UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION Securities Act of 1933 Release No. 7583 / September 23, 1998 Securities Exchange Act of 1934 Release No. 40465 / September 23, 1998 Investment Advisers Act of 1940 Release No. 1754 / September 1998 Administrative Proceeding File No. 3-9715 : In the Matter of : : ORDER INSTITUTING PROCEEDINGS CS FIRST BOSTON INVESTMENT : PURSUANT TO SECTION 8A OF THE MANAGEMENT CORPORATION, : SECURITIES ACT OF 1933, : SECTION 21C OF THE SECURITIES : EXCHANGE ACT OF 1934, AND : SECTIONS 203(e) AND 203(k)(1) : OF THE INVESTMENT ADVISERS : ACT OF 1940, MAKING FINDINGS, : IMPOSING REMEDIAL SANCTIONS : AND CEASE-AND-DESIST ORDER Respondent. : : I. The Commission deems it appropriate and in the public interest that proceedings be, and hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act"), Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), and Sections 203(e) and 203(k)(1) of the Investment Advisers Act of 1940 ("Advisers Act") against CS First Boston Investment Management Corporation ("CSFBIMC"). II. In anticipation of the institution of these administrative proceedings, CSFBIMC has submitted an Offer of Settlement that the Commission has determined to accept.[1] Solely for the purposes of these proceedings and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and prior to hearing and without admitting or denying the findings set forth herein, CSFBIMC consents to the entry of this Order Instituting Proceedings Pursuant to Section 8A of the Securities Act of 1933, Section 21C of the Securities Exchange Act of 1934, and Sections 203(e) and 203(k)(1) of the Investment Advisers Act of 1940, Making Findings, Imposing Remedial Sanctions and Cease-and-Desist Order ("Order"). The Commission has determined that it is appropriate and in the public interest to accept the Offer of Settlement from CSFBIMC, and accordingly is issuing this Order. III. FACTS Based on the foregoing, the Commission finds that:[2] A.Respondent During the period from December 1993 until March 1994, CSFBIMC was the investment adviser for The CS First Boston Offshore Cash Reserve Fund (the "Offshore Fund" or the "Fund"). CSFBIMC was registered with the Commission as an investment adviser pursuant to the Advisers Act at all relevant times. B.Summary This proceeding involves CSFBIMC's management of the Offshore Fund, which the firm marketed as a near money market fund and whose investment objective was to achieve the highest level of income consistent with preservation of capital and low volatility of net asset value ("NAV"). CSFBIMC violated the antifraud provisions of the federal securities laws because, contrary to the Fund's offering circular and investment policies, CSFBIMC invested most of the Fund's net assets in risky derivative securities. Through the Fund's portfolio manager, CSFBIMC also inflated the values of certain securities in the Fund's investment portfolio, resulting in an NAV that was overstated. In addition, through the Fund's principal salesman, an employee of CSFBIMC (the "Salesman"), CSFBIMC distributed false and misleading marketing materials and the Salesman knowingly misrepresented, among other things, the size of the Fund, the number of investors in the Fund, and the content and composition of the Fund. The Salesman, without the authorization of CS First Boston ("First Boston"), also told an investor that its investment in the Fund would be guaranteed by First Boston, when in fact it was not. Finally, CSFBIMC failed reasonably to supervise with a view to preventing the portfolio manager's and the Salesman's violations of the federal securities laws, and did not have established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect the violations. C.The Formation Of The Offshore Fund During the Fall of 1993, CSFBIMC made plans to create, develop and market an unregistered offshore fund, eventually entitled the "CS First Boston Offshore Cash Reserve Fund," designed for sophisticated institutional investors. Unlike a traditional money market fund subject to Rule 2a-7 under the Investment Company Act of 1940, the original concept of the Fund was to be an offshore, near money market fund with an enhanced yield, which would be obtained by investing in instruments with a longer weighted average maturity than the 90-day weighted average maturity required for Rule 2a-7 money market funds. CSFBIMC's internal plan was to have the Fund's securities portfolio consist of approximately 70% money market instruments and 30% securities with an average duration of approximately two years, with most of the longer-term portion of the portfolio invested in structured rate notes ("SRNs"),[3] which can be, and in this case were, volatile derivative securities. CSFBIMC prepared an offering circular, dated December 15, 1993, for the Offshore Fund. The initial offering circular (the first of three for the Fund) did not contain any disclosure about investments in SRNs, but disclosed the following investment objective: "The Fund's investment objective is to seek a high level of current income, consistent with the preservation of capital and the maintenance of liquidity through investment principally in money market instruments and fixed income securities."[4] The offering circular also represented that "the Fund will normally attempt to maintain a Net Asset Value per Share that when rounded to the nearest whole cent will equal $1.00." D.CSFBIMC's Misrepresentations and Omissions In December 1993, as final plans for launching the Fund were being made, the Salesman solicited an outside investor (the "Investor") to invest in the Fund and provide some of the "seed capital" needed to get the Fund started. The Salesman told the Investor that First Boston would be contributing $100-150 million of its own money to the Fund and that there were other institutional clients already invested in the Fund. The Salesman also told the Investor that First Boston would guarantee the Investor at least a 4% return through the end of January 1994 (a rate that was substantially higher than then-current domestic money market rates) and that the Investor's principal was not at risk because any losses sustained by the Fund would be covered by First Boston. The Investor invested $300 million in the Fund on January 4, 1994. Contrary to the Salesman's representations, there were no other non-First Boston affiliated investors in the Fund, and First Boston itself invested only $5 million in the Fund. The Salesman continued this deception throughout January and February 1994. To induce the Investor to keep its original $300 million in the Fund and to make additional investments, the Salesman told the Investor that it would receive an above-market interest rate through the end of February. The Salesman also reiterated to the Investor on several occasions that First Boston would guarantee the Investor's investment in the Fund. By early February 1994, the Investor invested an additional $550 million in the Fund, bringing its total investment to $850 million. While the Salesman was deceiving the Investor, the Fund's portfolio manager (the "Portfolio Manager"), also an employee of CSFBIMC, embarked on a risky and unauthorized investment strategy that was inconsistent with the Fund's offering circular and investment policies. Rather than use the initial $300 million invested by the Investor to build a portfolio similar to the 70/30 model portfolio, the Portfolio Manager used virtually all of the money to buy volatile SRNs.[5] Also, using reverse repurchase agreements, the Portfolio Manager leveraged the Fund to buy additional risky securities. By January 27, 1994, the Fund was leveraged by $255 million, and the SRNs and other longer duration securities totaled $451 million (or approximately 150% of the Fund's contributed capital). During February 1994, after the Investor invested the additional $550 million in the Offshore Fund, approximately 58% of the Fund's net assets was invested in SRNs. During the relevant time, CSFBIMC failed reasonably to monitor the Portfolio Manager's investment activities, including whether his transactions were consistent with the Fund's offering circular and investment policies. Moreover, the firm did not have established procedures, and a system for applying such procedures, which would reasonably be expected to prevent and detect violations. E.The Misleading Marketing Materials During December 1993 through February 1994, CSFBIMC distributed to the Investor and other clients certain marketing materials that misrepresented, among other things, the size of the Fund, the number of investors in the Fund, and the content and composition of the Fund. These materials included pie graphs, portfolio charts, correspondence and offering circulars. Except for the offering circulars, none of the marketing materials were approved by CSFBIMC prior to distribution, in violation of CSFBIMC's policies. CSFBIMC had insufficient procedures in place to ensure that the marketing materials were reviewed and approved prior to distribution and to otherwise ensure that the marketing materials were accurate. F.CSFBIMC's Mispricing Of The SRNs In December 1993, CSFBIMC hired an administrator for the Offshore Fund. However, because the administrator did not have the ability to price the SRNs owned by the Fund, CSFBIMC decided that the Portfolio Manager would be responsible for doing so. Although the offering circular represented that the securities would be priced by independent dealers, many of the prices were determined by the Portfolio Manager without the aid of any independent pricing mechanism. As set forth below, his estimated values were deliberately inflated, causing the Fund's NAV to be overstated. On January 10, 1994, the Portfolio Manager received a telephone call from the administrator notifying him that the prices that he had provided to them resulted in an NAV that was less than $1.00 per share. Without consulting his supervisors or anyone else at CSFBIMC, the Portfolio Manager told the administrator to change the prices of four of the SRNs, which resulted in a recalculated NAV of $1.00. A few days later, CSFBIMC management learned about the NAV break from the administrator. CSFBIMC immediately conducted an internal review and prepared a memorandum summarizing the findings. However, nothing was done to change the way the securities owned by the Fund were priced.[6] **FOOTNOTES** [1]:In determining to accept the Offer of Settlement, the Commission considered the remedial acts promptly undertaken by CSFBIMC and the cooperation it afforded the Commission staff. [2]:The findings herein are made pursuant to CSFBIMC's Offer of Settlement and are not binding on any other person or entity in this or any other proceeding. [3]:SRNs are over-the-counter securities, the terms of which are negotiated by the dealer (usually a bank or securities firm) and the purchaser. SRNs generally commit the dealer to provide a return linked to one or more desired interest rates, currencies or other assets. While the payment of principal and interest to the purchaser typically is guaranteed by the dealer, the amount of such payments can fluctuate, depending on the terms of the SRN. [4]:The second offering circular, dated January 24, 1994, disclosed that the Fund could invest in SRNs, but failed to disclose the degree of risk to which the Fund was exposed as a result of the Fund's significant position in these securities. [5]:The SRNs purchased by the Portfolio Manager, most of which were linked to one or more foreign interest rates, were dollar denominated and principally protected (i.e., the dealers were obligated to repay the par amount of the SRNs at maturity). However, many of the SRNs were inverse floaters that had coupon rates that could reset to zero if the interest rate or rates to which they were linked rose above certain predetermined levels. As set forth below, United States and world interest rates increased rapidly during early 1994, causing a substantial decline in the value of the SRNs purchased by the Portfolio Manager. [6]:The only new procedure adopted by CSFBIMC was that it instructed the administrator to contact certain individuals other than the Portfolio Manager if the NAV broke $1.00 again, and it made those individuals responsible for determining whether it was appropriate to reprice the portfolio. The Portfolio Manager continued to price the portfolio himself without the aid of any independent pricing mechanism. Shortly thereafter, the Portfolio Manager stopped calling independent dealers to get price quotes for the SRNs and, instead, began providing the administrator with his own "off the cuff" estimates of their values. The Portfolio Manager's estimates changed very little from day to day -- thus keeping the NAV stable -- even though the bond market was in turmoil. On February 4, 1994, after approximately three years of generally declining rates, the Federal Reserve increased the Fed Funds rate from 3% to 3.25%. This action by the Federal Reserve caused a general climb in United States and world interest rates during February 1994, and those increases caused a decline in the value of the Fund's portfolio, with some of the SRNs on the verge of becoming non-accruing by February 24. However, that decline was not reflected in the portfolio's NAV, as priced by the Portfolio Manager. On February 24, one of the Portfolio Manager's colleagues obtained a copy of the Fund's portfolio spreadsheet and noticed a pricing discrepancy. CSFBIMC then reassigned the pricing responsibility to another employee, who obtained price indications for all of the Fund's securities on March 2, at which time the portfolio was valued at an NAV of $.9727, or a net loss of approximately $24 million. IV. OPINION 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. 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. CSFBIMC willfully violated each of the foregoing antifraud provisions.[7] The Portfolio Manager's excessive purchase of SRNs rendered the Offshore Fund's offering circular materially false and misleading. The Salesman distributed materially false and misleading marketing materials relating to the Offshore Fund and knowingly misrepresented, among other things, the size of the Fund, the number of investors in the Fund, and the content and composition of the Fund. He also told the Fund's sole outside investor that its investment in the Fund would be guaranteed by First Boston, when in fact it was not. Pursuant to Section 203(e)(6) of the Advisers Act, the Commission is authorized to impose sanctions on an investment adviser for failure reasonably to supervise, with a view toward preventing violations, any person who violates the federal securities laws, if that person is subject to the adviser's supervision. CSFBIMC lacked adequate procedures to ensure that marketing materials distributed by the Salesman and the Salesman's oral representations did not mislead or make misrepresentations to investors or potential investors. CSFBIMC also lacked adequate procedures to ensure that the Portfolio Manager complied with the Fund's investment policies. Even after becoming aware of the NAV break in January 1994, which might have led the firm to discover the Portfolio Manager's improper pricing of SRNs, CSFBIMC did not review his practices until late February 1994. Accordingly, CSFBIMC failed reasonably to supervise the Salesman and the Portfolio Manager. V. FINDINGS Based on the above, the Commission finds that CSFBIMC willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Advisers Act, and that CSFBIMC failed reasonably to supervise with a view to preventing its employees' violations of the federal securities laws. **FOOTNOTES** [7]:In applying the term "willful" in Commission administrative proceedings instituted pursuant to Sections 15(b), 15B, 15C, 17A, 19(h) and 21B of the Exchange Act, Section 9 of the Investment Company Act of 1940, and Section 203 of the Advisers Act, the Commission evaluates on a case-by-case basis whether the respondent knew or reasonably should have known under the particular facts and circumstances that its conduct was improper. In this case, as in all Commission administrative proceedings charging a willful violation under these statutory provisions, the Commission applies this standard to persons -- specifically, securities industry professionals -- who are directly subject to Commission jurisdiction and who have a responsibility to understand their duties to the investing public and to comply with the applicable rules and regulations which govern their behavior. VI. ORDER Accordingly, IT IS HEREBY ORDERED that, A.CSFBIMC be, and hereby is, censured; B.CSFBIMC cease and desist from committing or causing any violations of, and committing or causing any future violations of, Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Advisers Act; and C.CSFBIMC pay a civil money penalty of $500,000 within ten (10) days of the entry of the Order, by U.S. Postal money order, certified check, bank cashier's check, or bank money order, made payable to the Securities and Exchange Commission and shall be hand-delivered or mailed to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312, under cover of a letter that identifies the respondent and the name and file number of this proceeding. A copy of the cover letter and of the form of payment shall be simultaneously transmitted to counsel for the Commission. By the Commission. _________________________ Jonathan G. Katz Secretary