Opinion
Case No. 2: 03-cv-326.
October 18, 2005
MEMORANDUM OPINION AND ORDER
Plaintiff, the United States Securities and Exchange Commission ("SEC"), brings this action alleging that Defendants, eight individuals and four entities, engaged in price manipulation, unregistered sales, unreported stock ownership as well as various other securities violations in connection with the reverse merger of BluePoint Linux Software Corporation ("BluePoint") and MAS Acquisition XI Corporation ("MAS XI"). This matter is currently before the Court on Defendant Aaron Tsai's objections (Doc. # 87) to the Magistrate Judge's February 14, 2005 Order.
Defendants include: (1) Sierra Brokerage Services, Inc., (2) Richard Geiger, (3) Jeffrey A. Richardson, (4) Aaron Tsai, (5) Michael M. Markow, (6) Global Guarantee Corporation, (7) Francois Goelo, (8) Yongzhi Yang, (9) KJ Consulting, Limited, (10) Ke Luo, (11) MM Management, Limited, and (12) Jerome B. Armstrong.
I. Background
A. Facts
Defendant Aaron Tsai incorporated MAS XI, a shell company with no revenues or earnings from operations, in October, 1996. (Declaration of Defendant Aaron Tsai, (Doc. # 65), at ¶¶ 6, 8). Tsai notes that MAS XI's sole purpose was to locate and consummate a reverse merger. (Tsai Dec. at ¶ 8). As explained by Tsai, a reverse merger is a process whereby "a private company desiring to become publicly traded can go public by merging with a public shell company through a share exchange transaction." (Declaration of Defendant Aaron Tsai, (Doc. # 65), at ¶ 5). Tsai further explained that "going public via reverse merger can be accomplished more quickly and inexpensively than an initial public offering ("IPO"), and may be a more viable process for an emerging growth company. . . ." (Id.).
Tsai was the President and controlling shareholder of MAS XI. (Id. at ¶ 7). MAS XI initially issued 8,500,000 shares of restricted stock to Tsai. (Id.). In 1999, Tsai disclosed his controlling interest in MAS XI to the SEC and voluntarily made MAS XI a reporting company under the Securities Exchange Act of 1934 by filing, inter alia, a Form 10-SB. (Id.).
Pursuant to the Securities Act of 1933, restricted stock could not be offered for public sale except in accordance with Rule 144 of the Act.
In January 1997, Tsai gifted 250,000 shares of his MAS XI stock to five of his friends in order to make the public shell company an attractive candidate for a prospective merger with a private company desiring to go public. (Id. at ¶ 9). Tsai purported to gift the 250,000 shares pursuant to Section 4(2) of the Securities Act of 1933. After gifting the 250,000 shares, the stock remained "restricted."
Tsai then engaged the assistance of Kensington Capital to help get the stock cleared for public sale on the Over-The-Counter Bulletin Board ("OTCBB"). To that end, Kensignton filed a Form 211 application with the National Association of Securities Dealers ("NASD"). (Exhibit G, attached to Declaration of Jarett B. Decker (attached to Doc. # 59)). On July 26, 1999, the NASD sent Kensington a letter indicating that MAS XI's Form 211 application was deficient because the tradable shares of MAS XI stock were too concentrated; the NASD letter inquired as to why 250,000 shares of MAS XI stock were held by only 5 individuals. (Exhibit H, attached to Decker Dec. (Doc. # 59)).
In addition, Defendant Tsai completed and filed a Form 10-SB/A in which he stated that the directors who had been gifted the 250,000 shares were accredited investors.
Thereafter, Tsai used blank stock-certificate power forms signed by the 5 investors to transfer varying amounts of shares to other individuals. In August 1999, Tsai arranged for the transfer of most of the 5 individuals' shares to 28 additional "friends, acquaintances or associates." (Tsai Dec. at ¶ 9). Tsai contends that he discussed MAS XI, its purpose as a shell company, the reverse merger process and the gifting of shares with each of the shareholders. (Id. at ¶ 11).
Kensington then submitted a supplement to the Form 211 application indicating that MAS XI shares were now held by 33 individuals. (Exhibit J, attached to Decker Dec. (Doc. # 59)). This supplement was also returned as deficient. (Exhibit M, attached to Decker Dec. (Doc. # 59)). Kensington thereafter submitted an unsigned opinion letter, purportedly drafted by Florida attorney Arthur Schlenkert, to the NASD indicating that certain shares of MAS XI stock had become freely tradeable. (Exhibit N, attached to Decker Dec. (Doc. # 59)). The unsigned letter indicated that the opinion was based upon the information provided by MAS XI President Tsai, and Tsai's August 31, 1999 certification that was referenced in the letter as exhibit A. (Exhibit O, attached to Decker Dec. (Doc. # 59)).
Based on this information, the NASD cleared the MAS XI shares for trading on the OTCBB. (Exhibit O, attached to Decker Dec. (Doc. # 59)). MAS XI thereafter consummated a reverse merger with BluePoint. As part of the reverse merger with BluePoint, the 33 shareholders of MAS XI received $100 each. (Tsai Dec. at ¶ 13; Declaration of Michael M. Markow (Doc. # 69) at ¶ 4). Tsai received $250,000. (Markow Dec. at ¶ 4).
On November 26, 2001, the SEC served an investigative subpoena upon Tsai requesting: "[a]ll documents that relate directly or indirectly to issuance, distribution, trading, or other transfers or proposed transfers of securities issued by Bluepoint Linux Software Corp. or MAS Acquisition XI Corp. . . . [including] . . . correspondence of any kind. . . ." (Exhibit P, attached toDecker Dec. (Doc. # 59)). Tsai, however, did not produce the Schlenkert letter relating to MAS XI. Tsai explains that he did not have a copy of the Schlenkert letter and did not realize that it had been submitted to the NASD.
On July 2, 2004, Schlenkert was issued a subpoena that commanded him to produce any documents relating to the September 2, 1999 letter to the NASD and all documents relating to MAS XI and/or BluePoint. (Exhibit R, attached to Decker Dec. (Doc. # 59)). The SEC also subpoenaed Schlenkert for a July 20, 2004 deposition. (Id.). In a fax sent to the SEC on July 9, 2004, Schlenkert told the SEC that he did not prepare any documents for MAS XI and speculated that Tsai must have altered a document prepared for MAS VIII. (Exhibit S, attached to Decker Dec. (Doc. # 59)). On July 10, 2004, Schlenkert sent another fax to the SEC. (Id.). This time, Schlenkert explained that, while he had provided a draft opinion for MAS XI, he did not complete the opinion letter because Tsai had failed to provide complete information and because Tsai had failed to pay for his services. (Id.).
After receiving the Schlenkert faxes, Jarett Decker, Delia Helpinstine, and Tracy Lo, all with the SEC, spoke with Schlenkert by telephone. During this ex parte communication, counsel for Plaintiff discussed the faxes sent by Schlenkert and the work Schlenkert performed for Tsai's companies, including MAS XI. (Exhibit 4, attached to Defendant Aaron Tsai's Motion to Preclude). At the direction of the Magistrate Judge, the conversation was memorialized in a September 15, 2004 letter. (Id.). Tsai contends that the faxes sent by Schlenkert, as well as all communications between Tsai and Schlenkert regarding legal advice, are protected by the attorney-client privilege and are otherwise confidential. Plaintiff, on the other hand, argues that Tsai's claims of privilege are defeated by application of the crime-fraud exception.
B. Procedural History
On April 11, 2003, Plaintiff filed this action against Defendants alleging various violations of the Securities Act. On September 2, 2004, Plaintiff filed a motion for a declaration that Defendant Aaron Tsai's claims of attorney-client privilege and confidentiality have been waived or do not apply. (Doc. # 59). On September 20, 2004, Defendant Tsai responded by filing a motion to preclude any confidential and/or privileged matters disclosed by attorney Schlenkert. (Doc. # 62). The parties provided further briefing on this issue and, on October 8, 2004, a hearing was held before the Magistrate Judge. On November 17, 2004, the Magistrate Judge issued an order preliminarily denying Plaintiff's motion for a declaration, but reserved ruling on Plaintiff's argument that the crime-fraud exception to the attorney-client privilege applied. (Order, at p. 21 (November 23, 2004)). Both parties, in addition to several other Defendants, filed additional briefs and evidence regarding application of the crime-fraud exception to the attorney-client privilege. On February 14, 2005, the Magistrate Judge issued a second order concluding that the crime-fraud exception did apply.
Defendant Tsai also sought to prevent Plaintiff from engaging in any further conversations or communications with attorney Schlenkert regarding confidential and/or privileged matters. (Doc. # 62).
II. Discussion
A. Standard
Defendant Tsai has raised a number of objections to the Magistrate Judge's February, 2005 Order. Section 636(b)(1)(A) of Title 28 of the United States Code, along with Federal Rule of Civil Procedure 72(a), govern a district court's review of a magistrate judge's nondispositive pretrial order. In particular, § 636(b)(1)(A) provides, in relevant part that "a judge may designate a magistrate judge to hear and determine any pretrial matter pending before the court. . . . A judge of the court may reconsider any pretrial matter under this subparagraph . . . where it has been shown that the magistrate judge's order is clearly erroneous or contrary to law. . . ." 28 U.S.C. § 636(b)(1)(A). Additionally, Rule 72(a) provides that a district court shall modify or set aside any portion of a magistrate judge's nondispositive pretrial order that is found to be clearly erroneous or contrary to law. Fed.R.Civ.P. 72(a). Therefore, this Court will review the Magistrate Judge's nondispositive pretrial order to determine whether it is either "clearly erroneous" or "contrary to law." See Gandee v. Glaser, 785 F. Supp. 684, 686 (S.D. Ohio 1992).
The "clearly erroneous" standard applies only to factual findings made by the Magistrate Judge, while legal conclusions will be reviewed under the more lenient "contrary to law" standard. Gandee, 785 F. Supp. at 686 (citations omitted). A finding is "clearly erroneous" when the reviewing court is left with the definite and firm conviction that a mistake has been made. Heights Community Congress v. Hilltop Realty, Inc., 774 F.2d 135, 140 (6th Cir. 1985), cert. denied, 475 U.S. 1019 (1986); Hood v. Midwest Sav. Bank, Case No. 2:97-cv-218, 2001 WL 327723, *2 (S.D. Ohio March 22, 2001). A decision is "contrary to law" when the magistrate judge has "misinterpreted or misapplied applicable law." Id. (citations omitted).
B. Application
1. Determining the Applicability of the Crime-Fraud Exception
In determining that the crime-fraud exception to the attorney-client privilege applied in this case, the Magistrate Judge noted that the following two-part test applied: "`First, the government must make a prima facie showing that a sufficiently serious crime or fraud occurred to defeat the privilege; second, the government must establish some relationship between the communication at issue and the prima facie violation.'" Order at p. 13 (February 14, 2005) (quotingIn re Antitrust Grand Jury, 805 F.2d 155, 164 (6th Cir. 1986)). The Magistrate Judge then concluded that the requirements for a prima facie showing are met if "`a prudent person [would] have a reasonable basis to suspect the perpetration of a crime or fraud.'" (Order at p. 13 (February 14, 2005) (quoting In re Antitrust Grand Jury, 805 F.2d 155, 166 (6th Cir. 1986)). Further, the Magistrate Judge concluded that, due to extensive briefing by the parties regarding the applicability of the crime-fraud exception, additional oral argument on that issue would not serve any meaningful purpose. (Id., at p. 22).
a. Oral Argument
Defendant Tsai argues that his request for oral argument on the applicability of the crime-fraud exception should not have been denied. In support of this position, Tsai cites Haines v. Liggett Group, Inc., 975 F.2d 81, 96-97 (3rd Cir. 1992) andIn re General Motors Corp., 153 F.3d 714 (8th Cir. 1998). Both cases stand for the position that, in a civil action, a court may not compel production of allegedly privileged materials without permitting the party asserting the privilege to present evidence and argument in support of nondisclosure. In re General Motors Corp., 153 F.3d at 716 (citing Haines, 975 F.2d at 97).
This Court agrees that, before admitting evidence or allowing inquiry based on the crime-fraud exception in a civil case, the party asserting the privilege should be permitted to present evidence and argument in support of nondisclosure. Defendant Tsai, however, argues that when the issue is whether the crime-fraud exception applies, as opposed to whether an in camera review should be held, Haines and In re General Motors Corp. suggest that an oral hearing should be allowed; "[i]f the party seeking to apply the exception has made its initial showing, then a more formal procedure is required than that entitling plaintiff to in camera review." Haines, 975 F.2d at 96-97.
Assuming that the Courts of Appeals for the Third and Eighth Circuits require an oral hearing before a court determines that the crime-fraud exception applies, this Court notes that the Sixth Circuit has not adopted such an approach. Moreover, this Court is unaware of any Sixth Circuit precedent requiring an oral hearing where the Court determines that such a hearing would not serve any useful purpose. While the Court recognizes the importance of the attorney-client privilege, the presentation of evidence and/or argument need not, in every case, take the form of oral argument. See Royal Surplus Lines Ins. v. Sofamor Danek Group, Inc., 190 F.R.D. 505, 517 n. 10 (W.D. Tenn. 1999) (concluding that, although Haines suggested "more formal procedure[s]," "additional arguments would serve no purpose").
In any event, this Court's local rules provide for oral argument only where "oral argument is deemed to be essential to the fair resolution of the case because of its public importance or the complexity of the factual or legal issues presented. . . ." S.D. Ohio Civ. R. 7.1(b)(2). See also Bovee v. Coopers Lybrand, 216 F.R.D. 596, 599 (S.D. Ohio 2003).
In this case, the Magistrate Judge specifically concluded that additional oral argument on the applicability of the crime-fraud exception would not serve any meaningful purpose. (Order, at p. 22 (February 14, 2005)). It does not appear that Defendant Tsai was prevented from submitting evidence or argument to the Magistrate Judge. In fact, the record reveals, as was noted by the Magistrate Judge, that the parties filed extensive briefs and submitted evidence in support thereof with respect to the applicability of the crime-fraud exception. Therefore, this Court cannot conclude that the Magistrate Judge's decision to decline oral argument was contrary to law.
Defendant Tsai complains that, following the October 8, 2004 hearing, Plaintiff supplemented the record three times. However, Defendant Tsai also supplemented the record following the October 8, 2004 hearing. Moreover, although Plaintiff filed its "Fourth Declaration of Tracy Lo" following the submission of Defendant Tsai's "Reply," Defendant Tsai made no effort to strike the supplemental filing, to file a surreply, or to request additional time to respond. Nor has Defendant Tsai identified any argument or evidence that would have been presented in response to the "Fourth Declaration of Tracy Lo."
In fact, the record reveals that the parties discussed, at least briefly, application of the crime-fraud exception during the October 8, 2004 hearing before the Magistrate Judge. (Transcript of October 8, 2004 Hearing, at pp. 128-134).
b. Evidentiary Standard
Defendant Tsai also argues that the Magistrate Judge should have applied a preponderance of the evidence standard to determine whether Plaintiff had established a prima facie showing of fraud in violation of the Securities Act. In support of this argument, Tsai relies primarily on Laser Indus. v. Reliant Tech., 167 F.R.D. 417 (N.D. Cal. 1996). Laser, however, is distinguishable from this case.
In Laser, an alleged patent infringer moved the court to pierce the patent holder's attorney-client privilege based on a claim that the communications at issue were in furtherance of a fraud on the United States Patent Office. The court held that, in order to pierce the attorney-client privilege, the party must establish a prima facie showing of common-law fraud by a preponderance of the evidence. Laser, 167 F.R.D. at 423, 430. The court also noted that, requiring the defendant to establish a prima facie showing of common-law fraud by a preponderance of the evidence was not "tantamount to requiring [the defendant] to `actually prove' the alleged fraud," because such a claim required proof by clear and convincing evidence. Laser, 167 F.R.D. at 438.
In this case, however, in order to establish fraud in violation of the Securities Act, Plaintiff need only satisfy the preponderance of the evidence standard. See Herman MacLean v. Huddleston, 459 U.S. 375, 387 (1983). Under these circumstances, requiring a prima facie showing of fraud in violation of the Securities Act to be established by a preponderance of the evidence would, in effect, eliminate the crime-fraud exception to the attorney-client privilege.
For example, if Plaintiff can prove fraud in violation of the Securities Act by a preponderance of the evidence, then there would be no need for discovery of the allegedly privileged materials.
In any event, the Sixth Circuit has not adopted the preponderance of the evidence standard in the context of the crime-fraud exception. Instead, the Sixth Circuit has repeatedly relied on the position that, the requirements of a prima facie showing are met if "`a prudent person [would] have a reasonable basis to suspect the perpetration of a crime or fraud.'" See United States v. Collis, 128 F.3d 313, 321 (6th Cir. 1997) (quoting In re Antitrust Grand Jury, 805 F.2d at 166). While the Sixth Circuit has yet to apply this standard in a civil case, several district courts within the Sixth Circuit have in fact done so. See In re Miller, 247 B.R. 704, 711 (N.D. Ohio 2000); Royal Surplus Lines Ins., 190 F.R.D. at 517;Glidden Co. v. Jandernoa, 173 F.R.D. 459, 481 (W.D. Mich. 1997).
This Court concludes that, in a civil action where the underlying claim for relief is a claim of fraud in violation of the Securities Act and application of the crime-fraud exception also depends on such an alleged violation, a prima facie showing is met where the party seeking production establishes that a prudent person would have a reasonable basis to suspect fraud in violation of the Securities Act. Therefore, this Court cannot conclude that the Magistrate Judge's order was contrary to law in this respect.
2. Establishing a Prima Facie Showing of Fraud
The Magistrate Judge concluded that Plaintiff had established a prima facie showing of fraud in violation of the Securities Act. Defendant Tsai raises a number of objections to this conclusion. For example, Defendant Tsai argues that the Magistrate Judge's decision was contrary to law to the extent that: (1) the Magistrate Judge concluded that Tsai's gifting of 250,000 shares of MAS XI stock was a distribution for "value" within the meaning of the Securities Act; and (2) Tsai controlled the initial 5 shareholders and that the additional 28 shareholders were nominees also controlled by Tsai. Defendant Tsai also raises a number of objections to the Magistrate Judge's factual findings: (1) that the January dispositions of the MAS XI stock were for "value;" (2) that the shareholders' were unaware that they had stock; (3) that "interstate means" were used to trade the stock with respect to the "gifting" of the 250,000 shares; and (4) that the five initial shareholders did not understand what stock powers were.
With respect to the Magistrate Judge's legal conclusions, this Court notes that the Magistrate Judge did not render a final decision with respect to those issues. For example, the Magistrate Judge did not conclusively determine that Tsai controlled the relevant shareholders. Instead, the Magistrate Judge merely held that Plaintiff "has made a sufficient showingat this stage," i.e., that a prudent person would have a reasonable basis to suspect that Tsai controlled the initial 5 shareholders and the additional 28 shareholders. (Order at p. 21 (February 14, 2005)).
With respect to the Magistrate Judge's factual findings, the question is not whether this Court would render the same decision, but whether there is any support for the Magistrate Judge's decision. See Heights Community Congress, 774 F.2d at 140. This Court concludes that there is some evidentiary support for the Magistrate Judge's factual findings. This Court therefore cannot conclude that the Magistrate Judge's decision was contrary to law or clearly erroneous in this regard.
3. Causal Connection Between Communications and Alleged Fraud
Defendant Tsai argues that the Magistrate Judge failed to make a factual finding with respect to whether Defendant Tsai intentionally engaged in fraudulent behavior and/or intentionally sought the advice of Schlenkert in furtherance of an alleged fraud. Tsai notes that a violation of Section 5 of the Securities Act of 1933, 15 U.S.C. § 77e, does not require proof of fraudulent or criminal intent. Defendant Tsai therefore argues that because the Magistrate Judge focused solely on a prima facie case under section 5 of the Securities Act, there was no decision with respect to whether the attorney-client communications were in furtherance of the alleged fraud.
As was discussed supra, in order to establish the applicability of the crime-fraud exception, Plaintiff must establish a prima facie showing that a sufficiently serious crime or fraud occurred and that there is some relationship between the communication at issue and the prima facie violation. In re Antitrust Grand Jury, 805 F.2d at 164. With respect to intent, the relevant inquiry is whether the party sought legal advice in furtherance of the crime or fraud. Id. at 168. See also In re BankAmerica Corp. Securities Litigation, 270 F.3d 639, 642 (8th Cir. 2001).
In this case, the Magistrate Judge generally concluded that Plaintiff had established a prima facie showing that the crime-fraud exception applied. However, the Magistrate Judge's February 2005 Order did not specifically discuss Defendant Tsai's intent or the connection between Tsai's communications with attorney Schlenkert and the alleged fraud. Defendant Tsai argues that, due to this failure, the Magistrate Judge's decision is both clearly erroneous and contrary to law.
Plaintiff argues that the Magistrate Judge did in fact conclude that Defendant Tsai communicated with attorney Schlenkert for the purpose of furthering the alleged fraud. Plaintiff first notes that the Magistrate Judge properly set forth the two-part test to determine the applicability of the crime-fraud exception and then found that Plaintiff had established a prima facie showing that the crime-fraud exception applied. Additionally, Plaintiff cites to the transcript of proceedings before the Magistrate Judge on October 8, 2004 in support of a finding that Defendant Tsai's communications with attorney Schlenkert were intended to further the alleged fraud.
During the October 8, 2004 hearing, the Magistrate Judge specifically found that Tsai could not have committed the alleged fraud without the letter from attorney Schlenkert. (Transcript of October 8, 2004 Hearing, at pp. 128-134). The Magistrate Judge thus found a direct connection between the communications with attorney Schlenkert and the alleged fraud. Moreover, Tsai's declaration states that Tsai sought legal advice from attorney Schlenkert with respect to the issuance and tradability of MAS XI stock. (Declaration of Aaron Tsai, at ¶ 13, attached to Defendant Aaron Tsai's Motion to Preclude). This Court concludes that the Magistrate Judge's findings are sufficient to establish that a prudent person would have a reasonable basis to suspect that Tsai sought attorney Schlenkert's assistance with the intent to further the alleged fraud. This Court therefore cannot conclude that the Magistrate Judge's February, 2005 Order was clearly erroneous or contrary to law.
4. Other Objections
Defendant Tsai also complains that the Magistrate Judge did not make any findings with respect to other MAS companies or transactions. While the February, 2005 Order does not specifically discuss the scope of the crime-fraud exception as applied in this case, by necessity, such an application must be limited to communications that are related to MAS XI. As was discussed supra, in order for the crime-fraud exception to apply, there must be some connection between the communication at issue and the alleged fraud. In this case, the alleged fraud relates to MAS XI. Therefore, to fall within the crime-fraud exception, the communications must have some connection to MAS XI.
Finally, Defendant Tsai complains that, despite Defendant Tsai's request for relief with respect to attorney Schlenkert's disclosure, the Magistrate Judge did not rule on that issue. However, in the November 2004 Order, the Magistrate Judge specifically noted that, after the Court ruled on the applicability of the crime-fraud exception, the Court would decide whether a remedy should be provided for Schlenkert's disclosures to the SEC. Admittedly, the Magistrate Judge's February, 2005 Order does not deal with this issue. Thus, the issue remains pending. This is not, however, a proper ground for reversing the Magistrate Judge's February, 2005 Order.
Defendant Tsai contends that it was inappropriate for Plaintiff to seek disclosure of privileged matters prior to a determination that the crime-fraud exception in fact applied.
WHEREUPON this Court concludes that Defendant Tsai's objections (Doc. # 87) to the Magistrate Judge's February 14, 2005 Order are without merit and are therefore OVERRULED. The Magistrate Judge's February 14, 2005 Order is AFFIRMED.
IT IS SO ORDERED.