Summary
discussing Certain Real Property
Summary of this case from In re Adelphia Communications Corp.Opinion
98 CIV. 1818 (DLC).
July 15, 2004
Larry P. Ellsworth, Michael K. Lowman, Ernesto G. Amparo, Lisa R. Hasday, Securities and Exchange Commission, Washington, D.C., for Plaintiff.
Robert B. Blackburn, Securities and Exchange Commission, New York, New York, for Plaintiff.
Paul A. Batista, New York, New York, for Defendants Thomas Cavanagh, Frank, Nicolois, and U.S. Milestone Corp. and Relief Defendants Cromlix LLC, Karen Cavanagh, and Beverly Nicolois.
Thomas R. Brooksbank, Reno, Nevada, for Defendant Thomas R. Brooksbank and Relief Defendant Edward C. Kaufer.
James E. Franklin, San Diego, California, for Pro Se Defendant James E. Franklin.
Thomas Hantges, Las Vegas, Nevada, for Pro Se Defendant Thomas Hantges.
OPINION ORDER
This securities fraud action grew out of a "pump and dump" scheme engineered by William Levy ("Levy"), Thomas Cavanagh ("Cavanagh") and Frank Nicolois ("Nicolois"). After entry of a preliminary injunction in 1998, the action was stayed for an extended period of time during a criminal investigation and prosecution of Levy, Cavanagh and Nicolois for false statements made in connection with this litigation. With the conclusion of the criminal proceedings, this civil litigation has resumed and the Securities and Exchange Commission ("SEC") now brings a motion for summary judgment against those defendants who have not settled this litigation.
Approximately forty-five persons or entities have either settled by paying full disgorgement or are in default. Only the claims against the ten defendants who are the subject of this motion remain outstanding.
The SEC seeks entry of judgment against Cavanagh, Nicolois, their company U.S. Milestone ("Milestone"), Thomas Brooksbank ("Brooksbank"), James Franklin ("Franklin"), and Thomas Hantges ("Hantges") for violation of Sections 5(a) and (c) ("Section 5") of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77e(a) and (c). It also seeks judgment against defendants Cavanagh, Nicolois and Milestone for violation of Section 10(b) ("Section 10(b)") of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b); Rule 10b-5 thereunder ("Rule 10b-5"), 17 C.F.R. § 240.10b5; and Section 17(a) ("Section 17(a)") of the Securities Act, 15 U.S.C. § 771(a). Finally, the SEC seeks judgment against relief defendants Karen Cavanagh, Beverly Nicolois, their jointly-owned company Cromlix, LLC ("Cromlix"), and Edward Kaufer ("Kaufer"). For the following reasons, the motion for summary judgment is granted.
Procedural History
On March 13, 1998, the SEC filed this action, alleging that certain defendants offered and sold securities of Electro-Optical Systems Corporation ("EOSC") in violation of the registration and anti-fraud provisions of the securities laws. The SEC asserted that the defendants had defrauded the public — principally small, on-line investors — of millions of dollars. That same day, a temporary restraining order was issued which, inter alia, suspended trading by the defendants in EOSC stock and froze the assets of defendants and the accounts of relief defendants that contained EOSC stock or the proceeds from the sales of the EOSC stock.
A preliminary injunction hearing ("Hearing") ran from March 31 to April 8. For the reasons explained in an Opinion of April 20, a preliminary injunction was issued. SEC v. Cavanagh, 1 F. Supp.2d 337 (S.D.N.Y. 1998) ("April 20 Opinion"). The April 20 Opinion found that the SEC had shown a substantial likelihood of success in proving that Cavanagh, Levy, Milesone, three companies described herein as the Spanish Nominees, George Chachas ("Chachas"), Brooksbank, Hantges, the Optimum Fund and Agira Trading violated Section 5. The Court entered a preliminary injunction against Levy, Cavanagh, Milestone, Chachas, and the Spanish Nominees, and freeze orders against all of these defendants. The April 20 Opinion found that the SEC had shown a substantial likelihood of success in proving that Cavanagh, Milstone, Chachas and the Spanish Nominees had violated Sections 17(a) and 10(b). Levy and one relief defendant appealed. The injunction was affirmed on appeal. SEC v. Cavanagh, 155 F.3d 129 (2d Cir. 1998).
In October 1998, the action was stayed at the request of, among others, defendants Cavanagh, Nicolois, Milestone, Levy and relief defendants Karen Cavanagh and Beverly Nicolois due to a criminal investigation. On March 13, 2003, Cavanagh and Nicolois requested that the stay be lifted since no prosecution had begun. They argued that the civil action be dismissed because of the "long, detrimental" stay. In fact, a sealed indictment had been returned on February 26, 2003.
At a conference on March 27, 2003, the defendants' motion to dismiss was scheduled. On April 4, Cavanagh and Nicolois learned of their indictment and requested a reimposition of the stay. On April 22, the Court denied their request in light of the defendants' stated intention to move to dismiss the action because of the length of the stay. Although they made no offer to forego that motion if a stay were reimposed, the defendants never filed the motion. On February 11, 2004, following the close of discovery, the SEC moved for summary judgment as to those defendants with whom it has not already settled.
Levy was indicted at the same time. Levy died on September 26, 2003, before the criminal charges against him were resolved.
Defendants Cavanagh, Nicolois, their wives (who are named as relief defendants), and their company Milestone, oppose summary judgment. They rely on their attorney's affidavit, on a Rule 56.1 Statement that contests relatively few of the 157 paragraphs in the SEC's Rule 56.1 Statement, and on excerpts from the record created at the Hearing. Cavanagh, Nicolois and Milestone do not contest that a fraud occurred. They argue principally that they relied on the advice of their attorney, Levy, and that the SEC has not sufficiently shown their scienter to establish a violation of Sections 17(a) and 10(b).
Defendants Franklin and Brooksbank also agree that the public was defrauded. They argue, however, that the SEC has failed to show that it is entitled to summary judgment since there are questions of fact as to whether Franklin and Brooksbank's sales of shares were exempt from registration under one of three possible exemptions.
In the event summary judgment is granted, defendants Cavanagh, Nicolois, and Milestone do not object to the relief sought by the SEC. Defendants Hantges, who concedes liability under Section 5, Franklin, and Brooksbank do object to the relief sought. Relief defendants Karen Cavanagh, Beverly Nicolois, Cromlix, and Kaufer only contest the underlying liability of the defendants, but not the relief sought against them.
Background
The following facts are undisputed, unless otherwise noted. A summary of the scheme precedes a more detailed description of the evidence. WTS Transnational, Inc. ("WTS") was a small development stage company with a dire need for capital. Cavanagh, Nicolois, and their investment banking firm Milestone, agreed to raise money for WTS. Levy, an attorney, prepared many of the legal documents and conducted many of the negotiations on behalf of Cavanagh, Nicolois and Milestone. They located a blank check or shell corporation called Curbstone as the vehicle to take WTS public.
At the time that WTS merged with Curbstone through a reverse stock acquisition, Levy, Cavanagh, Nicolois, Milestone, and three offshore companies (the Spanish Nominees) with whom they were associated as described below, obtained for pennies per share a large block of shares of the new public company, renamed EOSC. There was no public disclosure of this transfer of shares or of the fact that this group now controlled virtually all of the public float of EOSC. The Spanish Nominees, Cavanagh and Nicolois resold the shares into the public market after Cavanagh, Nicolois and others had taken the steps described below to inflate the price for the EOSC shares to over $5 per share.
Curbstone was owned by four partners, including Brooksbank, Franklin, and Hantges (collectively, the "Curbstone Management Group"). The fourth partner, Chachas, was the person principally responsible for the negotiations with Levy and the Milestone group. The four Curbstone partners were paid in cash and in EOSC shares for their sale of Curbstone. They each profited handsomely from these transactions, including through an option agreement that gave them the opportunity to sell their shares at prices ranging from $3 to $6 over the course of the months following the merger. With this overview, a more detailed description of the chronology of events follows.
WTS, a private company, was trying to develop optical fingerprint recognition technology. It needed money to do so. Charles Weaver ("Weaver"), the President of WTS, met Cavanagh and Nicolois in July 1997. Milestone, a company owned by Cavanagh and Nicolois, agreed to procure financing for WTS. Cavanagh and Nicolois told Weaver that they had $4 million in off-shore accounts that there were willing to invest in the company through a private placement.
On September 22, WTS and Milestone executed a letter of intent that allowed Milestone the exclusive right to raise $1 million in equity capital for WTS in a private placement offering in exchange for 30% of the WTS stock, and after raising such money, a one year option to raise an additional $3 million for another 10% of the stock. In total, WTS agreed to give up 40% of its stock for $4 million.
Meanwhile, Levy began to search for a public shell company to merge into WTS. Levy first informed Weaver of this fact in November 1997, when he told him that "an investor" wanted a public company. Levy asserted that WTS must become public before the investor would give it money. Levy also tried to change the terms of the investment. He wanted WTS to give up 40% of its stock for a $1 million investment. Weaver immediately complained to Nicolois. Weaver specifically complained that Levy's plan for a $5 per share follow-on investment would result in an "astronomical" market capitalization of $53 million. According to Weaver, a market capitalization of approximately $3 million following a $1 million investment, or $10 to $15 million following a $4 million investment was more appropriate.
On November 13, Weaver and Nicolois executed a Letter of Intent. Milestone agreed to use its best efforts to have Milestone or its clients advance to WTS $1 million as a note convertible into 30% of WTS's issued and outstanding common stock and then to raise an additional $3 million in funds for WTS. WTS would become a wholly owned subsidiary of a publicly traded company before December 15, with WTS shareholders receiving 95% of the issued and outstanding capital of the new company and the shell's shareholders retaining 5%.
After the execution of the letter of intent, Cavanagh caused the Optimum Fund, a Grand Cayman entity over which Cavanagh had control, to make a $500,000 bridge loan to WTS, less fees. The bridge loan was convertible into equity.
Meanwhile, Levy selected a shell company, Curbstone. Throughout the negotiations that followed, the shares owned by the Curbstone Management Group were treated as one block. Chachas was authorized to negotiate the merger with WTS. Chachas envisioned two payments modeled on an earlier transaction, the Capital Advisors Acquisition Corporation ("Capital Advisors") transaction, that he had negotiated with Levy. As reflected in contemporaneous documents, Chachas expected that the Curbstone Management Group would receive $125,000 in cash and $1.2 million through "market makers" for 300,000 shares in the new company ("Curbstone Management Shares"), priced in three equal units of between $3 to $5 per share.
Franklin disputes that the shares of the four owners of Curbstone were treated as one block. He has offered no evidence, however, to support any other view of the evidence. He concedes that Chachas handled all of the negotiations for the four, and that all of the documents concerning the sale of their shares in Curbstone treated their ownership interest in Curbstone as a block.
Levy acted as counsel for both Milestone and WTS in the negotiations with Chachas. Draft term sheets specified that the Curbstone Management Group was to provide "free trading" Curbstone stock.
On December 2, Chachas sent Levy what he characterized as the only two acceptable alternatives for closing the reverse merger and "our best and final effort." Under the first alternative, the Curbstone Management Group would be paid (1) $125,000 in cash at a closing on December 5, and a further payment of $2.352 million in four installments between December 16 and March 13, 1998. The latter payment was for the purchase of 542,000 shares in the new company owned by the Curbstone Management Group. To insure performance by the purchasers, the Curbstone transfer agent would not release newly issued common stock to WTS or cancel the 2,596,659 shares of Curbstone common stock due to be cancelled at the time of the merger until the first installment payment of $450,000 had been received, which was due no later than December 16.
The second alternative presented by Chachas included an immediate payment of a non-refundable $10,000 deposit, with the balance of the $125,000 in cash and a first installment payment of $450,000 due at a December 16 closing. The remainder of the 542,000 Curbstone Management Shares would be available for purchase in three installments spanning the time between December 16 and March 13, 1998. Under both alternatives, there would be no change in the Curbstone transfer agent until March 15, 1998, or until all of the 542,000 shares had been acquired, whichever occurred first.
On December 3, Chachas sent Levy a written outline of the terms reflecting their further discussions. They finally agreed on the following:
1) A $25,000 non-refundable payment, which Levy sent to Chachas on December 8.
2) A $100,000 payment for the sale of 2,563,000 Curbstone shares controlled by the Curbstone Management Group, which payment Levy sent to Chachas on December 12.
3) The purchase of 150,000 Curbstone Management Shares for $450,000 or $3 per share, which payment was also made on December 12.
4) An oral agreement that Milestone had three options to purchase the Curbstone Management Shares as follows: 150,000 shares at $4 per share by February 13, 1998; 150,000 shares at $5 per share by March 13, 1998; and 92,000 shares at $6 per share by April 17, 1998.
5) A lock up agreement in which the Curbstone Management Group agreed not to sell an additional 200,000 shares they held until March 15, 1998.
Under this agreement, the vast majority of the shares held by the Curbstone Management Group would not be cancelled. Instead, they would be sold for $100,000 on December 12. The sale of these shares made the market fraud possible. Chachas understood at first that the shares were being purchased by Milestone. After the agreement for the sale was entered, however, he was told that for the first time that the share certificates were to be issued in the names of three Spanish companies: Cambiarios S.L. ("Cambiarios"), Construcciones Solariegas, S.L. ("Construcciones"), and Customer Safety, S.L. ("Customer Safety") (collectively, the "Spanish Nominees"). Chachas understood the Spanish Nominees to be clients of Milestone. No member of the Curbstone Management Group spoke to the Spanish Nominees or performed any due diligence regarding them. The Curbstone Management Group asserts that it relied solely upon representations contained in the Purchase Agreements described below, which stated that the purchasers were accredited investors and had "no present agreements" to resell the shares.
As a result of selling the approximately 2.5 million shares to the Spanish Nominees, it was no longer the case that all but 5% of the shares of the new entity would be traded for WTS stock. Rather, Milestone and those associated with it held 16% of the EOSC stock, and this stock constituted the vast majority of the EOSC stock that was issued without a restrictive legend and was thus available to be sold to the public.
Chachas and Brooksbank for Curbstone, and Weaver for WTS, executed the Exchange Agreement ("Exchange Agreement"). The Exchange Agreement bears the date December 5, and provides that Curbstone would deliver to the WTS shareholders 15,488,120 shares of authorized, but previously unissued unregistered shares of Curbstone in exchange for all of the issued and outstanding shares of WTS owned by the WTS shareholders. It represents that the Curbstone shares given to WTS in exchange for the WTS stock had not been registered and would be issued with a restrictive legend. It states that the authorized capital stock of Curbstone consisted of 3,521,876 shares of stock issued and outstanding prior to the closing. It provides that the closing would be held on or before January 16, 1998. Weaver and WTS were not informed of the sale of the shares to Milestone and the Spanish Nominees.
On December 8, Levy wired Chachas $25,000 — the non-refundable purchase fee. It was paid by Milestone through the client escrow account that Levy maintained for Milestone. None of this money came from or was reimbursed by the Spanish Nominees.
On December 5, Chachas faxed to Levy a single form of a purchase agreement for the purchase of the 2,563,000 shares. Levy faxed the form to Milestone that day, and Nicolois, after consulting with Cavanagh, filled in the names and addresses of the Spanish Nominees, the number of shares, the price per share and dated the agreements December 1, 1997. With the transaction split into three units no one purchaser owned over 5% of the EOSC stock, thereby avoiding the Section 13(d) reporting requirements under the Exchange Act. After consulting again with Cavanagh, Nicolois faxed the purchase agreement to Tur Ortola in Spain on December 10. Tur Otola executed at least the agreement for Cambiarios. On this same date, Brooksbank and Chachas executed a corporate resolution directing the transfer agent to issue and cancel the shares for the WTS/Curbstone transaction. They sent the form to the agent on December 18.
On December 11, the three purchase agreements ("Purchase Agreements"), dated as of December 1, and executed on behalf of the Spanish Nominees, were faxed to Milestone's offices. Each of the Spanish Nominees was a newly formed entity. With this purchase, the Spanish Nominees acquired the entire 2.5 million share block for $.039 per share. The Purchase Agreements included the representations by the Curbstone Management Group that the shares "have been registered securities and will be free of restrictive legend upon delivery," and that Chachas would hold the shares until "all conditions for the Closing of the Agreement for Exchange of Stock Between Curbstone and WTS . . . have been satisfied. . . ." The Purchase Agreements did not encompass the shares to be acquired under the option agreement.
During this time, Cavanagh and Nicolois were preparing for the resale into the public market of the shares sold to the Spanish Nominees. They called a broker, Cosimo Tacopino ("Tacopino") at Donald Co., and advised him that they would soon receive a large Curbstone/EOSC stock position and that he would have to make a market in EOSC so that they could liquidate the position. On December 11, Cavanagh and Nicolois told Tacopino that they would be sending Donald Co. "Express Forms" to open accounts for the three Spanish Nominees and one for another Spanish company called Inversora Dactilar ("Inversora"). Nicolois filled out the new account applications for the Spanish Nominees and faxed them to Donald Co. Tacopino spoke to no other representative of the Spanish Nominees prior to opening these accounts. Cavanagh and Nicolois instructed Tacopino to use these accounts to liquidate EOSC stock upon its receipt.
When Chachas wrote Levy on December 12, to advise him that the agreement between Curbstone and WTS had been fully executed in his opinion and that the transaction had closed, Levy wired Chachas $550,000, representing $100,000 for the sale to the Spanish Nominees of the 2.5 million share block, and $450,000 for the exercise of the first round of options under the option agreement. The money was sent from the Milestone escrow account and not from the Spanish Nominees. Levy immediately sent Chachas a Closing Memorandum noting that the "prerequisites have been fulfilled (except certain schedules, shareholder lists and certain signatures which should all be delivered to you by Tuesday)," December 16. On December 19, Chachas distributed the $550,000 among the four members of the Curbstone Management Group, as well as the sum earned through a parallel acquisition negotiated between Levy and the Curbstone Management Group.
At this same time, Milestone was managing a $1 million offering of EOSC shares purportedly under Regulation S. First, a bridge loan from the Optimum Fund was converted into 1,054,241 EOSC shares at a price of $.47 per share. Then Agira Trading ("Agira"), a British Virgin Island company that Cavanagh and Nicolois controlled, purportedly invested $500,000 for an identical number of shares at the same price per share.
On December 16, Chachas wrote to Levy to confirm the division among the Spanish Nominees of "2,563,000 Free trading [shares] purchased at $100,000." Chachas obtained a CUSIP number and was notified that the company would bear the OTC trading symbol of EOSC.
On December 17, Chachas instructed Curbstone's transfer agent American Registrar and Transfer Company ("ARTCO") to issue 17,596,601 new Curbstone shares; cancel Curbstone stock certificates representing 33,659 shares; transfer record ownership of 2,563,000 shares to the Spanish Nominees, reissue the certificates to them "WITHOUT LEGEND", send the certificates to Levy; and forward an updated shareholder list to Chachas. (Emphasis in original.) Richard Day ("Day"), the president of ARTCO, completed these tasks within two hours because of Chachas' desire that it be done as quickly as possible. Day shipped the certificates to Levy on December 18. That afternoon, Chachas and Brooksbank, acting as the "entire Board of Directors" of Curbstone executed a corporate resolution accepting their own resignations as officers and directors, and appointing in their stead WTS employees as officers and directors. The transfer agent also sent 500,000 shares to Levy, 2,108,481 shares to Milestone, and 857,081 shares to Inversora Dactilar, S.L., a Spanish entity that Cavanagh indicated would provide additional financing for EOSC.
On December 19, Cavanagh told Tacopino that the WTS/Curbstone deal had been completed and to start making a market in EOSC stock. No public announcement had yet been made about the creation of EOSC. Tacopino was told by the head of compliance at Donald Co. that the market had to set the price of EOSC stock. Quotes on the NSAD bulletin board consist of bid and ask prices. The former is the price at which a market maker is willing to buy; the latter is the price at which a market maker is willing to sell. At 9:56 a.m., Tacopino posted an initial Donald Co. quote of $.50 bid and no ask price. Within ten minutes, Cavanagh called Tacopino and said that he wanted the bid price to be at or above $5, and that Tacopino had to keep the market price at or above $5 per share. Tacopino told Cavanagh that he was not permitted to raise the bid price until a street order or participation from other market makers justified it. Cavanagh assured Tacopino that there would be plenty of orders coming. Cavanagh and Nicolois assured Tacopino that "they would be constantly bringing in buying whether through other brokerage firms, PR firms" or otherwise.
Cavanagh immediately placed a buy order with Ara Proudian ("Proudian") at Alexander Westcott to buy 500 shares of EOSC at $7 per share through the account of the Optimum Fund. Cavanagh insisted that the order be at $7 over Proudian's objection that that was out of line with the current market price. (A share price of $7 reflected a market capitalization for EOSC of $140,000,000.) When Proudian placed the order with Tacopino at $7, Tacopino's only response was "sold." Since Donald Co. did not yet have any EOSC stock in its inventory, the sale created a short position in Donald Co.'s proprietary trading account. Cavanagh and Nicolois had told Tacopino that the accounts of the Spanish Nominees would be available to him to cover his short position at or above $5 per share.
Cavanagh contends that his order was a limit order for a purchase at a price up to $7 per share. This dispute is discussed below.
Based on this sale, at 10:21 to 10:22 a.m., Tacopino changed the Donald Co. bid to $5 and ask to $7. A second trade in EOSC occurred at 10:53 a.m. Jean-Pierre Neuhaus ("Neuhaus"), an associate of Cavanagh and Nicolois, placed the order through the account of Banca del Gottardo in Zurich, Switzerland Cavanagh and Nicolois later gave Neuhaus 130,000 EOSC shares for free out of the Construcciones account.
A default has been entered against Neuhaus.
A third trade of EOSC stock occurred at 11:13 a.m. A Milestone client named Bernd Stieghorst, with Cavanagh's participation, placed an unsolicited order to buy 2,500 shares at or about $5 ½ Tacopino did not charge either Stieghorst or Cavanagh any commission on the transaction. Cavanagh and Nicolois later gave Stieghorst 70,000 EOSC shares for free.
A default has been entered against Stieghorst.
A fourth trade of EOSC stock occurred at 2:10 p.m. Chachas placed a market order for 100 EOSC shares through the e-trade account owned by Chachas and Brooksbank in the name of Dillon Trading. The order was filed at $5 7/8. When Cavanagh and Nicolois called Tacopino later on December 19 to inquire about the EOSC trading for the day, they expressed disappointment and Cavanagh assured Tacopino that he "would be sending in buy orders and there would be other retail firms getting involved, and the stock should trade heavily." Levy's secretary and the boyfriend of Nicolois' daughter later placed orders; they sold their stock for a profit in February.
After the close of the market on December 19, Curbstone made its first public announcement of the WTS acquisition. The announcement was reported on the business wire. The announcement included the following:
Curbstone Acquisition Corp., a public company, Friday announced that it had completed the acquisition of 100 percent of the stock of WTS Transnational Corp., a privately held company, in exchange for the original issuance of 15,488,120 shares of Curbstone common stock. Curbstone has changed its name to Electro-Optical Systems Corp. The Bulletin Board symbol has been changed to "EOSC." The directors and officers of Curbstone have resigned and have elected the directors and officers of WTS to succeed them.
The announcement did not disclose the sale of stock to the Spanish Nominees, the existence of the option and lock-up agreements between Milestone and the Curbstone Management Group, that there were over 20 million shares of Curbstone issued and outstanding, or that 3.5 million shares of purportedly free-trading Curbstone stock, virtually the entire market float of Curbstone, was under the control of Cavanagh and Nicolois. The market float is the shares allegedly available for trading in the public market.
On December 23, Chachas filed a Curbstone Form 8-K, the document on which a registered company reports a change in control. Levy, as the attorney for the merger had responsibility for this filing, but had asked Chachas to do it. Chachas asserts that he consulted with Levy regarding the contents, but Levy denies that. Among other things, the Form 8-K did not disclose the sale of shares to the Spanish Nominees, the option agreement, the lock-up, or the transfer of stock to Levy and to Milestone. It represented that no broker was associated with the transaction and that no fee had been paid to a broker despite the substantial payments to Cavanagh and Nicolois. The public was not advised that the market float consisted of millions of shares and that it was controlled by Milestone and those associated with Milestone.
Between December 24 and 26, the shares for the Spanish Nominees were deposited into trading accounts at Donald Co. Cavanagh and Nicolois soon began directing the distribution of about one million of these shares to twenty-nine friends, relatives and business associates. In this connection, Cavanagh and Nicolois ordered the opening of eight new customer accounts at Donald Co. to receive some of this stock. These accounts included those of various relief defendants including Cromlix. Cavanagh and Nicolois caused 100,000 EOSC shares to be transferred into the Cromlix brokerage account. Cavanagh and Nicolois told Tacopino that these transfers represented their compensation on the deal. Tur Ortola also told Tacopino that this stock was the compensation due Cavanagh and Nicolois on the EOSC deal. All orders to transfer stock and proceeds originated with Milestone in New York; none of the orders came from Spain.
With two exceptions, each of these relief defendants has settled with the SEC by repaying fully the receipts from the sales of this stock. Cromlix has not settled. A default was entered against one other account holder.
Cromlix was a corporation created in December 1997 by Cavanagh and Nicolois for the benefit of their wives, Karen Cavanagh and Beverly Nicolois, who were the company's sole shareholders.
Cavanagh and Nicolois ultimately directed the sale of these shares into the market, generating $531,812.50 for Cromlix, Karen Cavanagh, and Beverly Nicolois.
Between December 19, and early March 1998, Tacopino, who controlled nearly the entire float of EOSC stock, kept the price above $5 per share despite heavy sales after January 16 of the shares originally sent to the Spanish Nominees. Tacopino believed that if he allowed the price to go above $5 to $6 his ability to sell would have ended. In this range, however, he was able to sell a continuous stream of shares. With rare exceptions, Tacopino liquidated the stock by trading "from the short side." This was the pattern he had followed in about 40 to 50 prior "Reg S" deals on which he had worked with Cavanagh and Nicolois. By selling short, he avoided the risk of a drop in price. Cavanagh and Nicolois had daily conversations with Tacopino about how the stock was trading and how he was liquidating the dozen or so accounts that they controlled. They told him which accounts should be used to cover each day's short positions.
In late December, Tacopino sold 102,100 shares from the Cambiarios account at the direction of Cavanagh and Nicolois for $555,260.07. In January 1998, at their direction, Tacopino sold 724,900 shares through the Cambiarios account for net proceeds of $3,775,704.03.
On January 9, 1998, Cavanagh told Tacopino "that there would be good things happening" in the EOSC stock and he should be long, not short, on the stock. Tacopino went from a position of 16,000 shares short to 27,000 shares long. Nicolois told Tacopino during a visit to Nicolois' house that the "good news" was that a public relations firm would be making a buy recommendation to its clients. This recommendation was arranged by Maier Lehmann ("Lehmann").
Lehmann refused to testify, but paid full disgorgement and agreed to an injunction and civil penalty. Shortly thereafter, he was murdered.
On January 12, an internet publication called The Future Superstock released its choice of EOSC as the "Stock Pick of the Year for 1998." It set a price target of $15 to $18 per share over the next three months to a year. That prediction assumed a market capitalization of $378,000,000 for a company that had received an investment of approximately $1 million from outside investors and that did not yet have a prototype that Weaver felt he could show to potential customers. That very day Weaver wrote an internal memorandum expressing concern about the unwarranted "hype" of the stock and stating that he would rather not say anything yet. "We do not have a product that we can show today. We will in about four months."
In late January, Ari Friedman approached David Pollack ("Pollack"), the president of ADL Data Systems, Inc. ("ADL"), about the possibility of distributing EOSC's fingerprint identification units. ADL provides software services to the health care industry. On January 29, Levy faxed Pollack the first draft of a press release which referred to an ADL purchase order. Pollack told Levy that this purchase order did not exist and that he did not intend to execute a blanket purchase order. Pollack insisted that any commitment to EOSC had to be conditioned on receiving a working unit that would satisfy him. Levy then faxed a draft letter detailing a proposed joint venture. Pollack and Weaver signed the letter, which refers to an attached purchase order that did not exist. It reads in part:
As per my negotiations with your agent, enclosed please find our Purchase Order for 1,000 units of your Fingerprint Identification system. These units are to be delivered to our office soon after we've had the opportunity to test your evaluation units and price will be finalized prior to shipment.
On January 30, EOSC issued a press release that Levy dictated to EOSC employee George Clarke ("Clarke"). When Clarke learned that there was no purchase order from ADL he ordered Levy to remove the reference to a purchase order from the press release. Levy insisted that investors needed the reference to a purchase order. Clarke crossed out the word "purchase" on the draft press release and told Levy that he could issue it. Neither Clarke nor Weaver saw the final version of the press release until long after it was issued. It read in part:
[EOSC] a public company, announced today that it received a Purchase Order from ADL Data Systems, Inc., a leading system integrator and software provider to the nursing home and health care industry, for an initial order of 1,000 Finger Print Verification Units for an undisclosed price. The Purchase Order and accompanying Letter of Agreement state that upon the successful evaluation and testing of these units initially with selected ADL nursing home clients, ADL agrees to market additional units in a joint venture with EOSC to national health care sources. ADL estimates that the first year of the joint venture following the test placement could result in the sale of a minimum of 15,000 units.
(Emphasis supplied.)
Meanwhile, Chachas and Cavanagh discussed the exercise of the second option. On February 23, 1998, Chachas ordered the transfer of 150,000 EOSC shares owned by the Curbstone Management Group to Construcciones. The Construcciones brokerage account at Donald Co. received the shares on February 24. This transfer was the exercise of the second tranche of the option agreement and required a payment of $4 per share. The $600,000 payment came from the Construcciones account at Donald Co. via the Levy Levy Trust Account for Milestone ("Trust Account"). Construcciones wired the money to the Trust Account on February 10, 1998, and on that same day the Trust Account posted the receipt of the $600,000. On February 12, the Trust Account sent Chachas $600,000.
Brooksbank asserts that Agira and not Construcciones paid for the shares. He relies on Nicolois' instruction to Levy on February 12 that he use $600,000 in escrowed funds from Agira to pay Chachas for the shares. Agira had in fact sent the Trust Account money on February 11, but not $600,000. On February 11, the Trust Account posted a deposit of $583,708.90 from Agira's Donald Co. brokerage account. That very day, Nicolois ordered Levy to extend a $300,000 bridge loan from Agira to EOSC, with $270,000 going to EOSC and the remaining $30,000 paid in fees to Milestone and Levy. Six days later, on February 17, however, Nicolois ordered Levy to transfer $300,000 from the Trust Account to a Swiss account for Agira. While the Agira transactions in February are confusing, they raise no question of fact requiring a trial. It is undisputed that the Curbstone Management Group sold 150,000 shares in February for $600,000 and that those shares went on Chachas' orders to Construcciones.
An amended Form 8-K was filed by Levy on February 18. EOSC had fired Levy for failing to correct statements in the December 23 Form 8-K about who had agreed to serve as EOSC Directors. After Cavanagh threatened EOSC with a loss of financing if it did not rehire Levy, EOSC rehired him and Levy made the February 18 filing for EOSC. It disclosed for the first time Regulation S sales to Agira Trading and Optimum Fund and corrected the total number of shares outstanding to reflect 21,084,818 shares.
Many other deficiencies in the December 23, Form 8-K remained uncorrected, however, including misstatements about the agreement of employees to serve as company directors. The February 18 filing continued to portray the merger as a stock for stock transaction without disclosing the additional terms that gave control of the float, and therefore the stock price, to Cavanagh, and Nicolois. It represented that, to the knowledge of EOSC management, no agreements as to any matters existed among the former shareholders and any other shareholders of EOSC. Cavanagh, Nicolois and Levy, each of whom reviewed the draft Form 8-K before it was filed, knew of the side agreements transferring stock to Levy and the Spanish Nominees, and the option agreement with the Curbstone Management Group. The Form 8-K also represented that 15,488,120 shares of Curbstone stock that were issued at the time of the acquisition went directly to WTS shareholders. In fact, of this quantity, 500,000 shares went directly to Levy and over 2 million went directly to Milestone. An additional 857,081 shares went to Inversora, the Spanish entity that Cavanagh indicated he had lined up to provide additional financing for EOSC, although no such financing was ever actually provided. Finally, the Form 8-K falsely stated that EOSC "presently expects to initiate its first commercial shipment" of its product in the third quarter of the year.
By early March, Tacopino had liquidated almost all of the shares originally received by the Spanish Nominees. He had succeeded in keeping the share price over $5. After March 11, the price fell below $3. Cavanagh and Nicolois assured Tacopino that they would send in buyers to "stabilize the market." At that time Cavanagh and Nicolois had large blocks of stock at Donald Co. in the name of Agira Trading, Invesora and Optimum Fund that were purportedly issued under Regulation S but not yet liquidated, and the 41 day minimum restriction period for that Regulation S stock was about to expire.
As discussed in more detail below, a Regulation S offering is an offering that is exempt from SEC registration requirements because it is made to overseas investors without an intent of resale into the U.S. market.
On February 26, Levy reported to Weaver that in an interview with the SEC staff he had told them that none of the Reg S stock had come back into the U.S. Market. Levy added, however, "not that it won't shortly."
On March 6, Cavanagh and Nicolois called Tacopino from Spain and told him to buy 100,000 shares through the Construcciones Account. Tacopino asked for a written order. Construcciones then sent a letter authorizing the purchase of 100,000 shares "in the $5 5/8 to $5 7/8 range." Tacopino made six purchases for a total amount of 100,000 shares at a price of $549,390. On March 12, Stieghorst, made two purchases of a total of 20,000 shares.
After the SEC contacted Chachas about EOSC, the four members of the Curbstone Management Group sold their remaining EOSC shares on March 11 and 12. On March 13, the TRO was entered and the SEC issued a stop trading order.
Discussion
The SEC has moved for summary judgment against ten defendants. One group is composed of Cavanagh and Nicolois, and their wholly-owned company Milestone, and relief defendants Karen Cavanagh and Beverly Nicolois, the wives of Cavanagh and Nicolois, and their company Cromlix. During the discovery period, each of these four individual defendants invoked his or her Fifth Amendment privilege against testifying. Cavanagh and Nicolois have each pleaded guilty to perjury for false statements made during the early days of this lawsuit. The SEC seeks judgment against Cavanagh, Nicolois and Milestone for violations of Section 10(b) of the Exchange Act and Rule 10b-5, and Sections 5(a) and (c), and 17(a) of the Securities Act.
The SEC has moved to preclude these defendants from presenting evidence in opposition to this summary judgment motion on the ground that they invoked the Fifth Amendment and refused to be deposed. That motion is addressed before the discussion of the claims on which the SEC seeks judgment. The issues regarding all relief defendants is presented towards the end of this Opinion.
The SEC has also moved for summary judgment against Brooksbank, Hantges, and Franklin, each of whom was a member of the Curbstone Management Group. The plaintiff seeks summary judgment on its Securities Act Sections 5(a) and (c) claims against these defendants for offering and selling securities without complying with the registration provisions of the securities laws. Finally, the SEC moves for summary judgment against relief defendant Kaufer.
Kaufer and Brooksbank were business associates. At Brooksbank's request, Kaufer invested a total of approximately two to three thousand dollars in Curbstone Management Group and Capital Advisors with an understanding that Kaufer would receive half of any income earned from the sales of the companies. Brooksbank gave Kaufer two payments representing one-half of the first two payments Brooksbank received in connection with the sale of Brooksbank's stock to three Spanish Nominees. Brooksbank gave Kaufer $65,000 on or about December 9, 1997, and $75,000 on or about February 13, 1998.
Summary judgment may not be granted unless the submissions of the parties taken together "show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Rule 56(c), Fed.R.Civ.P. The moving party bears the burden of demonstrating the absence of a material factual question, and in making this determination the court must view all facts in the light most favorable to the non-moving party. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247 (1986); Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986). "A dispute regarding a material fact is genuine if the evidence is such that a reasonable jury could return a verdict for the nonmoving party." Mount Vernon Fire Ins. Co. v. Belize NY, Inc., 277 F.3d 232, 236 (2d Cir. 2002) (citation omitted). When the moving party has asserted facts showing that it is entitled to judgment, the opposing party must "set forth specific facts showing that there is a genuine issue for trial," and cannot rest on the "mere allegations or denials" of his pleadings. Rule 56(e), Fed.R.Civ.P.; accord Burt Rigid Box, Inc. v. Travelers Property Cas. Corp., 302 F.3d 83, 91 (2d Cir. 2002). While evidence as a whole must be assessed to determine whether there is a trial-worthy issue, Bickerstaff v. Vassar College, 196 F.3d 435, 448 (2d Cir. 1999), conclusory statements are insufficient to defeat a motion for summary judgment. Opals on Ice Lingerie v. Body Lines, 320 F.3d 362, 370 n. 3 (2d Cir. 2003). In addition, documents and affidavits submitted to create a factual dispute must be "admissible themselves or must contain evidence that will be presented in an admissible form at trial." Santos v. Murdock, 243 F.3d 681, 683 (2d Cir. 2001) (per curiam); see Rule 56(e), Fed.R.Civ.P. Thus, in determining whether to grant summary judgment, this Court must (1) determine whether a genuine factual dispute exists based on the admissible evidence in the record; and (2) determine, based on the substantive law at issue, whether the fact in dispute is material.
Rule 56.1 of the Local Civil Rules of the United States District Courts for the Southern and Eastern Districts of New York ("Local Rule 56.1") "requires a party moving for summary judgment to submit a statement of the allegedly undisputed facts on which the moving party relies, together with citation to the admissible evidence of record supporting each such fact." Giannullo v. City of New York, 322 F.3d 139, 140 (2d Cir. 2003) (emphasis supplied). See also Local Rule 56.1(a), (d). "[W]here there are no citations or where the cited materials do not support the factual assertions in the Statements, the Court is free to disregard the assertion." Holtz v. Rockefeller Co., Inc., 258 F.3d 62, 73 (2d Cir. 2001). If the opposing party fails to controvert a properly supported fact in the moving party's Rule 56.1 statement, that fact will be deemed admitted. See Local Rule 56.1(c); Giannullo, 322 F.3d at 140.
Local Rule 56.1 provides in full:
(a) Upon any motion for summary judgment pursuant to Rule 56 of the Federal Rules of Civil Procedure, there shall be annexed to the notice of motion a separate, short and concise statement of the material facts as to which the moving party contends there is no genuine issue to be tried. Failure to submit such a statement may constitute grounds for denial of the motion.
(b) The papers opposing a motion for summary judgment shall include a separate, short and concise statement of the material facts as to which it is contended that there exists a genuine issue to be tried.
(c) All material facts set forth in the statement required to be served by the moving party will be deemed to be admitted unless controverted by the statement required to be served by the opposing party.
(d) Each statement of material fact by a movant or opponent must be followed by citation to evidence which would be admissible, set forth as required by Federal Rule of Civil Procedure 56(e).
(Emphasis supplied.)
On March 30, 2004, the SEC served all defendants and relief defendants with a Notice To Pro Se Litigants Opposing Motion For Summary Judgment. This notice informed the defendants that they may not oppose summary judgment simply by relying on the allegations in their pleadings. The notice stated that the defendants must submit admissible evidence and affidavits in accordance with Rule 56, Fed.R.Civ.P., in order to counter facts asserted by the SEC and raise issues of facts for trial. This notice advised the defendants and relief defendants that if they did not timely respond with affidavits, including sworn statements based on personal knowledge that would be admissible at trial, or documentary evidence contradicting facts asserted by the SEC, the court may accept the SEC's factual assertions as true.
I. Preclusion Motion
The SEC has moved to preclude Cavanagh, Nicolois, Milestone and their wives from presenting any evidence in opposition to this motion for summary judgment (or at trial) on the ground that they asserted their Fifth Amendment right against self-incrimination and refused to testify during the discovery period in this action. Alternatively, the SEC moves to preclude these defendants and relief defendants from relying on the testimony that Cavanagh gave in 1998, since he has refused to testify on two subsequent occasions on the ground that his testimony may incriminate him. To the extent that these defendants raise issues of fact, they do so principally through citations to Cavanagh's Hearing testimony. Finally, the SEC argues that, at the very least, it is entitled to an adverse inference against any defendant who has invoked the Fifth Amendment privilege.
The Fifth Amendment provides that "no person . . . shall be compelled in any criminal case to be a witness against himself." U.S. Const. Amend V. An individual is entitled to invoke the privilege against self-incrimination during a civil proceeding.See, e.g., Minnesota v. Murphy, 465 U.S. 420, 426 (1984);Asherman v. Meachum, 957 F.2d 978, 981 (2d Cir. 2002). The trier of fact, however, can draw an inference "against a party to a civil suit that invokes the Fifth Amendment privilege against self-incrimination." Nabisco, Inc. v. PF Brands, Inc., 191 F.3d 208, 226 (2d Cir. 1999). See also United States v. U.S. Currency in the Amount of $119,984.00 More or Less, 304 F.3d 165, 177 (2d Cir. 2002). In addition, a "party who asserts the privilege against self-incrimination must bear the consequence of lack of evidence, and the claim of privilege will not prevent . . . summary judgment if the litigant does not present sufficient evidence to satisfy the usual evidentiary burdens in the litigation." United States v. Certain Real Property and Premises Known As: 4003-4005 5th Ave., Brooklyn, N.Y., 55 F.3d 78, 83 (2d Cir. 2003) (citation omitted). Nonetheless, because all parties — those who invoke the Fifth Amendment and their opponents — should have every reasonable opportunity to litigate a civil case fully and because the exercise of Fifth Amendment rights should not be made unnecessarily costly, courts should further the goal of permitting as much testimony as possible to be presented in the civil litigation, despite the assertion of privilege, and balance the rights of all parties to the litigation. Id. at 84. Courts should "give due consideration to the nature of the proceeding, how and when the privilege was invoked, and the potential for harm or prejudice to opposing parties." Id. When a party who has invoked the privilege seeks to withdraw the claim of privilege a particularly careful inquiry is required.
Since an assertion of the Fifth Amendment is an effective way to hinder discovery and provides a convenient method for obstructing a proceeding, trial courts must be especially alert to the danger that the litigant might have invoked the privilege primarily to abuse, manipulate or gain an unfair strategic advantage over opposing parties. If it appears that a litigant has sought to use the Fifth Amendment to abuse or obstruct the discovery process, trial courts, to prevent prejudice to opposing parties, may adopt remedial procedures or impose sanctions. In such circumstances, particularly if the litigant's request to waive comes only at the `eleventh hour' and appears to be part of a manipulative, `cat-and-mouse approach' to the litigation, a trial court may be fully entitled, for example, to bar a litigant from testifying later about matters previously hidden from discovery through an invocation of the privilege.Id. at 84-85 (citation omitted).
The authority to impose sanctions for abuse of the discovery process comes from a court's broad discretion to control and remedy abuses of the discovery process. Id. at 85 n. 7 (citing Rule 26, Fed.R.Civ.P.; National Hockey League v. Metropolitan Hockey Club, Inc., 427 U.S. 639, 643 (1976)). Courts in this circuit have repeatedly precluded testimony when the party had refused to submit to discovery in reliance on the privilege against self-incrimination. See Certain Real Property, 55 F.3d at 85-87; SEC v. Cassano, No. 99 Civ. 3822 (LAK), 2000 WL 777930 (S.D.N.Y. June 19, 2000); Glimcher Properties Ltd. Partnership v. NJMM, LLC., No. 99 Civ. 1492 (JSM), 2000 WL 1738415, at *3 (S.D.N.Y. Nov. 21, 2000); SEC v. Softpoint, Inc., 958 F. Supp. 846, 857 (S.D.N.Y. 1997) (J. Sotomayor) (precluding defendant from offering any testimony in opposition to summary judgment even though defendant had submitted to an SEC investigatory examination prior to the litigation), aff'd, 159 F.3d 1348 (2d Cir. 1998); SEC v. Benson, No. 84 Civ. 2262 (PNL), 1985 WL 1308 (S.D.N.Y. Apr. 9, 1985).
Cavanagh and Nicolois and their wives testified in 1998, in connection with the Hearing. Specifically, Cavanagh testified at a deposition and at the Hearing. Nicolois testified as a non-party at a deposition in May 1998. Their wives were also deposed in 1998. Thereafter, these individuals invoked their Fifth Amendment privilege and refused to testify. Cavanagh and Nicolois refused to provide testimony on September 10, 1998 and March 8, 1999, respectively. More recently, on October 24, 2003, Cavanagh and Nicolois again invoked their Fifth Amendment privilege and refused to answer any questions of substance at their depositions. Their wives similarly invoked their Fifth Amendment privilege two days earlier, on October 22. None of these parties have submitted an affidavit in opposition to summary judgment or indicated a desire now to submit to depositions.
Others associated with Nicolois and Cavanagh have also refused to respond to the SEC's questions on the ground that their answers may incriminate them: Tur Ortola and Benjamin Pineda Lloret, representatives of the Spanish Nominees, and Lehmann.
As noted above, this civil litigation was stayed for several years during a criminal investigation. Nicolois, Cavanagh, and Levy were indicted on February 26, 2003, for sworn statements in 1998 in this action. The indictment recited the following background facts. A March 13, 1998 TRO issued by this Court, as amended on March 20, required Cavanagh and Levy to file sworn accountings. A July 31 amended complaint added Nicolois as a civil defendant, and through an August 19 Stipulation and Order he was also required to provide a sworn accounting. Cavanagh's March 23, 1998 accounting failed to disclose that he was the beneficial owner of two Swiss bank accounts. Levy's March 20, 1998 accounting failed to disclose his receipt of 95,000 EOSC shares and $561,000 from the sale of those shares. In his April 14, 1998 amended affidavit, Levy again failed to disclose these transactions. At his May 26, 1998 deposition, Nicolois denied knowing of any foreign accounts held by Cavanagh even though Nicolois had signed bank documents granting him a power of attorney over one of Cavanagh's Swiss bank accounts. The seven count indictment charged the defendants with violations of 18 U.S.C. § 1621 and 1503.
On December 11, 2003, Cavanagh and Nicolois each pleaded guilty to one count of perjury pursuant to a plea agreement with the Government that calculated their sentencing guidelines range as six to twelve months. Cavanagh admitted that he knowingly executed and swore to a false financial statement that omitted the fact that he had signatory rights on a Swiss bank account. Nicolois admitted knowingly testifying falsely under oath in May of 1998 that he did not know that Cavanagh had signatory rights over a Swiss bank account.
On March 11, 2004, the Honorable Shira Scheindlin sentenced each defendant principally to two years of probation with six months of home detention as a special condition. The Court rejected the defendants' requests to forego a fine. She imposed fines of $10,000 on Cavanagh and $5,000 on Nicolois to impress upon them the seriousness of their offense and to serve as a warning should they be tempted again to engage in criminal conduct.
The SEC's motion to preclude these defendants and relief defendants from offering any evidence in opposition to summary judgment must be denied. To the extent that these defendants have pointed to any evidence that would be admissible at trial it shall be considered.
The SEC's motion to preclude these defendants and relief defendants from relying on Cavanagh's Hearing testimony, however, must be granted. Summary judgment practice is intended to identify whether there are disputed issues of fact created by admissible evidence that require a trial. Cavanagh's Hearing testimony is, of course, inadmissible unless offered at trial by a party opponent. There is no evidence that Cavanagh himself will testify at trial, and the SEC would be able to show substantial prejudice if he attempted to do so. Cavanagh has refused since September 1998 to be deposed in this action. During much of this time he was the target of or a defendant in a criminal proceeding. At no point since that prosecution ended, however, has Cavanagh sought to reopen discovery and to submit to a deposition. He does not make that offer in opposition to the SEC's motion to preclude and has not submitted his own affidavit in opposition to summary judgment. He has, therefore, not established that he would in fact testify at trial and has deprived the SEC of an opportunity to depose him in advance of trial.
Cavanagh's attorney, Paul A. Batista ("Batista"), has submitted an affirmation in opposition to summary judgment which principally discusses the criminal prosecution and presents legal arguments. The SEC has moved to strike the affirmation. The affirmation is accepted solely as a supplemental brief on behalf of Cavanagh and the other defendants represented by Batista.
II. Section 5
The SEC has moved for summary judgment against Cavanagh, Nicolois, Milestone, Franklin, Brooksbank and Hantges for a violation of Sections 5(a) and (c) of the Securities Act. All of these defendants except Hantges resist a finding of liability.
Section 5(a) provides in pertinent part
(a) Unless a registration statement is in effect as to a security, it shall be unlawful for any person, directly or indirectly —
(1) . . . to sell such security through the use or medium of any prospectus or otherwise; or
(2) to carry or cause to be carried . . . any such security for the purpose of sale or for delivery after sale.15 U.S.C. § 77e(a). Section 5(c) makes it unlawful for any person, "directly or indirectly," by means of interstate commerce, "to offer to sell" a security "unless a registration statement has been filed as to such security. . . ." 15 U.S.C. § 77e(c). See also Demaria v. Andersen, 318 F.3d 170, 173 (2d Cir. 2003). A sale includes "every contract of sale or disposition of a security or interest in a security, for value." 15 U.S.C. § 77b(a)(3). An offer to sell securities includes "every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value."Id.
The purpose of the registration requirement, and of the Securities Act as a whole, is to "protect investors by promoting full disclosure of information thought necessary to informed investment decisions." SEC v. Ralston Purina Co., 346 U.S. 119, 124 (1953). Section 5 requires issuers of securities to disclose, among other things, information about the issuer's financial condition, the identity and background of management, and the price and amount of securities to be offered. 15 U.S.C. § 77g, 77aa.
To establish a prima facie violation of Section 5, the SEC must prove three elements: (1) that no registration statement was in effect for the securities; (2) that the defendant directly or indirectly sold or offered to sell the securities; and (3) that interstate means were used in connection with the offer or sale.Europe and Overseas Commodity Traders v. Banque Paribas London, 147 F.3d 118, 124 n. 4 (2d Cir. 1998). A registration statement is transaction specific. "Each sale of a security . . . must either be made pursuant to a registration statement or fall under a registration exemption." Cavanagh, 155 F.3d at 133 (citation omitted). Registration statements are "filed for offerings and not for securities." Id. To prove a violation of Section 5, a plaintiff need not establish scienter. See Pinter v. Dahl, 486 U.S. 621, 638 (1988) (strict liability for a Securities Act Section 12 claim); SEC v. Universal Major Indus., 546 F.2d 1044, 1047 (2d Cir. 1976) (addressing equitable relief sought against an aider and abetter). See also In re WorldCom, Inc. Sec. Litig., 294 F. Supp.2d 431, 441-43 (S.D.N.Y. 2003) (strict liability for Securities Act Section 11 claim). If the SEC has made out a prima facie case of a violation, the defendant bears the burden of showing that the securities transactions at issue fall within one of the enumerated exemptions from registration.Ralston Purina Co., 346 U.S. at 126; Cavanagh, 155 F.3d at 133.
The SEC has presented evidence to establish that each of these defendants violated Section 5. They have shown that no registration statement was filed for the sales of stock by the Curbstone Management Group that are the focus of the Section 5 claims, including sales to the Spanish Nominees and sales through the option agreement.
The SEC has shown that Chachas, on behalf of Franklin, Brooksbank, Hantges and himself, negotiated from December 1 to 12, 1997, with Levy, on behalf of Cavanagh, Nicolois, and Milestone, to sell almost all of their ownership interest in Curbstone. The Curbstone Management Group sold stock to the Spanish Nominees in December 1997, sold other stock through the option agreement in December and early 1998, and sold their own EOSC shares to the public in March 1998. Cavanagh, Nicolois and Milestone were, at a minimum, indirect sellers of EOSC stock. Through Levy's negotiations they arranged for the sale of the Curbstone shares to the Spanish Nominees and the resale of those, shares to the public. They arranged for a market maker for EOSC stock, set up the brokerage accounts to liquidate the EOSC stock, and oversaw the sale of that stock through a dozen Donald Co. brokerage accounts.
A. Cavanagh, Nicolois, U.S. Milestone
Cavanagh, Nicolois and Milestone do not claim that there was any exemption under the law that would have eliminated the need to file a registration statement. Cavanagh, Nicolois, their wives and Milestone contend, however, that there are material, disputed issues of fact regarding three issues: (1) whether a registration statement was in effect; (2) whether Cavanagh, Nicolois or Milestone sold or offered to sell securities as to which no valid registration statement was effective; and (3) whether Cavanagh and Nicolois were entitled to rely on the advice from their counsel, Levy, that a valid registration statement covering the transfers of EOSC securities was in effect or that a legitimate exemption was available. As to the first issue, the defendants have not pointed to any evidence to suggest that a registration statement for these sales was in effect. As the Second Circuit has emphasized in this very litigation, the registration requirement is transaction specific. Cavanagh, 155 F.3d at 133. As to the last — the advice of counsel defense — that defense provides no protection against a violation of a strict liability statute like Section 5. The factual basis for this asserted defense is addressed infra, in connection with the Section 10(b) claim.
In their Local Civil Rule 56.1 Statement, these defendants appear to contest several facts upon which the SEC relies to show that they were deeply involved in the sale and distribution of shares for which there was no registration statement. When their citations to record evidence are examined, however, in every instance but one, their citations do not relate to the facts they assert are in dispute. As significantly, in every instance but those discussed below in connection with an advice of counsel defense, their only citation is to prior testimony given by Cavanagh at the Hearing. For the reasons already explained, the defendants may not rely on Cavanagh's Hearing testimony to raise a disputed issue of fact.
Cavanagh and Nicolois rely on Cavanagh's Hearing testimony to place certain facts in dispute. When their references to his testimony are examined, however, those passages do not contradict the assertions and evidence cited in the SEC's 56.1 Statement. Thus, they have not provided evidentiary support for their contentions that they were not engaged in the distribution of the Curbstone Management Group's stock; that they did not tell Weaver that they wanted to invest $4 million; that Tacopino's evidence about their roles in the sale of EOSC stock is inaccurate; that Cavanagh did not participate in the Stieghorst's 11:13 a.m. trade on the first day of EOSC trading; that Cavanagh and Nicolois did not control the market float; that Cavanagh did not pressure Weaver to issue the January 1998 press release; and that Cavanagh did not pressure Weaver to retain Levy.
Cavanagh and Nicolois assert that the approximately one million shares distributed from the Spanish Nominee accounts to twenty-nine accounts in the names of their friends, family and associates were transferred principally to fulfill "moral obligations from previous transactions." This assertion does not raise an issue of fact that the distribution of these shares was made at their direction. Finally, Cavanagh asserts that WTS's machine was demonstrated to him in July 1997 and that it worked perfectly. Even if this testimony were admissible, it is insufficient to raise an issue of fact with respect to Weaver's testimony that in January 1998 the company did not yet have a usable prototype to show to potential customers.
It should be noted, however, that even if the defendants could rely on Cavanagh's Hearing testimony, it raises a dispute regarding only a single fact. Cavanagh admitted at the Hearing that he placed an order for a purchase of EOSC stock on December 19 with a broker named Proudian at Alexander Westcott. He asserted, however, that the order had an upper limit of $7, and was not an order with a fixed price of $7. The SEC has relied on the contemporaneous account records and the testimony of two brokers to assert that Cavanagh placed a fixed price order at $7. Even if it were appropriate to consider Cavanagh's testimony, this single factual dispute, given the abundance of evidence on which the SEC has relied, does not create a material issue of fact with respect to any element of any of the claims with which the defendants are charged.
B. Brooksbank and Franklin
Brooksbank and Franklin resist summary judgment principally by arguing that one or more of three exemptions to registration protect them from liability under Section 5. They have submitted affidavits which to a large extent are not based on personal knowledge. The SEC's motion to strike portions of their affidavits, and portions of Brooksbank's Rule 56.1 Statement are addressed before turning to the issue of whether they have raised questions of fact that require a trial on the three asserted exemptions from registration.
1. Brooksbank's Affidavit and Rule 56.1 Statement
The SEC has moved to strike those portions of the Brooksbank affidavit and Rule 56.1 Statement that are not based on personal knowledge or otherwise admissible evidence. Brooksbank's affidavit in opposition to the summary judgment motion contains very little information based upon first hand knowledge or otherwise admissible evidence. For example, Brooksbank recites in considerable detail conversations between Levy and Chachas. He does not assert that he has any first hand knowledge of those conversations. He denied in his testimony in 1998 that he had any recollection of the contents of the few conversations with Levy in which he participated, and continues to this day to assert that he had no role in the negotiations for the sale of the Curbstone stock and depended entirely on Chachas. In his 1998 testimony Brooksbank also denied any knowledge of the substance of the negotiations.
With few exceptions, Brooksbank has not presented any admissible evidence that raises a question of fact regarding his liability under Section 5. A summary of his more fact-based contentions is included here. As this summary illustrates, these contentions are largely irrelevant to the issue of his liability under Section 5.
Brooksbank accepts that a serious fraud and manipulation was perpetrated, but blames Levy, Cavanagh and Nicolois. Brooksbank principally argues that, as an attorney, he provided substantial, uncompensated legal work on behalf of Curbstone that entitled him to the money and stock he received through the sale of the Curbstone Management Shares; that he is responsible for bringing Chachas to Curbstone and relied upon him as a securities law expert; that in particular he relied upon Chachas when Chachas represented to him the Curbstone sale was legal and exempt from the Section 5 registration requirements; that Chachas negotiated the transaction on behalf of Curbstone and that the other three members of the Curbstone Management Group were not involved in the negotiations, execution or delivery of the Purchase Agreements; that the Curbstone December Form 8-K was prepared by Levy and that Chachas's role was to submit it to the SEC through its EDGAR system; that Brooksbank was no longer an affiliate of Curbstone/EOSC when he sold his shares; that Brooksbank's shares were sold to Construcciones and Tacopino's early liquidation of Spanish Nominee shares was from the Cambiarios account; that while Cavanagh and Nicolois had significant influence over the market float, it remains a disputed issue of fact whether they controlled the Spanish Nominees.
Brooksbank asserts that Chachas told him that no registration was necessary because of the exemption contained in Section 4(1), since the four members of the Curbstone Management Group "were no longer affiliates of Curbstone" after the merger.
Brooksbank wrongly asserts that the SEC cannot rely on Tacopino's testimony because Brooksbank was denied an opportunity to cross-examine Tacopino. At a November 6, 2003 conference held to discuss Brooksbank's complaint about the SEC not giving him notice that would allow him to participate in certain depositions by telephone, the SEC stated that it had provided Brooksbank with notice of all depositions, including Tacopino's, and denied that Brooksbank ever asked to participate in Tacopino's deposition by telephone. Tacopino's deposition did not conclude until November 7, and Brooksbank cross-examined Tacapino. At the November 6 conference, Brooksbank did not indicate that he was prejudiced by his failure to participate in the earlier portions of Tacopino's deposition, and never brought to the Court's attention any complaint of prejudice despite being given an opportunity to review deposition transcripts and identify any prejudice.
The only factual assertions with potential relevance to the Section 5 claim are the asserted reliance on Chachas' representations about the exemption from registration and the assertion that Brooksbank was no longer an affiliate when the Curbstone shares were sold. The later assertion is addressed in connection with the discussion of the Section 4(1) exemption,infra.
The law concerning a defendant's reliance on advice of counsel is set forth below in connection with the defenses that Cavanagh and Nicolois interpose to the securities fraud charges. Since a Section 5 claim is a strict liability claim, Brooksbank's scienter is not at issue and his assertion of Chachas' advice does not raise a question of fact requiring a trial.
2. Franklin's Affidavit
The SEC moves to strike those portions of Franklin's affidavit that are not based on personal knowledge. In his affidavit Franklin describes himself as a former stockbroker who worked from 1994 to 2000 as president of an IPO consulting firm in an effort to obtain financing for small companies. In 1996, Franklin agreed to work with Chachas on Curbstone and invested approximately $5,000 in the company. Franklin's job was to find a company to buy Curbstone. Franklin became a member of the Curbstone Board of Directors, and then in the summer of 1997 resigned when Chachas requested him to do so. Franklin gave all of his shares to Chachas, along with a power of attorney. Franklin participated in none of the negotiations regarding the WTS transaction. Chachas told Franklin that he was the attorney, "let me worry about the legal matters."
Franklin admits that there was a massive fraud, but contends that he assumed that all of the transactions in which he was involved were legal. He represents that any violation of the law on his part was through inadvertence, and not because of any unlawful intent.
Beyond this description of his involvement with Curbstone and his state of mind, Franklin has also incorporated into his affidavit a description of events based on his review of materials produced during this litigation. As was true in connection with Brooksbank's affidavit, those portions of the affidavit that do not reflect events in which he participated are treated only as argument and have been considered to the extent that they identify admissible evidence to support their assertions of fact.
3. Brooksbank, Franklin: The Exemptions to Registration
Two of the three members of the Curbstone Management Group — Brooksbank and Franklin — resist summary judgment by asserting that there are exemptions from registration that apply to their transactions. Their submissions do not create any material issue of fact to support their contention that these exemptions prevent a finding of liability against them under Section 5. The three exemptions on which they rely are Section 4(1), putative Section 4(1)½, and Regulation S. The first two of these purported exemptions were considered at the Hearing and rejected.
In the course of their submissions, Brooksbank and Franklin make a number of assertions of fact without presenting or referring to any admissible evidence to support those facts. For instance, they assert that one or more of the Spanish Nominees had knowledge about the business of WTS. Those facts without evidentiary support are given no weight in the analysis of their opposition to the summary judgment motion. Giannullo, 322 F.3d at 140.
Section 4(1) Exemption
Section 4(1) of the Securities Act exempts from registration those transactions conducted by someone other than an "issuer, underwriter or dealer." 15 U.S.C. § 77d(1). The purpose of this exemption is to allow free trading among individual investors of securities that have already been registered. SEC v. Culpepper, 270 F.2d 241, 247 (2d Cir. 1959).
The securities laws define an issuer, with exceptions that have no relevance here, as "every person who issues or proposes to issue any security." 15 U.S.C. § 77b(a)(4). An issuer includes "any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control of the issuer." 15 U.S.C. § 77b(a) (11). "A control person, such as an officer, director, or controlling shareholder, is an affiliate of an issuer and is treated as an issuer when there is a distribution of securities." Cavanagh, 155 F.3d at 134.
The term "affiliate" is defined in Rule 144 of the securities regulations as "a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer." 17 C.F.R. § 230.144(a) (1). A person is not an "affiliate" for the purposes of Section 5 and Section 4(1), however, if at the time he sold the corporation's shares he had not been an "affiliate" of the issuer for the preceding three months. See 17 C.F.R. § 177.144(k); United States v. Sprecher, 988 F.2d 318, 319 (2d Cir. 1993). Ordinarily, an affiliate may not rely on a Section 4(1) exemption. Cavanagh, 155 F.3d at 134.
"Control" is defined in Rule 405 as the "possession, direct or indirect, of the power to direct or cause the direction of the management policies of a person, whether through the ownership of voting securities, by contract, or otherwise." 17 C.F.R. § 230.45. The determination of whether a person occupies a "control" position does not turn upon a single factor such as stock ownership, but rather "depends on the totality of the circumstances, including an appraisal of the influence the individual has on the management and policies of the company."Cavanagh, 1 F. Supp.2d at 366 (citing United States v. Corr, 543 F.2d 1042, 1050 (2d Cir. 1976)).
17 C.F.R. § 230.144(k) provides in full:
Termination of certain restrictions on sales of restricted securities by persons other than affiliates. The requirements of paragraphs (c), (e), (f) and (h) of this section shall not apply to restricted securities sold for the account of a person who is not an affiliate of the issuer at the time of the sale and has not been an affiliate during the preceding three months, provided a period of at least two years has elapsed since the later of the date the securities were acquired from the issuer or from an affiliate of the issuer. The two-year period shall be calculated as described in paragraph (d) of this section.
(Emphasis supplied.)
Under the doctrine of integration, the merger of Curbstone with WTS and the sales to the Spanish Nominees are treated as one.Cavanagh, 1 F. Supp.2d at 364. See also Geiger v. SEC, 363 F.3d 481, 487 (D.C. Cir. 2004) (defendant did not have to be involved in the final step of the distribution to be considered a seller for Section 5 purposes); Universal Major Indus., 546 F.2d at 1047; SEC v. Lybrand, 200 F. Supp.2d 384, 396 (S.D.N.Y. 2002) (finding the sales and transfer at issue were a single transaction for each entity, and that defendants were affiliates of the issuer even after they resigned as officers and directors and transferred a majority of shares).
Neither Brooksbank nor Franklin has raised an issue of fact to show an entitlement to rely on the Section 4(1) exemption at trial. Each member of the Curbstone Management Group was an issuer. Each member owned approximately one-quarter of Curbstone and agreed that Chachas could offer to sell and sell their stock as a block. Brooksbank, along with Chachas, was an officer and director of Curbstone. Franklin's resignation from the Curbstone Board of Directors in the summer of 1997 does not alter this analysis or raise a question of fact regarding his status as an affiliate in December 1997.
Brooksbank's effort in his affidavit to deny that the Curbstone Management Group's stock was sold as a block contradicts his deposition testimony and is therefore rejected.Bickerstaff v. Vassar College, 196 F.3d 435, 455 (2d Cir. 1999) ("[A] party may not create an issue of fact by submitting an affidavit in opposition to a summary judgment motion that contradicts the affiant's previous deposition testimony."). For instance, in his March 1998 deposition Brooksbank testified that "there were four people — irrespective of what the shares of stock stated, there were four people who each participated equally as on our end as a group."
Brooksbank and Franklin assert that Weaver took control of Curbstone before December 18, 1997, and that they were no longer affiliates of the company on that date. In particular, they assert that they were not affiliates at the precise point on December 18 when the shares issued to the Spanish Nominees pursuant to the Purchase Agreements and when the shares they sold as Milestone exercised the first option were shipped by the transfer agent to Levy. They emphasize that the Exchange Agreement which effected the merger is dated December 5.
As the April 20 Opinion described, Chachas and Levy worked together to make it appear that the sale of Curbstone to WTS had occurred before the sale of shares to the Spanish Nominees and the exercise of the first option.
There is evidence that the resignations of the officers and directors were not accepted on December 18 until after the transfer agent issued the shares to the Spanish Nominees.
Offers for sale of unregistered securities are as prohibited as sales. It is undisputed that the defendants offered their stock for sale while affiliates. The defendants also have not raised an issue of fact as to whether the merger and these stock sales should not be treated as an integrated transaction. These sales of shares, the remainder of the sales of under the option agreement, and the lock-up agreement, were material parts of the consideration for the reverse acquisition. Since this was an integrated transaction, it is irrelevant to resolve on what precise day control passed from the Curbstone Management Group to Weaver. In any event, under SEC regulations, Brooksbank and Franklin would have retained their affiliate status for three months after control passed. See 17 C.F.R. § 230.144(k).
Brooksbank and Franklin argue in a similar vein that their February 1998 sales through the exercise of the second option, and their own March 1998 sales of EOSC shares to the public are exempt because they were no longer affiliates of EOSC. As noted, the option agreement and the lock-up agreement were negotiated in December and were integral parts of the agreement pursuant to which the Curbstone Management Group sold its shares. They were part of the integrated transaction and cannot be excised from it. When the substance of the transactions are examined, as they must be, none of the facts to which the defendants point are material.
Brooksbank argues that Allison v. Ticor Title Ins. Co., 907 F.2d 645 (7th Cir. 1990), requires a different result. It does not. Allison observed that each sale of a security must be lawful and that a prior illegal sale will not taint a future sale if an exemption from registration is available for that sale.Id. at 648. This unremarkable proposition gives no comfort to Brooksbank unless he can identify an exemption from registration for his sales. The Purported Section 4(1)½ Exemption
In connection with the sale of their shares to the Spanish Nominees, Brooksbank and Franklin rely on an implied exemption to registration which is referred to as the Section 4(1)½ exemption because it falls between the cracks of the Sections 4(1) and 4(2) exemptions, which allow, respectively, for private sales among persons who are not issuers, underwriters, or dealers, and for private sales by an issuer. The Section 4(1)½ exemption is said to allow affiliates to sell substantial amounts of their stock to private investors without registration. See Cavanagh, 1 F. Supp.2d at 368. As is the case for an issuer claiming an exception for a private sale under Section 4(2), an affiliate claiming a Section 4(1)½ exemption has the burden of establishing that such sales do not constitute a disguised public distribution. See id. at 368-69.
Although the SEC has never articulated exactly what steps an issuer or affiliate must take to fall within the private placement exemption under Section 4(2), the elicitation of bare representations that the buyer does not have any present agreement to resell is plainly insufficient. As the SEC has advised,
An issuer may not establish a claim to an exemption under Section 4(1) [now 4(2)] merely by collecting so-called "investment representations" from a limited group of purchasers if in fact a distribution by such persons occurs. Counsel and their issuer and underwriter clients cannot base a claim to exemption from registration under the Securities Act upon the mere acceptance at face value of representations by purchasers that they take for investment and disclaim responsibility for investigation and consideration of all relevant facts and circumstances pertinent to a determination that the transactions do not involve a public offering.
Securities Act Release No. 3825, 1957 WL 7724, at *5 (SEC Aug. 12, 1957) (emphasis added). Even assuming that the law recognizes an implied exemption under purported Section 4(1)½ the defendants have not shown that there exists a question of fact as to whether their sales to the Spanish Nominees was a qualified private distribution.
A portion of Brooksbank's Section 4(1)½ exemption argument is mistakenly premised on the assertion that the sale of the stock of the Curbstone Management Group in connection with the exercise of the second option was to Agira Trading. At his deposition Brooksbank testified that he did not know who had purchased his shares. As already discussed, the records show Construcciones, one of the Spanish Nominees, received Brooksbank's February shares.
The undisputed evidence is that the Spanish Nominees were formed for the purpose of buying United States securities just weeks before the closing of the transaction, and took steps to resell and transfer their shares into the American market as soon as they received the shares. Cavanagh and Nicolois opened brokerage accounts at Donald Co. in order to liquidate those shares as Levy and Chachas were negotiating the sale of Curbstone. Tacopino began selling the EOSC stock, through short sales, as soon as the sale of Curbstone closed and before the accounts opened in the names of the Spanish Nominees had even received the EOSC shares. Cavanagh and Nicolois directed Tacopino's sales of the shares from the Spanish Nominees' accounts. The Curbstone Management Group's cooperation with this scheme was critical. The Group provided "free trading" Curbstone stock, that is, stock that was free of any restrictive legends. No member of the Group performed any due diligence as to the identity of the Spanish Nominees or their investment objectives.
Brooksbank and Franklin rely on a representation in the Purchase Agreements that covered the sale of the 2.5 million shares to the Spanish Nominees to raise a question of fact as to whether they could have reasonably understood that this was a private distribution and that there would be no sales to the public. The agreement with the Spanish Nominees contained the following representation: "The Purchaser is investing solely for its own account and has no present agreements to transfer rights to this subscription Agreement or to the Shares to any other person." This representation is insufficient to raise a question of fact about whether the sale was reasonably understood to be sale of shares that would not be resold to the American public. These defendants have not presented sufficient facts to show that they conducted any investigation which would have permitted them to rely reasonably upon this limited representation.
Brooksbank relies on Chachas' testimony at the Hearing to the effect that he believed that he was dealing with sophisticated investors who did not have a present intention to distribute shares. Without evidence of any investigation to provide a reasonable basis for that asserted belief, this assertion is insufficient to raise a question of fact requiring a trial.
Chachas testified at the Hearing that he did no research on the Spanish Nominees and did not even know their identities until Levy sent the Purchase Agreements back to him.
Brooksbank and Franklin assert that they sold their stock in December to Construcciones, and that it resold its stock for the first time in February, or forty-nine days after "enormous changes" had occurred. The enormous changes are apparently the rise in the price of the stock manipulated by Cavanagh and Nicolois. Brooksbank and Franklin argue that this is compelling evidence that Construcciones did not intend to resell the stock immediately, and that the purchase was made for purposes of investment rather than resale, and thus qualifies for a Section 4(1)½ exemption.
Brooksbank has presented no evidence that he understood at the time that his shares would go to Construcciones. In his March 20, 1998 deposition, in response to an inquiry about who had purchased his stock, Brooksbank testified that "you know, I don't care who would buy my stock."
Even assuming that the flow of paperwork demonstrates that Brooksbank's or Franklin's individual Curbstone shares went to Construcciones, that does not raise an issue of fact regarding Construcciones intent or the applicability of an implied Section 4(1)½ exemption. Again, the undisputed evidence requires the resale of the Spanish Nominees' shares into the public markets to be viewed as a single controlled stream of sales that ran from December on. There is no evidence that anyone made the decision about when and from which particular account to sell these shares except Cavanagh and Nicolois and that they controlled through Tacopino the timing of the liquidation of the Spanish Nominees' shares so that sales were made from December through March at a rate which would preserve a market price over $5 and yet liquidate the accounts as quickly as possible. Thus, the fact that the Construcciones' shares were not sold first is not a sufficient basis to find that the sale to one of the three nominees should be segregated from the sales to the other nominees such that it is entitled to an exemption from registration requirements.
Since Construcciones only received 850,000 shares in December, it could not have received shares from both Brooksbank and Franklin at that time.
In a similar vein, Franklin argues that what is at issue is the purchaser's intent at the time of purchase, and that that intent may change legitimately over time. Franklin asserts that an investment intent can be found where the purchaser holds for a market rise, like that which occurred here. Franklin has not pointed, however, to any admissible evidence that would entitle a jury to find that there was an intent by the Spanish Nominees at the time they purchased shares to hold them for investment.
Franklin relies on Ralston Purina Co., 346 U.S. 119. Ralston Purina Co. held that the defendant's offerings of stock to its employees should have been registered because it did not fall into the "private offering" exception to the registration requirement contained in Section 4(1). In so holding, the Court stated that application of the private offering exemption "should turn on whether the particular class of persons affected need the protection of the Act." Id. at 125. Franklin argues that the entities that received the securities at issue were created or completely controlled by Levy, and did not have the need for the information which would have been provided in a registration statement. As the undisputed evidence shows, however, the unrestricted stock sold to the Spanish Nominees was funneled immediately and directly to the public. In any event, no party has provided evidence of precisely who the Spanish Nominees were or what they knew. Franklin has not raised a question of fact that would permit him to argue to the jury that a Section 4(1)½ exemption applies here.
Section 4(1) states, in part, that "transactions by an issuer not involving any public offering" are exempt from the registration requirements of Section 5. See 15 U.S.C. § 77d.
Regulation S
Finally, Brooksbank and Franklin argue that the sale of their stock to the Spanish Nominees is exempt from registration under Regulation S. Regulation S, adopted in SEC Release No. 33-6863 (April 24, 1990), is a non-statutory exemption for securities offered and sold outside the United States from the registration requirements under Section 5 of the Securities Act. 17 C.F.R. § 230.901. In order to qualify under Regulation S, "both the sale and the offer pursuant to which it was made must be outside the United States." Banque Paribas London, 147 F.3d at 124 n. 5 (citing Offshore Offers Sales, Securities Act Release No. 6863, 1990 WL 311658 (S.E.C. Apr. 24, 1990)). If two "safe harbor" exemptions within Regulation S are met, the offer and resale of securities are deemed to take place outside the United States for the purpose of Section 5. See id.; 17 C.F.R. § 903 (issuers); 17 C.F.R. § 230.904 (sellers). Regulation S, however, "does not apply to transactions that, though in technical compliance, are designed to evade the registration requirement." Geiger, 363 F.3d at 488.
Regulation S was amended in 1997. All citations to Regulation S that follow are to the pre-1997 version in effect at the time of the contested transactions.
17 C.F.R. § 230.901 provides:
For the purposes only of Section 5 of the Act ( 15 U.S.C. § 77e), the terms offer, offer to sell, sell, sale, and offer to buy shall be deemed to include offers and sales that occur within the United States and shall be deemed not to include offers and sales that occur outside the United States.
To qualify as a safe harbor for offers or sales by an affiliate, the offer or sale must be made in an offshore transaction, 17 C.F.R. § 230.903(a); the issuer may make no effort to sell the securities that are directed to persons in the United States, id. at .903(b); all offering materials must include appropriate offering restrictions, including the prohibition against selling the securities in the United States unless they are registered or there is an applicable exemption from registration, id. at 903(c) (iv) (D) and 17 C.F.R. § 230.902(h); and the offers or sales cannot be made to or for the benefit of United States persons before 40 days from the date of the transaction, 17 C.F.R. § 230.903(c)(2) (iii).
Brooksbank and Franklin have not raised a material issue of fact regarding the application of Regulation S to these transactions. It is of course undisputed that each of the sales at issue here was a domestic transaction and for the benefit of United States persons. The Purchase Agreements and other documents created in connection with the sale of the Curbstone stock to the Spanish Nominees contained no restrictions. There was no statement that the Curbstone/EOSC stock was subject to Regulation S and its restrictions. To the contrary, the documents reflected that it was "free trading." Chachas instructed the transfer agent for the Curbstone Management Group to issue the shares "without legend." The stock went from an American transfer agent into an American brokerage account and from there to the public.
Brooksbank contends that his sale to Construcciones was "very consistent" with Regulation S since it was a sale to a Spanish company and Constucciones held the stock for at least forty days. For the reasons already explained in connection with the Section 4(1)1/2 exemption argument, Brooksbank has not pointed to any evidence that would permit a jury to find that Construcciones, unlike the other two nominees, bought with the intention of holding its shares offshore and for investment purposes.
III. Sections 10(b) and 17(a)
The SEC moves for summary judgment on two fraud claims brought under, Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act against Nicolois, Cavanagh and Milestone. The SEC contends that defendants Cavanagh, Nicolois and Milestone participated, along with Levy and Tacopino, in a scheme to manipulate the price of EOSC stock during late 1997 and early 1998.
Section 17(a) provides that
It shall be unlawful for any person in the offer or sale of any securities . . . by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly —
(1) to employ any device, scheme, or artifice to defraud, or
(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.15 U.S.C. § 77q(a). Section 10(b) provides, in pertinent part, that:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange — . . .
(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.15 U.S.C. § 78j (b).
Rule 10b-5, the parallel regulation, describes what constitutes a manipulative or deceptive device and provides that it is unlawful for any person, directly or indirectly:
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
17 C.F.R. § 240.10b-5.
Stock market manipulation is the "intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities." Ernst Ernst v. Hochfelder, 425 U.S. 185, 199 (1976). "The gravamen of manipulation is deception of investors into believing that prices at which they purchase and sell securities are determined by the natural interplay of supply and demand, not rigged by manipulators." Gurary v. Winehouse, 190 F.3d 37, 45 (2d Cir. 1999). To prove its claims under Sections 10(b) and 17(a)(1), the SEC must show: (1) that defendants, using the instrumentalities of interstate commerce, engaged in conduct designed to deceive, or to defraud investors, and (2) that defendants acted with scienter. Aaron v. SEC, 446 U.S. 680, 691, 697 (1980); Sante Fe Indus., Inc. v. Green, 430 U.S. 462, 476 (1977); Ernst, 425 U.S. at 199; Cavanagh, 1 F. Supp.2d at 376-77. In addition, a plaintiff must show that "[s]cienter, as used in the securities fraud statutes, means intent to deceive, manipulate, or defraud, or at least knowing misconduct."SEC v. First Jersey, 101 F.3d 1450, 1467 (2d Cir. 1996) (citation omitted). The SEC is not required to establish scienter, however, under Sections 17(a)(2) and (3). Aaron, 446 U.S. at 696-97; First Jersey, 101 F.3d at 1467.
The SEC has shown through undisputed evidence that Cavanagh, Nicolois and Milsetone engaged in a classic market manipulation. They and their agents merged a shell company with a small and not yet successful operating company, sold stock bearing no restrictive legend in an unregistered transaction, took control of virtually the entire market float, created a false impression of interest in the stock, filed an untimely, incomplete and misleading registration statement, issued a false press release, and drove the stock price north of $5 in a "pump and dump" scheme from which they and their associates pocketed millions of dollars. They understood that the prices they created in the market reflected a market capitalization for the EOSC stock that was completely unjustified at that point in the company's history.
A. Disputed Issues of Fact
Cavanagh, Nicolois and Milestone oppose summary judgment on these fraud claims. They contend that there are material, disputed issues of fact regarding whether they engaged in a manipulative scheme, whether they acted with the requisite scienter, and whether they were entitled to rely on advice of counsel. As was true in the case of the Section 5 claim, however, they have failed to present sufficient evidence to raise any material issue of fact that would require a trial.
In addition to the facts that they attempt to dispute which are described above in connection with the Section 5 claim, these defendants dispute only three additional facts. They rely entirely on Hearing testimony from Cavanagh, which as explained above, his more recent invocation of the Fifth Amendment prevents them from doing.
For instance, they dispute that at the time of the Future Superstock story that EOSC did not have a usable prototype to show to potential customers. With regard to the prototype, Cavanagh testified at the Hearing that he saw a demonstration of the WTS technology in July 1997, and that the machine worked "perfectly." The SEC relies on testimony from Weaver, the president of WTS/EOSC, for the assertion that EOSC did not yet have a usable prototype to show to potential customers. As already discussed, this testimony is not directly in conflict. It is undisputed that WTS considered itself to be in the development stage when it entered discussions with Cavanagh and needed money to complete that work so to that it could present a prototype to potential customers. Cavanagh has offered no evidence that WTS/EOSC had demonstrated its product to any potential customer as of the time of the Future Superstock story or considered itself ready to do so.
A description of the technology and its reliability, as it was demonstrated to the Court in April 1998, can be found atCavanagh, 1 F. Supp.2d at 358-59.
Cavanagh denies that he pressured EOSC to issue the press release. The passage of his Hearing testimony on which Cavanagh relies does not address that issue. The SEC has relied on testimony from EOSC's Clarke.
Cavanagh Hearing testimony at page 1053.
Finally, Cavanagh denies that he threatened Weaver in order to make him rehire Levy. Again, the passage of his Hearing testimony on which Cavanagh relies does not address the issue. The SEC has submitted evidence from Weaver, among others, on this point.
Cavanagh Hearing testimony at page 1047.
Even if it were appropriate to consider Cavanagh's testimony, and even if it did raise a question of fact on these three issues, it would make no difference. The defendants have not raised issues of fact that are material to the SEC's undisputed evidence of their market manipulation.
B. Reliance on Advice of Counsel
Cavanagh, Nicolois and Milestone principally assert that they relied entirely on Levy for legal advice "in connection with all relevant transactions." To establish a reliance on the advice of counsel defense, a defendant "has to show that he made complete disclosure to counsel, sought advice as to the legality of his conduct, received advice that his conduct was legal, and relied on that advice in good faith." Markowski v. SEC, 34 F.3d 99, 105 (2d Cir. 1994). See also United States v. Evangelista, 122 F.3d 112, 117 (2d Cir. 1997). Even if these elements were satisfied, "reliance is not a complete defense, but only one factor for consideration." Markowski, 34 F.3d at 105. A defense of reliance on advice of counsel is available only to the extent that it might show that a defendant lacked the requisite specific intent. Stichting Ter Behartiging Van De Belangen Van Oudaandeelhouders In Het Kapitaal Van Saybolt International B.V. v. Schreiber, 327 F.3d 173, 183 (2d Cir. 2003); Int'l Star Class Yacht Racing Ass'n v. Tommy Hilfiger, U.S.A., Inc., 80 F.3d 749, 754 (2d Cir. 1996).
Cavanagh, Nicolois and Milestone rely on prior testimony given by Levy, who died on September 26, 2003, and by Cavanagh at the Hearing to support their advice of counsel defense. For the reasons already described, they cannot rely on Cavanagh's testimony. The passages in Levy's Hearing testimony on which the defendants' rely do not reflect that Cavanagh or Nicolois asked Levy for legal advice or that he gave them any on the many issues related to the SEC's evidence of a market manipulation. None of this proffered evidence addresses the manipulation of a market price in EOSC stock before there was a public announcement of the merger, or the control of the market float, or the liquidation of the shares sold to the Spanish Nominees. Levy's prior testimony is inadequate to raise a question of fact that the defendants may be entitled to rely on a good faith defense to the fraud claims.
In 1975, the Second Circuit affirmed a preliminary injunction entered against Levy for participation in a similar market manipulation scheme. Cavanagh, 1 F. Supp.2d at 345.
The passage in Cavanagh's Hearing testimony on which he relies for his assertion of an advice of counsel defense (pages 898 to 901) does not indicate that Levy gave Cavanagh any legal advice or that he was asked to do so. The passage includes Cavanagh's assertion that he considered Levy to be acting as the attorney for U.S. Milestone and not as the attorney for either Nicolois or him. Cavanagh admits in the course of these pages that he introduced Levy to Weaver, asked Levy to locate a dormant public shell to be used as a merger partner, and admits that Levy negotiated with Weaver the size of U.S. Milestone's finder's fee and its consideration, and also negotiated the reverse merger acquisition. None of this proffered evidence reflects a discussion of SEC registration requirements, the applicability of any exemptions to registration, or the issuance of shares without a restrictive legend.
In these pages (pages 731, 735, 739, 842-43, 847), Levy states that he functioned as an attorney for U.S. Milestone and for WTS. He describes his compensation for those services. He asserts that Cavanagh had "no role" in the press release and that Milestone had "no role" in preparing the Form 8-K. He testified that Cavanagh had no role in "framing" the legal document that governed the bridge loan. Finally, he denied that Cavanagh ever asked him to violate the securities law or to do anything improper. At the Hearing, Levy also testified that he never provided a legal opinion to Cavanagh on whether the Curbstone Management Group could lawfully sell shares without a legend.
IV. Remedies
The SEC has moved for a permanent injunction against Cavanagh, Nicolois, and Milestone from violating Section 10(b), Rule 10b-5, Section 17(a), and Section 5; and against Brooksbank, Hantges, and Franklin from violating Section 5. The SEC also seeks disgorgement of the total amount of market fraud — $15,564,863.02 — plus interest from Cavanagh, Nicolois, and Milestone, less any disgorgement amounts actually paid by other defendants and relief defendants. From the remaining defendants against whom this motion is brought, the SEC seeks disgorgement of the amounts they personally received, and in the case of the members of the Curbstone Management Group, the amount received by the entire group. Lastly, the SEC asks that Cavanagh, Nicolois, and Milestone be required to pay the maximum civil penalty under Section 21(d)(3) of the Exchange Act ("Section 21(d)(3)") and Section 20(d) of the Securities Act ("Section 20(d)"), and that Brooksbank, Hantges, and Franklin each be required to pay under Section 20(d) a civil penalty of at least $125,000 to $175,000. 15 U.S.C. § 78u(d)(3) 77t(d).
The SEC seeks disgorgement of $889,275 jointly and severally from Brooksbank, Hantges, and Franklin as a result of the Curbstone Management Group's sale of shares to the Spanish Nominees ($1,175,000 minus $285,725 disgorged by Chachas). The SEC also seeks disgorgement of $168,500 from Brooksbank, $201,601.20 from Hantges, and $33,700 from Franklin, which sums represent proceeds each received from individual sales of EOSC stock to the public market in March 1998. The SEC requests joint and several disgorgement liability against relief defendants Karen Cavanagh, Beverly Nicolois, and Cromlix for $531,812.50 for the proceeds of EOSC stock sold by Cromlix. The SEC seeks $140,000 for disgorgement of EOSC stock proceeds from relief defendant Kaufer, for which the SEC alleges he is jointly and severally liable with Brooksbank, who transferred the money to him. In each case, the SEC also seeks prejudgment interest.
While Cavanagh, Nicolois, and Milestone contest liability, they have not disputed that the requested injunctions, disgorgement, and civil penalties are appropriate. Brooksbank, Hantges, and Franklin, however, resist the permanent injunction, and Brooksbank and Hantges contest the SEC's request for disgorgement and civil penalties.
Brooksbank does not contest joint and several liability for the disgorgement of the $140,000 he gave to Kaufer.
1. Permanent Injunction
"Injunctive relief is expressly authorized by Congress to proscribe future violations of federal securities laws."Cavanagh, 155 F.3d at 135. See 15 U.S.C. § 78u(d). In order to obtain a permanent injunction, the SEC must show that there is a "substantial likelihood of future violations of illegal securities conduct." Cavanagh, 155 F.3d at 135. In making this determination, a court should look to:
the fact that the defendant has been found liable for illegal conduct; the degree of scienter involved; whether the infraction is an `isolated occurrence;' whether defendant continues to maintain that his past conduct was blameless; and whether, because of his professional occupation, the defendant might be in a position where future violations could be anticipated.Id. (citation omitted). See also SEC v. McNulty, 137 F.3d 732, 741 (2d Cir. 1998) (affirming injunction based in part on defendant's efforts "shift responsibility to others" and "persistent denial" of any wrongdoing). In analyzing whether a defendant has a propensity for future violations, courts should look to the "totality of the circumstances." SEC v. Lorin, 76 F.3d 458, 461 (2d Cir. 1996) (citation omitted). In particular, "the commission of past illegal conduct is highly suggestive of the likelihood of future violations. . . . [P]ast violations may in certain circumstances justify an inference that a defendant is likely to violate the law in the future if not enjoined." SEC v. Management Dynamics Inc., 515 F.2d 801, 807 (2d Cir. 1975).See also SEC v. Commonwealth Chemical Securities, Inc., 574 F.2d 90; 99 (2d Cir. 1978).
The SEC has established that there is a substantial likelihood that Brooksbank, Hantges, and Franklin will commit future Section 5 violations. The SEC has established that these defendants violated the securities laws. Brooksbank and Franklin still maintain that their sales of the Curbstone Management Shares were legal, among other things, pressing arguments regarding exemptions that were rejected in Cavanagh, 1 F. Supp.2d 337 . Brooksbank is an attorney; Hantges and Franklin are former securities industry professionals. They are, or have been, engaged in occupations which present further opportunities for violations of the securities laws. The circumstances in which the present violations occurred show that these defendants were at the very least reckless as to whether the Curbstone Management Group was aiding a fraud on the market and whether their personal profits were earned through a fraud. They proceeded to sell their shares in February and March 1998 despite overwhelming evidence that there had been a massive market manipulation. Finally, this violation was not an isolated occurrence. At the time of the WTS/Curbstone transaction, the Curbstone Management Group worked with Levy on a nearly identical reverse merger for another shell company that they owned, Capital Advisors. There is every reason to believe that Capital Advisors, which was restructured in the same way as Curbstone, would have been utilized for a "pump and dump" market manipulation but for the SEC's intervention. Franklin was recently sued by the SEC for Section 5 violations and securities fraud for his involvement in a stock website, "Red Hot Stocks." Brooksbank set up an entity Franklin used in connection with this project, and in the course of the SEC investigation into the website, Franklin instructed Brooksbank to send abroad documents pertaining to the company and Brooksbank complied. For his part, Hantges was sued in federal court in 2003 for civil RICO and common law fraud.
The Court declined to preliminarily enjoin Brooksbank and Hantges. Cavanagh, 1 F. Supp.2d at 373.
In addition to his work on behalf of Curbstone and Capital Advisors, Brooksbank has been in private practice primarily as collections attorney since 1986. Hantges currently owns a commercial real estate lending business. From 1980 to 1995, he worked in the securities industry as a stockbrocker. Franklin asserts that he is currently unemployed. He was formerly a registered representative, holding Series 7 and Series 163 licenses from the NASD, and was associated with several broker-dealers between 1984 and 1989. Until 2000, Franklin owned and ran a company called IPO Consultants that, among other things, arranged financing for private companies through reverse mergers into public shell companies.
Curbstone Management Group controlled Capital Advisors, a second shell company which had no operating assets and was intended to be merged with another private company. Capital Advisors was reorganized in 1996 at the same as Curbstone and in identical fashion. The Curbstone Management Group merged the Capital Advisors shell through a third-party financier, WCM Investments ("WCM") with a private operating company, Harvard Financial Services, Inc. ("Harvard"). Levy represented Harvard and WCM. The Curbstone Management Group entered into an agreement on July 14, 1997 to negotiate the merger of Capital Advisors with Harvard which included the transfer of stock through option sales to the financier, WCM. An Agreement for Exchange of Stock was entered on July 23, 1997 between Harvard and Capital Advisors. The part of the deal transferring stock option sales to WCM was not mentioned in the publicly disclosed Agreement for Exchange of Stock. WCM nonetheless agreed to pay the Curbstone Management Group in, among other things, legendfree Capital Advisors shares and options for such shares. On December 12, 1997, Levy faxed Chachas a press release announcing that Capital Advisors had completed the acquisition of Harvard.
Brooksbank argues in his opposition to this motion that the Curbstone and Capital Advisors transactions were "totally isolated." He does not, however, dispute that the two shell companies had identical restructuring and that the deals were extremely similar. In addition, at his June 1998 deposition, Brooksbank testified that the two deals proceeded at the same time, had the same parties negotiating the terms, and that they were, in his mind, "identical projects."
Brooksbank and Hantges represent that they are not currently violating the securities law and will not do so in the future. Such contentions are insufficient to prevent the imposition of an injunction that is otherwise justified. See Management Dynamics, 515 F.2d at 807 (a permanent injunction may be appropriate despite "defendant's disclaimer of an intent to violate the law in the future, or even cessation of the illegal acts").
Brooksbank and Hantges emphasize that they relied on Chachas. Their argument illustrates their continued efforts to shift blame and responsibility for their illegal actions. They knew or should have known that a registration statement was required for the sale of stock, and that they were assisting and profiting extravagantly from a market fraud. These defendants were sophisticated businessmen with extensive securities industry experience. See SEC v. Frank, 388 F.2d 486, 489 (2d Cir. 1968) (a defendant cannot escape liability by "closing his eyes to what he saw and could readily understand"). The SEC has shown that a permanent injunction against Brooksbank, Franklin, and Hantges is warranted.
Brooksbank asserts that he has tried to act responsibly, as demonstrated by his deposit into the Court's registry, first attempted in December 1998, of $170,000, which represents the proceeds that he received from one of his three sales of shares. Brooksbank contends that Kaufer received the money from the sale of one half of the shares sold by Brooksbank, and that he and Kaufer each presently have the benefit of $140,000.
2. Disgorgement of Proceeds
As an exercise of its equity powers, a court may order defendants to disgorge their earnings from violations of the securities laws. SEC v. Fischbach Corp., 133 F.3d 170, 175 (2d Cir. 1997). The "primary purpose" of disgorgement is the deterrence of future violations "by depriving violators of their ill-gotten gains." Id. It is a "nonpunitive equitable remedy."Commodity Futures Trading Com'n v. Vartuli, 228 F.3d 94, 113 (2d Cir. 2000). "The effective enforcement of the federal securities laws requires that the SEC be able to make violations unprofitable. The deterrent effect of an SEC enforcement action would be greatly undermined if securities law violators were not required to disgorge illicit profits." First Jersey, 101 F.3d at 1474. "[D]isgorgement need only be a reasonable approximation of profits causally connected to the violation. So long as the measure of disgorgement is reasonable, any risk of uncertainty should fall on the wrongdoer whose illegal conduct created the uncertainty." SEC v. Warde, 151 F.3d 42, 50 (2d Cir. 1998). When apportioning liability for disgorgement among multiple defendants courts have the discretion to find joint and several liability when two or more individuals collaborate in the illegal conduct. See First Jersey, 101 F.3d at 1475.
Once a court determines that disgorgement is appropriate, it has the discretion to charge prejudgment interest. In deciding whether an award of prejudgment interest is warranted, a court should consider "(i) the need to fully compensate the wronged party for actual damages suffered, (ii) considerations of fairness and the relative equities of the award, (iii) the remedial purpose of the statute involved, and/or (iv) such other general principles as are deemed relevant by the court." Id. at 1476. In an enforcement action brought by a regulatory agency, however, "the remedial purpose of the statute takes on special importance." Id. When disgorgement is ordered in an SEC-initiated proceeding, the IRS underpayment rate is appropriate. Id. "[E]ven if litigation was protracted through some fault of the SEC, the award of prejudgment interest for the entire period is proper because defendant had use of unlawful profits for the entire period." Warde, 151 F.3d at 50 (citation omitted).
Disgorgement in the amounts and manner requested by the SEC is an appropriate remedy here against all defendants. Prejudgment interest at the IRS underpayment interest rate is warranted. In particular, joint and several liability for the Curbstone Management Group defendants for the proceeds earned from the sales to the Spanish Nominees is appropriate. The four men acted as one in the negotiation and sale of shares to the Spanish Nominees, Levy, and Milestone, and through the option and lock up agreements. Their concerted action was essential to the success of the scheme.
Prejudgment interest is not to be charged on the approximately $170,000.00 that Brooksbank deposited in the Court's registry on April 28, 1999, except for the accrued and unpaid interest on these proceeds as of April 28, and the interest accruing thereon.
Hantges contends that Grupo Mexicano De Desarrollo, S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999), compels a different result. It does not. Grupo Mexicano held that a district court lacks authority to freeze assets pending the adjudication of a contract claim for money damages. Id. at 333. There are various bases on which to distinguish Grupo Mexicano, including the fact that the SEC has shown that it is entitled to summary judgment against Hantges and it seeks disgorgement as an equitable remedy based on that judgment.
Hantges contends that the disgorgement remedy is limited to securities violations involving fraudulent intent. Using their powers of equity, courts can and have granted disgorgement against defendants found liable under strict liability statutes such as Section 5. See, e.g., Geiger, 363 F.3d at 488. See also SEC v. Palmisano, 135 F.3d 860, 865 (2d Cir. 1998) (Congress has expressly endorsed disgorgement for violations of the Securities Act).
Brooksbank asserts that the SEC's disgorgement calculation is wrong because it seeks proceeds rather than profits. Brooksbank's argument fails for several reasons. Neither Brooksbank nor Hantges or Franklin submitted evidence to dispute the data from which the SEC calculated the disgorgement figures. Disgorgement of proceeds as opposed to profits is appropriate here. Defendants are not entitled to deduct costs associated with committing their illegal acts.
Brooksbank did not submit any evidence or itemization of his or Curbstone Management Group's costs in carrying out the transactions at issue. Franklin asserts without documentation that he invested $5,000 into Curbstone.
3. Civil Penalties
Sections 21(d)(3) and 20(d) provide three tiers of civil penalties for securities law violations. Each tier provides for the penalty not to exceed the "gross amount of pecuniary gain to such defendant as a result of the violation." 15 U.S.C. § 77t (d). Tier I penalties, for non-scienter violations, shall not exceed $5,000 per natural person for each violation.Id. Tier II penalties are available if the violation involved "fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement" and shall not exceed $50,000 per natural person. Id. Tier III penalties are available if the violation involved "fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement" and the violation "resulted in substantial losses or created a significant risk of substantial losses to other persons" and shall not exceed $100,000 per natural person. Id.
The dollar amounts of these penalties must be adjusted for inflation. See 17 C.F.R. § 201.1001 (raising the maximum penalty to $110,000 per violation) and 201.1002.
Courts have discretion in determining the appropriate amount of any penalty and the amount should be determined in light of the facts and circumstances surrounding the violations. 15 U.S.C. § 78u(d)(3) 77t(d). A monetary penalty is designed to serve as a deterrent against securities laws violations. Palmisano, 135 F.3d at 866. In determining what penalty to impose, courts look to the following factors: (1) the egregiousness of the violations; (2) a defendant's scienter; (3) the repeated nature of the violations; (4) a defendant's failure to admit wrongdoing; (5) whether a defendant's conduct created substantial losses or the risk of substantial losses to others; (6) a defendant's lack of cooperation with authorities; and (7) whether the penalty that would otherwise be appropriate should be reduced due to a defendant's demonstrated current and future financial condition. Lybrand, 281 F. Supp.2d at 730 (collecting cases). A court may also consider evidence of a defendant's financial deception, including any evidence of a defendant's violation of asset freeze orders. Id.
For Cavanagh, Nicolois, and Milestone, the SEC has requested a civil penalty for each sale or offer to sell. The formula for this penalty would be: $100,000 multiplied by four statutory violations multiplied by each of these defendants' sales or offers to sell. In the alternative, the SEC asks for a civil penalty against these defendants equal to the total loss to investors which the SEC calculates as $15,564.863.02. As stated above, Cavanagh, Nicolois, and Milestone do not contest the SEC's request for civil penalties. The civil penalty assessed against each of these defendants shall be $1,000,000.
These defendants have violated four securities laws — Sections 5(a), 5(c) and 17(a) of the Securities Act, and Section 10(b) of the Exchange Act.
With respect to Brooksbank, Hantges, and Franklin, the SEC has asked for a civil penalty of at least $125,000 to $175,000. Brooksbank and Franklin continue to deny their own liability. All three defendants were essential participants in a significant market manipulation from which they earned hundreds of thousands of dollars. None of them has presented any evidence that his financial condition warrants a reduction in the size of a penalty. Considering these facts and the others already discussed in this Opinion, a penalty of $125,000 is imposed on each of these three defendants.
In conjunction with a 1998 settlement with the SEC, the Court ordered Chachas to pay a $100,000 penalty.
Without providing any documentation or evidence, Brooksbank argues in his opposition to this motion that civil penalties will "financially destroy" him.
V. Section 5 Claims: Recovery from Relief Defendants
The SEC has moved for summary judgment against relief defendants Karen Cavanagh, Beverly Nicolois, Kaufer, and Cromlix. The SEC seeks to disgorge the EOSC proceeds these defendants received. While the relief defendants have opposed summary judgment on the underlying violations against the defendants, they have not contested the legality of such a remedy against relief defendants or the amount of money the SEC seeks to disgorge from them.
Federal courts may order disgorgement "against a person who is not accused of wrongdoing in a securities enforcement action where that person: (1) has received ill-gotten funds; and (2) does not have a legitimate claim to those funds." Cavanagh, 155 F.3d at 136. When there has been no consideration given for the receipt of the ill-gotten gains, there is no legitimate claim to the funds and a relief defendant must return the proceeds. See id. at 137.
The SEC has submitted sufficient evidence to award summary judgment and to disgorge the proceeds received by Karen Cavanagh, Beverly Nicolois, Cromlix and Kaufer. Karen Cavanagh and Beverly Nicolois, through Cromlix, received proceeds from the sale of EOSC stock transferred to them at their husbands' direction from the Spanish Nominees. Neither Karen Cavanagh nor Beverly Nicolois paid consideration for these shares. A default judgment has already been entered against the Spanish Nominees. Similarly, Kaufer received part of the proceeds Brooksbank received from Curbstone Management Group's sale of unregistered EOSC shares. Kaufer has not asserted any legitimate claim to this money; he did not pay material consideration for what was essentially a gift from Brooksbank.
Conclusion
The SEC's motion for summary judgment against defendants Cavanagh, Nicolois, and Milestone for violations of Sections 5(a), 5(c) and 17(a) of the Securities Act, and Section 10(b) of the Exchange Act is granted. The SEC's motion for summary judgment against Brooksbank, Franklin, and Hantges for violations of Sections 5(a) and (c) is granted. Summary judgment against relief defendants Karen Cavanagh, Beverly Nicolois, Cromlix, and Kaufer is also granted.
Defendants Cavanagh, Nicolois, and Milestone are permanently enjoined from violating, directly or indirectly, Sections 5(a), 5(c) and 17(a) of the Securities Act, and Section 10(b) of the Exchange Act. Cavanagh, Nicolois, and Milestone are ordered to pay, jointly and severally, disgorgement of $15,564,863.02 — plus interest, less any disgorgement amounts actually paid by other defendants and relief defendants. Cavanagh, Nicolois, and Milestone are each ordered to pay a civil penalty of $1,000,000.
Defendants Brooksbank, Franklin, and Hantges are permanently enjoined from violating, directly or indirectly, Sections 5(a) and (c). Brooksbank, Franklin, and Hantges are ordered to pay, jointly and severally, disgorgement of $889,275.00 — plus interest. In addition, Brooksbank, Franklin, and Hantges are ordered to individually pay disgorgement of $185,337.79, $50,926.50, and $304,654.29, respectively, plus interest. Brooksbank, Franklin, and Hantges are each ordered to pay a civil penalty of $125,000.
Relief defendants Karen Cavanagh, Beverly Nicolois, and Cromlix are ordered to pay, jointly and severally, disgorgement of $803,660.75. Relief defendant Kaufer and defendant Brooksbank are ordered to pay, jointly and severally, disgorgement of $213,150.97. Prejudgment interest is awarded for these amounts.
The SEC's motion to preclude defendants Cavanagh, Nicolois, and Milestone, as well as relief defendants Karen Cavanagh, and Beverly Nicolois from offering any evidence in opposition to summary judgment is denied. The SEC's motion to preclude these defendants and relief defendants from relying on Cavanagh's Hearing testimony is granted.
The SEC's motions to strike inadmissible portions of Brooksbank's and Franklin's affidavits and statements of material facts, as well as Batista's affirmation are granted to the extent described herein.
The SEC shall prepare proposed judgments based on these rulings.
SO ORDERED.