UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7579 / September 14, 1998 SECURITIES EXCHANGE ACT OF 1934 Release No. 40435 / September 14, 1998 INVESTMENT ADVISERS ACT OF 1940 Release No. 1751 / September 14, 1998 INVESTMENT COMPANY ACT OF 1940 Release No. 23434 / September 14, 1998 ADMINISTRATIVE PROCEEDING File No. 3-9704 ______________________________ ) ) ) In the Matter of )ORDER INSTITUTING PUBLIC )PROCEEDINGS, MAKING FINDINGS, )IMPOSING REMEDIAL SANCTIONS, STEPHEN H. BROWN, )AND ISSUING CEASE-AND-DESIST )ORDER Respondent. ) ______________________________) I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest to institute public administrative proceedings pursuant to Section 8A of the Securities Act of 1933 ("Securities Act"), Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), Sections 203(f) and 203(k) of the Investment Advisers Act of 1940 ("Advisers Act"), and Sections 9(b) and 9(f) of the Investment Company Act of 1940 ("Investment Company Act"), against Respondent Stephen H. Brown ("Brown"). In anticipation of the institution of these proceedings, Brown has submitted an Offer of Settlement to the Commission, which the Commission has determined to accept. Solely for the purpose of these proceedings, and any other proceedings brought by or on behalf of the Commission, or in which the Commission is a party, and prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. 201.100, et seq., and without admitting or denying the findings set forth herein, except as to the Commission's jurisdiction over him and the subject matter of this proceeding, which Brown admits, Brown consents to the entry of this Order Instituting Public Administrative Proceedings, Making Findings, Imposing Remedial Sanctions and Issuing Cease-and- Desist Order ("Order"). II. Accordingly, IT IS ORDERED that an administrative proceeding pursuant to Section 8A of the Securities Act, Section 21C of the Exchange Act, Sections 203(f) and 203(k) of the Advisers Act, and Sections 9(b) and 9(f) of the Investment Company Act be, and hereby is, instituted. III. On the basis of this Order and the Offer of Settlement submitted by Brown, the Commission finds that:[1] A.Respondent STEPHEN H. BROWN, age 37, is a resident of San Francisco, California. From September 13, 1993, through April 25, 1994, Brown was employed by Mitchell Hutchins Asset Management, Inc. as the day-to-day co-portfolio manager of the PaineWebber Short-Term U.S. Government Income Fund. B.Other Relevant Entities MITCHELL HUTCHINS ASSET MANAGEMENT, INC. ("Mitchell Hutchins") is a broker-dealer registered under the Exchange Act and an investment adviser registered under the Advisers Act. It is wholly owned by PaineWebber Inc., a registered broker-dealer. Mitchell Hutchins serves as the investment adviser and administrator of the PaineWebber Short-Term U.S. Government Income Fund. Mitchell Hutchins also acts as the distributor of each class of the Fund's shares. THE PAINEWEBBER SHORT-TERM U.S. GOVERNMENT INCOME FUND (the "Fund"), a diversified series of a registered, open-end, management investment company, commenced operations on May 3, 1993.[2] The Fund's assets totalled approximately $1.7 billion as of November 30, 1993, and approximately $1 billion as of May 31, 1994. C.Summary This proceeding involves Stephen H. Brown's conduct in managing the PaineWebber Short-Term U.S. Government Income Fund, which Mitchell Hutchins marketed as a higher-yield and somewhat higher- risk alternative to money market funds and bank certificates of deposit. Brown violated the antifraud provisions of the federal securities laws when he invested the Fund's assets in securities that exposed investors to significantly higher levels of risk than had been disclosed in the Fund's offering materials. The prospectus disclosed that the Fund's investment objective was to achieve the highest level of income consistent with preservation of capital and low volatility of net asset value ("NAV"). The appendix to the prospectus also disclosed that the Fund had "no present intention" of investing in certain classes of interest only ("IO") and principal only ("PO") stripped mortgage-backed securities. Contrary to the Fund's investment objective and "no present intention" statement, Brown invested the Fund's assets in inappropriate IO and PO securities commencing in late September 1993 and continuing through February 1994. When interest rates increased sharply beginning in February 1994, the Fund incurred significant losses, performing well below comparable funds. Brown frequently overrode the prices of certain securities in the Fund's portfolio, thereby overstating its NAV. He accomplished this by substituting overstated values for the prices provided by the Fund's custodian bank, a practice that violated the Fund's disclosed valuation method. He also employed a method that materially understated a measure of portfolio volatility. This conduct had the effect of obscuring the volatile NAV effects of the inappropriate IO and PO securities he purchased. D.Mitchell Hutchins' Disclosures and Representations Regarding the Fund's Volatility and Securities Portfolio The Fund was offered to the public by means of a prospectus and other materials prepared by Mitchell Hutchins. The prospectus, which was incorporated into the Fund's registration statement, stated that "[t]he Fund's investment objective is to achieve the highest level of income consistent with the preservation of capital and low volatility of net asset value" (emphasis added). In addition, the prospectus disclosed that the Fund would invest in U.S. Government securities, including mortgage-backed securities. The appendix to the prospectus stated that the Fund had "no present intention" of investing in certain mortgage- backed securities -- IO and PO strips of collateralized mortgage obligations ("CMOs") that were not planned amortization class bonds ("non-PAC IOs and POs").[3] E.Brown's Purchases of Certain IO and PO Securities WereContrary to the Fund's Investment Objective and Limitations In September 1993, Brown became employed at Mitchell Hutchins as the Fund's co-portfolio manager, with day-to-day responsibility for managing the Fund's portfolio. While being interviewed for the position of co-portfolio manager, Brown's eventual supervisor and another senior co-portfolio manager told him that non-PAC IOs and POs were not permitted in the Fund. Despite these instructions, the prospectus's "no present intention" statement, and the Fund's low-volatility investment objective, Brown first purchased a non-PAC PO, for more than $15 million, on September 30, 1993. Thereafter, between September 30, 1993, and February 14, 1994, Brown purchased a total of six non-PAC POs and three non-PAC IOs for an aggregate purchase price of more than $162 million. By February 1994, non-PAC IOs and POs constituted approximately 6% of the Fund's portfolio. In addition, Brown purchased other securities that were more volatile than permitted by the Fund's low-volatility investment objective. Specifically, during the period from October 1993 through January 1994, Brown purchased five PAC inverse IOs for a total purchase price of more than $34 million.[4] For the first three quarters after its inception, the Fund showed a strong performance. For example, for the period from January 1 through March 31, 1994, the A shares, B shares, and D shares ranked 2, 9, and 7, respectively, out of 103 comparable funds. When interest rates increased sharply in the first half of 1994, however, the Fund incurred significant losses. For example, the Fund's NAV fell from $2.46 per share on March 31, 1994, to $2.25 per share on June 30, 1994, placing the Fund's performance among the bottom four of 105 comparable funds during the second quarter of 1994. F.Brown Frequently Mispriced Certain Portfolio Securities The Fund's prospectus and statement of additional information ("SAI") described the method that it would use to value portfolio securities. The SAI disclosed that the Fund would value its portfolio securities based on their current market value where market quotations were readily available. Where market quotations were not readily available, or did not adequately reflect, in Mitchell Hutchins' judgment, a security's "fair value," the SAI disclosed that portfolio securities would be valued based on appraisals received from a pricing service or appraisals based on information provided by recognized dealers in those or similar securities. Finally, in the absence of any of the foregoing market indicators, the SAI disclosed that portfolio securities would be "valued at fair value as determined in good faith by or under the direction of the Trust's board of trustees." The Fund's portfolio was valued as of the end of each business day. The Fund received from its custodian bank ("custodian") a daily report of prices for each of the portfolio securities where dealer quotations could be obtained; these prices, in turn, provided the principal basis for the daily calculation of the Fund's NAV. Pursuant to the Fund's stated valuation method, the custodian-provided prices, in most instances, reflected quotations received from a pricing service or from a dealer (usually the dealer that sold the security to the Fund). Pursuant to the firm's procedures, Brown could substitute another value for a custodian-provided price if he determined that the latter did not adequately reflect a security's "fair value"; this practice was known as price "overriding." Prior to the time that Brown assumed day-to-day responsibility for managing the Fund, price overrides were relatively infrequent. By contrast, during his tenure at the Fund from October 1993 through April 1994, Brown frequently overrode prices provided by the custodian, on many days altering the prices of approximately 5 to 25 securities. On more than 40 occasions, Brown overrode custodian-provided prices for a particular security for more than a two-week period. Moreover, he overrode custodian-provided prices for two of the non-PAC securities for almost the entire time that they were held by the Fund.[5] Brown overrode custodian-provided prices with prices that he derived based on his own method, which did not take into account whether the securities currently could be sold at the prices he calculated. Although Brown's price calculations were a key component in valuing the Fund's portfolio (and, in turn, the NAV), Brown kept no documentation to support his calculations. Brown's price overrides were reported on "override sheets," a Mitchell Hutchins form ultimately reviewed by a chief investment officer. Even when he knew he was overriding custodian-provided prices for portfolio securities, Brown submitted pre-printed override sheets provided by Mitchell Hutchins that inaccurately stated that no custodian-provided price was available. When Brown overrode custodian-provided prices, in most cases, he replaced them with higher prices. For example, from November 29, 1993, to April 22, 1994, he overrode the prices of at least 17 securities in the Fund's portfolio, including non-PAC IOs and POs and PAC inverse IOs, and substituted higher values that ranged from approximately 9% to 62% (averaging approximately 27.5%) above the available dealer quotations. Because the Fund's NAV is a function of the value of its securities portfolio, Brown's overrides caused the Fund's NAV to be overstated. For example, following the increase in interest rates during February through April 1994, Brown overrode custodian-provided prices for a substantial number of securities, resulting in inflation of the Fund's NAV by more than $0.01 per share for a total of 36 days during the period from March 1 to April 25, 1994. Brown's overrides had the effect of obscuring the increased volatility of the Fund's NAV caused by his purchases of non-PAC IOs and POs and inverse IOs. This, in turn, had the effect of obscuring his purchases of those securities. Brown further obscured the volatile effects of these purchases by employing a method that materially understated the portfolio's aggregate duration, which generally measures how a portfolio's value will change in response to specified changes in interest rates. Legal Analysis Brown Willfully Violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder, and Willfully Aided and Abetted and Caused Violations of Sections 34(b) and 13(a)(3) of the Investment Company Act Section 17(a) of the Securities Act makes it unlawful, in the offer or sale of securities, (1) to employ any device, scheme or artifice to defraud, or (2) to obtain money or property by means of any untrue statement of material fact or any omission to state a material fact necessary to make the statements made, in light of the circumstances in which they were made, not misleading, or (3) to engage in any transaction, practice, or course of business that operates as a fraud or deceit upon a purchaser. Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful to employ any device, scheme or artifice to defraud in connection with the purchase or sale of securities. Brown's purchases of non-PAC IOs and POs and inverse IOs rendered materially false and misleading Mitchell Hutchins' public disclosures regarding the Fund's volatility and contents. The Fund ceased being a low-volatility fund when Brown purchased these impermissible securities for its portfolio. The prospectus statement that the Fund had "no present intention" of investing in non-PAC IOs and POs also became materially false and misleading when Brown commenced his purchases of those types of securities. Brown knew that, or acted with reckless disregard for whether, his purchases of those securities rendered the foregoing prospectus disclosures materially false and misleading. As a result of the foregoing, Brown willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Section 34(b) of the Investment Company Act makes it unlawful to, among other things, make any untrue statement of material fact in any registration statement. Because the Fund's prospectus was incorporated into its registration statement, Brown willfully aided and abetted and caused Mitchell Hutchins to violate that provision when he purchased securities that rendered materially false and misleading the prospectus disclosures described above. Section 13(a)(3) of the Investment Company Act provides that, unless authorized by the vote of a majority of its outstanding voting securities, no registered investment company shall deviate from any investment policy that is changeable only if authorized by shareholder vote, or deviate from any policy recited in its registration statement pursuant to Section 8(b)(3) of that Act. The Fund's prospectus disclosed that its low-volatility investment objective was a "fundamental polic[y] that may not be changed without shareholder approval." Brown caused the Fund to deviate from this fundamental policy by purchasing non-PAC IOs and POs and inverse IOs for its portfolio, thereby contravening the Fund's investment objective. As a result of the foregoing, Brown willfully aided and abetted and caused a violation of Section 13(a)(3) of the Investment Company Act. Brown Willfully Aided and Abetted and Caused Violations of Sections 206(1) and 206(2) of the Advisers Act, and Section 31(a) of the Investment Company Act and Rule 31a-1(a) Thereunder Section 206(1) of the Advisers Act makes it unlawful for an investment adviser to employ any device, scheme or artifice to defraud any client or prospective client. Section 206(2) makes it unlawful for an investment adviser to engage in any transaction, practice, or course of business that operates as a fraud or deceit upon any client. Brown knew that, or acted with reckless disregard for whether, his pattern of overriding custodian-provided prices was contrary to the Fund's disclosed valuation method. Brown similarly knew that, or acted with reckless disregard for whether, the foregoing conduct resulted in an inflation of the NAV reported to the Fund by Mitchell Hutchins. Brown also knew that, or acted with reckless disregard for whether, by inflating the NAV and reporting inaccurate aggregate duration figures, he was obscuring the volatile effects of the non-PAC IO and PO and inverse IO securities on the Fund's NAV, and thereby obscuring his purchases of those securities. As a result of the foregoing, and as a result of Brown's purchases of securities that were contrary to the disclosures in the Fund's prospectus and registration statement, Brown willfully aided and abetted and caused Mitchell Hutchins' violations of Sections 206(1) and 206(2) of the Advisers Act. Under Section 31(a) of the Investment Company Act and Rule 31a- 1(a) thereunder, registered investment companies are required to maintain and keep current such books, accounts and other documents constituting the basis for financial statements required to be filed with the Commission under Section 30 of the Investment Company Act, which include balance sheets showing the aggregate value of securities held and the amounts and values of securities owned as of the date thereof. For the period from October 1993 through April 1994, Brown did not maintain documentation regarding his basis for overriding the prices of securities held in the Fund's portfolio or the methodology and calculations he used to derive override prices. As a result, Brown willfully aided and abetted and caused violations of the recordkeeping requirements set forth in Section 31(a) of the Investment Company Act and Rule 31a-1(a) thereunder. IV. Respondent Brown has submitted a sworn financial statement and other evidence and has asserted his financial inability to pay a civil penalty. The Commission has reviewed the sworn financial statement and other evidence provided by Brown and has determined that he does not have the financial ability to pay a civil penalty. V. In view of the foregoing, the Commission deems it appropriate and in the public interest to impose the sanctions set forth in Brown's Offer of Settlement. Accordingly, IT IS ORDERED THAT: A.Brown shall cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Sections 206(1) and 206(2) of the Advisers Act, and Section 34(b) of the Investment Company Act, and shall cease and desist from causing any violation and any future violation of Sections 13(a)(3) and 31(a) of the Investment Company Act and Rule 31a-1(a) thereunder; B.Brown be, and hereby is, barred from association with any investment adviser, investment company, broker, dealer, or municipal securities dealer from the date of the entry of this Order, provided that he may reapply to become so associated after three years from the date of this Order. Such application shall be made to the appropriate self-regulatory organization, or if there is none, to the Commission; C.Brown shall comply with his undertaking to reasonably cooperate with investigations, administrative proceedings and litigation conducted by the Commission arising from or relating to the matters described in this Order; and D.The Division of Enforcement may, at any time following entry of this Order, petition the Commission to: (1) reopen this matter to consider whether Brown provided complete and accurate financial information at the time such representations were made; (2) determine the amount of the civil penalty to be imposed; and (3) seek any additional remedies that the Commission would be authorized to impose in this proceeding if Brown's Offer of Settlement had not been accepted. No other issues shall be considered in connection with this petition other than whether the financial information provided by Brown was fraudulent, misleading, inaccurate, or incomplete in any material respect, the amount of civil penalty to be imposed, and whether any additional remedies should be imposed. Brown may not, by way of defense to any such petition, contest the findings in this Order or the Commission's authority to impose any additional remedies that would have been available in the original proceeding. By the Commission. Jonathan G. Katz Secretary **FOOTNOTES** [1]:The findings made herein are pursuant to Respondent's Offer of Settlement and shall not be binding on any other person or entity in this or any other proceeding. [2]:The Fund later was renamed The Paine Webber Low Duration U.S. Government Income Fund. [3]:IOs and POs with prepayment protection, or "PAC bonds," are designed to provide relatively predictable payments according to an established schedule, provided that repayments on the underlying mortgage assets fall within a certain range (i.e., as long as early payoffs by mortgagors fall within certain parameters.) Non-PAC IOs and POs, on the other hand, are significantly more volatile because, among other things, they lack prepayment protection and absorb the effects of changes in prepayments for PAC classes. Indeed, the Fund's prospectus stated that non-PAC IOs and POs "are extremely sensitive to the rate of principal payments (including prepayments) on the underlying [m]ortgage [a]ssets." [4]:Inverse IOs, which may be either PAC or non-PAC, vary inversely with certain stated interest rates. These securities generally are more volatile than other IO securities because of their extreme sensitivity to interest rate fluctuations. [5]:On September 30, 1993, Brown purchased the first non-PAC PO; he subsequently overrode custodian-provided prices for that security each day from October 18 until January 26, 1994, when it was sold. He purchased a non-PAC IO on October 20, 1993, and overrode its custodian-provided prices every day from November 2, 1993, through February 14, 1994, when he sold it.