SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 34-40646 / November 9, 1998 Admin. Proc. File No. 3-9212 ________________________________________________ : In the Matter of the Application of : : SCATTERED CORPORATION : and : LEON AARON GREENBLATT, III : ANDREW ALVIN JAHELKA : RICHARD OWEN NICHOLS : LAURA BRYANT : : For Review of Action Taken by the : : THE CHICAGO STOCK EXCHANGE, INC. : ________________________________________________: OPINION OF THE COMMISSION REGISTERED SECURITIES ASSOCIATION -- REVIEW OF DISCIPLINARY PROCEEDINGS Market-making firm, its principals, and floor nominee were found, after disciplinary proceeding, to have violated antifraud, market manipulation, and books and recordkeeping provisions of the Exchange Act, Exchange Act rules, and stock exchange rules. Held, proceeding set aside because fairness of proceeding was impaired when outside private law firm simultaneously provided legal counsel to the exchange hearing examiner and to the exchange in litigation against Applicants based on the same facts. APPEARANCES: C. Philip Curley and Judi A. Lamble, of Robinson Curley & Clayton, P.C., for Scattered Corporation, Andrew A. Jahelka, and Richard O. Nichols. Leland W. Hutchinson, Jr. and Elizabeth D. Sharp, of Freeborn & Partners, for Leon A. Greenblatt, III. Lawrence R. Samuels, Jacquelyn F. Kidder, and Patricia K. Smoots, of Ross & Hardies, for Laura A. Bryant. Douglas J. Hagerman and Carolyn Knecht, of Foley & Lardner, Brian D. Roche and Michael J. Kaufman, of Sachnoff & Weaver, Ltd., and Daniel J. Liberti, of The Chicago Stock Exchange, Inc., for The Chicago Stock Exchange, Inc. Appeal filed: January 8, 1997 Last brief received: May 8, 1997 I. Scattered Corporation ("Scattered"), an Illinois corporation and former member of The Chicago Stock Exchange, Inc. (the "CHX"); Leon A. Greenblatt III, Scattered's secretary and 50% owner; Andrew A. Jahelka, Scattered's president and 30% owner; Richard O. Nichols, Scattered's treasurer and 20% owner; and Laura Bryant, registered CHX market maker and Scattered's nominee on the CHX trading floor, (hereinafter collectively referred to as the "Applicants") appeal from disciplinary action by the CHX. The CHX found that the Applicants sold short shares of LTV Corporation ("LTV") common stock ("Old LTV Stock"), manipulated the price of Old LTV Stock, and employed deceptive devices, in violation of the Securities Exchange Act of 1934 ("Exchange Act") and The Chicago Stock Exchange Rules ("CHX Rules"). [1] The CHX also found that the Applicants violated CHX Rules in that they abused their positions as registered market makers. Further, the CHX found that the Applicants, other than Bryant, excessively traded Old LTV Stock, violated various books and recordkeeping provisions of the Exchange Act and CHX Rules in connection with Scattered's LTV trading and failed to provide information to the CHX during its investigation. The CHX also found that the Applicants, other than Nichols and Bryant, manipulated the stock price of American Healthcare Management, Inc. ("AHI") common stock, in violation of the Exchange Act and CHX Rules. The CHX expelled Scattered from CHX membership and fined it $3.5 million. It permanently barred Greenblatt from association with any CHX member and fined him $1.3 million. The CHX suspended Jahelka, Nichols and Bryant from association with any CHX member for two years, one year, and one year, respectively, and fined them individually $750,000, $580,000, and $350,000, respectively. The CHX also fined Scattered, Greenblatt, Jahelka, and Nichols, jointly and severally, $300,000; and separately fined Greenblatt, Jahelka, and Nichols, jointly and severally, $50,000. The CHX also ordered disgorgement of one-half of the Applicants' trading profits. We base our findings on an independent review of the record. II. This case arises out of the Applicants' massive short selling of Old LTV Stock during LTV's bankruptcy reorganization proceedings, which resulted in a plethora of litigation. In much of this litigation, the Applicants and the CHX participated in a variety of capacities. The CHX found itself playing multiple roles in the litigation concerning the applicants, thereby creating the possibility that the CHX's impartiality in adjudicating the Applicants' case could be affected. This issue became a focal point in the disciplinary proceeding. The Applicants' Trading In Old LTV Stock In 1986, LTV filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. In February 1993, LTV filed a plan of reorganization (the "Plan") with the U.S. Bankruptcy Court for the Southern District of New York, which was approved on May 27, 1993. Pursuant to the Plan, Old LTV Stock would cease to trade on June 28, 1993. On that date, owners of Old LTV Stock would receive one warrant to purchase 1.08 shares of common stock in the reorganized LTV ("New LTV Stock") in exchange for every 100 shares of Old LTV Stock held. When the Plan was announced, Old LTV Stock was trading for more than 30 cents. The Plan included an estimate that, upon implementation of the Plan, shares of New LTV Stock would be worth approximately 3 or 4 cents. New LTV stock would begin trading on June 29, 1993. The Applicants sought to capitalize on investor confusion about the true value of Old LTV Stock during the period leading up to June 28, 1993, the date the LTV reorganization would become final. They assumed most investors would not read or understand the actual valuation of Old LTV Stock prescribed in the Plan and that, therefore, demand for Old LTV Stock would be high, even though its value after the reorganization would be almost nothing. After the Plan was filed, but prior to the Bankruptcy Court's approval of the Plan, the Applicants began selling Old LTV Stock short on both the CHX and on the New York Stock Exchange, Inc., anticipating that the price of Old LTV Stock would fall. Under this Commission's short sale rules, a short seller must deliver the stock sold short if and when demanded by the purchaser. From February 26, 1993 to June 28, 1993 (the "Trading Period"), the Applicants sold short approximately 170 million shares of Old LTV Stock. At that time, there were only approximately 122 million shares of Old LTV Stock outstanding. The Applicants planned, in the event purchasers demanded delivery of the Old LTV Stock that had been sold short, to deliver "when, as, and if issued" warrants ("When-issued Warrants"). The When- issued Warrants would entitle the holder to exchange Old LTV Stock for New LTV Stock six months after the implementation of the Plan. They were substantially the same as the warrants issued pursuant to the LTV reorganization plan. Buyers were not required to accept When-issued Warrants in lieu of Old LTV Stock, although by the time the When-issued Warrants were to be issued Old LTV Stock would no longer be trading. As an alternative, buyers could "buy-in," i.e., make covering purchases of LTV shares in the open market and charge the difference to Scattered. [2] Buyers would have an economic incentive to demand delivery of stock or buy-in only if the market price of Old LTV Stock was higher than the short position price specified in their contract with Scattered. The Applicants gambled, however, that most purchasers of Old LTV Stock would not demand delivery of their shares, or "buy-in" if Scattered could not deliver Old LTV Stock, because the price of Old LTV Stock would continue to fall throughout the Trading Period. Had the Applicants been required either to deliver shares or to make good on "buy-ins," they would have had to make a capital outlay that could have bankrupted the firm. This possibility alarmed the CHX and its subsidiaries the Midwest Clearing Corporation (the "MCC") and the Midwest Securities Trust Corporation (the "MSTC") because it placed the MCC and the MSTC at risk of insolvency. As Scattered's clearing firm at that time, the MCC was obligated to complete Scattered's trades in the event of its default. The MSTC was the guarantor of the MCC's trades and would be required to pay out any losses on Scattered's trades from its Participant Fund. Consequently, both the CHX and the MCC demanded and received assurances from the Applicants regarding the firm's ability to meet its obligations in the event of buy-ins. The MCC withheld Scattered's accrued commissions and profits, totalling several million dollars, to cover any potential exposure resulting from a Scattered bankruptcy. The MSTC also required Scattered to make additional contributions to the MSTC's Participant Fund and withheld Scattered's settlement credits in order to ensure that the LTV short positions could be covered in the event of Scattered's default. Because the Applicants had assessed the market for Old LTV Stock accurately, they avoided having to deliver shares prior to the end of the Trading Period, and netted approximately $27 million in short-selling profits. Numerous investors on the buy side of Scattered's trading incurred substantial losses. Litigation Arising Out of Trading in Old LTV Stock Soon after the trading in Old LTV Stock ceased, several groups of LTV shareholders who had purchased Old LTV Stock during the Trading Period, led by the market-making firm of Sullivan & Long, filed complaints against Scattered, Greenblatt, Jahelka, and Nichols. These cases were consolidated in the United States District Court for the Northern District of Illinois in a class action complaint (the "Class Complaint"). The Class Complaint alleged that Scattered and its principals committed securities fraud in violation of Exchange Act Section 10(b) and Rule 10b-5, sold unregistered securities in violation of Section 12(1) of the Securities Act of 1933, obtained unjust enrichment, and violated the Racketeer Influenced and Corrupt Organizations Act. It named the CHX and the MCC as third-party defendants, seeking to impose a constructive trust on Scattered's LTV trading profits. On March 29, 1994, the district court dismissed the Class Complaint with prejudice. [3] The court held that the plaintiffs had failed to allege any set of facts that would entitle them to relief. The court concluded that Scattered had neither made misleading statements nor engaged in market manipulation as alleged in the Class Complaint. Instead, the court found that Scattered had injected accurate information into the market, bringing the price of Old LTV Stock into line with its actual value. The United States Court of Appeals for the Seventh Circuit affirmed. [4] Concurrently, other related litigation ensued between the Applicants, on the one hand, and the CHX, the MCC, the MSTC, and their personnel and officers on the other. During the last week of the Trading Period in June 1993, the CHX sought to impose new "cash delivery" rules in order to prevent Scattered from continuing to sell Old LTV stock short. In response, Scattered sought, in Illinois Chancery Court, an order temporarily restraining the CHX and the MCC from imposing the new "cash delivery" rules. After the requested order was denied, Scattered and Greenblatt initiated a suit in Illinois Circuit Court seeking damages against the MCC and the MSTC. In July 1993, the MCC initiated disciplinary proceedings against Scattered and Greenblatt, which resulted in the denial of Scattered's access to MCC and MSTC clearing facilities. The MCC accused Scattered and Greenblatt of falsifying certain documents when applying for clearing privileges through the MCC the previous year. Although the MCC's allegations did not relate to Scattered's LTV trading, these same allegations of document falsification appeared in the complaint in the instant CHX disciplinary proceeding and were among the findings of violation against these Applicants. Another suit brought by Scattered and Bryant in the United States District Court for the Northern District of Illinois sought to bar the CHX from requiring that Scattered open a special account for market makers, a "V account," with the MCC. This complaint was dismissed. [5] In 1994, Scattered and Greenblatt also sued the CHX and its Board of Directors and other CHX personnel in Delaware and Illinois for allegedly misusing CHX member funds. After several years, these cases were also dismissed. [6] Next, in June 1994, the CHX expelled Greenblatt from its trading floor for allegedly acting in an abusive and disruptive manner. We granted Greenblatt's motion to vacate the CHX's action and remanded the matter for further development of the record. [7] Foley & Lardner's Representation Of The CHX In July 1993, the CHX dissolved its in-house legal department and contracted with the law firm of Foley & Lardner ("Foley") to perform the duties of general counsel and all of CHX's legal work. One of Foley's partners, George Simon, acted as the CHX's general counsel and former CHX general counsel Craig Long became a Foley partner and an officer of the CHX. In virtually all of the litigation discussed above, the CHX, the MCC, the MSTC, and associated individuals were represented by Foley. [8] During a meeting among CHX, MCC, and MSTC personnel on July 9, 1993, Simon and Long initiated the CHX's investigation into whether Scattered had violated any CHX rules during the Trading Period. Subsequently, in August 1993, Simon corresponded with attorneys at the Federal Reserve Board to inquire whether Scattered's arbitrage strategy had violated Federal Reserve System margin requirements. Simon also appeared as counsel or as a witness in one or more of the aforementioned proceedings between the Applicants and the CHX and related entities and persons. Later in 1993, Simon, on behalf of the CHX, retained the law firm Sachnoff & Weaver ("Sachnoff") to represent the CHX Division of Market Regulation ("Market Regulation") in pursuing the investigation into possible wrongdoing by the Applicants in connection with LTV trading. Sachnoff's legal fees were reviewed and approved by Foley prior to being submitted to the CHX for payment. Market Regulation's investigation resulted in the institution of the instant disciplinary proceeding in late November 1993. The allegations in Market Regulation's proceeding substantially reiterated, among other things, the allegations in the Sullivan & Long litigation that Applicants had manipulated the market for Old LTV stock. Once the proceeding was instituted, Simon, on behalf of the CHX, hired Gordon L. Nash (an attorney not associated with Foley) to serve as the CHX Hearing Examiner. In February 1994, J. Scott Early became a Foley partner. Shortly thereafter, Simon appointed him to assist the Hearing Examiner. Prior to this appointment, however, Simon had directed Early to review various files concerning Scattered, including files relating to the ongoing litigation matters between the CHX and the Applicants. Early billed only a brief amount of time to the review of these files, but it is not disputed that Early was not restricted in his ability to review Foley files relating to Scattered. On April 22, 1994, Foley implemented a formal screening mechanism to screen Early from other matters involving Scattered pending within Foley ("the Screen Agreement"). The Screen Agreement prohibited Simon, Long, John D. Lien, Dean M. Jeske, and J. Lynn Dennison (collectively, the "Screened Attorneys") [9] from "discussing with Scott Early or any other Foley attorneys who subsequently represent the hearing officer the substance of his representation of the hearing officer and/or the merits of the Scattered Disciplinary Proceeding." The Screened Attorneys were also restricted from access to Early's computer hardware and software and any files or documents associated with his representation of the Hearing Examiner. Early agreed that he would not discuss or share information obtained during his representation of the Hearing Examiner with the Screened Attorneys. The Screen Agreement was extremely limited in scope. The record indicates that at least five other Foley attorneys other than the Screened Attorneys worked on Scattered-related litigation. The Screen Agreement did not prohibit Early from accessing Applicant-related files other than those relating to the Scattered disciplinary matter, or prevent Early from obtaining remuneration from Foley's representation of the CHX. While it prevented the Screened Attorneys from discussing the Applicants' disciplinary proceeding with Early, the Screen Agreement did not prevent them from discussing with Early issues related to the ongoing litigation matters between the CHX and the Applicants. In June 1994, the Applicants sought to have Foley and Sachnoff disqualified from participating in the CHX disciplinary proceedings due to: (1) Foley's representation of the CHX and the MCC in the Class Complaint litigation and other proceedings involving Scattered, (2) Early's participation in the Scattered disciplinary proceeding, and (3) Sachnoff's relationship with Foley. Market Regulation opposed Applicants' efforts in pleadings submitted by Sachnoff. In addition, however, Foley attorney James M. Caragher (not one of the Screened Attorneys) filed two briefs on behalf of Foley opposing the disqualification motions. Scattered objected to the filing of these briefs by Foley on the grounds that the firm was not a party to the disciplinary proceeding and that Caragher's partner, Early, would be assisting the Hearing Examiner in ruling on Foley's briefs. In October 1994, the Hearing Examiner denied the disqualification motions. The CHX Judgment On June 22, 1995, the Hearing Examiner issued a Proposed Written Judgment and Determination (the "Proposed Judgment") finding substantially all of the violations alleged in the CHX's complaint against Scattered. The Proposed Judgment found that the CHX disciplinary proceedings were not controlled by the Seventh Circuit's decision in Sullivan & Long finding that no manipulation had occurred, and imposed sanctions. In accordance with CHX rules, the Proposed Judgment was submitted to CHX president Erwin Schulze. [10] Schulze subsequently adopted the Proposed Judgment, but increased the sanctions by ordering the Applicants to disgorge "half of the moneys received" to a fund payable to persons harmed by their actions. The Applicants appealed the judgment to the CHX Judiciary Committee. On July 17, 1996, the CHX Judiciary Committee affirmed the Hearing Examiner's decision, as adopted by the CHX president, although it modified the rate of interest applied to the judgment. Initially, Foley acted as counsel to the CHX Judiciary Committee. The Applicants again raised their conflict of interest claims. In response, the CHX Judiciary Committee retained Baker & McKenzie to represent it and then denied Applicants' motions as moot. The Applicants appealed to the CHX Executive Committee and renewed their arguments that Foley should have been disqualified from acting as counsel for the Hearing Examiner. The CHX Executive Committee, represented by Kirkland & Ellis, denied the motions and affirmed the judgment on December 31, 1996. Scattered then appealed the matter to this Commission. III. This case raises complex issues on the merits. However, we must first examine whether the CHX's disciplinary proceeding was fair, involving as it did Foley's simultaneous representation of the CHX as counsel to the Hearing Examiner adjudicating the Applicants' alleged violations and as counsel in various ongoing litigation matters involving these same Applicants and the same and related conduct. We conclude that the proceeding was not fair, and that subsequent review by the CHX president, Judiciary and Executive Committees did not cure that unfairness. In light of this determination, we do not reach the other issues in this case. Fairness Standards for SRO Disciplinary Proceedings Disciplinary proceedings against members of an exchange and their associated persons are governed by Section 6(b)(7) of the Exchange Act, which provides that an exchange may not be registered with this Commission unless its rules "provide a fair procedure for the disciplining of members and persons associated with members[.]" [11] Section 19(e)(1)(A) of the Exchange Act governs our review of disciplinary actions taken by self- regulatory organizations ("SROs"), including exchanges. [12] This section provides that, in reviewing an SRO proceeding, we shall determine whether the member or person engaged in the conduct found by the SRO, whether the proceedings were conducted in accordance with the rules of the SRO, and whether the rules were applied in a manner consistent with the purposes of the Exchange Act. In this connection, we have indicated that a principle governing all SRO disciplinary proceedings is fairness. [13] Our past cases reviewing the fairness of SRO proceedings have focussed on the fairness of the SRO's internal procedures, including organizational structure as it affects the fairness and impartiality of the course of the proceeding. [14] SRO rules, as well as the rules of many government agencies, by necessity address the entity's dual role in its disciplinary program as enforcer and adjudicator. SROs (and government agencies) routinely perform such dual roles, and provide through their internal structures and procedures protection against the harms that may be caused by potential conflicts. For example, litigation and adjudicatory functions are typically handled by different offices within the entity or different staff with different reporting chains. [15] Such entities also protect against ex parte communications between parties and those involved in the decision-making process. [16] Where such separation of functions are not scrupulously observed, courts do not hesitate to stop an agency from proceeding. [17] Consistent with these principles, the CHX was responsible for assuring the fairness of its decisional process in this case. The CHX's responsibility was not diminished by its decision to delegate all legal functions to a general counsel who is not in its employ, but rather is a partner with an outside law firm. The CHX was then obliged to ensure that the law firm conducted its actions on behalf of the CHX in a way that did not affect the integrity and fairness of the disciplinary proceeding against the Applicants. Need for Safeguards in Delegating Conflicting Functions to Law Firm Since we have not previously been presented with a situation raising this issue, we have looked by analogy to the authorities governing the handling, by private law firms, of conflict-of- interest issues in the representation of multiple clients. We look primarily to both the American Bar Association's Model Rules of Professional Conduct ("Model Rules") and the American Law Institute Restatement (Third) of the Law: The Law Governing Lawyers ("Restatement"), rather than Illinois state law, for a national standard appropriate to a federal agency. [18] We note, however, that Illinois rules, and case law interpreting them, are consistent with the Model Rules and Restatement. While we recognize that, as relevant here, Foley only had one client (the CHX), the firm represented the CHX in its performance in different roles. Because those roles entailed fundamentally different objectives and interests, we believe the principles governing the propriety of a law firm's representation of multiple clients provide insight here. [19] The Model Rules instruct that attorneys within a single law firm cannot simultaneously represent adverse or conflicting interests, without appropriate safeguards. Rule 1.7(a) of the Model Rules provides that a lawyer shall not represent a client if the representation of that client will be directly adverse to another client, unless the lawyer reasonably believes the representation will not adversely affect the relationship with the other client and the client consents after disclosure. [20] Rule 1.7(b) of the Model Rules provides that a lawyer shall not represent a client if the representation of that client may be materially limited by the lawyer's responsibilities to another client or to a third person, or by the lawyer's own interests, unless the lawyer reasonably believes the representation will not be adversely affected and the client consents after disclosure. [21] The first question we must answer, then, is whether the CHX's various roles as litigant for which Foley provided representation conflicted with the CHX's role as adjudicator in this disciplinary proceeding, given that both the litigation and the disciplinary proceeding involved the same or related facts. We find that there was a conflict. In its role as adjudicator of the disciplinary proceeding, the CHX had to view the facts with an independent eye to assess whether or not a violation had occurred. In its role as litigant, on the other hand, the CHX took the position that the Applicants had engaged in fraudulent conduct in connection with their LTV trading. For example, months before Foley attorneys represented the CHX Hearing Examiner, Foley represented the CHX's subsidiary the MCC in litigation against the Applicants in the Illinois courts, in a dispute arising from the MCC's imposition of cash delivery rules. In the course of the litigation, the MCC took the position that the Applicants' LTV trading had violated the antifraud provisions of the federal securities laws and CHX rules. Moreover, Simon's correspondence with the Federal Reserve Board questioning the propriety of the Applicants' arbitrage activities and the ultimate referral of the investigation of the Applicants' conduct to Sachnoff & Weaver evidences participation by Foley in the preliminary stages of the prosecutorial efforts against Applicants. Finally, in the MCC disciplinary proceeding, Scattered and Greenblatt were charged with fraudulent conduct in connection with their application, over a year earlier, for clearing privileges on the MCC. The MCC was represented, in the appeal to its Board of Directors, by Foley. The same allegations against Applicants in these three proceedings resurfaced in the instant proceeding. We return to the Model Rules and the Restatement for further guidance as to the consequences of our finding that the CHX was represented by one law firm in its two conflicting roles. If one attorney within a law firm is prohibited from representing a particular client because the client's interests conflict with those of another client, all other attorneys in that firm are also prohibited from representing that client, unless there are appropriate safeguards. [22] Two concerns are addressed by such a prohibition. First, the law presumes that client confidences held by one attorney within a law firm cannot be shielded from another attorney within the same firm. [23] The resulting disqualification of a conflicted attorney presumed to have shared client confidences is called "imputed" or "vicarious" disqualification. [24] Under this doctrine, the potential for inadvertent sharing of confidences among lawyers is sufficient for triggering disqualification of a law firm; actual sharing of confidences need not be shown. [25] Second, representation of clients with conflicting interests raises the question whether the firm's representation lacks the unquestioned loyalty to its clients that the legal profession demands. [26] In such cases, courts must disqualify counsel to enforce the attorney's duty of absolute fidelity to her clients and to guard against the danger of inadvertent use of confidential information. [27] Where, as here, one of the adverse interests being represented is that of an adjudicator in a disciplinary proceeding, the harm inherent both in the possible sharing of confidential information and in divided loyalty is that the fairness of the proceeding may be impaired. In ruling on the fairness of agency proceedings, courts have held that the potential for bias can be shown where the decisionmaker had ex parte communications about the matter, or had, in a factually related case, taken an adversarial position against one of the parties. [28] Bias has also been found where the same attorney represents a party in litigation over certain conduct while, at the same time, advising an adjudicator in its decision in a case arising from the same conduct. [29] Under such circumstances, the commingling of adjudication and litigation functions creates the potential for bias. [30] Effectiveness of Measures Taken to Protect Against Bias Since the CHX had arranged for legal representation in all capacities by Foley, it was incumbent on the CHX to ensure that adequate safeguards were taken to protect against the impact of conflicting functions by the various Foley attorneys working on CHX matters. For insight, we turn again to the resolution of conflict issues in private law firms in situations where adverse interests are represented simultaneously or subsequently. The United States Court of Appeals for the Seventh Circuit has indicated that, once such a conflict is established, the next step is to determine whether the conflict can be cured by a screening mechanism adopted by the firm. [31] In examining the attempt to screen the adjudicatory function of the CHX in this case from other functions with which it was in conflict, we consider the elements of an effective screen: (1) the screened lawyer cannot participate in the matter giving rise to the conflict, (2) the screened lawyer cannot discuss the conflicted matter with any member of the firm, [32] (3) the screened lawyer must be able to represent through sworn testimony that he or she has not imparted any confidential information to the firm, and (4) the screened lawyer cannot have access to any files or documents relating to the conflicted matter. [33] In addition, courts have suggested that two other factors should also be considered: the screen must be implemented in a timely fashion, [34] and the screened lawyer cannot share in any of the fees from the matter creating the conflict. [35] Relevant authority also suggests that the possible effectiveness of a screen arrangement is severely undermined where the adverse representation is concurrent, rather than successive: In the first situation, the work is ongoing, papers are circulating, and the attorneys are actively going about their tasks, discussing, as people do, their everyday cares with their associates. By contrast, in the second situation, . . . [t]he other representation is over and done with -- documents relating to it are filed away, and the attorneys who worked on it are newly occupied with fresh business. [36] Even more of a danger is the potential in a concurrent representation of an improper division of the firm's loyalty. [37] We find that the screen Foley erected in April 1994 was ineffective. Although the Screen Agreement kept Early from communicating with the Screened Attorneys about the disciplinary proceedings, it did not prevent Early from communicating with other Foley attorneys not bound by the Screen Agreement (including Caragher, who filed Foley's response to the Applicants' disqualification motions in the disciplinary proceedings). The Screen Agreement did not separate Early from Foley files developed in the ongoing litigation matters with the Applicants. Also, the Screen Agreement did not prevent Early from participating in fees derived by Foley's representation of the CHX in its litigation with the Applicants. [38] We also find that the screen was not established in a timely fashion. Disciplinary charges against the Applicants were filed in late 1993; by that time, on behalf of the CHX, Foley had already filed motions to dismiss in the Sullivan & Long litigation, the MCC had concluded disciplinary proceedings against the Applicants, and the Applicants had commenced litigation in Illinois Chancery Court against the MCC and the MSTC. Foley played a role as counsel to the CHX, the MCC, and the MSTC in each of these legal proceedings. Foley did not implement the screen, however, until several weeks after Early was appointed in April 1994. We do not know whether any confidential information passed between Early and other Foley attorneys. There is no credible evidence in the record to support Applicants' claims that the Screen Agreement was breached. However, under the standards discussed above, such a showing is not necessary. We also find that, on the facts of this case, Foley's representation of the CHX in adverse postures resulted in the firm's loyalties being improperly divided. Foley's representation of the CHX in other fact-related litigation involving Applicants was extensive both in scope and in potential remuneration for the firm. For example, Foley's involvement in the litigation that conflicted with Foley's role as advisor to the Hearing Examiner gave the firm an interest in the outcome of the disciplinary hearing. Further, Foley had conducted the preliminary investigation into whether violations of law had occurred as a result of Scattered's LTV trading. The result of this preliminary investigation was the referral to Sachnoff & Weaver to develop the investigation and prosecute violations, if necessary. Thus, Foley, in representing the CHX in its role as investigator of possible violations, had already developed an interest in pursuing the matter against the Applicants. The CHX's Contentions In defense of the fairness of its disciplinary proceeding, the CHX contends first that "the fact that [Foley] lawyers represented the Exchange in other litigation may have made those lawyers adverse to Scattered in that other litigation . . . [but] did not render [Foley] the investigator and prosecutor of the disciplinary charges." Foley represented the CHX in its role as adjudicator of the Applicants. Foley's representation of the CHX in matters that were "adverse to Scattered" involved the same conduct at issue in the disciplinary proceedings. Thus, Foley, on behalf of the CHX, was involved in roles in conflict with the CHX's role as adjudicator of the Applicants. The CHX next claims that the independence of its Division of Market Regulation in the investigation and prosecution of the disciplinary case against the Applicants was maintained by the hiring of outside counsel, the Sachnoff firm, to represent Market Regulation. This argument is similarly inapposite. The independence of the adjudicator, and counsel advising him, is the issue here. In any event, as our analysis above demonstrates, the hiring of Sachnoff occurred after Foley had already taken steps in the investigative process against Scattered. Further, Foley's role in reviewing and approving Sachnoff's bills to the CHX placed Foley in a position to oversee Sachnoff in its prosecutorial role while Foley was advising the adjudicator. The CHX contends that, "even if . . . Simon and other [Foley] lawyers participated in the investigation or prosecution of this disciplinary proceeding, there is no evidence that these [Foley] lawyers participated in any way in the adjudication of this matter." The CHX claims that Early did not have improper contacts with Sachnoff attorneys or other screened and non- screened Foley attorneys working on Scattered litigation matters. The CHX also argues that the Hearing Examiner explicitly found, when ruling on the Applicants' disqualification motions, that, regardless of the scope and timing of the screen, there was no improper communication between Early and any other Foley attorney representing CHX. The CHX contends that the Applicants are incorrect in their assertion that the Hearing Examiner did not rule objectively on their disqualification motions. The CHX offers an affidavit by Early in support of these claims. The affidavit, however, suffers from some of the same deficiencies as does the Screen Agreement. Early declares that he has not discussed his representation of the Hearing Examiner or the Scattered disciplinary proceeding with any other Foley attorney or any CHX staff. However, his declaration does not address discussions that may have occurred concerning Foley's other representation of the CHX, the MCC, and the MSTC in litigation matters adverse to the Applicants. Nor does it address Early's access to Foley files. More to the point, however, as our analysis above demonstrates, actual breaches of confidentiality need not be shown. That there was no adequate protection against such possible breaches is sufficient to impair the fairness of the proceeding against the Applicants. Moreover, Early's independence was further compromised by his financial interest in Foley's earnings from CHX as a client, and by the submission to the Hearing Examiner of a brief authored by one of Early's partners at Foley. [39] Finally, the CHX posits that due process permits the combination of investigative, prosecutorial and adjudicatory functions within the same agency. [40] We have no quarrel with this general proposition. As we discussed earlier, many administrative agencies and SROs are compelled to perform such combinations of functions. Compliance with fundamental requirements of fairness, however, demands that adequate precautions be taken against the possibilities for prejudice that may inhere in such an administrative structure. For the reasons discussed above, we do not believe adequate precautions were taken here. IV. We find that the conflicts of interest that entangled those providing the CHX with legal representation deprived the Applicants of a fair proceeding before a fair tribunal. [41] We find that the conflicts, and resultant potential for bias, so infected the whole proceeding that all of the allegations, including those relating to American Healthcare Management Inc. (otherwise not implicated in the various conflicting litigation involving the CHX and Applicants), must be dismissed. Accordingly, we set aside the findings of violation and sanctions imposed by the Chicago Stock Exchange concerning the Applicants. An appropriate order will issue. [42] By the Commission (Chairman LEVITT and Commissioners JOHNSON, CAREY, and UNGER); Commissioner HUNT not participating. Jonathan G. Katz Secretary **ENDNOTES** [1]: Specifically, the CHX found violations of Section 10(a), 15 U.S.C. §78j(a), and Rule 10a-1 thereunder (17 C.F.R. §240.10a-1); and of Sections 9(a)(2), 9(a)(4), and 10(b), 15 U.S.C. §§78i(a)(2), 78i(a)(4) and 78j(b), and Rule 10b-5 (17 C.F.R. §240.10b-5) thereunder; and various CHX rules. [2]:See Exchange Act Rule 10a-2(a); United States v. Naftalin, 441 U.S. 768, 771 n.2 (1979). [3]: Scattered Corporation Securities Litigation, 844 F. Supp. 416, 419-21 (N.D. Ill. 1994). [4]:Sullivan & Long, et al. v. Scattered Corporation, 47 F.3d 857 (7th Cir.) cert. denied sub nom. Harkins v. Scattered Corp., 516 U.S. 818 (1995). [5]:See Scattered Corp. v. The Chicago Stock Exchange, Inc., No. 95-C-3598 (N.D. Ill. 1995), Fed. Sec. L. Rep. (CCH) ¶98,986, aff'd., 98 F.3d 1004 (7th Cir. 1996). A related action involved Scattered's appeal to this Commission of the CHX's failure to process Scattered's application for registration as a market maker. CHX had refused to process the application until Scattered opened a 'V account'. We dismissed as moot. Scattered Corporation, Exchange Act Release No. 37249 (May 29, 1996), 62 SEC Docket 12. [6]:See Scattered Corp. v. The Chicago Stock Exchange, Inc. et al., Civil Action No. 14010, 1996 Del. Ch. LEXIS 79 (Del. Ct. Ch. 1996); Scattered Corp. and Laura Bryant v. Allan Bretzer, No. 95 L 10788 (Cir. Ct., Cook County motion for stay filed September 11, 1995). [7]:Leon A. Greenblatt, III, Exchange Act Release No. 34953 (November 9, 1994), 57 SEC Docket 2977. [8]:In the Delaware litigation, the CHX was represented by other counsel. The CHX directors and employees were represented by local counsel assisted by attorneys from Foley. Compare, however, Scattered Corp. v. The Chicago Stock Exchange, Inc., et al., Civil Action No. 14010, 1996 Del. Ch. LEXIS 79 (July 12, 1996), with Scattered Corp. v. The Chicago Stock Exchange, et al., Civil Action No. 14010, 1997 Del. Ch. LEXIS 50 (April 7, 1997) (Foley assisted local counsel for the CHX directors and employees before the Delaware lower court, and assisted local counsel for the CHX on remand from the Delaware Supreme Court). It is unclear from the record whether, or in what capacity, Foley was involved in the parallel Illinois state court litigation. [9]:The latter three represented the CHX in the Class Complaint litigation. [10]:Chicago Stock Exchange Rule 5(b). [11]:15 U.S.C. §78f(b)(7). [12]:15 U.S.C. §78s(e)(1)(A). [13]:See U.S. Associates, Inc., 51 S.E.C. 805, 810 (1993). [14]:See, e.g., Datek Securities Corp., 51 S.E.C. 542, 545- 46 (1993). There, we vacated a decision by the National Association of Securities Dealers ("NASD") because the hearing panel included two members whose firms had an interest in the outcome of the proceeding. We determined that the potential for bias on the part of these panelists impaired the ability of the panel to render an impartial decision. [15]:See, e.g., Administrative Procedure Act, 5 U.S.C. § 554(d) ("An employee or agent engaged in the performance of investigative or prosecuting functions for an agency in a case may not, in that or a factually related case, participate or advise in the decision, recommended decision, or agency review[.]"); New York Stock Exchange, Inc., Constitution Article IX, Section 3 (NYSE hearing officers shall have no duties or functions relating to the investigation or preparation of disciplinary matters). [16]:See, e.g., Administrative Procedure Act, 5 U.S.C. §554(d) (the person responsible for an initial decision shall not have ex parte communications with a person or party on a fact in issue, unless on notice and opportunity for all parties to participate). [17]:See, e.g., Amos Treat & Co. v. SEC, 306 F.2d 260, 265 (D.C. Cir. 1962). There, a member of the Commission participated in an adjudicatory function concerning a matter that had been initiated during that member's tenure as director of the division prosecuting the case. In directing the district court to enjoin the Commission's proceedings, the D.C. Circuit said: "It is not enough that here no corruption has been charged . . .. What must control is the policy . . . and the principles . . . that the investigative as well as the prosecuting arm of the agency must be kept separate from the decisional function." [18]:Cf. In re Dresser Industries, Inc., 972 F. 2d 540 (5th Cir. 1992) (applying ethical rules announced by the national profession, rather than local court rules, to question of whether party's motion to disqualify counsel should be granted, on the grounds that while local rules are appropriate for local court to determine conduct of attorneys subject to sanctions, local rules alone cannot regulate parties' rights). [19]:Cf. SEC v. Fehn, 97 F. 3d 1276, 1294 (9th Cir. 1996) (discussing the ethical dilemma inherent in an attorney attempting to represent a client in an SEC investigation of previous disclosure violations and at the same time, attempting to advise that same client as to ongoing disclosure requirements), cert. denied, 118 S.Ct. 59 (1997). [20]:See also Restatement, Section 201 (Proposed Final Draft No. 1, 1996) ("Unless all affected clients and other necessary persons consent to the representation . . ., a lawyer may not represent a client if the representation would involve a conflict of interest"). [21]:See also, id. [22]:See Model Rule 1.10(a); see also Restatement Section 203 (Proposed Final Draft No. 1, 1996). [23]:See, e.g., Novo Terapeutisk Laboratorium A/S v. Baxter Travenol Laboratories, Inc., 607 F.2d 186, 196 (7th Cir. 1979) (en banc); United States for Use and Benefit of Lord Electric Co., Inc. v. Titan Pacific Const. Corp., 637 F. Supp. 1556, 1564 (W.D.Wa. 1986). [24]:See, generally, Note, The Chinese Wall Defense to Law- Firm Disqualification, 128 U.Penn.L.Rev. 677, 689 (1980). [25]:See, e.g., Analytica, Inc. v. NPD Research, Inc., 708 F.2d 1263, 1267-69 (7th Cir. 1983). [26]:See, e.g., Trone v. Smith, 621 F.2d 994, 998-99 (9th Cir. 1980) (total professional commitment to a client is endangered by simultaneous representation of adverse interests); La Salle National Bank v. Triumvera Homeowners Ass'n., 109 Ill.App.3d 654, 664, 440 N.E.2d 1073, 1080 (Ill. App. 1982). [27]:See La Salle National Bank, supra, 109 Ill.App.3d at 664-65 (citing Silver Chrysler Plymouth, Inc. v. Chrysler Motors Corp., 518 F.2d 751 (2d Cir. 1975)). [28]:See, e.g., Grolier Incorporated v. FTC, 615 F.2d 1215, 1220 (9th Cir. 1980) (discovery into administrative law judge's prior involvement allowed where law judge presiding over case had previously served as confidential assistant to FTC commissioner authorizing the same case); Trans World Airlines, Inc. v. Civil Aeronautics Board, 254 F.2d 90, 91 (D.C. Cir. 1958) (former solicitor who had represented Postmaster General in litigation against party and who later became member of administrative board disqualified from ruling on related litigation). [29]:See, e.g., Walker v. City of Berkeley, 951 F.2d 182, 184 (9th Cir. 1991) (where same person served as both counsel to administrative decisionmaker and as advocate in a federal court proceeding involving the same parties and the same underlying issue, petitioner was denied a fair hearing); American General Ins. Co. v. FTC, 589 F.2d 462, 464-65 (9th Cir. 1979) (member of FTC should have disqualified himself from participation in the Commission's decision where he had previously participated in the case as counsel). [30]:See, e.g., Yamaha Motor Corporation v. Riney, 21 F.3d 793, 798 (8th Cir. 1994) (where ample evidence showed bias on the part of state commissioner, bias rendered the commission incompetent to decide the issues before it.) [31]:See, e.g., Schiessle v. Stephens, 717 F.2d 417, 421 (7th Cir. 1983). [32]:See Westinghouse Electric Corp. v. Kerr-McGee Corp., 580 F.2d 1311, 1321 (7th Cir.) (screen that segregated two groups of attorneys from each other was insufficient to rebut presumption of shared confidences because it did not shield contacts with non-segregated attorneys), cert. denied 439 U.S. 955 (1978). [33]:See, generally, Peterson, Rebuttable Presumptions and Intra-firm Screening: The New Seventh Circuit Approach to Vicarious Disqualification of Litigation Counsel, 59 Notre Dame L.Rev. 399, 410-11 (1984). See also Rule 1.10(e) of the Illinois Rules. [34]:See EZ Paintr Corporation v. PADCO, Inc., 746 F.2d 1459, 1462 (Fed. Cir. 1984) (screen implemented three months after conflict occurred and after disqualification motion was filed was too late to rebut presumption of shared client confidences); see, also, Parker, Private Sector Chinese Walls: Their Efficacy as a Method of Avoiding Imputed Disqualification, 19 J. Legal Prof. 345, 349 (1995) ("As to timeliness, the most common defect is that the firm establishes screening mechanisms sometime after the disqualified attorney has joined the firm.") [35]:See, e.g., Kovacevic v. Fair Automotive Repair, Inc., 641 F. Supp. 237, 244 (N.D.Ill. 1986) (screen timely implemented was sufficient to rebut presumption of shared confidences, provided that the conflicted attorneys agree not to share in the profits or fees derived from the conflicted representation). [36]:The Chinese Wall Defense, supra, at 691. See also analysis of cases addressing concurrent and successive representation by law firms contained therein. [37]:See Cinema 5, Ltd. v. Cinerama, Inc., 528 F.2d 1384, 1387 (2d Cir. 1976). [38]:Nothing in the record addresses the compensation arrangement for Foley partners involved in the representation of the CHX. It would appear, however, that a specific agreement not to share in compensation derived from any conflicted representation has been required. See Kovacevic, 641 F. Supp. at 244. [39]:Cf. Yamaha Motor Corporation v. Riney, supra, 21 F.3d at 798 ("Bias can be shown by a finding that the adjudicator prejudged the issues or had a pecuniary interest in the subject of the action. In general, the test is whether the adjudicator's situation is one 'which might lead him not to hold the balance [between the parties] nice, clear and true." citing Tumey v. Ohio, 273 U.S. 510, 532 (1927)). [40]:Citing Gibson v. F.T.C., 682 F.2d 554, 560 (5th Cir. 1982), cert. denied, 460 U.S. 1068 (1983); and Swanson v. Board of Police Commissioners., 197 Ill. App. 3d 592, 598- 601, 555 N.E. 2d 35, 40-42 (Ill. App.), appeal denied, 133 Ill. 2d 574, 561 N.E. 2d 708 (1990) (Table). [41]:The CHX and the Applicants have both filed various procedural and evidentiary motions. We deny such motions to the extent they conflict with this opinion. [42]:All of the arguments advanced by the parties have been considered. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed in this opinion. UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. 40646 / November 9, 1998 Admin. Proc. File No. 3-9212 ________________________________________________ : In the Matter of the Application of : : SCATTERED CORPORATION : and : LEON AARON GREENBLATT, III : ANDREW ALVIN JAHELKA : RICHARD OWEN NICHOLS : LAURA BRYANT : : For Review of Action Taken by the : : CHICAGO STOCK EXCHANGE, INC. : ________________________________________________: ORDER DISMISSING DISCIPLINARY ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION On the basis of the Commission's opinion issued this day, it is ORDERED that the disciplinary action taken by the Chicago Stock Exchange, Inc. against Scattered Corporation, Leon A. Greenblatt, III, Andrew A. Jahelka, Richard O. Nichols, and Laura Bryant, and its assessment of costs, be and they hereby are, set aside. By the Commission. Jonathan G. Katz Secretary