Full opinion text
DECISION AND ORDER LAGUEUX, Senior District Judge. The Plaintiff in this case, the Securities and Exchange Commission (“SEC” or “Commission”) brought a civil suit against the investment firm of Slocum, Gordon, & Co. (“SG & C”) and its two founding partners, John J. Slocum, Jr. (“Slocum”) and Jeffrey L. Gordon (“Gordon”). The Commission’s chief allegation against these Defendants is that they defrauded both the SEC and their clients between the years 1996 and 2000 through a practice commonly called “cherry picking,” whereby certain stocks were initially purchased for clients and later re-allocated to the SG & C firm account if the stocks went up in value prior to the settlement date. In addition to the Commission’s cherry picking allegations, the SEC claims-that Defendants engaged in fraudulent or deceptive conduct by a registered investment advisor by improperly commingling client funds and securities with firm funds and securities,' breaching its record-keeping requirements, and making material misrepresentations and omissions, both in interactions with clients and in filings with the SEC. According to the Commission, Defendants’ conduct and office practices resulted in violations of federal securities laws. The SEC also asserts separate claims against Defendants Slocum and Gordon, alleging that they individually aided and abetted all securities violations committed by their firm. These various claims make up an eight count complaint filed by the Commission, alleging violations of the Securities Act of 1933 (“Securities Act”), 15 U.S.C. § 77q(a), the Securities Exchange Act of 1934 (“Exchange Act”) 15 U.S.C. § 78j(b), and the Investment Advisers Act of 1940 (“Advisers Act”), 15 U.S.C. §§ 80b-4, 80b-6(l)-(4), and 80b-7. The SEC also alleges violations of certain regulations promulgated under these statutory provisions. See 17 C.F.R. §§ 240.10b-5; 275.204-2(a)(3); and 275.206(4)-2(a)(2). Although plead generieally in the Commission’s complaint, it is helpful for this writer to further categorize these different counts as they relate to the various forms of fraud alleged against Defendants. Counts 1 and 2 are counts under the anti-fraud sections of the Securities Act and the Exchange Act, and relate only to the SEG’s allegations of securities fraud by way of cherry picking favorable securities for the firm’s benefit. Counts 3, 4, 5, and 6 are brought under the Advisers Act, and are technical counts regarding organizational structure of the firm’s account system, its operation practices during the relevant time period, and the Defendants’ obligation as fiduciaries to disclose material facts to their clients and the SEC. Counts 7 and 8 are aiding and abetting counts, and, as such, only apply if liability is found under one or more of the other claims in the Commission’s complaint. After conducting a trial in this case without a jury, and then reviewing the trial testimony, exhibits, and the parties’ post-trial submissions, the Court now renders a decision in this cas,e. As to Counts 1, 2, 5, 6, 7, and 8, the Court finds that the Commission failed to meet its burden of proof, and renders a decision on these counts in favor of Defendants. However, for the reasons articulated herein, the Court finds in favor of the Commission on Count 4 and in part on Count 3. Based on the evidence submitted, the Court concludes that Defendants did improperly commingle client funds and securities with firm funds and securities, in violation of Section 206(4) of the Advisers Act and Rule 206(4)-2(a)(2) thereunder. See 15 U.S.C. § 80b — 6(4); 17 C.F.R. § 275.206(4)-2(a)(2). Although this technical violation was not willful, the Court finds that the commingling of client and firm assets created a potential conflict of interest, which Defendants, as fiduciaries, .were required to disclose to their clients regardless of their lack of intent to defraud. See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 196-97, 84 S.Ct. 275, 11 L.Ed.2d 237(1963). As a result, the Court finds that Defendants engaged in a course of business which “operated as a fraud” upon their clients, in violation of Section 206(2) of the Advisers Act. 15 U.S.C. § 80b-6(2). I. Bench Trial Standard Following a bench trial, “the court shall find the facts specifically and state separately its conclusions of law thereon,” before proceeding to enter judgment. Fed. R.Civ.P. 52(a); see also Cafe La France, Inc. v. Schneider Securities, Inc., 281 F.Supp.2d 361, 363 (D.R.I.2003). In making its factual findings, it is appropriate for the Court to weigh the credibility of the witnesses presented. Fed.R.Civ.P. 52(a); see also Gautieri v. U.S., 167 F.Supp.2d 207, 209 (D.R.I.2001). Having thus articulated the legal standard, the Court proceeds to make its findings of fact and conclusions of law based on the evidence presented. II. Findings of Fact Due to its importance to the facts in this case, this writer ■ deems it necessary' to explain the company infrastructure in place at SG & C between 1996 and 2000 with great detail and specificity. As a result, the Court’s findings of fact are bifurcated into two sections. In Part One, the Court will find, facts relating to the establishment, operation, and account structure of SG & C during the relevant time period. This section will provide the necessary background for understanding the technical issues in this case. In-Part Two, the Court will find facts relating to the SEC’s examination, investigation, and the specific transactions before the Court for scrutiny. PART ONE: BACKGROUND A. The Firm Profile SG & C is a small investment advising firm registered under the federal Advisers Act, 15 U.S.C. § 80a-l et seq., as amended. The firm’s only office is located at 39 Mill Street, Newport, Rhode Island. Slocum and Gordon, the firm’s two founders, and Defendants in this cause of action, established the investment company in late 1978 and registered it with the Commission in January 1979. From its inception, SG & C was a small-scale, old-fashioned investment firm, seeking to provide personalized investment services to the “middle market,” or mid-sized, investment accounts. Over its years of operation, SG & C managed investment accounts for individual clients, families, and charitable organizations in the Newport area. The company also handled personal trades for firm partners, former partners, and their close family members. SG & C offered their clients many different types of investment services, ranging from placing trades to paying bills. In some cases, SG & C even prepared their clients’ tax returns. By offering customized services to meet their individual client’s needs, and largely by word-of-mouth advertising, SG & C was able to attract and retain a large client base in the Newport area. Approximately 75 to 80 percent of the firm’s revenue came from providing portfolio management and other services to clients. In addition to these various client accounts, SG & C maintained a firm trading account (“trading account”), which provided the remaining 25 to 20 percent of the firm’s annual revenue. The trading account benefitted the firm, and, in turn, the partners, who each received a percentage of the firm’s annual profits. In addition, profits gleaned from the trading account were used to offset errors made in client trades. Although all investment advisers working at SG & C had the opportunity to make trades for the firm trading account, only Slocum and Gordon actually engaged in firm trades. B. Partners and Employees At the time of trial, SG & C was comprised of three partners, Slocum, Gordon, and Barclay Douglas, Jr. (“Douglas”). A fourth partner, Jane Lippincott (“Lippin-cott”), was also affiliated with SG & C during part of the time period at issue; however, she left SG & C to open her own investment firm on January 2, 2000. In addition to these partners, SG & C maintained two office employees between 1996 and 2000: LuAnn Shoemaker (“Shoemaker”), the firm’s Operations Manager, and Kimberly Stahm (“Stahm”), a secretary/receptionist. 1. Investment Advising and Portfolio Management Although SG & C’s partners and employees described themselves as wearing many different hats in the course of their daily firm activities, each person working for SG & C had his or her own individual responsibilities. Slocum and Gordon acted as investment portfolio managers for the majority of the firm’s client base between 1996 and 2000, and were also responsible for trades done for the firm’s benefit in its trading account. In addition to these duties, Gordon was the firm’s managing partner, and was responsible for overseeing the firm’s budget, dealing with financial issues, and overseeing the firm’s tax preparation on an annual basis. Gordon was also responsible for insuring SEC compliance by updating and filing the required ADY Form with the SEC annually. During this time period, Lippincott also acted as an investment portfolio manager for approximately ten percent of SG & C’s client accounts. In addition to her work on these accounts, Lippincott assisted Slocum in managing about a quarter of his client accounts, prepared individual tax returns for clients, and worked on creating a computer database of corporate research information coming into the firm. Lippin-cott did not engage in any securities trades for the firm during her tenure as a partner, and confined her trading activities to her client accounts and personal accounts. 2. Firm Operations Douglas was the partner in charge of operations, and he oversaw and managed the firm’s operations department. Douglas was responsible for maintaining firm accounts, client accounts, and recording all day-to-day transactions. He also oversaw the firm’s record keeping and supervised the flow of cash from both client accounts and the firm’s line of credit through its clearing account and custodial account when the other partners purchased firm or client securities. Between 1996 and 2000 Douglas worked strictly in operations, and did not engage in any form of securities trading for clients or the firm. As a result, he is not joined as a Defendant in this cause of action. Also assisting in SG & C’s firm operations were Shoemaker and Stahm. Shoemaker, the firm’s Operations Manager, worked under Douglas’ direction, and oversaw the settlement of securities transactions,, distribution of funds to clients, and communicated with banks regarding both firm and client transactions. As Operations Manager, Shoemaker handled the paperwork associated with virtually every security transaction taking place at SG & C during the relevant time period. Stahm served as a secretary and receptionist, and, although she would lend a hand as necessary, she was not intimately involved in the firm’s operations. At the time of trial, both Shoemaker and Stahm were still employees of SG & C. C. ■ Trading Strategies at SG & C During the time period in question, SG & C employed two different trading strategies for securities transactions depending on whether the trade was for clients or the firm account. At trial, Defendants Slocum and Gordon outlined these two distinct trading strategies in detail. 1. Trading for Clients Defendants Slocum and Gordon both testified that the majority of their clients were generally interested in conservative, long-term investments. As a result, Slocum and Gordon’s policy for client trades was to “buy on weakness and sell on strength” after a significant holding period. At the core of this philosophy was the concept of strategically investing client funds to promote returns while minimizing risk. To facilitate their long-term holding strategy for client trades, Slocum and Gordon would follow the market constantly, receiving information from Reuter’s, from individual stock brokers, from periodicals, and from conversations with larger investment firms. Using these different sources, Slocum and Gordon would scour the market seeking securities that were appropriately positioned for long-term investments in their different clients’ accounts. When they determined that a security was properly positioned for such a long-term investment, SG & C would initiate a purchase for its clients. Although they both engaged in long-term holdings for client trades, the two partners used different methods for choosing appropriate securities. This was largely due to the different types of accounts and client needs at issue. The clients advised by Gordon were generally income-oriented, often requiring a monthly remittance for their regular expenses. Accordingly, Gordon was usually interested in securities with a high dividend yield, and sometimes strategically purchased securities to take advantage of ex-dividend dates. Gordon also tried to capitalize on periods of market weakness, hoping to buy shares at a low price and then sell later at a higher price. In contrast, Slocum’s client-base was more growth-oriented, and less focused on receiving a monthly remittance from their stock investments. As a result, Slocum based his investment decisions for clients on research indicating that a company was in a solid, growth-oriented mode. When a security fit this description, Slocum would purchase a position for his clients tailored to meet their individual needs regarding cash flow, tax consequences, interest, and his client’s attitude towards risk. Gordon testified that his client purchases were always intended as long-term investments, meaning that he would try to buy a stock on weakness with the intention of holding the security over an extended period until its price increased enough to generate the desired rate of return. This desired rate of return, according to Gordon, was typically in the neighborhood of ten percent. If a security began to rise in price more quickly than originally anticipated, thus achieving the desired rate of return after only a short period of time, the two investment advisers would sell the client security prematurely. Slocum explained that he would sometimes sell a client security earlier than he originally intended if the stock began to decline in value or met his price goals early. Gordon testified that regardless of the reason to sell early, the investment advisers considered such a trade a “short-term holding” rather than a “short-term trade.” Slocum and Gordon both testified that they generally refrained from engaging.in short-term trades, also known as momentum trades, for most clients, because they considered these trades risky and contrary to the clients’ conservative investment goals. Indeed, between the years 1996 and 2000, 98% of SG & C’s client trades were long term holdings. See Exhibit 8. During the time period at issue, SG & C was very successful in its long-term client investments, in some cases generating as much as a 95% return for their clients. See Defendants’ Post Trial Memorandum at 3. 2. Trading for the Firm When trading for their firm account, however, SG & C investment advisers employed a different strategy. SG & C took advantage of anticipated market surges by engaging in short-term, momentum trades for their firm trading account. Both Slocum and Gordon testified that the decision to make a firm trade was event-driven. If circumstances arose that led Slocum or Gordon to anticipate that a particular company’s stock was going to suddenly go up in price, Slocum and Gordon would initiate a purchase of the security for the firm’s trading account. ■ Both Slocum and Gordon testified that they relied on publically available information in deciding to engage in a firm trade. Although both investment advisers employed the same short-term, ■ momentum philosophy for firm trading, Slocum and Gordon employed somewhat different methods for choosing which securities to purchase. Slocum testified that while both he and Gordon generally engaged in the samé type of trading for the firm account, he and his partner weighed certain factors differently in selecting securities for firm trades. Slocum would look at public events and their possible effect on stock prices, such as earning releases or other events that might attract attention to a particular company, and then base his determination to engage in a firm trade on a prediction as to the outcome of these events. Gordon testified that he would most often attempt to buy stocks for the firm during a perceived upward momentum in the stock over a period of time, trying to participate in an upward move as it was occurring. Slocum also testified that sometimes he would purchase a security for the firm before purchasing it for clients to “test the water” and see if the security would be a profitable investment. As a result, sometimes SG & C would purchase a security for the firm and then later, under different market conditions, purchase a position in the same security for their clients. Both Slocum and Gordon would execute firm trades independently from each other, and there was no requirement that the two advisers discuss their decision to engage in a particular firm trade with the other partners. The firm trades were financed through money borrowed from the firm’s line of credit at Sovereign Bank, and were typically held for no more than three days after the day of purchase before being sold. In every case, firm trades were sold before settlement, which occurred on the third day after the purchase or sale of a security, and is the date on which payment for the transaction is due. Because SG & C’s firm' trades were event-driven, they occurred irregularly: at times firm trades occurred. weekly, at other times firm trades did not occur for months at a time. Generally, though, over the time period in question both Slocum and Gordon together averaged less than one firm trade per week. Typically, SG & C generated under $5,000 in profit for their firm from any single firm trade. However, during the unusual “seismic bull market” of the late 1990s, SG & C’s firm trades were very successful. Between 1996 and 2000, SG & C maintained a 98% success rate on their firm trades, resulting in an aggregate profit of $1,253,246 for SG&C. D. Placement of Trades and Documentation When the investment advisers at SG & C made a security purchase or sale for their clients or for the firm, there was a set process established within the firm for facilitating and recording the transaction. Both Slocum and Gordon testified that the first step in any security transaction at SG & C was identifying an appropriate security for either a firm or a client trade, using the criteria outlined above. Next, the investment advisers testified that they would determine which entity (the firm or particular clients) was going to purchase the particular security. When dealing with client accounts, this decision was made on an account-by-account basis after Slocum and Gordon considered the particular trading criteria each different client had established for their account. Both Slocum and Gordon testified that they would typically generate rough drafts, or other notes describing the transaction and working out the appropriate client list for the trade. These rough drafts or scratch sheets were not retained by SG & C after the business day, and were never made a part of their business records. Ultimately, however, Slocum and Gordon testified that they would generate a rough list of the client accounts intended to participate in a particular- transaction and the particular dollar value of shares appropriate for each intended client’s purchase. Typically, Slocum and Gordon would purchase positions in securities, or round lots made up of multiple thousand-share blocks, and the accompanying client list would describe what portion of this larger block was intended for a particular client. Once the stock was identified and a rough draft of a client list prepared, or, for a firm trade, the decision to place the trade was made, Slocum and Gordon would call a broker and initiate a purchase. The firm used multiple brokers, all of whom would get a commission on the trade per security. At this point in time, Slocum and Gordon would have to specify to the broker whether they wanted a market order, a limit order, or a market-not-held order. As the witnesses testified, a market order instructed the broker to simply buy the number of shares Slocum or Gordon requested at whatever the current market price was at the time. A limit order instructed the broker to order a specific stock at a specific price, and required the broker to refrain from initiating a purchase until the requested purchase price could be achieved. Market-not-held orders instructed the broker to purchase the security at the market price, but allowed the individual broker to use his or her own discretion to determine the moment of sale if a price was fluctuating. Gordon testified that he generally used limit orders for client trades and market orders for firm trades. Gordon also testified that sometimes for firm trades he would instruct the broker to simply purchase a particular offering of stock at the asking price. In these situations, Gordon would utilize a limit order for a firm trade. Slocum never testified as to his ordering preferences. Once the call to the broker was made, Slocum and Gordon would take a blank “transaction entry form” (“TE form”), a generic form created by SG & C for all security transactions, and fill out the top portion of the form, indicating the date, the security traded, the purchase, the number of shares, the nature of the order (market, limit, or market-not-held), and the broker with whom they were dealing. While Slocum and Gordon would often handwrite the necessary data on the top portion of the TE form themselves, they would sometimes be too busy to do so, and would ask Shoemaker to fill out the form for them. In these cases, Slocum or Gordon would provide Shoemaker with either their rough draft notes of the transaction or explain the details of the transaction to her orally, and she would handwrite the appropriate information on the top portion of the TE form. It is important to note that at this point in time the transaction to purchase the security was not complete. When purchasing a security, SG & C investment advisers did not consider a purchase or sale truly initiated until the broker called SG & C with an “execution,” which is the exact price at which the trade was effectuated and the number of shares purchased. Generally the broker would call back before .the market closed on that same day with the execution, confirming that the trade was made. Gordon testified that while sometimes the broker would give him the execution immediately when he initially placed the order, other times it would take minutes or hours for the broker to call SG & C with the execution. WThen the broker called back, anyone at SG & C who answered the phone might receive.-the execution information. Often, this information was received by Shoemaker or Stahm, and they would either forward it to the appropriate investment adviser or write the execution information on the TE form themselves. Sometimes the broker would call back and say, “Nothing done,” indicating that no trade could be effectuated. In these situations, because the purchase or sell never actually took place, Slocum and Gordon not only considered the transaction aborted, but, rather, that it “ceased to exist.” Consequently, because Slocum and Gordon did not consider a transaction initiated until a positive execution was received, the TE form memorializing the transaction was not completely filled out until the execution came back from the broker. When a positive execution was received, indicating that a security trade was in progress, the TE form would be completed in full. There were several ways that this was accomplished at SG & C. The first possible method was for the investment adviser to personally handwrite all the necessary information, including all client names and their account numbers, or firm information, on the TE form. This happened on some occasions, especially when a security transaction was simple and easy to describe. The second possible method, utilized frequently by Gordon, was entering client data on a computerized version of the TE form he created on his personal computer: Gordon testified that he used his spread-sheet style, computerized TE form for the majority of his client transactions, and would handwrite the TE forms only for simple client transactions or for some firm transactions. Slocum was not successful in his attempts to make use of the computerized TE form, so he rarely employed this method of record-keeping. The third possible way SG & C investment advisers completed the TE form was by partially handwriting the form themselves and then passing the form to Shoemaker, along with' any rough drafts or notes generated on the transaction, for her to add any omitted information to the TE form. In this third situation, Shoemaker would transfer all necessary data from the adviser’s rough draft or verbal description to the TE form in her own handwriting. While both advisers utilized Shoemaker to fill out parts of their TE forms, Slocum relied on her most heavily due to his frequent periods out of the office. Slocum and Gordon both testified that they had an ongoing understanding with Shoemaker that a partially filled out TE form that left client information blank, and that was not accompanied by a separate rough draft list of client information, was always intended for the firm. Shoemaker confirmed this understanding, and added that while she would typically assume an unlabeled trade was for the firm, she would always check with Slocum and Gordon after affirming it to make sure. Douglas testified that it was his policy in a situation where a TE form omitted client information to hold it, and that, if affirming things that day instead of Shoemaker, he would not affirm it until he spoke with Slocum and Gordon to orally confirm with them that it was intended as a firm trade. When presented with such a partially-completed TE form for a firm trade, Shoemaker testified that, after confirming it was a firm trade, she would complete the TE form herself in her own handwriting to indicate that it was a firm trade. Gordon testified that it was always the goal to get the TE form completed as fast as possible, but, due to the delay in receiving the broker’s execution information, the TE forms were rarely completely filled out at one sitting, or even by one person. As a result, multiple handwritings and multiple ink colors often appear on the TE forms. Indeed, Gordon testified to his intermittent use of multiple different pens in a day, at least one of which was a four-color pen. By the end of the day every day, the investment advisers -and Shoemaker would usually make sure that all TE forms were properly filled out and placed in a particular file folder maintained by Shoemaker in the operations department, referred to by SG & C employees as the “blue folder” or the “pending transactions folder.” Once a TE form entered the blue folder, Shoemaker considered it transferred to the operations department for processing, and she would then write on it herself as needed to facilitate the different procedures necessary to her work in operations. She would also insert other pieces of information on the TE form that were not always available to the investment adviser on the trade day, such as the settlement date, the principal amount, and the commission fees associated with the transaction. These pieces of information were always provided to Shoemaker as a part of her confirmation and affirmation systems in operations. After a TE form entered the blue folder in operations on a trade day it would remain there until Shoemaker removed the folder toward the end of the day to begin organizing the trades in preparation for the affirmation process the next morning. Once a TE form entered the blue folder, it was never altered by the investment advisers except under very unique circumstances, such as a particular client not having sufficient funds in his or her account to purchase the intended security. In such a situation, the form would be returned to the particular investment adviser for either Slocum or Gordon to reallocate the number of shares purchased between the different clients listed. E. The Operations Department, Affirmation, & Settlement The SG & C operations department, although overseen by Douglas, was largely managed by Shoemaker, a longtime employee who did not participate in the profits generated by the firm and, in particular, did> not participate at all in the capital gains generated by the firm account. Shoemaker and Douglas were a team that employed essentially the same procedures. On any given trade day, after an order to purchase or sell was instigated by the investment advisers and the TE form was surrendered to operations, Shoemaker and Douglas would begin their multi-step process of affirmation, confirmation, and settlement. The first step in this process was entering all pending transactions on a white marker board located in the operations department. Shoemaker usually updated the white marker board on a daily basis, and usually retained four weeks worth of trading information on the board, including both buys and sells. For the current week, Shoemaker would include the settlement date for each transaction, which was always three days after the day the trade was placed, and was the date on which payment for the transaction was due. The purpose of the white board was for everyone in the firm to see the pending transactions, and for Shoemaker and Douglas to keep appraised of pending settlement dates so that they could insure that the appropriate funds were available to finance the transaction. The second step in the process was affirmation, which typically occurred the morning after a trade was made (T +1). Affirmation was a process by which Shoemaker would go on-line with SG & C’s custodial account at IBT (formerly BankBoston), and review all the information listed regarding trades placed the day before. Shoemaker would then cross-reference this information against the TE forms in her blue folder. For each trade where everything on the computer screen matched the TE form, Shoemaker would electronically affirm the trade. By affirming a trade, Shoemaker was notifying the bank custodian that the transaction was correct, and instructing them to begin arrangements to either receive a transfer of funds to pay for the trade or to prepare to sell their security holdings and receive payment therefor. Shoemaker would not affirm the trade if she did not have the TE form in front of her, and would not affirm the trade if the information on her TE form was inconsistent with what appeared on the affirmation screen. The third step in the process was confirmation. Once she affirmed the trade, Shoemaker would often print the visible screen to generate a temporary paper confirmation that the trade had gone through. She would then attach this document to the TE form, indicating that the trade was affirmed, and that she was awaiting a paper confirmation from the broker. After a broker called to provide the execution price and confirm the trade, he or she would also mail a paper version of the confirmation to SG & C. Shoemaker testified that this was usually received in the mail prior to settlement day, and that when she received it she would replace the print-out affirmation copy attached to the TE form with the hard copy confirmation from the broker. Shoemaker would staple these papers together and return them to the blue "folder to await settlement day. The fourth step in the process was settlement, which occurred on the third day after a trade (T + 3). Settlement was the process by which SG & C directed payment for a pending security transaction, and it involved dealing with the various bank accounts SG & C maintained for these purposes. In anticipation of settlement day, on the second day after the trade (T+2), Shoemaker would check the balance on the firm’s line of credit at Sovereign Bank to verify the available funds to pay for any firm trade executed two days prior. In addition to preparing for payment of firm trades, the operations department would prepare the necessary sales sheet to debit each client’s individual money market account at Merrill Lynch in order to pay for their trades. On occasion, wiring instructions for payment of the securities were faxed to the bank that afternoon. By noon on the third day following the trade, or settlement date, the following occurred: for the purchase of a security, funds were transferred into the firm’s clearing account at Fleet Bank from SG & C’s line of credit (for firm purchases) or from clients’ individual money market accounts (for client purchases). The funds from both sources remained briefly in the Fleet clearing account and were then transferred into the custodial account at IBT. Once within the custodial account, the funds were distributed by the custodian through the Depository Trust Company to the broker through which the securities were purchased. For a sale, the procedures were reversed. See Exhibit P. Following the completion of a transaction, Douglas generally, or Shoemaker, entered the information on SG & C’s computer system, posting the trades to the appropriate accounts. This was referred to within the firm as “keypunching.” On a daily basis, Douglas and Shoemaker received reports from Merrill Lynch as to the balances in the clients’ individually segregated accounts at that firm. On a monthly basis, Shoemaker and Douglas sent information to the custodian, which held the securities in electronic- form, to reconcile the custodial account and the SG & C account. F. . Bank Accounts and Cash Flow at SG &C . SG & C kept all clients’ records, as well as its own investment records, in individually segregated accounts on its trust department-style, internal computer system. To further accomplish the segregation of client assets from its operating accounts, SG & C created a separate nominee partnership on the advice of counsel in 1979. This fictional entity, Wanton & Co., was a registered nominee with the American Society of Corporate Secretaries. Although a separate entity with a separate tax identification number, Wanton & Co. existed only .on paper, and was entirely controlled by SG & C. Between 1996 and 2000, SG & C maintained a series of bank accounts for- different purposes. Client funds were kept in individual, segregated money market accounts at Merrill Lynch. These accounts were held under the name of Wanton & Co. rather than SG & C. SG & C operating funds were kept in their own, separate checking account, and were held under the firm’s name. In addition, SG & C maintained an $800,000 line of credit for the firm through Sovereign Bank. This line of credit was used to finance firm trades, and then immediately paid off following each transaction. SG & C also maintained a single clearing account at Fleet Bank and a single custodial account at IBT (formerly BankBoston). These unique accounts warrant further description. 1. The Fleet Clearing Account The Fleet clearing account was a single bank account maintained by SG & C for the purpose of moving funds to their custodial .account at IBT to facilitate a stock purchase, or for receiving funds back from IBT after a security sale was effected. Thus, the Fleet account served as an intermediary holding pen for funds as they left the segregated client accounts at Merrill Lynch and the firm’s line of credit at Sovereign on their way to be converted into securities by the custodian. Assets were only present in the Fleet clearing account for a short period of time. Indeed, Slocum and Gordon testified that funds were simply routed through this bank account en route to the custodian. However, both client funds and firm funds from the line of credit were routed through the same bank account. See Exhibit P. Although SG & C maintained records of which funds in the clearing account belonged to clients, and which belonged to the firm, these funds were not segregated by Fleet in any manner. When SG & C sold a security, the funds from the purchase were also routed through the Fleet clearing account en route back to either the firm or the client accounts at Merrill Lynch. Again, these assets were not segregated in the Fleet account, and it was up to Shoemaker and Douglas to insure that the funds were wired correctly to their respective post-trade locations. Shoemaker testified that after a firm security was sold and the funds were routed to the Fleet account, some of the money in the Fleet account would be used to repay the firm’s line of credit, and any additional profits from a firm trade would ultimately be deposited in the firm’s operations account. She also testified that after a client trade, any client funds’in the Fleet account would be wired to Merrill Lynch, where they were then deposited in the appropriate client account. Only Shoemaker, Douglas, and the operations department at SG & C retained records of who owned these clearing account funds and how they should be distributed. 2. The IBT Custodial Account Prior to 1988, SG & C kept the securities for its clients in a bank vault in Newport. After the SEC examined SG & C’s system in 1988 and recommended changes to their method of holding securities, SG & C opened and maintained the IBT custodial account for its clients’ securities. According to Gordon, the concept of the custodial account was based on SG & C’s interpretation of the Gardner and Preston Moss SEC No Action Letter issued in 1982. See Exhibit AA. In a letter Gordon wrote the SEC in 1988, explaining the new system, Gordon makes reference to SG & C’s reliance on the Gardner and Preston Moss No Action Letter. See Exhibit 39. The single custodial account was established under the name of Wanton & Co., and was intended by SG & C to serve as an electronic vault for securities. However, the IBT custodial account, as it existed, was more akin to a bank account than an electronic vault. When SG & C would initiate a stock purchase, the funds for that purchase, whether for the firm or for clients, would both enter this account from the clearing account at Fleet and coexist together in the IBT account for a short period of time until they could be gathered by the custodian and utilized to pay for the securities ordered. Once these funds were used to purchase the securities, the IBT account would then hold the securities, without distinguishing between firm and client ownership, until SG & C made a decision to sell them. When a decision to sell was made, IBT would sell the securities indicated, and then, for a short period, would hold the funds before routing them back to SG & C through the clearing account at Fleet. While the IBT custodial account held securities, and also for the short periods of time that it held funds before transferring them to the clearing account, these assets were not segregated in any way within the bank itself, but rather all registered under the name of Wanton & Co. The only record of which entity owned what particular security, or to what party the funds were payable, whether clients or the firm, was maintained by SG & C alone in their internal records. SG & C submitted monthly reports to IBT explaining their calculation of which securities belonged to clients and which belonged to the firm, and these monthly reports were the only method the bank had of assigning ownership to the different securities. No records were submitted regarding the funds, as they were only in the account for a short period of time. However, although the monthly report on security ownership was submitted to IBT, no internal, bank-based segregation of the client securities and the firm securities was performed, or even attempted. The custodial account was maintained as one, single account containing both firm and client assets, registered under the name of Wanton & Co. G. Compliance Initiatives atSG&C SG & C employed several different procedures in an effort to maintain SEC compliance. When first establishing their investment firm in 1978 and 1979, Slocum and Gordon sought the advice of counsel, and formulated their account structure in accordance with their attorney’s recommendations. SG & C also relied on the advice of counsel in reformulating their account structure to include the use of a separate custodial account in 1988. See Exhibit 39. In addition, SG & C filed an annual compliance report with the Commission, known as an ADV Form, which outlined SG & C’s trading practices and account structure. See Exhibits 32, 33, and 34. The ADV Form was prepared by Gordon, and he also bore the responsibility for updating it on an annual basis. Attached to this report was a firm brochure, which Gordon described as a user-friendly version of the information provided on the ADV form that SG & C prepared for new clients. This client brochure was submitted to the SEC annually along with the ADV Form. The annual filing of an updated ADV Form, along with the attached firm brochure, represented the firm’s method of communicating with the SEC and disclosing the firm’s practices. Both the ADV Form and the firm brochure indicated that SG & C bought and sold securities for itself that it also recommended to clients. In addition, the ADV Form included the following language describing SG & C’s firm trading policies: [The] firm or its partners may take short-term trading positions for their own accounts and securities which for reasons of market risk or holding period expectations the firm may deem inappropriate for clients’ accounts. However, in any case where either the firm or its partners make purchases or sales of securities whose objectives coincide with the fundamental investment philosophy of the firm, those transactions will always be in conformity with other similar transactions for clients. Exhibit 32, Schedule F. SG & C filed this paperwork with the Commission regularly through the relevant time period. Other regular controls SG & C had in place were annual surprise examinations by their independent auditor, Deloitte & Touche. Deloitte & Touche had a long standing relationship with SG & C. Each year, in accordance with the requirements of Rules 206(4) — 2 and 204-2(b) of the Advisers Act, Deloitte & Touche performed a confirmation of securities held by the custodian, IBT, and the client accounts at Merrill Lynch, and also examined those aspects of the SG & C’s books and records as were “considered necessary in the circumstances.” See Exhibit Y27. Deloitte and Touche did not, however, conduct a comprehensive audit of SG & C’s records, and did not examine any assets in the Fleet clearing account. After each annual examination, Deloitte & Touche issued a letter to SG & C explaining the parameters of their examination and opining that “no matters came to [their] attention that caused [them] to believe that the investment accounts should be adjusted or that [SG & C] was not in compliance.... ” See Exhibits Y25-Y32. Although Deloitte & Touche always clearly explained in its letters that their surprise examination did not constitute an audit made in accordance with generally accepted auditing standards, and included language in each letter specifying that it “[did] not express an opinion on the investment accounts [at issue],” Gordon testified that he considered a positive letter from Deloitte & Touche to indicate that SG & C procedures were appropriate and that SG & C was in compliance with the SEC. During the relevant time period, Deloitte & Touche examined SG & C’s accounts annually, and each time SG & C received a letter from Deloitte & Touche indicating that no potential compliance issues were uncovered in the course of its confirmation procedures. Another essential aspect of SG & C’s compliance initiatives were the sporadic examinations of its accounts and procedures by the SEC itself. The SEC descended on SG & C and examined its books and record-keeping procedures periodically over its years of operation. Prior to the relevant time period, the Commission’s two most recent examinations occurred in 1988, which spurred SG & C to create its custodial account, and in 1994, which resulted in alterations to SG & C’s ADV Form, imposition of monthly updates to the firm’s general and auxiliary ledgers, and inclusion of additional information on the firm’s TE forms. Whenever SG & C effected a substantial change in any of its accounting procedures in response to SEC examinations, Gordon would write a letter to the SEC explaining the firm.’s changes and its efforts toward achieving compliance. One such example is Exhibit 39, Gordon’s letter to the, SEC explaining the firm’s decision to establish the custodial arrangement with IBT. Gordon testified that although he wrote and sent this letter to the SEC explaining .the custodial account, he never received a response from the Commission. He also testified that although he relied on the Gardner and Preston Moss “No Action Letter” in creating the SG & C custodial relationship, he never sought a separate “No Action Letter” from the SEC for SG & C. When the Commission examined SG & C’s records and procedures in 1994, and deficiencies were identified by the Commission, Gordon also generated a letter describing the firm’s steps towards compliance. See Exhibit W-5. The 1994 examination by the SEC resulted in no negative commentary regarding the SG & C’s account structure, so SG & C assumed that it was in compliance with the applicable rules and regulations. After the 1994 examination, SG & C’s next visit from the Commission occurred in March of 2000, which gave rise to the investigation generating the allegations at issue in this case. PART TWO: CHERRY PICKING ALLEGATIONS A. The SEC Examination in 2000 In March of 2000, the SEC returned for a surprise examination of SG & C. As in past SEC examinations, Gordon instructed Shoemaker and Douglas to make all firm records available to the SEC auditors, and to allow them access to any information they needed. However, this time, as Commission representatives began to examine SG & C, it became clear that the Commission was unhappy with several of SG & C’s operating practices. First and foremost among these questionable practices was SG & C’s cash flow and bank account structure, which allowed funds coming to and from the firm’s line of credit and client funds to coexist in the same clearing and custodial accounts. When coupled with both SG & C’s high rate of success on short-term firm trades and the firm’s practice of only partially completing TE forms at any one sitting, the SEC became concerned .that the SG & C investment advisers were engaged in a process known as cherry picking. Cherry picking, as defined at trial, is a practice by which an investment adviser purchases a security, waits to evaluate its performance, and then allocates it to himself or his firm rather than clients if it “pops,” or goes up quickly within a short period of time. To explain this another way, an investment adviser engaging in cherry picking buys securities in blocks without determining an intended recipient. Then, between trade day and settlement day, he watches the security’s performance. If the value increases significantly, he allocates the security to the firm, thus picking the “cherry” for himself. However, if the value decreases prior to settlement, or if it stays the same, the investment adviser allocates the security to his clients, thus leaving them the “pit.” During its examination, the SEC became suspicious of SG & C’s operations practices because, dhe to the commingling of funds and SG & C’s inconsistent procedure for preparing TE forms, the window of opportunity for such activity was present. As a result of these findings, the Commission instigated a formal investigation of SG & C and its operational practices during the spring and summer of 2000. This investigation ultimately resulted in this cause of action. B. The Commission’s Evidence At trial, the only first-hand evidence of a cherry picking scheme offered by the Commission was the testimony of SG & C’s former partner, Jane Lippincott, who left the firm in January of 2000 to start her own business. All the Commission’s other evidence of cherry picking was circumstantial evidence based on trading patterns it considered suspicious. At trial, Lippincott, who was not a defendant, testified under subpoena, and received immunity -from the Commission in exchange for her testimony against her former partners and firm. 1. Lippincott’s Firm Involvement Lippincott originally started working at SG & C as a summer intern while she was a college student at the University of Rhode Island. After her graduation in 1981, she began working full-time, and became a partner in 1991. - Although a partner and a portfolio manager, Lippincott did not manage more than 10% of SG & C’s client accounts, and did not engage in firm trading. According to Lippincott, this constituted around 20 client accounts, however, she admitted that several of these accounts were her family members or her own personal accounts. Throughout her tenure- at SG & C, Lippincott considered Slocum her mentor and friend, and she testified that the vast majority of her client accounts were given to her by Slocum, and that Slocum assisted her with her trading decisions for these accounts. In fact, she testified Slocum was so involved in her purchase and sale decisions that it was rare for her to ever complete and sign a TE form entirely on her own over all the years she served as a partner. In the mid-1990s Lippincott had her first child, and reformed her work schedule so that she was only in the office three days a week’ and the other days she worked from home. During the last years of her association with SG & C, Lippincott became very involved in competitive tennis, and was often out of the office engaging in tennis-related activities or other business opportunities not associated with SG & C. This gradual distancing from the firm continued until the fall of 1999, when Lippincott approached Slocum and Gordon about increasing her partnership share. At the time, she confided in Slocum that she was considering leaving the firm if her share was not substantially increased. Shortly thereafter, Lippincott was present at a meeting where Gordon outlined how the partnership shares were distributed, and informed all SG &1C partners that in order to increase their share of the firm’s profits they needed to either take on additional client accounts or increase their participation in .the firm trading account. Lippincott testified that after this meeting she deduced that she was not going to be able to achieve the percentage share she was interested in without substantially increasing her work load, so she decided to leave the firm. Lippincott tendered her resignation letter to Slocum on January 2, 2000'. During the SEC’s investigative hearings, Lippincott testified that Slocum and Gordon were engaged in a general practice of cherry picking profitable securities for the firm’s account, and specifically mentioned Halliburton as a security that SG & C cherry picked during the relevant time period. However, at trial, the evidence showed that Lippincott was entirely mistaken about the Halliburton trades, because these trades were initiated in every instance for clients rather than for the firm. When confronted with this disparity, Lippincott admitted that she was mistaken about these trades, since no portion of the profits went to the firm account. The only other possible example of cherry picking Lippincott mustered was the American Home Products transaction, which the Court will now discuss. 1. American Home Products In addition to her Halliburton assertions, Lippincott claimed to have personally witnessed one instance of cherry picking at SG & C regarding a trade of American Home Products stock on Wednesday, August 18, 1999. The circumstances surrounding this transaction were as follows. The morning of August 18, Lippincott and Slocum discussed purchasing 3,000 shares of American Home Products (“AHP”). Lippincott testified that she believed this purchase was for clients, however she could not remember which clients, and never fiiade a list or any form of rough draft or notes regarding which clients she or Slocum intended it for. Lippincott also failed to recall the reason why the purchase was initiated. Slocum testified that it was intended as a firm trade, and was event-driven. Specifically, Slocum testified that he wanted to make á firm trade in AHP on August 18 because he had heard rumors of a potential merger between AHP and Glaxo-Wellcome, another major pharmaceutical company, which he hoped would cause the stock to increase rapidly over a short period of time. After the decision to purchase was made, Slocum had Lippincott call a particular broker at the firm Hambrecht & Quist to place the trade. SG & C had previously had a relationship with Hambrecht & Quist, but had not utilized the firm for trading for over a year and a half. Slocum testified that he had Lippincott initiate the trade with Hambrect & Quist because a particular broker she had dealt with favorably in the past, Richard Vesse, had recently transferred within‘that firm from its San Francisco office to the Boston office, and he thought that this trade would be an opportunity for Lippincott to utilize her friendship with-Vesse to reestablish SG & C’s relationship with the brokerage firm. Slocum also testified that Lippincott had been utilizing research services offered by Hambrecht & Quist during that time period, and that he wanted to “increase her stature” with the broker by demonstrating that she was in a position to pay for the research with commission fees. Lippincott confirmed that she called Hambrecht & Quist to initiate the trade because of her past association with Vesse. After Lippin-cott placed the trade and filled out some portions of the TE form for it, including the date, the security transaction, the broker, the representative, the execution price, and the settlement date, see Exhibit MM-12, she immediately left the office for the remainder of the week to play in a tennis tournament. Lippincott did not return from her tennis tournament until Monday, August 23, 1999. At that point, Lippincott testified that she became aware that Slocum and Shoemaker had processed the AHP transaction as a firm trade, and Slocum was in the process of' selling it for a profit. Lip-pincott testified that she had a conversation with Slocum where he indicated to her that the AHP stock had “popped” so he had “run it through the firm account.” Slocum denies having such a conversation with Lippincott, and also denies ever using the term “pop” in relation to a security. Shoemaker confirms that Slocum and Gordon were not in the habit of describing stocks that went up quickly as having, “popped,” and testified that the only person she ever heard use this term to describe securities was Lippincott. Shoemaker also testified that she never altered the paperwork mid-stream to change a trade’s allocation .from particular clients to the firm account. Lippincott testified that she was annoyed that the trade was not allocated for clients, but admitted that she took no steps to notify others in the firm, such as Shoemaker, Douglas, or Gordon, that the trade was supposed to be for clients. She also testified that she made no attempt to correct the error herself. Lippincott also failed to remember which clients she intended the transaction for, and never made or submitted a list of these clients to Slocum or Shoemaker before leaving the office for her tennis tournament the week before. Taking all of this into consideration, the Court is not persuaded that the AHP was reallocated from client accounts to the firm. The fact that Lippincott left the AHP TE form without a client list, especially in light of Slocum and Shoemaker’s stated policy to regard blank TE forms as firm trades, indicates that this trade was, at most, an error made in favor of the firm, and not an example of cherry picking. Slocum testified that he believed the TE form represented a firm trade, and that no client list was ever brought to his attention regarding it at any point in time. The testimony indicated that if Lippincott had approached her partners and indicated that the AHP trade was erroneously marked up as a firm trade, SG & C would have had the opportunity to correct the error, both on the transaction TE form and through their accounts. However, Lippincott never notified any of her coworkers that she intended this as a client trade, but had forgotten to attach a client list before leaving to play tennis* This example does not constitute cherry picking. . 2. Lippincott’s Conversations Lippincott also testified to several conversations she had with Slocum and Gordon after leaving the firm that she interpreted negatively. The first is a conversation with Slocum where the two were discussing Lippincott’s difficulties in starting her own investment business. Lippincott’s new investment firm had no client base, and, as a result, generated no commission fees from clients. When talking with Slocum about this business, she testified that Slocum commented that she “didn’t have clients to fall back on.” Lippincott interpreted this . comment as meaning that she didn’t have client accounts and thus could not cherry pick and pass the “pits” on to her clients. Slocum testified that what he meant by this statement was that Lip-pincott could not fall back on her commission fees from clients when the market was in a down-swing. The second is a comment that Slocum made to her regarding the SEC investigation in 2000, where he joked that SG & C “should have booked a loss.” Lippincott also interpreted this comment as an admission that, cherry picking had been occurring at SG & C. ' At her SEC hearing, Lippincott testified that her beliefs about the Halliburton transactions influenced her interpretation of both of these comments. Although impeached with this prior testimony at trial, Lippincott refused to admit that she could have been mistaken about Slocum’s meaning in either context. In light of her misunderstanding, however, the Court is compelled to discount her interpretation. Finally, Lippincott testified about a telephone conversation she had with Gordon during the SEC investigation, where she testified that Gordon told her that he wanted to make sure Lippincott was “on the same page” as he and Slocum were regarding her recollection of events. Lip-pincott’s handwritten notes of this conversation were introduced into evidence at trial, and they included the statements “trading account issues were known before the trade and not after the trade” and that the “firm never had a trading account, just borrowed money, dollars.” See Exhibit 43. Lippincott testified that, in her opinion, neither of these statements from her notes were accurate descriptions of practices at SG & C. Gordon denied ever telling Lip-pincott that SG & C never had a trading account, and testified that his telephone conversation with Lippincott was merely intended to bring her up to speed on the SEC investigation since she had been a firm partner during the relevant time period. Although Gordon’s conversation with Lippincott during the Commission’s investigation suggests that he was aware that SG & C’s practices were under fire, and that some of the firm’s operations were questionable in the eyes of the Commission,' it is not enough to establish that cherry picking had occurred. 4. Family Trades & Howard Trades In addition to the Lippincott testimony, the SEC’s other trade-specific evidence focuses on their analysis of 22 short-term trades SG & C made for clients during the relevant