.C. at __,

[1977-1978 Transfer Binder] Fed.Sec.L.Rep. (CCH)

4 81,243, at 88,339-7 (footnote omitted). Therefore, the

loans were material under the TSC standard. Jd. at —_,

[1977-1978 Transfer Binder] Fed.Sec.L.Rep. (CCH)

{ 81,243, at 88,339-9.

Steadman argues that the SEC found only a potential

conflict of interest, and TSC requires an actual conflict

before liability may be imposed. This misreads TSC. The

relevant part of the TSC opinion involved the nondisclo-

sure of facts that may have indicated possible market

manipulation in the context of a proxy solicitation, a

completely different context than what is involved here.

More importantly, the Court was addressing the suffi-

ciency of the plaintiff’s case for summary judgment, 7.e.,

whether the omission was material as a matter of law. The

Court was not called upon to decide the quantum of

evidence necessary to establish a material omission at

trial. The Court reaffirmed in TSC that the issue of

materiality is a mixed question of law and fact and that

divining the significance of the inferences a reasonable

investor would draw from a given set of facts is peculiarly

within the competence of the trier of fact. Turning again

to the facts of the case before it, the Court said that facts

suggesting that one corporation controls another may be

material even though in actuality there is no control; the

influence of the one company over the affairs of the other

would be of importance to shareholders. 426 U.S. at 453 &

n.15, 96 S.Ct. at 2134-35. Here, the Commission is the trier

of fact. It decided that, under the circumstances of this

case, the potential for Steadman’s abuse of his influence

over where the funds did their banking was sufficiently

great that shareholders would want to know about the

loans. That finding is not wrong as a matter of law, and

we affirm it.‘

B. Scienter

Steadman strenuously urges that scienter—an intent

to deceive, manipulate, or defraud—is a necessary element

of any enforcement action by the SEC under the anti-

fraud provisions of the securities laws. Since the Commis-

sion failed to find that Steadman acted with the requisite

intent, he would have us set aside its decision and order.

There is some support for this position. In Ernst & Ernst v.

Hochfelder, 425 U.S. 185, 214, 96 S.Ct. 1375, 1391, 47

L.Ed.2d 668 (1976), the Supreme Court decided that

scienter must be proved in a private damage action under

rule 10b-5. Whether that holding should be extended to

Commission enforcement actions under the statutes that

Steadman was found to have violated is the question

before us. We turn to an examination of each relevant

section.

* McDonough v. Champburger Corp., 488 F.2d 948 (5th Cir.

1974), does not require a contrary result. We there decided that

the omitted facts were not material because other disclosed facts

adequately revealed the possible conflict of interest, if indeed

there was one at all. Jd. at 952. Steadman and SSC disclosed no

facts concerning their borrowings from the banks.

1. Section 10(b) of the Exchange Act.

The Commission found that Steadman violated sec-

tion 10(b) of the Exchange Act and rule 10b-5, section

17(a) of the Securities Act, and sections 206(1) and (2) of

the IAA. In SEC v. Blatt, 583 F.2d 1825, 1833 (5th Cir.

1978), we held that the Commission must prove scienter in

an injunctive action under section 10(b). Steadman con-

tends that this holding compels the conclusion that scien-

ter also is required in a disciplinary enforcement action

such as this one.’ Because the Commission failed to in-

dicate whether it considered the other violations inde-

pendent and sufficient bases for the sanctions imposed, the

argument continues, we should reverse the decision.

We need not decide what state of mind must be shown

in a disciplinary action for a violation of section 10(b), for

the Commission has indicated to our satisfaction that the

section 10(b) violation is mere surplusage in this case. In

its opinion, in the context of distinguishing the Hochfelder

case, the Commission stated:

The instant case does not resemble Hochfelder. This is

not a private action for money damages. It is a

proceeding intiated by a public authority for the

prophylactic purpose of preventing future harm to

the public interest. Nor does this case rest solely on

‘The Blatt case was brought pursuant to section 21(d) of

the Exchange Act, 15 U.S.C. § 78u(d) (1976), which authorizes

the Commission to seek injunctive relief in dic. .ct court for

violations of that act. The case before us is an administrative

proceeding under section 15(b) of the Exchange Act, 15 U.S.C. §

780(b) (1976), section 9(b) of the of the ICA, 15 U.S.C. § 80a-

9(b) (1976), and section 203(f) of the IAA, 15 U.S.C. § 80b-3(f)

(1976).

Rule 10b-5* Indeed, it does not turn on 10b-5 at all. The

references to that rule in the order for proceedings

and in this opinion are merely cumulative.

*° Section 17(a) of the Securities Act and the provisions

of the Investment Company Act... are independent bases

for liability.

—_._- S.E.C. at -— , [1977-1978 Transfer Binder]

Fed.Sec.L.Rep. (CCH) § 81,243, at 88,339-10 (three foot-

notes omitted) (emphasis added). The clear import of

these words is that section 10(b) and rule 10b-5 are not

essential to the opinion and order.

2. Section 17(a) of the Securities Act.

Section 17(a) of the Securities Act provides:

It shall be unlawful for any person in the offer or

sale of any securities by the use of any means or

instruments of transportation or communication in

interstate commerce or by the use of the mails,

directly or indirectly —

(1) to employ any device, scheme, or artifice

to defraud, or

(2) to obtain money or property by means of

any untrue statement of a material fact or any

omission 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 misleading, or

(8) to engage in any transaction, practice,

or course of business which operates or would

operate as a fraud or deceit upon the purchaser.

15 U.S.C. § 77q(1976). In Hochfelder the Court noted that

the language of rule 10b-5 appears to have been derived in

significant part from this section.’ Hochfelder held that

scienter is required under rule 10b-5. Petitioner argues

that this indicates strongly that scienter also is required

under section 17(a).

Hochfelder exposes the sophistry in this argument.

The Court imposed a scienter element on rule 10b-5

because the rule can be no broader than its parent statute,

section 10(b) of the Exchange Act, whose language the

Court interpreted to require an intent to defraud.’ Section

® Rule 10b-5 provides:

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 facility of any

national securities exchange,

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

fraud,

(b) To 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 misleading, or

which operates or would operate as a fraud or deceit upon

any person, in connection with the purchase or sale of any

security.

17 C.F.R. § 240.10b-5 (1978).

7 Section 10(b) provides:

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 facility of any

national securities exchange—

« * -

(b) To use or employ, in connection with the purchase

or sale of any security registered on a national securities

exchange or any security not so registered, any manipula-

tive or deceptive device or contrivance in contravention of

such rules and regulations as the Commission may prescribe

as necessary or appropriate in the public interest or for the

protection of investors.

15 U.S.C. § 78j(b) (1976).

17(a) is, of course, a congressional enactment, not an

administrative rule, and its language is quite different

from that of section 10(b). Indeed, in a passage that cuts

against Steadman’s position, the Court stated:

Viewed in isolation the language of subsection

(b), and arguably that of subsection (c) [of rule 10b-

5], could be read as proscribing, respectively, any

type of material misstatement or omission, and any

course of conduct, that has the effect of defrauding

investors, whether the wrongdoing was intentional or

not.

425 U.S. at 212, 96 S.Ct. at 1390 (emphasis added).

Subsections (b) and (c) of rule 10b-5 are nearly word-for-

word identical with subsections (2) and (3) of section

17(a), respectively. We think that the Court would regard

these subsections of section 17(a) as requiring no intent to

defraud.

Steadman responds that the Securities Act and the

Exchange Act have traditionally been construed in pari

materia, and that to impose a scienter requirement under

one but not the other would disrupt the “single com-

prehensive scheme of regulation” that these statutes

form. Globus v. Law Research Service, Inc., 418 F.2d 1276,

1286 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S.Ct. 913,

25 L.Ed.2d 93 (1970). But Hochfelder observes that Con-

gress fashioned standards of fault under these acts on a

particularized basis. ‘“Ascertainment of congressional in-

tent with respect to the standard of liability created by a

particular section of the Acts must therefore rest prima-

rily on the language of that section.” 425 U.S. at 200, 96

S.Ct. at 1384. We turn then to an examination of the

language of section 17(a).

‘ We are not the first to travel this road. In SEC v.

Coven, 581 F.2d 1020 (2d Cir. 1978), cert. denied, 440 U'S.

950, 99 S.Ct. 1432, 59 L.Ed.2d 640 (1979), the Second

Circuit, in a well-reasoned opinion that included a canvass

of the legislative history, concluded that scienter is not

required in an SEC injunctive action under subsection

17(a)(2). We adopt that conclusion for the reasons given

in the Coven opinion. Accord, SEC v. American Realty

Trust, 586 F.2d 1001, 1005-06 (4th Cir. 1978); SEC v.

Southwest Coal & Energy Co., 439 F.Supp. 820, 826

(W.D.La.1977), appeal docketed, No. 78-1130 (5th Cir. Jan.

17, 1978). Moreover, we adopt the further suggestion in

Coven that “the clear import of the critical phrase in

subsection (3), ‘operates as a fraud,’ is to focus attention

on the effect of potentially misleading conduct on the

public, not on the culpability of the person responsible.”

581 F.2d at 1026 (emphasis in original) (footnote

omitted). When construing identical language in section

206(2) of the IAA, see note 10 infra, language which was

undoubtedly copied from subsection 17(a)(3), the Su-

preme Court said: “Congress, in empowering the courts to

enjoin any practice which operates ‘as a fraud or deceit’

upon a client, did not intend to require proof of intent to

injure ... .” SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. 180, 195, 84 S.Ct. 275, 284, 11 L.Ed.2d 237 (1963).*

Steadman objects that Coven is distinguishable as an

injunctive action in which the Commission need only prove

that the defendant is about to engage in unlawful con-

duct, i.e., not every element of a section 17(a) violation

need be proved. We think that Coven’s analysis of the

statutory language does not depend on the character of

relief sought; the words used by Congress carry the same

® Read literally, subsection 17(a)(3) requires a finding that

the course of business in which Steadman engaged operated as a

fraud on the funds’ shareholders. The Commission made no such

finding in this case. A remand for rectification of this lapse

would be a wasted gesture, however, because Capital Gains holds

that nondisclosure of a material fact is conduct that “operates as

a fraud or deceit” within the meaning of section 206(2) of the

IAA. 375 US. at 198-99, 84 S.Ct. at 286. We think the same

conclusion is inescapable under subsection 17(a) (3).

meaning regardless of whether the SEC seeks an in-

junction or a stronger sanction. As we shall discuss, the

severity of the sanctions affects the factual showing nec-

essary to support them, but it does not affect the basic

elements of the offense. Accordingly, we hold that scienter

need not be proved to establish violations of subsections

17(a)(2) and (3).°

We come now to subsection 17(a)(1). This clause

contains the word “device” that the Supreme Court in

Hochfelder found to be suggestive of intentional conduct

when read together with “manipulative” and “deceptive.”

425 U.S. at 197, 96 S.Ct. at 1383. The latter two words do

not appear in subsection 17(a)(1), but the three words of

that section—device, scheme, and artifice—must each be

read in conjunction with the words “to defraud.” The

resu.ting phrases—device to defraud, scheme to defraud,

artifice to defraud—carry strong implications of in-

tentional conduct. We do not think Congress would have

used such language if it meant to reach merely negligent

actions. The use of the term “employ” further supports our

reading of the section. See Hochfelder, 425 U.S. at 199 n.20,

96 S.Ct. at 1384.

* Steadman argues that Sanders v. John Nuveen & Co., 554

F.2d 790, 794-96 (7th Cir. 1977), suggests a contrary result. On

the assumption that a private right of action for damages exists

under subsection 17(a)(2), a question it did not resolve, the

Seventh Circuit there commented that scienter must be proved

in such an action, for to interpret the subsection otherwise

would nullify other sections of the Securities Act that specifi-

cally provide for private actions. We cannot agree with Stead-

man’s contention that the logic in Sanders should control in the

type of proceeding now before us. Even if scienter may be

required to harmonize a hypothetical implied private cause of

action with the rest of the act, there is no reason to hold scienter

an element of the action specifically contemplated by the

statute.

In adjudicating a violation of section 17(a), the Com-

mission failed to find that Steadman acted with an intent

to defraud, and thus an essential element of a subsection

17(a)(1) violation is missing. There is an indication in a

footnote to the Commission’s opinion that the section

17(a) infraction rests only on subsections (2) and (3). See

____ § EC. at ___ n.81, [1977-1978 Transfer Binder]

Fed.Sec.L.Rep. 7 81,243, at 88,339-10. Perhaps this oblique

footnote sufficiently conveys the SEC’s intent to disclaim

reliance upon subsection 17(a)(1). To the extent that the

SEC relied upon subsections (2) and (3) of section 17(a),

under which scienter is not a requirement, the violations

are supported by substantial evidence and we vould af-

firm; nevertheless, since we find other reasons to send this

ease back for reconsideration, the Commission on remand

can clarify its opinion with regard to the subsections of

section 17(a) that it considers were violated.

3. Sections 206(1) and (2) of the IAA.

What we have said in discussing section 17(a) of the

Securities Act applies equally to the language of subsec-

tions (1) and (2) of section 206 of the IAA.” The wording

of these provisions, which make it unlawful for an in-

vestment adviser ‘“(1) to employ any device, scheme, or

artifice to defraud any client or prospective client; (2) to

engage in any transaction, practice, or course of business

which operates as a fraud or deceit upon any client or

It shall be unlawful for any investment adviser, by use

of the mails or any means or instrumentality of interstate

commerce, directly or indirectly —

(1) to employ any device, scheme, or artifice to

defraud any client or prospective client;

(2) to engage in any transaction, practice, or

course of business which operates as a fraud or deceit

upon any client or prospective client;

15 U.S.C. § 80b-6(1), (2) (1976).

prospective client,” is drawn from subsections 17(a)(1)

and (3), respectively. As we already have noted, the

Supreme Court has ruled that scienter is not required

under section 206(2). SEC v. Capital Gains Research

Bureau, Inc., 375 U.S. at 195, 84S. Ct. at 284. The Court in

that case said nothing about part (1) of section 206. We

think that the language of this subsection must be con-

strued to have the same meaning as subsection 17(a)(1),

for to do otherwise would produce a serious anomaly;

language copied directly from the Securities Act would

have a different meaning under the IAA. We are aware

that in Capital Gains, the Court emphasized that the

intent of the IAA was to impose fiduciary standards on

investment advisers. This general purpose for the statute

argues in favor of liability for negligence alone, but

“{a]scertainment of congressional intent with respect to

the standard of liability created by a particular

section ... must... rest primarily on the language of that

section.” Hochfelder, 425 U.S. at 200, 96 S.Ct. at 1884. The

language of section 206(1) clearly connotes intentional

conduct and nothing in either the House or Senate Com-

mittee reports indicates that this phrase in the IAA is to

be interpreted differently than the same phrase in the

Securities Act. See H.R.Rep.No.2639, 76th Cong., 3d Sess.

(1940); S.Rep.No.1775, 76th Cong., 3d Sess. (1940).

Although the violation of section 206(2) can be supported

without a showing of scienter, here the Commission found

a violation of section 206(1) without finding the requisite

scienter. Because the Commission’s findings do not sup-

port some of the violations, we remand so that the Com-

mission can reconsider whether it would impose the same

sanctions under the violations we uphold.

II. ADVISORY FEES

SSC’s management contract with at least two of the

mutual funds limited SSC’s annual advisory fee to one

percent of each fund’s average net assets. Apparently the

fee was paid in installments throughout the year based on

estimates of the assets under management. At the end of

the fiscal year," because of a sharp decline in value of these

funds’ assets, it became clear that payments to SSC had

exceeded the contractual maximum. Thus SSC owed the

two funds a total of $260,000. SSC did not refund the

money immediately. Instead, it suggested, and the funds’

directors agreed, that the overrun would be repaid in

installments at six percent interest.

On these facts the Commission found that SSC had

received “compensation” within the meaning of subsec-

tion 15(a)(1) of the Investment Company Act of

1940(ICA), 15 U.S.C. § 80a—15(a)(1) (1976), because the

obligation to refund the fees arose as soon as the fiscal-

year-end computations were made, and SSC reaped an

economic benefit by stretching out the repayments.

Subsection 15(a)(1) prohibits an adviser from receiving

“compensation” not “precisely” described in the advisory

contract.’ Because SSC’s contracts did not provide for

extended payment terms for fee overruns, the Commis-

sion held SSC in willful violation of the section and found

that Steadman had aided and abetted the violations.

"The relevant fiscal year ended on June 30, 1970, for one

fund and on January 31, 1971, for the other.

2? Section 15(a) provides in part:

It shall be unlawful for any person to serve or act as

investment adviser of a registered investment company,

except pursuant to a written contract, which contract,

whether with such registered company or with an in-

vestment adviser of such registered company, has been

approved by the vote of a majority of the outstanding

voting securities of such registered company, and—

(1) precisely describes all compensation to be paid

thereunder;

15 U.S.C. § 80a-15(a) (1) (1976).

Steadman attacks these conclusions on several bases.

He first argues that the arrangements made between SSC

and the funds for repayment of the advisory fee overruns

cannot reasonably be considered compensation to SSC. He

cites as authority Jn re Imperial Financial Service, Inc., 42

S.E.C. 717, [1964—1966 Transfer Binder] Fed.Sec.L.Rep.

(CCH) 9 77,287 (1965), in which the SEC refused to hold

that a loan, repaid at seven percent interest, constituted

compensation to an affiliated borrower. The Commission

responds that it explicitly noted in Jmperial that in a

given case an interest-bearing loan could be treated as

compensation under the ICA, but because seven percent

was a very generous rate at the time, the Commission did

not decide whether that loan was compensation. Here, it

points out, six percent was a very low rate for the time,

and even if the interest were at market rate," the funds’

forbearance to demand immediate payment of the amount

due was a substantial economic benefit to SSC.

We think the Commission has the better argument.

In Jmperial, it did not foreclose itself from treating as

compensation the type of repayment schedule involved

here. The question presented is a rather technical one,

and substantial deference is due the construction of a

statute made by those charged with its execution. E. J. du

Pont de Nemours & Co. v. Collins, 432 U.S. 46, 54, 97 S.Ct.

'’ Steadman and the Commission are unable to agree what

the prime rate for commercial loans was at the time. The SEC

says eight percent, Steadman says six to six-and-one-half

percent. Even taking Steadman’s best figure—six percent—it

is clear that he was getting a good deal, because the best rate he

was able to negotiate with a commercial bank on the loans

discussed in Part I was one-half percent over prime. Moreover,

the portfolio manager for one of the funds testified that in

November 1970, the same time frame when these over-runs

were due, the funds could get eight-and-one-half to nine

percent by investing in short term commercial paper. Joint

App. at 94.

2229, 2234, 53 L.Ed.2d 100 (1977). The Commission’s

construction is not unreasonable, and we uphold it.

Steadman fares no better with his other contentions.

That the arrangement was approved by the funds’ direc-

tors and on the advice of counsel does not render the

violation any less willful, for “willful” in this context

simply means that the act constituting the violation was

done intentionally; “[t}here is no requirement that the

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

Acts.” Arthur Lipper Corp. v. SEC, 547 F.2d 171, 180 (2d

Cir. 1976) (footnote omitted) (quoting Tager v. SEC, 344

F.2d 5, 8 (2d Cir. 1965)), cert. denied, 434 U.S. 1009, 98

S.Ct. 719, 54 L.Ed.2d 752 (1978). As to the finding that

Steadman aided and abetted the violation, his control of

SSC is a substantial ground for the inference that he was

involved in every important activity of that company, and

there is independent evidence in the record to support this

inference.

Finally, Steadman points out that in finding that the

failure to disclose the installment repayment arrange-

ment was a violation of the antifraud provisions, see

footnote 1, paragraph 3, supra, the Commission failed to

find that the omitted facts were material. It is true that

the Commission did not explicitly state in its opinion that

these facts were material, but it adopted the Adminis-

trative Law Judge’s findings that the antifraud statutes

had been violated, and we think it sufficiently clear that

the SEC also adopted the finding that these facts were

material.

Ill. TENDER SOLICITATION FEES

In 1969, tender offers were made for securities held by

three of the Steadman funds. In accordance with the

custom in the industry, the offerors paid tender solic-

itation fees to brokers who successfully solicited their

clients to tender their shares. The funds’ shares were

tendered through Republic Securities Corporation (RSC),

a wholly owned broker-dealer subsidiary of SSC. RSC

collected tender solicitation fees equal to two percent of

the value of the securities tendered—about $32,000. RSC

kept half of this amount and paid the other half to the

tendering funds.

Subsection 17(e)(1) of the ICA, 15 U.S.C. § 80a-

17(e)(1) (1976), prohibits an affiliated person of an in-

vestment company from receiving compensation for the

sale of the company’s property except in the course of his

business as a broker.’ The Commission found that RSC

“ The full text of section 17(e) provides:

It shall be unlawful for any affiliated person of a

registered investment company, or any affiliated person of

such person—

(1) acting as agent, to accept from any source any

compensation (other than a regular salary or wages

from such registered company) for the purchase or sale

of any property to or for such registered company or

any controlled company thereof, except in the course of

such person’s business as an underwriter or broker; or

(2) acting as broker, in connection with the sale of

securities to or by such registered company or any

controlled company thereof, to receive from any source

a commission, fee, or other remuneration for effecting

such transaction which exceeds (A) the usual and

customary broker’s commission if the sale is effected on

a securities exchange, or (B) 2 per centum of the sales

price if the sale is effected in connection with a secon-

dary distribution of such securities, or (C) 1 per centum

of the purchase or sale price of such securities if the sale

is otherwise effected unless the Commission shall, by

rules and regulations or order in the public interest and

consistent with the protection of investors, permit a

larger commission.

RSC thought it was complying with the one percent limitation

of subsection (2)(C) when it remitted half the fee to the funds.

was not acting as a broker in this transaction and there-

fore should have paid all of the fees it received to the

tendering funds:

Where no brokerage is needed, no fee may be

collected. These fees paid were to “soliciting bro-

kers.” Republic did no soliciting. It merely trans-

mitted the tendered securities. No broker was

needed for that.

The decision to tender had already been made by

the investment adviser. For making such decisions it

received an advisory fee. It could not pocket a second

fee for the very same service by donning its broker-

dealer hat.

m—~_~ on , [1977-1978 Transfer Binder]

Fed.Sec.L.Rep. (CCH) 981,248, at 88,339-15 (footnotes

omitted). In support, the SEC cites its decision in Jn re

Provident Management Corp, 44 S.E.C 442, [1970-1971

Transfer Binder] Fed.Sec.L.Rep. (CCH) 9 77,937 (1970),'

where it found improper the retention of tender solic-

itation fees by an affiliated broker who performed no

“compensable services.”

There is no dispute that RSC is an affiliated person of

the tendering funds. Steadman contends, however, that

RSC performed substantial services for the funds in

gathering the shares and effecting the transfers and that

these were brokerage services for which it could collect a

fee. Steadman attacks the conclusion that “where no

brokerage is needed, no fee may be collected” as novel and

'® Steadman’s attack on the precedential value of Provident

is without merit. Although that opinion was issued in con-

nection with an offer of settlement, the Commission’s construc-

tion of the securities laws in settled cases as well as litigated

ones is entitled to great weight. E. J. duPont de Nemours & Co.

v. Collins, 482 U.S. 46, 54, 97 S.Ct. 2229, 2234, 53 L.Ed.2d 100

(1977).

unsupported. He also argues that the funds accrued a net

benefit on the transaction since the whole two percent fee

would have been lost to them if they had used an unaffil-

iated broker, whereas by using RSC they collected half the

fee.

We think that we must defer to the Commission’s

expertise on this issue also. Its argument that the services

performed by RSC were part of what the funds were

paying their manager, SSC, to do is not unreasonable.

Section 17(e) was intended to prohibit conflicts of interest

between a fund and affiliated persons advising it on

portfolio transactions. United States v. Deutsch, 451 F.2d

98, 109 (2d Cir. 1971), cert. denied, 404 U.S. 1019, 92 S.Ct.

682, 30 L.Ed.2d 667 (1972). SSC faced such a conflict in

advising the funds whether to tender, knowing that its

subsidiary would pocket a fee if they did. That the funds

might also gain is no answer. Accordingly, the Commis-

sion’s finding of section 17(e) violations by RSC is af-

firmed. There is substantial evidence to support the

conclusion that Steadman aided and abetted the viola-

tions. He personally reviewed the accounting treatment

given the transaction and ordered the splitting of the fees

between RSC and the funds. Hence, we also affirm the

Commission’s finding that Steadman violated section

17(e).

IV. REPORTING VIOLATIONS

By the terms of its management contracts with the

funds, SSC undertook to see that the funds filed with the

SEC reports required by law. The annual reports for at

least three funds were filed late for three consecutive

years, 1970 to 1972, and the annual reports for Steadman’s

four broker-dealer companies were late in both 1971 and

1972. In the Commission’s view, the principal problem

involved the 1971 reports. These were filed more than a

year late, “ ‘so late as to be of minimal value in serving the

purposes intended by the requirements for filing the

reports.’ ” __ S.E.C. at , [1977-1978 Transfer Bind-

er] Fed.Sec.L.Rep. (CCH) § 81,248, at 88,339-16 (quoting

from Administrative Law Judge’s Initial Decision).

Steadman does not deny that the reports were late.

He does not dispute that the applicable statutes were thus

violated, see note 1, paragraph 5, supra; he simply con-

tends that there is no evidence that the violations were

willful. He points out that it is uncontested that it took

seven months to replace SSC’s controller after he resigned

in 1971, that SSC’s independent auditor was changed in

the same year, and that SSC sought but was denied

extensions for at least some of the reports.

The Commission responds that these facts in mitiga-

tion do not excuse the violations or render them less

willful. We agree. The record discloses that as early as

1969, SSC’s auditors were advising Steadman of serious

deficiencies in the accounting procedures and internal

organization, including the lack of sufficient personnel, of

SSC and its subsidiaries. They warned that the growth in

assets under management had not been matched by

changes necessary to handle the increased workload. In

1970, under pressure from the banks to meet his loan

payments, Steadman implemented a stringent cost-

cutting drive that included a significant reduction in

personnel. His problems were thus of his own making. On

these facts, the Commission was justified in concluding

that Steadman was more interested in economizing than

in maintaining the organization necessary to manage the

funds properly.

V. SANCTIONS AND BURDEN OF PROOF

Steadman’s principal argument for reversal of the

Commission’s order is that the wrong burden of proof was

used in the administrative proceedings. We have reserved

treatment of this issue for discussion in conjunction with

his attack on the severity of the sanctions imposed upon

him because, in our view, the two are closely related. We

conclude that when the Commission chooses to order the

most drastic remedies at its disposal, it has a greater

burden to show with particularity the facts and policies

that support those sanctions and why less severe action

would not serve to protect investors.

A. Burden of Proof

The Commission applied a “preponderance of the

evidence” standard in this case. Steadman cites Collins

Securities Corp. v. SEC, 183 U.S.App.D.C. 301, 562 F.2d 820

(D.C.Cir. 1977), for the proposition that a “clear and

convincing evidence” standard is required. In Collins, the

defendant was charged with manipulating the market for

the shares of a particular company in violation of various

antifraud provisions of the securities laws. The court

acknowledged that the traditional standard of proof in

administrative proceedings is the preponderance of the

evidence. It expressed concern, however, that in a secu-

rities case involving allegations of fraud the evidence is

often circumstantial in nature and requires to a signifi-

cant degree the drawing of inferences to establish the

violation. In addition, on the basis of this inferential

proof the administrative agency may impose sanctions

amounting in effect to a deprivation of livelihood. Thus

the court discerned ‘‘a need to subject such evidence to a

standard which will ensure that any remedial sanctions

are imposed only in those circumstances where the evi-

dence is of such a quality as to make the sanctions appear

just and reasonable.” Jd. at 304, 562 F.2d at 823. After

noting that the clear and convincing evidence standard

has been imposed in certain other types of cases, most

notably those involving civil fraud, the court concluded

that, for SEC disciplinary proceedings in fraud cases, this

standard drew the necessary “realistic correlation be-

tween the burden of persuasion and the available rem-

edies.” Jd. at 307, 562 F.2d at 826.

Other cases cited by petitioner are relevant but not

directly on point. In Addington v. Texas, a ieee

99 S.Ct. 1804, 60 L.Ed.2d 323 (1979), the Supreme Court

decided that the fourteenth amendment requires at least

the clear and convincing evidence standard in civil in-

voluntary commitment proceedings. In a general dis-

cussion of the function of a standard of proof, the Court

noted:

One typical use of the [clear and convincing]

standard is in civil cases involving allegations of

fraud or some other quasicriminal wrongdoing by the

defendant. The interests at stake in those cases are

deemed to be more substantial than mere loss of

money and some jurisdictions accordingly reduce the

risk to the defendant of having his reputation tar-

nished erroneously by increasing the plaintiff’s bur-

den of proof.

Id. at ___., 99 S.Ct. at 1808. The case before the Court did

not, of course, involve allegations of fraud, and no holding

was made respecting such cases. In requiring more than a

mere preponderance of evidence for civil commitment, the

Court focused primarily on the deprivation of liberty

entailed in confinement; it also noted that “adverse social

consequences” can result from involuntary commitment to

a mental hospital. Jd. at , 99 S.Ct. at 1809.

Spevack v. Klein, 385 U.S. 511, 87 S.Ct. 625, 17 L.Ed.2d

574 (1967), and In re Ruffalo, 390 U.S. 544, 88 S.Ct. 1222, 20

L.Ed.2d 117 (1968), also cited by Steadman, both hold that

disbarment from the practice of law is a penalty that

triggers the minimum protections of due process—notice,

a hearing, and the right not to testify against oneself.

Steadman does not suggest that he was denied these

protections in this case; rather, he argues that due process

also requires a heightened standard of proof before he

may be barred permanently from his profession.

To the extent that Collins rests on a concern that

there are particular risks for a respondent in a fraud

proceeding because the proof is necessarily circumstantial

and inferential, we are not persuaded. In his proceeding,

the only fact to which Steadman points as being based on

disputed inferences is his state of mind—whether he acted

with an intent to defraud. But we have held that scienter

is not an element of a violation of subsections (2) and (3)

of section 17(a) of the Securities Act or of section 206(2)

of the IAA, statutes on which the Commission relies to a

significant degree in this case. These are commonly called

“antifraud” provisions, but the offenses they define are

fraud in the broadest “remedial” sense of that term and

require no showing of intent to injure or injury. See SEC

v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 195,

84 S.Ct. 275, 284, 11 L.Ed.2d 237 (1963). The facts

necessary to establish a violation of these sec-

tions—nondisclosure of a material fact—are capable of

proof by ordinary direct or circumstantial evidence as in

any other administrative proceeding.

We are more impressed by Steadman’s argument that

the potential for severe sanctions that results from viola-

tion of these sections demands a higher burden of proof.

Before the Commission, Steadman faced indefinite ex-

clusion from the investment advisory business and the

forced sale of all his interest in SSC. The order the

Commission rendered is indistinguishable in its effect on

the respondent from disbarment from the practice of law.

While many jurisdictions use a preponderance standard in

disbarment proceedings, many others apply a higher

standard. See 7 C.J.S. Attorney & Client § 33a(3) (1937 &

Supp.1979); 7 Am.Jur.2d Attorneys at Law § 67 (1963 &

Supp.1979) (collecting cases). The higher standard rests

in large part on the concern that disbarment means

deprivation of livelihood. See, e. g., In re Fisher, 179 F.2d

361, 369-70 (7th Cir.), cert. denied, 340 U.S. 825, 71 S.Ct.

59, 95 L.Ed. 606 (1950).

We are reluctant to say, however, that in all dis-

ciplinary proceedings under the securities antifraud pro-

visions the Commission must prove its case by clear and

convincing evidence. Debarment from the industry is not

the only sanction the SEC can impose. The available

remedies also include mere censure, limitation of the

respondent’s activities, or suspension for up to twelve

months. 15 U.S.C. § 80b-3(f) (1976).'* Thus, the stakes are

not as high for every respondent in a Commission pro-

ceeding as they came to be for Steadman.

The burden of proof serves to allocate between the

litigants the risk of erroneous decision in a proceeding.

Addington v. Texas, __. U.S. at , 99 S.Ct. at 1808.

Balanced against the risk to Steadman is the risk that the

investing public will be inadequately protected. The

public interest in high standards of conduct in the secu-

rities business is a great one. If the burden of proof

imposed on the Commission is too high, its ability to police

the industry is impaired. We cannot say here, as the Court

could in Addington v. Texas, id. at , 99 S.Ct. at 1810,

that “the possible injury to the individual is significantly

greater than any possible harm to the state.” Accordingly,

we do not see why they should not bear the risk of error

equally.

We do not wish to minimize the seriousness of the

sanctions laid upon Steadman. From his perspective,

In addition, 15 U.S.C. § 80a-9(b) (1976) permits the

permanent or temporary, conditional or unconditionai, prohibi-

tion of service of an officer, employee, or director of a registered

investment adviser.

exclusion from the industry is clearly a penalty. See

Arthur Lipper Corp. v. SEC, 547 F.2d 171, 180 n.6 (2d Cir.

1976), cert. denied, 434 U.S. 1009, 98 S.Ct. 719, 54 L.Ed.2d

752 (1978); cf. In re Ruffalo, 390 U.S. at 550, 88 S.Ct. at

1226 (disbarment is a penalty). But see Blaise D’Antoni &

Associates v. SEC, 289 F.2d 276, 277(5th Cir.) (revocation

of broker registration not a penalty), cert. denied, 368 U.S.

899, 82 S.Ct. 178, 7 L.Ed.2d 95 (1961). But imposing a high

burden of proof to establish the facts of a securities-laws

violation is not the only means to protect a respondent.

We are empowered to set aside Commission orders that

are arbitrary and capricious. 5 U.S.C. §§ 551, 702, 706,

(1976). We subscribe to the common-sense notion that

the greater the sanction the Commission decides to im-

pose, the greater is its burden of justification. Where, as

here, the most potent weapon in the Commission’s “arse-

nal of flexible enforcement powers,” Ernst & Ernst v.

Hochfelder, 425 U.S. 185, 195, 96 S.Ct. 1875, 1882, 47

L.Ed.2d 668 (1976), is used, the Commission has an obliga-

tion to explain why a less drastic remedy would not

suffice.

We have not lost sight of the limitations on our power

to review administrative sanctions. Our role is to decide

only whether, under the applicable statute and the facts as

found, the agency has made “an allowable judgment in its

choice of the remedy.” Jacob Siegel Co. v. FTC, 327 U.S. 608,

612, 66 S.Ct. 758, 760, 90 L.Ed. 888 (1946), quoted in Butz v.

Glover Livestock Commission Co., 411 U.S. 182, 189, 93 S.Ct.

1455, 1459, 36 L.Ed.2d 142 (1973). The fashioning of an

appropriate and reasonable remedy is for the Commission,

not this court, and the Commission’s choice of sanction

may be overturned only if it is found “unwarranted in law

or... without justification in fact.” American Power &

Light Co. v. SEC, 329 U.S. 90, 112-18, 67 S.Ct. 133, 146, 91

L.Ed. 103 (1946), quoted in Butz v. Glover Livestock Com-

mission Co., 411 U.S. at 185-86, 93 S.Ct. at 1458. In our

view, however, permanent” exclusion from the industry is

“without justification in fact” unless the Commission spe-

cifically articulates compelling reasons for such a sanction.

For example, the facts of a case might indicate a reason-

able likelihood that a particular violator cannot ever

operate in compliance with the law, see SEC v. Blatt, 583

F.2d 1325, 13834 (5th Cir. 1978), or might be so egregious

that even if further violations of the law are unlikely, the

nature of the conduct mandates permanent debarment as

a deterrent to others in the industry, see p. 1142 infra. We

do not intend to limit the Commission by indicating these

possible grounds for debarment, but rather give them as

examples of the type of situation that would seem to

justify that penalty. With this in mind, we proceed to

examine the sanctions imposed upon Steadman.

B. The Sanctions

In its brief, the Commission has candidly conceded

that Steadman’s status as a fiduciary to the funds was

“vitally significant” in assessing the seriousness of his

conduct. Respondent’s Brief at 67. The opinion under

review concludes that Steadman was “egregiously faith-

less” in that role because of (1) his intentional and

protracted concealment of his banking relationships and

(2) his causing flagrant and intentional breaches of his

companies’ contractual and fiduciary duties to see that the

funds fulfilled their reporting obligations. _____ S..E.C.. at

—__— & n.90, [1977-1978 Transfer Binder] Fed.Sec.L.Rep.

'™*Permanent” in this context really means “indefinite”

since the Commission retains the power to modify its orders. See

In re Steadman Securities Corp., S.E.C. at n.100,

[1977-1978 Transfer Binder] Fed.Sec.L.Rep. (CCH) § 81,243, at

88,339-23. This does not make the sanction less severe, however.

'’ The Commission might consider modelling its use of, and

explanation for, debarment after the way in which disbarment

has been enforced against certain members of the legal profes-

sion.

(CCH) 9 81,243, at 88,339-20. Harsh sanctions were im-

posed because the misconduct in this case was particularly

serious, and past misconduct gives rise to an inference of

probable future misconduct. Leniency in this case, it was

felt, would pollute the ethical climate in the industry and

encourage others to act irresponsibly.

We do not agree with Steadman that the Commission

has unconstitutionally made a conclusive presumption of

future wrongdoing on the basis of past misconduct, but we

do agree that a fuller explanation of the need for these

sanctions is required. At least the Commission specifically

ought to consider and discuss with respect to Steadman

the factors that have been deemed relevant to the issuance

of an injunction:

the egregiousness of the defendant’s actions, the

isolated or recurrent nature of the infraction, the

degree of scienter involved, the sincerity of the de-

fendant’s assurances against future violations, the

defendant’s recognition of the wrongful nature of his

conduct, and the likelihood that the defendant’s occu-

pation will present opportunities for future viola-

tions.

SEC v. Blatt, 583 F.2d at 1334 n.29. To say that past

misconduct gives rise to an inference of future misconduct

is not enough. What is required is a specific enumeration

of the factors in Steadman’s case that merit permanent

exclusion.

We heartily endorse the Commission’s view that while

scienter is not required to make out violations of several of

the statutory sections involved here, the respondent’s

state of mind is highly relevant in determining the

remedy to impose. It would be a gross abuse of discretion

to bar an investment adviser from the industry on the

basis of isolated negligent violations. More than that was

shown here, however. The Commission found that the

concealment of Steadman’s collateral banking relations

was “systematic, calculated and protracted,” —._ S..E.C.

at __., [1977-1978 Transfer Binder] Fed.Sec.L.Rep.

(CCH) 9 81,243, at 88,339-11; accordingly, it found that he

and his corporate instrumentalities intended to deceive.

This conclusion is markedly undercut, though, by the

Commission’s refusal to adopt the Administrative Law

Judge’s finding that the funds’ custodial accounts were

intentionally offered to the banks as an inducement to

make the loans.” Such a finding by the Commission would

have significantly strengthened its conclusion that the

failure to disclose the loans was intended to deceive. Use of

the funds’ custodial accounts as leverage to obtain loans

for the adviser and its president would be an obvious and

serious breach of fiduciary duty, the concealment of which

clearly would have been fraudulent. In the absence of such

a finding, we have only the coincidence that Steadman

and SSC borrowed from the funds’ custodians. We do not

retreat from our affirmation that these facts were mate-

rial, but they are less supportive of an intent to deceive

than other conclusions the record arguably permits. We do

not say there is a lack of substantial evidence to support

the finding of scienter—there is such support—but in

considering what sanctions the Commission’s opinion will

justify, we think the Commission has not articulated a

sufficient justification for expulsion from the industry.

'® There is no satisfactory explanation for the Commission’s

failure to make this finding except that it was considered

unnecessary. The opinion notes that the live testimony at the

hearing was against a causal link, and the documentary evi-

dence supporting such a link was received by the Adminis-

trative Law Judge over Steadman’s objections to its admissibil-

ity and probative weight. Therefore, the Commission concluded,

“questions of fact are raised. We do not reach them.”

S.E.C. at , [1977-1978 Transfer Binder] Fed.Sec.L.Rep.

(CCH) 981,243, at 88,339-13 (footnote omitted).

We also are troubled by the Commission’s position

that it may consider violations of section 36(a) of the ICA,

15 U.S.C. § 80a-35(a) (1976),” in assessing sanctions for

violations of other sections of the securities laws.” Section

36(a) permits the Commission to apply to a federal dis-

trict court for an injunction against an officer of an

investment adviser who has engaged or is about to engage

in acts constituting “a breach of fiduciary duty involving

personal misconduct.” It gives no power to the Commis-

sion, an administrative agency, to adjudicate such

breaches, and the Commission has held that it cannot do

so. In re Carl L. Shipley, ___ 8.E.C. ___., [1973-1974

Transfer Binder] Fed.Sec.L.Rep. (CCH) 9 79,833 (1974).

Here, the Commission reaffirms a position it took in dicta

in Shipley: in a proceeding where it finds willful violations

*0 15 U.S.C. § 80a-35(a) provides:

The Commission is authorized to bring an action in the

proper district court of the United States, or in the United

States court of any territory or other place subject to the

jurisdiction of the United States, alleging that a person

serving or acting in one or more of the following capacities

has engaged within five years of the commencement of the

action or is about to engage in any act or practice con-

stituting a breach of fiduciary duty involving personal

misconduct in respect of any registered investment com-

pany for which such person so serves or acts—

*1The statutes commonly referred to as the ICA and the

IAA were enacted as titles I and II respectively of the Act of

August 22, 1940, ch. 686, 54 Stat. 789 (codified at 15 U.S.C.

§§ 80a-1 to 80a-52, 80b-1 to 80b-21 (1976)). Section 9(b) of

title I, 15 U.S.C. § 80a-9(b) (1976), and section 203(f) of title II,

id. § 80b-3(f), both authorize the Commission to bar persons

from the investment adviser and investment company business

for willful violations of any provision of title I or title II, the

Securities Act, or the Exchange Act. The ICA and the IAA

therefore overlap, and, as a general matter, it is not improper to

refer to violations of one in assessing sanctions under the other.

However, as we explain, this does not mean the Commission may

poach on the jurisdiction entrusted solely to a federal district

court.

of other provisions of the securities laws, on the issue of

sanctions it may consider whether the respondent has also

violated section 36(a). We agree that section 36(a) is a

“reservoir of fiduciary obligations imposed upon affiliated

persons to prevent gross misconduct or gross abuse of

trust not otherwise specifically dealt with in the Act.”

Brown v. Bullock, 194 F.Supp. 207, 238-39 n.1 (S.D.N.Y.),

aff'd, 294 F.2d 415 (2d Cir. 1961). But responsibility for its

enforcement is vested in the courts, not the Commission.

The statutory distinction between the functions of the

agency and the courts would be effectively read out of the

law if the Commission could bring section 36(a) into its

own enforcement proceedings through the back door by

professing reliance upon it only at the stage of assessing

sanctions. We are aware that SEC v. Capital Gains

Research Bureau, Inc., 375 U.S. at 191-92, 84 S.Ct. at 282-

83, emphasizes that the purpose of the IAA (and, by

implication, the ICA, see note 21 supra) was to regulate

the “delicate fiduciary nature of an investment advisory

relationship.” SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. at 191, 84 S.Ct. at 283 (quoting 2 L. Loss,

Securities Regulation 1412 (2d ed. 1961)). We do not

think this overall purpose is a warrant to read sections

206(1) and (2) of the IAA, the sections found to have been

violated here, as the vehicle to reach all breaches of

fiduciary trust. The Court in Capital Gains relied on the

broad purpose of the statute to hold that section 206(2)

does not require a showing of scienter, but that is far from

adopting the position the Commission takes here. The

Commission may impose sanctions only for violations of

the statutes assigned to its jurisdiction, and that does not

include section 36(a). This is not to say that in imposing

sanctions, the Commission may not consider violations

occurring in the context of a fiduciary relationship to be

more serious than they otherwise might be. This is not

due to any contribution from section 36(a), however, but

because the “public interest” the Commission is required

to consider in fashioning its orders must be construed

liberally to effectuate the prophylactic purpose of the

securities laws. See SEC v. Capital Gains Research Bureau,

Inc., 875 U.S. at 195, 84 S.Ct. at 284-85.

As we have indicated, see p. 1139 supra, the Commis-

sion also may consider the likely deterrent effect its

sanctions will have on others in the industry.” Permanent

debarment, however, is not the only remedy at the Com-

mission’s disposal that acts as a deterrent; each of the

remedies has that capacity to varying degrees. The

Commission should articulate why a lesser sanction would

not sufficiently discourage others from engaging in the

unlawful conduct it seeks co avoid.

We remand this case to the Commission for reconside-

ration of its order in light of our holdings. We do not hold

that the Commission abused its discretion here; we simply

say that it impermissibly considered section 36(a) rele-

vant to the issue of sanctions and failed to explain its

reasoning in sufficient detail for us to assess the reason-

ableness of the remedies it ordered.”

2 Arthur Lipper Corp. v. SEC, 547 F.2d 171 (2d Cir. 1976),

cert. denied, 434 U.S. 1009, 98 S.Ct. 719, 54 L.Ed.2d 752 (1978), is

not to the contrary. The court there said, ‘‘[t]he purpose of such

severe sanctions [as revocation of registration and debarment

from the industry] must be to demonstrate not only to petition-

ers but to others that the Commission will deal harshly with

egregious cases.” Jd. at 184. The court rejected the sanctions

because it found that under the circumstances of that case, the

violations were not egregious. It did not reject the notion of

deterrence as a proper factor for consideration.

*? Steadman’s argument that the Commission’s order vio-

lates the ex post facto clause of the Constitution, U.S. Const. art.

1, § 9, cl. 3, is without merit. He correctly notes that prior to

1970, the Commission was without power to sanction persons, as

opposed to companies, for violations of the IAA and ICA. These

powers were added by the Investment Company Amendments

Act of 1970, Pub.L.No.91-547, 84 Stat. 1413 (codified in scattered

(footnote continued )

V. CONCLUSION

We summarize here our holdings adverse to the Com-

mission, which will affect the proceedings on remand:

1. Scienter is an element of a violation of subsec-

tion 17(a)(1) of the Securities Act, and section 206(1)

of the IAA.

2. When the Commission imposes the most drastic

sanctions at its disposal, it has a duty to articulate

carefully the grounds for its decision, including an

explanation of why lesser sanctions will not suffice.

3. Section 36(a) of the ICA may not be consid-

ered by the Commission in imposing sanctions for

violations of other securities laws.

The petition for review is therefore granted in part

and denied in part; the order is set aside and the cause is

remanded for reconsideration consistent with this opin-

ion. ,

REMANDED.

(footnote continued )

sections of 15 U.S.C.). Hence, he contends, to the extent the

order is based on pre- 1970 conduct it is invalid. The Commission

provides two answers, either of which is sufficient. First, the

violations continued well after 1970 and the same order would

have issued if only post-1970 conduct were considered.

S.E.C. at n.93, [1977-1978 Transfer Binder]

Fed.Sec.L.Rep. (CCH) 981,243, at 88,339-21. Second, the

amendments went only to remedy; they effected no substantive

change in the law. Steadman’s conduct was violative of the

statute before and after 1970. Since it does not penalize an act

innocent when done, the order is not. ex post facto. Calder v.

Bull, 3 U.S. (3 Dall.) 386, 390, 1 L.Ed. 648 (1798).

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

[CAPTION OMITTED IN PRINTING]

Before WISDOM, GODBOLD and TJOFLAT, Circuit

Judges.

JUDGMENT

This cause came on to be heard on the petition of

Charles W. Steadman, for review of an order of the

Securities and Exchange Commission, and was argued by

counsel;

ON CONSIDERATION WHEREOF, It is now here ordered

and adjudged by this Court that the order of the Secu-

rities and Exchange Commission in this cause be, and the

same is hereby remanded to Securities and Exchange

Commission in accordance with the opinion of this Court.

October 4, 1979

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

[ CAPTION OMITTED IN PRINTING]

On Petition For Rehearing

(November 27, 1979)

Before WISDOM, GODBOLD and TJOFLAT, Circuit

Judges.

’ PER CURIAM:

IT Is ORDERED that the petition for rehearing filed in

the above entitled and numbered cause be and the same is

hereby DENIED.

ENTERED FOR THE COURT:

/s/ [Illegible]

United States Circuit Judge

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