S.E.C. v. Steadman

• Decision Date: 26 June 1992
• Docket Number: 91-5130,Nos. 91-5090,s. 91-5090
• Citation: 967 F.2d 636
• Parties: , Fed. Sec. L. Rep. P 96,843 SECURITIES AND EXCHANGE COMMISSION v. Charles W. STEADMAN, et al., Appellants (Two Cases).
• Court: U.S. Court of Appeals — District of Columbia Circuit

Page 636

967 F.2d 636

296 U.S.App.D.C. 269, Fed. Sec. L. Rep. P 96,843

SECURITIES AND EXCHANGE COMMISSION v. Charles W. STEADMAN, et al., Appellants (Two Cases).

Nos. 91-5090, 91-5130.

United States Court of Appeals, District of Columbia Circuit.

Argued Feb. 3, 1992.

Decided June 26, 1992.

Peter J. Nickles, with whom William H. Allen, Coleman S. Hicks, and Elliott Schulder, Washington, D.C., were on the brief, for appellants in 91-5090 and 91-5130.

Martha H. McNeely, Sp. Counsel, S.E.C., with whom James R. Doty, General Counsel, Jacob H. Stillman, Associate Gen. Counsel, and Paul Gonson, Sol., Washington, D.C., were on the brief, for appellee in 91-5090 and 91-5130.

Before: EDWARDS, SILBERMAN, and HENDERSON, Circuit Judges.

Opinion for the Court filed by Circuit Judge SILBERMAN.

SILBERMAN, Circuit Judge:

This is an appeal from the district court's grant of an injunction against appellants for violation of the securities laws. The Securities and Exchange Commission (SEC) brought the action essentially because the Steadman Funds did not register under state Blue Sky laws for 17 years. The SEC claimed that appellants were obliged to disclose to investors that the Funds' non-registration was illegal and to book substantial liabilities for penalties that might accrue as a result. Appellants dispute that they had any duty to book such liabilities or, even if they did, that the liabilities were material. We conclude that appellants were, at most, obliged to include a general footnote in their financial statements disclosing their contingent liabilities. But because they did not act with scienter, we reverse the district court's principal fraud findings (which require scienter) and vacate the injunction.

I.

Charles W. Steadman is chairman, president, and chief executive officer of Steadman Security Corporation (the Corporation), an investment adviser registered with the SEC. The Corporation is contractually responsible for managing the assets and conducting the regulatory affairs of a group of mutual funds known as the Steadman Funds. As of 1989, the Funds had approximately 26,000 investors in 50 states and managed roughly $29 million in assets. ¹ Although a board of trustees (formerly directors) runs the business of each Fund, each Fund has entered into an investment advisory agreement with the Corporation, pursuant to which the Corporation manages the Fund's investment portfolio and handles its regulatory affairs. The Corporation is owned entirely by the three adult children of Charles Steadman. Mr. Steadman himself is the principal officer of the Corporation and the chairman of the board of trustees and president of each individual Fund.

Prior to 1971, the Steadman Funds operated in a traditional manner. The Funds sold shares through sales offices located throughout the United States, and all Funds were registered under the Blue Sky laws of the states in which their shares were sold. In 1971 the directors of the Funds decided to make a fundamental change in the way most of the Funds did business, closing the various sales offices and selling shares only by mail order from an office in the District of Columbia. The Steadman Funds thus eliminated their sales commissions and became "no-load" mutual funds, which were, at that time, relatively rare. The boards of the various Funds formally ratified this action three years later, in September 1974.

The Funds thereafter allowed their state securities (Blue Sky) registrations to lapse. The boards of directors of the various Funds made a conscious decision to discontinue state registration based upon an opinion letter provided by Carl L. Shipley, an outside attorney. According to testimony by Mr. Steadman and the Corporation's independent auditors, Coopers & Lybrand, who also relied on the Shipley letter in reviewing the Funds' financial statements, the opinion stated without qualification that registration under state Blue Sky laws was unnecessary as long as all sales of shares took place only in the District of Columbia, a jurisdiction which did not require registration. Although a copy of the opinion is unavailable and therefore its precise reasoning cannot be fixed, the record suggests that the opinion was premised primarily on the view that the Due Process Clause of the Fourteenth Amendment to the Constitution would forbid the states from asserting regulatory jurisdiction over securities offerings made through the mail that in-state purchasers had agreed would be deemed to take place in the District of Columbia. ²

When the Funds switched to doing business by mail order, they accordingly issued an amended prospectus, both to existing and potential investors. This prospectus advised investors that:

Fund shares are not registered under the local laws of the various states. They are registered under the federal securities laws. The rights of investors are governed exclusively by federal laws and the laws of the District of Columbia and all offers and acceptances are deemed to take place in the District of Columbia.

For the next 17 years, the Funds openly revealed their non-registration under state Blue Sky laws. Every prospectus was filed with the SEC and prominently featured the language quoted above, and each investor who purchased shares in one of the Funds signed an investment application confirming his understanding that "the Fund's shares are registered under the Federal securities laws and not the local laws of the various states." During the 17 years in which the Funds were not registered, the SEC never commented on or criticized either the non-registration or the nature of the Funds' disclosure of their non-registration. No state securities authority ever asserted a claim under its Blue Sky law, and no individual investor complained.

In 1987, however, the SEC investigated the Steadman Funds' failure to register with the states and concluded that the failure gave rise to several federal securities law violations, including fraud. The Shipley opinion letter, on which the Funds had relied in allowing their state registrations to lapse, turned out to be based on an incorrect reading of the law. In a related context, the Supreme Court had, two decades prior to the Shipley letter, upheld the authority of the states to enforce their Blue Sky laws against out-of-state mail order businesses. See Travelers Health Ass'n v. Virginia, 339 U.S. 643, 70 S.Ct. 927, 94 L.Ed. 1154 (1950). The SEC determined that 46 states required the registration of mutual fund shares during the period in which the Steadman Funds had not registered, and it charged that the Funds were liable for unpaid fees during that period amounting to between $694,020 and $3,351,409. The Commission also noted that non-registration could subject the Funds to penalties, shareholder rescission suits, and large legal fees. Although non-registration under Blue Sky laws does not in itself violate federal law, the SEC charged the Funds, the Corporation, and Mr. Steadman with federal securities fraud, pricing, and disclosure violations based on what the Commission believed were material misstatements of the Funds' net asset values (NAVs) and net asset values per share that resulted from their failure to book liabilities for the unpaid Blue Sky fees and penalties. The Commission also charged the Steadman Funds with several unrelated technical violations of the securities laws.

Appellants immediately took a number of corrective actions. They brought themselves into compliance with the technical provisions of the securities laws they had been charged with violating. The Funds also retained an attorney to contact the various state securities authorities to inform them of the SEC investigation and the Funds' non-registration and to ask whether they intended to pursue any claims or other enforcement actions against the Funds. After learning of the states' reactions to the inquiries, the Funds booked contingent liabilities of $128,150 and entered into negotiations with state regulators in an effort to settle the claims arising from the Funds' failure to register. Only 25 states demanded payment of penalties, and by the time the trial began, the Funds had succeeded in settling with all but six of them for a total of $100,646.

The district court determined that Steadman, the Corporation, and the Funds had violated various provisions of the federal securities laws. See SEC v. Steadman, Civ. No. 89-2026 (D.D.C. Feb. 27, 1991) (Mem. Op.). Contrary to the Shipley opinion letter (but not disputed by the Funds), the court observed that the Funds "were subject to the enforcement of state registration laws" and were therefore legally obligated to register with the states even after they became mail order no-load funds. Id. at 14. It followed, according to the district court, that the Funds' failure to register gave rise to financial liabilities that the Funds were obliged to disclose. Those reflected the penalties that the states might have levied because of appellants' non-registration. The court accepted the SEC's estimate of the fees the Funds would have paid over the 17 years of non-registration, $694,020, as a proxy for the penalties for which the Funds were liable. See id. at 19.

These undisclosed liabilities were held to have been material. The SEC contended, and the court agreed, that the appropriate standard for determining materiality in the mutual fund industry is a penny a share: any liability greater than that, regardless of the share price, is material. $694,000 exceeded a penny a share for the Funds. The district court further held that "[e]ven if ... a minimum was not reasonably estimatable [sic], [appellants] should have discussed potential liabilities in a footnote." Id. at 20. The failure to do that was also material, because "[a] reasonable shareholder would find it material that defendants' failure to register under state Blue Sky laws subjected the Funds to large potential liabilities,...