Securities Law and Regulation: Equity Funding Revisited: Once Again

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Securities Law and Regulation: Equity Funding Revisited: Once AgainAuthor(s): John G. GillisSource: Financial Analysts Journal, Vol. 34, No. 6 (Nov. - Dec., 1978), pp. 6-8+46+75-76Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478185 .

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Securities Law~~~~~~~~~

Jand Regulation by John G. Gillis

Equity Funding Revisited-Once Again On September 1, 1978, an Adminis- trative Law Judge of the Securities and Exchange Commission (SEC) wrote another chapter in the continuing saga of the Equity Funding scan- dal that was unearthed in March of 1973. Judge David Markun (conclud- ing an SEC administrative proceeding that had begun in August of 1976) found that Raymond Dirks, a securi. ties analyst and leading actor in the Equity Funding revelations, and five investment advisers had violated the rule against trading on inside information. Dirks was suspended from as- sociation with any broker and dealer for 60 days, and four of the advisers- The Boston Company Institutional Investors, Inc., John W. Bristol & Co., Inc., Manning & Napier, and Tomlin, Zimmerman & Parmelee, Inc.-were censured. The fifth adviser, the Dreyfus Corporation, although found to have violated the law, was not censured because the judge determined it was not necessary in the public interest to do so.

Dirks has appealed the decision to the full Commission (and his suspen- sion is thus not in effect), while the SEC Division of Enforcement has also appealed with respect to the sanctions imposed against him. There is no word yet whether the Commis- sion will review the entire case on its own motion, which it has the right to do and which it did in the first tipper- tippee inside information case, In- vestors Management Company, in 1970.

Background

From 1960 to 1966, Equity Funding Corporation of America was essen- tially a marketing organization selling, through subsidiaries, life insurance, mutual fund shares and combin- ations thereof. In 1967, it expanded into mutual funds, insurance companies, marketing companies, financial institutions, real estate and oil and gas.

Equity Funding experienced an outstanding growth record in the insurance industry. On the week ending March 9, 1973, its common shares reached a trading high of over $28 per share on a daily volume of about 10,000 shares. From that time, however, its share prices began to decline. On March 26, 1973, trading of its shares on the New York Stock Ex- change (NYSE) reached almost 770,000 shares, and on March 27, its common share price hit a low of $14, at which point trading was suspended. During the same period some of Equity Funding's debentures experienced a similar drop in market price and steep rise in volume.

On March 28, 1973, the day after the NYSE suspended trading in the common stock, the SEC suspended trading in all securities of Equity Funding. On April 2, the SEC filed a suit for an injunction and, on the following day, a permanent injunction was granted by consent against violations of the securities laws. On April 5, Equity Funding filed a petition in bankruptcy, which was approved the following day. On April 10, the court appointed a trustee for Equity Fund- ing. (The company has been success- fully reorganized as the Orion Capital Corporation.)

On November 1, 1973, indictments were returned against 22 persons (including some of Equity Funding's officers and directors) for conspiracy to commit various federal crimes and for substantive conduct that was the ob- jective of the conspiracy. All the de- fendants either pled guilty or were convicted of one or more of the counts against them.

Activities of the Advisers In March of 1973, and before,

Raymond Dirks was a securities analyst specializing in the insurance industry. (He is currently employed in the securities business.) He was gener-

ally familiar with Equity Funding and had occasional contact with some of its officers. Through his contacts in the field he obtained and disclosed the information (later found by the courts to have been inside, non-public and material) that Equity Funding had (1) issued and carried on its books a substantial number of fictitious life insurance policies, assets and earnings and (2) publicly issued false and fraudulent statements of insurance premiums, income and other financial data.

Five investment advisers sold or di- rected sales of large blocks of Equity Funding securities without disclosure of the information (except, as discussed below, the limited disclosure by Dreyfus), in violation of Rule 10b-5 under the Securities Exchange Act. Each of the investment adviser respondents had different communications with Dirks, at different times during the period of March 12 to March 26, and each engaged in different activities.

The Boston Company Institutional Investors (III), a subsidiary of the Boston Company, had its first contact when Dirks called one of its portfolio managers on March 12. (This manager had had previous contact with Dirks over several preceding years.) During this conversation, Dirks told the manager, who was joined by the president of III, of alleged massive insurance fraud, forgery of assets and other events that had been related to Dirks a few days earlier (on March 7) by a former employee of an Equity Funding subsidiary. (Dirks identified his source only as a former employee of Equity Funding.)

Some time after this conversation, III instituted its own investigation of Equity Funding, which included con- versations with a partner of Haskins & Sells (the former auditor for Equity Funding Life Insurance Company) and others. On two occasions- March 13 and 14-III representatives consulted outside counsel by telephone for a total of about 20 minutes

6 E FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1978



and received oral legal advice that the information conveyed by Dirks ap- peared not to be inside information. (Judge Markun later found that outside counsel had not been given complete information.)

On March 15, after considerable internal discussion and initial dis- agreement about the desirability of liquidating its Equity Funding holdings, and following a lengthy meeting on March 13 between Dirks and the III president (at which Dirks disclosed the detailed revelations of his source), III sold part of its holdings of Equity Funding (36,500 common

shares-$943,000 proceeds-and $260,000 of convertible debentures). On March 21, after subsequent con- versations with Dirks, who had gone to California on March 20 and had already interviewed two former employees of Equity Funding, III sold its remaining Equity Funding holdings (371,500 shares-$7,100,000-and $436,000 of convertible debentures). (Judge Markun found that III had not disclosed to Goldman Sachs, through whom it made its sales, any of the information that it had obtained through Dirks and the one former employee to whom it had talked.)

John W. Bristol & Co., Inc., a wholly-owned subsidiary of the Bos- ton Company that operated inde- pendently, had between December 1971 and March 22, 1973, accumu- lated 457,000 shares of Equity Fund- ing stock for its clients. On March 22, John Bristol was told by a friend at Goldman Sachs that an unspecified affiliate of Bristol & Co. had sold a large block of Equity Funding stock on March 21. Bristol spoke with a representative of III, to acknowledge that III had been the seller, and was told of the allegations of fraud at Equity Funding. Other representatives of III who subsequently talked to Bristol representatives identified Dirks as the conveyer of the allegations, named his source as a former employee of Equity Funding and conveyed the results of III's oral legal communications and independent in- vestigations.

On March 23, Bristol and others talked with various analysts in an at- tempt to learn more about the allegations. They also spoke with two Equi- ty Funding executive vice presidents, who denied the rumors.

On March 26, Bristol and Co. called Dirks in California. Dirks indicated that he had been talking with former employees of Equity Funding over the weekend, that "what he had heard was not good," and that if he were in Bristol's position he would sell the stock. He also mentioned that he had been speaking with Haskins & Sells and a Wall Street Journal re- porter about the allegations, and that a former comptroller of Equity Fund- ing had talked to Haskins & Sells at his suggestion.

Shortly after this telephone call, Bristol & Co. solicited a bid for 457,000 shares from Salomon Broth- ers, which was accepted at $17.50. Bristol & Co. Profit Sharing Plan sold an additional 600 shares of Equity Funding stock through another broker for a price of $10,399, and convertible debentures were sold through a third broker for a net price of $149,000. The sales of the clients' common stock and convertible debentures did not settle, as Salomon Brothers and the other broker refused delivery, alleging violations of the an- tifraud provisions of the securities laws. (Judge Markun found that Bris- tol & Co., in liquidating its clients'

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and employees' profit sharing trust holdings, failed to disclose to the brokers Dirks' information about the alleged fraud.)

The Dreyfus Corporation acted as the investment adviser to several mutual funds, including the Dreyfus Fund and the Dreyfus Special Income Fund. A Dreyfus analyst who covered the insurance industry for all portfolio managers had over time consulted Dirks' reports and associates.

In early 1973, the Dreyfus Fund acquired a position in Equity Fund- ing common stock, and on March 21 the Income Fund purchased from Goldman Sachs $500,000 (face amount) of convertible debentures. On March 21, after the purchase of the debentures, the analyst and one of the two Income Fund portfolio managers discussed with a representative of Goldman Sachs the reason for the trading weakness of Equity Funding securities. The latter stated that Dirks "had issued a sell recommendation" (not correct) and made negative com- ments. He also said that he had talked with an Equity Funding vice president who had denied Dirks' allegations.

Late on either March 21 or March 22, the second Income Fund portfolio manager learned about the purchase of the Equity Funding debentures and told his associate that he did not believe the debentures were a suitable investment. The two agreed that they should be sold. Although the Dreyfus analyst had tried to reach Dirks by telephone, he had not succeeded; thus no one at Dreyfus had spoken with Dirks at the time Dreyfus placed an order with Goldman Sachs to sell the debentures. However, there followed a series of telephone calls to and from Dirks in California; Dirks at first did not communicate any allegations of fraud, telling only of other possible problem areas (i.e., the "soft story" as opposed to the "hard story"), but fi- nally revealed the fraud allegations and his sources.

The Dreyfus debenture sell order, which had not been filled because of the unsettled market for Equity Fund- ing securities, was suspended pending further checking. Dreyfus at that time (March 23) revealed its information to Goldman Sachs. However, one of the Dreyfus portfolio managers subse-

continued on page 46

8 E FINANCIAL ANALYSTS JOURNAL



cant discoveries. An oil and gas company's 10-K annual report for

1976 and subsequent years must show undeveloped acreage by state, country or other appropriate geo- graphical area. While too broad to allow meaningful appraisals, these specifications can be helpful when coupled with more definitive information disclosed in annual reports or elsewhere. Voluntary company disclosures of the results of exploratory and testing activities often provide clues as to the probable worth of undeveloped holdings. Industry trade jour- nals, such as the Oil and Gas Journal, monitor theories and activities aimed at discovery of oil and gas reserves and report on the results of any significant efforts, successful or not.

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Securities

an Regulation continued from page 8

quently met with Dirks while on a business trip to California, and in further telephone calls Dirk indicated that a current employee of Equity Funding had confirmed the fraud. After these events, and following meetings with some former Equity Funding employees, including Secrist, Dreyfus reentered the debenture sell order without additional disclosure, and Goldman Sachs purchased the debentures.

Manning & Napier (M&N), an adviser in Rochester, New York, had by June 1972 purchased approximately 6,000 Equity Funding common shares for client accounts. The man- aging partner, Manning, had been concerned about the price action of the stock in the second half of 1972 and through February 1973 and had

sold some Equity Funding holdings. During this period, Manning had become increasingly pessimistic about Equity Funding as an investment and had talked with Equity Funding per- sonnel about company developments. For about 10 days prior to M&Ns liq- uidation of its Equity Funding holdings, Manning had considered selling the stock for a variety of reasons.

On March 21, 1973, Manning called an Oppenheimer & Co. representative, who informed him that there were rumors circulating about Equity Funding and identified Dirks as a source. The Oppenheimer representative further told Manning that the rumor involved questionable accounting practices, but that he placed no credence in it. On the evening of March 23, after having tried unsuc- cessfully to reach Dirks, Manning told his Equity Funding employee contact that he was "getting out" of Equity Funding.

On the morning of Monday, March 26, Dirks returned Manning's call and told him that Equity Funding had

written bogus insurance policies and that the source of this information was a former Equity Funding employee. Manning then spoke with the Op- penheimer representative, who opined that top management at Equi- ty Funding could not be involved in any fraudulent scheme. Nevertheless, on March 26 Manning liquidated all Equity Funding holdings (5,450 shares-net proceeds of about $90,000) without disclosure of the information to the selling brokers.

Tomlin, Zimmerman & Parmelee, Inc. (TZP), an investment adviser in New York City, had from May 1971 to March 23, 1973, acquired for client accounts some 25,920 common shares and $60,000 of convertible debentures of Equity Funding. During the week of March 12, a Goldman Sachs representative told Tomlin that Goldman Sachs had traded a large block of Equity Funding stock at a deep discount. By March 19, after investigation, the representative still did not know the reason for this trade. On March 20, however, he called Tomlin

continued on page 75

46 El FINANCIAL ANALYSTS JOURNAL / NOVEMBER-DECEMBER 1978



Securities Law and Regulation

continued from page 46

and Zimmerman to indicate that he had heard through several intermedi- aries that Dirks had a negative story about Equity Funding.

On March 20 and 22, Dirks phoned Tomlin and Zimmerman from California and discussed various accounting matters without mention- ing the fictitious insurance (although he may have indicated that he was in touch with a former employee of an Equity Funding subsidiary). Follow- ing the first conversation, Tomlin spoke with several analysts, who indicated that there seemed to be nothing wrong with Equity Funding's accounting and that the stock was a good investment.

On the morning of March 23, a Goldman Sachs salesman called Zim- merman and told him that he thought the market action on Equity Funding prices would begin to be favorable. After this call, TZP purchased 3,000 shares as part of a block trade from Goldman Sachs.

On March 26, Dirks called TZP and spoke with Zimmerman and Tomlin. Dirks at that time related that his "source" had told him there was fictitious insurance on the books of an Equity Funding subsidiary and that he was inclined to believe the allegation despite the fact that Equity Funding's president, Goldblum, had flatly denied it. Dirks said that he had reported the allegation of fictitious insurance to Haskins & Sells, former auditors, and to Seidman & Seidman, current auditors.

Immediately after this conversation, Tomlin and Zimmerman de- cided to sell all Equity Funding securities held in TZP client accounts and did so prior to the lunch hour on March 26. Some 27,000 shares of common stock and $60,000 of deben-

tures were sold (mostly through Gold- man Sachs). (The judge found that TZP had at that time conveyed none of its information to the selling brokers.)

Legal Findings

Judge Markun, after a detailed analysis and findings of facts, spent almost 80 pages of his 180 page decision discussing the legal issues raised. These will be considered in detail in a subsequent article in this column, but they can be summarized as follows.

(1) The information regarding allegations of fraud at Equity Funding received by the selling advisers was non-public at the times they received it and still non-public when they sold or attempted to sell Equity Funding securities.

(2) Secrist and five other former employees of Equity Funding (including an employee of a contractor doing computer work for Equity Funding), and one current employee from whom Dirks obtained information, were clearly "inside sources" because they were reporting information that had come to their attention while employees of Equity Funding or a subsidiary.

(3) The selling advisers were "tip- pees" and subject to the same liability as the inside tippers, even though they received their information through Dirks, an intermediary.

(4) "One who knows himself to be a beneficiary of non-public, selective- ly disclosed inside information must fully disclose it or refrain from trading."

(5) The information was material under the tests of "importance to a reasonable investor" and "substantial market impact." Moreover, weighing the probability against the magnitude of the information (especially after Dirks had substantially confirmed the allegations with one current and six former employees) supported the likelihood of the validity of the allegations, and thus the likelihood of materiality.

(6) The fact that state and federal agencies (and others) knew of the allegations did not exonerate the re-

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spondents, especially as the latter had more complete and specific information.

(7) The advisers did not disclose the information to the brokers (although Dreyfus had made a limited, inadequate disclosure), and the brokers did not have comparable information.

(8) There existed "scienter"-an intent to deceive, manipulate or de- fraud-even though the question of whether scienter was legally necessary in this matter was not reached.

(9) A fiduciary's obligation to clients does not require commission of an illegal act-i.e., trading on inside information.

( 10) The defense of good faith reli- ance on advice of counsel was not established because full disclosure of all the facts was not made to counsel (among other reasons).

(11) The defense of protection under the free speech provisions of the First Amendment was not available to Dirks because he was not an agent of the press or a newsgatherer, and "commercial speech" protection is subject to compliance with relevant legal regulations.

(12) Dirks' defense of "significant public interest" was rejected because his action did not, in the short term, give the information to the public, but only to select investors.

(13) In imposing sanctions, Judge Markun considered that none of the respondents had been subject to prior disciplinary action, that they enjoyed good reputations, had incurred substantial legal costs and paid substantial settlements for civil actions.

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complete) information to Goldman Sachs.

The judge found that Dirks "was less than candid in his testimony, particularly as respects the degree of his alleged disbelief of the allegations of fraud at Equity Funding at various stages of his investigation." The judge further found that Dirks "evidenced a lack of appreciation for the fundamental purpose underlying the insider trading rule," that his public interest argument failed (for reasons noted

above), that "he has not had difficul- ty" in continuing his professional ca- reer, and that "on the whole, Dirks sustained less (if any) financial loss or loss of reputation" than did other respondents (noting that he thought Dirks may have taken a year off to write a book). Moreover, the judge stated that the adviser respondents "appear to have learned more from the experience in terms of future cau- tion than has Dirks." a

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76 E FINANCIAL ANALYSTS JOURNAL



Documents

Securities Law and Regulation: Equity Funding Revisited: Once Again