The opinion of the court was delivered by: OBERDORFER
Plaintiff Securities and Exchange Commission ("SEC") seeks to enjoin defendants Charles W. Steadman, Steadman Security Corporation ("SSC"), Steadman Financial Fund, Steadman Investment Fund, Steadman Oceanographic, Technology & Growth Fund, Steadman American Industry Fund, and Steadman Associated Fund (collectively "the Funds") from violations of federal securities laws. During a period from 1971 to 1988 the Funds sold shares to residents of the states but did not register under state securities laws ("Blue Sky laws"). The SEC asserts that, as a result of defendants' failure to register under state laws, the Funds accrued undisclosed and unrecognized liabilities for fees, penalties, and shareholder rescission suits. The SEC further contends that defendants' failure to recognize this liability from 1971 to 1989 resulted in material misstatements of net asset value ("NAV") of the Funds' shares.
SEC alleges the following eight causes of action against defendants: (1) That defendants' misstatements of NAV defrauded investors, violating section 17(a) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77q(a), section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5; (2) that SSC, aided and abetted by Steadman, used the mails in connection with a fraud in violation of sections 206(1) and (2) of the Investment Advisers Act of 1940 ("Advisers Act"), 15 U.S.C. §§ 80b(6)(1) & (2); (3) that the Funds, aided and abetted by Steadman, violated section 22(c) of the Investment Company Act ("ICA") of 1940, 15 U.S.C. § 80a-22(c), and Rule 22c-1, 17 C.F.R. § 270.22c-1; (4) that defendants failed to disclose material facts in reporting to the SEC in violation of section 34(b) of the ICA, 15 U.S.C. § 80a-33(b); (5) that from November, 1985 to May, 1986 defendant SSC performed advisory services for the Funds without approval from the boards of trustees in violation of section 15(a) of the ICA, 15 U.S.C. § 80a-15(a); (6) that SSC, aided and abetted by Steadman, improperly maintained custody of client funds in violation of section 206(4) of the Advisers Act, 15 U.S.C. § 80b-6(4), and Rules 206(4)-2(a)(2)(ii) and (a)(5), 17 C.F.R. § 275.206(4)-2(a)(2)(ii) and (a)(5); (7) that defendant SSC failed to file required forms in violation of section 204 of the Advisers Act, 15 U.S.C. § 80b-4, and Rule 204-1(a)(1), 17 C.F.R. 275.204-1(a)(1); and, (8) that SSC failed to file proper reports in violation of section 17(A)(d)(1) of the Exchange Act, 15 U.S.C. § 78q-1(d)(1) and Rule 17Ad-13(a), 17 C.F.R. 240.17Ad-13(a).
The SEC moved for preliminary injunction in the early stages of this case. On August 4, 1989, an evidentiary hearing on that motion was held. Before the motion for preliminary injunction was decided, however, the parties entered into settlement negotiations. In October, 1990, the SEC moved for summary judgment on all charges except those arising under section 15(a) of the Advisers Act, 15 U.S.C. § 80a-15(a). In support of and in opposition to the summary judgment motion, the parties presented supplemental briefs and affidavits and oral argument. However, the case was not resolved on summary judgment and proceeded instead to trial. On November 7 and 8, 1990, the parties presented evidence on all factual matters not addressed at the preliminary injunction and summary judgment stages. Witnesses ratified earlier deposition testimony and the parties supplemented the record with designated portions of that deposition testimony.
Defendant Charles Steadman is Chairman of the Board, President, Chief Executive Officer, and Treasurer of SSC and Chairman of the Board of Trustees and President of each fund. Steadman is a graduate of the Harvard Law School and served as legal counsel to mutual funds organized by the Steadman family from the early 1950's to the early 1960's. From the early 1960's on, Steadman has served as an officer and director of mutual funds owned by the family. See Transcript (November 7, 1990) ("1990 Tr. I") at 125-26 and 144. SSC is a Delaware corporation owned by United Securities, Inc., which maintains offices in Washington, D.C. United Securities is a Maryland corporation whose sole shareholders are the three adult children of Mr. Steadman. SSC became registered with the SEC as an investment adviser on December 31, 1971.
The Funds are five no-load, open-end management investment companies organized as common law trusts under the laws of the District of Columbia. In 1971-72, the Funds had net assets of approximately $ 130-135 million and 75,000 shareholder accounts. See 1990 Tr. I at 117-18. However, as of mid-1989, the Funds' net assets were approximately $ 28.9 million in over 25,000 shareholder accounts. Complaint & Answer para. 12. The Funds' shareholders include residents of all fifty states. SSC supervises the Funds' relations with federal and state regulatory bodies pursuant to investment advisory agreements with each of the Funds and subject to the direction of the Trustees of the Funds.
Defendants assert that the decision to discontinue state registrations was based on an opinion letter written in the early 1970's by Carl Shipley, a private attorney who was general counsel to at least three of the five funds and Director of the Oceanographic Fund, Inc. See Plaintiff's exhibit ("Pl. ex.") 14. Peter Nunn, the Coopers & Lybrand accountant who was responsible for auditing defendants' financial statements, also relied upon Shipley's opinion. See 1990 Tr. I at 87; Designated Deposition of Peter Nunn ("Nunn Dep.) at 43; Transcript of Hearing on Motion for Preliminary Injunction (August 4, 1989) ("1989 Tr.") at 59. However, neither Steadman nor Nunn have seen a copy of the original opinion letter since the early 1970's. 1989 Tr. at 76 & 91-92. Unable to produce the 1971 letter, which Steadman and Nunn remembered as being several pages long, defendants instead produced from a file used in 1974 board meetings a single page, unsigned, undated letter on SSC stationary addressed to the Steadman American Industry Fund from Carl Shipley, General Counsel, opining that state registration was unnecessary. See 1990 Tr. I at 87 & 108, see also infra at § III-B. Steadman testified that this letter was not the original one relied on by defendants in 1971. 1990 Tr. I at 108.
On September 25, 1974, at meetings of the boards of directors, four of the five Funds resolved to conduct distribution on a mail order basis, following a discussion of the costs of state registration. See Pl. ex. 14. Mr. Steadman testified that Shipley's opinion was discussed extensively at those meetings. 1990 Tr. I at 107. However, neither the resolution nor the minutes of the meetings make any reference to a decision to permit state Blue Sky law requirements to lapse or to Mr. Shipley's legal opinion that registration was not required.
Upon the advice of Mr. Steadman and SSC the Funds took the position that sales were effected only in the District of Columbia, a jurisdiction that does not require registration. This position was disclosed to shareholders, who were required upon application to sign a statement of understanding that the Funds' shares were not registered "under the local laws of the various states" and that the rights of the applicant were governed exclusively by the laws of the District of Columbia and the United States. See Steadman Declaration (July 31, 1989) ("1989 Steadman decl.") at ex. 3. Similarly, beginning in 1971, the Funds' prospectuses stated: "Fund shares are not registered under the local laws of the various states. . . . The rights of investors are governed exclusively by federal laws and the laws of the District of Columbia . . ." See id. at ex. 2. The prospectuses made no mention of state laws requiring registration, of Supreme Court decisions upholding state application of Blue Sky laws, or of the risk that the states could assert fines and penalties and investors could rescind purchases upon a determination that state law in fact required registration. See, e.g. Hall v. Geiger-Jones Co., 242 U.S. 539, 550, 61 L. Ed. 480, 37 S. Ct. 217 (1917); Travelers Health Ass'n v. Virginia, 339 U.S. 643, 94 L. Ed. 1154, 70 S. Ct. 927 (1950).
From at least 1970 until May 26, 1988, defendants forwarded the Funds' prospectuses and investment applications to residents of the various states through the mails, almost exclusively upon written or telephone request by potential investors. However, at times, though not continuously, defendants also solicited investors directly. For example, defendants sent a promotional mailing to 10,000 potential investors in conjunction with U.S. Life Insurance Company and another promotional mailing to 30,000 potential investors who are subscribers of Money Magazine, Country Living, Life Style, and Changing Times. In addition, defendants advertised in the Washington Post and the Eastern Airline Shuttle Magazine. The advertisements included a coupon which could be detached and mailed to the Funds' offices in Washington, D.C., in order to request a Prospectus.
The SEC began investigating defendants' failure to register under state Blue Sky laws and other activities in 1987-88. In the course of its investigation and in preparation of this case, the SEC surveyed the fifty states to determine the state registration requirements and fees the Funds would have paid had they registered since 1971. The results of the SEC's survey revealed that forty-six states require registration of mutual fund shares. For each state that requires registration, the SEC determined the minimum initial registration fee and the minimum subsequent annual fee from the "Investment Company Institute Blue Sky package." See Declaration of Peter Smith (October 15, 1990) ("Smith decl.") at para. 3. For example, many states charge a minimum fee plus a percentage of anticipated sales. The minimum ranges from $ 50 to $ 1000. Using the minimum for each state, for each fund, for each year in which the Funds failed to register, the SEC calculated defendants' minimum liability to be $ 694,020. Id. at paras. 7-8; Affidavit of Peter Smith (July 17, 1989) ("Smith aff.") para. 24(f). The SEC calculated defendants maximum liability for fees to be $ 3,351,409. See id. These estimates did not include any provision for shareholder rescission suits, no attorney's fees, no interest, and no penalties.
In September, 1988, after the SEC began its investigation, the trustees resolved to seek a buyer for the Funds and, if no sale was effectuated by January 31, 1989, to liquidate the Funds in cash payments to the shareholders. See 1989 Steadman decl. at para. 15. That date passed, the Funds were not liquidated, and several further resolutions and agreements towards liquidation were made but not executed. See, e.g., Smith aff. at paras. 37-41. Defendants maintain that SEC attempted to force the Funds to liquidate and that the Trustees have consistently held the view that effecting liquidation by a transfer of assets to an ongoing fund was preferable to distributing cash to shareholders. 1989 Steadman decl. at paras. 13-17.
In June, 1989, defendants retained Philip Lehmkuhl as counsel for the Funds to contact the securities commissions of each state, to determine what claims, if any, the states would assert against defendants for the failure to register, and to settle claims against the Funds by the states. Lehmkuhl was retained only by the Funds and did not have authority to discuss or settle claims by the states against SSC or Steadman. Transcript (November 8, 1990) ("1990 Tr. II") at 25. However, Lehmkuhl testified that the Funds have "virtually no employees" and that he communicated mainly with Steadman and Max Katcher, executive vice president of SSC and treasurer of the Funds. See id. at 31; Designated Deposition of Philip Lehmkuhl ("Lehmkuhl Dep.") at 16.
On June 16, 1989, Lehmkuhl wrote to the states informing them (in the first paragraph) that the Funds planned to liquidate their assets. Thereafter, the letter disclosed that the Funds had not registered with any state for 17 years. Attached to each letter was a summary of sales data in that state from 1984-1989. In closing, the letter requested a response as to whether the state intended to take some enforcement action against the Funds for their failure to register. See Pl. ex. 47. Forty-four states responded. By October, 1990, financial settlements had been reached between twenty-five states and the Funds, as a result of which the Funds have made payments to the states totaling $ 100,646. See Declaration of Max Katcher (Oct. 25, 1990) ("Katcher decl.") para. 1. The states typically based their settlement demands on fees that would have been paid or a multiple of the fees that would have been paid. See 1990 Tr. II at 28; Lehmkuhl Dep. at 93-94. However, some states that did not seek financial relief nonetheless sought either cease and desist orders or consent decrees providing that defendants would not sell in those states again without registering under the state laws. See 1990 Tr. II at 27. As of October, 1990, settlement with the Funds had been reached in all but six states. See Katcher decl. at para. 1.
At least some of the states based their settlement positions on defendants' representation that they intended to effectuate a cash liquidation of the Funds. The states, seeking to minimize depletion of shareholders' assets, settled with defendants for less than they would demanded have had they been informed that defendants planned to transfer the Funds' assets. For example, Ellyn L. Brown, the Securities Commissioner of the State of Maryland, attested that Maryland did not plan to take enforcement action against the Funds but that "this decision was made in large part on the representation of the Funds' counsel that the Funds would liquidate (i.e. return all available cash to the Funds' shareholders for their shares of the Funds). . . ." Affidavit of Ellyn Brown (August 3, 1989) ("Brown Aff.") at paras. 3-4. Because of this representation, the Maryland Division of Securities "determined to avoid further depletion of the assets of the Funds available to investors in that the apparent failure of the Funds' adviser to register shares was not the responsibility or fault of investors." Id. at para. 5. At the August 4, 1989 hearing, Lewis W. Brothers, Jr. from Virginia's Division of Securities also testified that Virginia's settlement position was based on liquidation of the Funds. 1989 Tr. at 49. When Lehmkuhl became aware in February or March of 1990 that defendants were contemplating a transfer of the Funds' assets rather than cash liquidation, he contacted the states a second time to inform them that liquidation was not the only possible course of action defendants might take. Lehmkuhl Dep. at 31. Lehmkuhl testified that following the receipt of that information, the states changed their settlement positions. However, he could not testify as to whether the changes were due to their receipt of his information that the Funds no longer planned to liquidate. Id. at 36.
Following the SEC investigation; in July, 1989, the Funds began to recognize contingent liabilities arising out of non-registration in calculating NAV. At that time, the Funds accrued liabilities of $ 78,150 for state claims arising out of non-registration and an additional $ 50,000 for shareholder rescission claims. See Declaration of Max Katcher (July 31, 1989) ("Katcher decl.") at paras. 11 & 16.
This Court has jurisdiction over the subject matter of this action pursuant to Section 22 of the Securities Act, 15 U.S.C. 77v(a), Section 27 of the Exchange Act, 15 U.S.C. 78aa, Section 44 of the ICA, 15 U.S.C. 80a-43, ...