Ethical Conduct. Charles Zandford was a securities broker for Prudential Securities, Inc, in Annapolis, Maryland. In 1987, he persuaded William Wood, an elderly man in poor health, to open a joint investment account for himself and his mentally retarded

Question

daughter. The stated investment objectives for the account were "safety of principal and income." The Woods gave Zandford discretion to manage their account and to engage in transactions for their benefit without prior approval. Relying on Zandford's promise to "conservatively invest" their money, the Woods entrusted him with $419,255. Zandford immediately began writing checks to himself on the account. Paying the checks required selling securities in the account. Before William's death in 1991, all of the money was gone. Zandford was convicted of wire fraud and sentenced to more than four years in prison. The Securities and Exchange Commission filed a suit in a federal district court against Zandford, alleging in part misappropriation of $343,000 of the Woods' securities and seeking disgorgement of that amount. Was Zandford's conduct sufficiently "in connection with a sale or purchase of securities" to constitute a violation of securities law? Did Zandford behave ethically? What effect might such conduct have on third parties? Discuss.

Answer 1

Ethical conduct
The court entered a judgment in part ordering Zandford to disgorge $343,000 in "ill-gotten gains." On Zandford's appeal, the U.S. Court of Appeals for the Fourth Circuit reversed this judgment. The SEC appealed to the United States Supreme Court, which reversed this decision and remanded the case, holding that Zandford's conduct was sufficiently "in connection with the purchase or sale of any security" to violate securities law. The Court explained that "[t]his is not a case in which, after a lawful transaction had been consummated, a broker decided to steal the proceeds and did so. Nor is it a case in which a thief simply invested the proceeds of a routine conversion in the stock market. Rather, respondent's fraud coincided with the sales themselves. . . . [E]ach sale was made to further respondent's fraudulent scheme; each was deceptive because it was neither authorized by, nor disclosed to, the Woods. With regard to the sales of shares in the Woods' mutual fund, respondent initiated these transactions by writing a check to himself from that account, knowing that redeeming the check would require the sale of securities." As to others, respondent's fraud represents [a great] threat to investor confidence . . . . Not only does such a fraud prevent investors from trusting that their brokers are executing transactions for their benefit, but it undermines the value of a discretionary account like that held by the Woods. The benefit of a discretionary account is that it enables individuals, like the Woods, who lack the time, capacity, or know-how to supervise investment decisions, to delegate authority to a broker who will make decisions in their best interests without prior approval. If such individuals cannot rely on a broker to exercise that discretion for their benefit, then the account loses its added value."