Opinion
Case No. 2:03-cv-326-JDH-MRA.
April 5, 2007
MEMORANDUM OPINION AND ORDER
This matter is currently before the Court on the Motion of Defendants Michael M. Markow ("Markow") and Global Guarantee Corp. ("Global Guarantee") (collectively, "the Markow Defendants") to Set Aside Entry of Default (R. at 185) and Plaintiff's Motion for Default Judgment (R. at 187). For the reasons set forth below, the Court grants the Markow Defendants' Motion to Set Aside Entry of Default and denies Plaintiff's Motion for Default Judgment.
Defendants' Motion for Summary Judgment and Plaintiff's Motion for Partial Summary Judgment, both filed July 20, 2005, are also currently pending in this case.
I. Background
On April 11, 2003, Plaintiff Securities and Exchange Commission ("SEC") filed its Complaint in this action against twelve defendants alleging several violations of securities laws. As to the Markow Defendants, in Count I the SEC alleges violations of section 5(a) and (c) of the Securities Act of 1933 ("Securities Act"), which prohibits the offering or selling of securities when no registration statement for those securities is in effect and when no exemption from registration is available. Counts VIII and IX allege that the Markow Defendants failed to report their beneficial ownership of a security in violation of multiple sections of the Securities Exchange Act of 1934 ("Exchange Act") and rules promulgated by the SEC thereunder. Violations of the Securities Act's general anti-fraud provision, section 17(a), are alleged in Counts II (section 17(a)(1)) and III (section 17(a)(2) and (a)(3)). Count IV alleges that the Markow Defendants employed a manipulative or deceptive device or contrivance in connection with the sale or purchase of a security, in violation of section 10(b) of the Exchange Act and SEC Rule 10b-5.
A. Creation of MAS XI and the Distribution of Its Shares
Defendant Aaron Tsai created MAS Acquisition XI Corporation ("MAS XI") in October 1996. When MAS XI was formed, Tsai was the corporation's chairman, president, and treasurer. Tsai caused MAS XI to issue him 8.5 million shares of the corporation's common stock. (MAS XI Form 10-SB, at 26 (Apr. 16, 1999), Pl.'s Mem. Supp. Ex. 21, July 20, 2005.) MAS XI was a shell corporation, and it hoped to complete a "reverse merger" with a private company. MAS XI issued shares of stock to five "former directors" both in January 1997 and September 1998. (Id.) These "former directors" were friends and acquaintances of Tsai, and at least three of the five never performed any services for MAS XI. (Tsai Dep. 92-93, Oct. 19, 2004, R. at 121.) Tsai gifted 50,000 of his own shares of MAS XI to each of the five "former directors." (MAS XI Form 10-SB/A, at 27 (June 22, 1999), Pl.'s Mem. Supp. Ex. 22, July 20, 2005.) Tsai transferred these shares to expand the corporation's shareholder base so as to improve the possibility of the shares being sold to the public in the future. (Tsai Dep. 30:19-31:17, Mar. 25, 2002, Pl.'s Mem. Supp. Ex. 3, July 20, 2005.)
In SEC v. M A West, Inc., No. C-01-3376, 2005 WL 1514101, at *2 (N.D. Cal. June 20, 2005), the court provided a good understanding of how a reverse merger occurs:
A "reverse merger" . . . is a transaction in which a private operating corporation (a "private" company) merges into a corporation whose stock has previously been offered to the public (a "public" company). Typically, the public company will at the time of the reverse merger be a "shell" company with minimal assets and liabilities and no actual operations. To complete the securities aspect of the reverse merger, the public shell company will exchange its treasury stock (along with, perhaps, shares from its stockholders) for all outstanding shares of the private company, and in consideration, the shareholders who control the public shell company will transfer most of their shares in the shell company to the owners of the private company. Often the public shell company will take on the name formerly used by the private company, and operations will carry on as before, except the formerly private company is now an issuer of publicly traded securities. The overall transaction thus provides a way for the private company effectively to offer its stock to the public.
The five "former directors" never received issued stock certificates for the shares that they owned as required by MAS XI's bylaws. (Tsai Dep. 65:8-66:13, Oct. 19, 2004.) Tsai did not follow other formalities of the corporation as well. For instance, Tsai held annual shareholders' meetings to elect directors, but only he attended. (Id. at 181:4-182:9.)
Using blank stock power forms signed by the five shareholders, Tsai transferred some of the shares of the "former directors" to an additional 28 individuals. (Id. at 104:14-105:22, 120:23-121:20.) The additional 28 people were either a friend of Tsai or a person that Tsai had met at Bible study. (Id. at 121:8-10.) Tsai executed these transfers "to further the purpose of the company . . . to become publicly traded." (Id. at 110:11-111:14.) The five "former directors" were unaware to whom they transferred their shares. Tsai determined the number of shares that were transferred from the "former directors" to each of the additional 28 (and from whom each transferee would receive his or her shares) on a "more or less arbitrary" basis. (Id. at 108:8-12, 109:3-6, 110:3-6.)
With the assistance of Kensington Capital Corporation ("Kensington"), Tsai sought to have the shares held by the 33 shareholders cleared for public trading by the National Association of Securities Dealers ("NASD"). Kensington had submitted a Form 211 application to NASD earlier, but it was deemed deficient by NASD because the tradeable shares were concentrated in the hands of only five shareholders. After Tsai expanded the number of shareholders to 33, Kensington sent a list to NASD showing that the original five shareholders had further distributed their shares. (Letter from Julio Serrano, Trader, Kensington, to David W. McClarin, Compliance Examiner, NASD Regulation, Inc. (Sept. 1, 1999), Pl.'s Mem. Supp. Ex. 28, July 20, 2005.) On December 13, 1999, NASD cleared the MAS XI shares for trading on the Over-the-Counter Bulletin Board. (Letter from David W. McClarin, Compliance Examiner, NASD Regulation, Inc., to Julio Serrano, Trader, Kensington (Dec. 13, 1999), Pl.'s Mem. Supp. Ex. 29, July 20, 2005.)
B. Reverse Merger Between MAS XI and Bluepoint Linux Software Company
Beginning in 1999, Defendant Yongzhi Yang worked as a consultant for Shenzhen Sinx Software Company ("Shenzhen Sinx"), a Chinese company. (Yang Dep. 16:22-23, 51:11-23, Dec. 1, 2004, R. at 113.) Shenzhen Sinx had developed a Chinese version of the Linux computer operating system. However, because Shenzhen Sinx was required to publish the source code for their software, competitors were able to copy Shenzhen Sinx's source code and integrate it into their own products. (Shenzen Sinx Software Co., Ltd. Business Plan at AT000226, Pl.'s Mem. Supp. Ex. 31, July 20, 2005.) This business risk was identified in Shenzhen Sinx's business plan, to which Yang, Markow, and Tsai all had access. (Yang Dep. 61:18-25, Dec. 1, 2004; Tsai Dep. 189:3-14, 191:4-7, Oct. 19, 2004; Markow Dep. 70:15-19, Dec. 3, 2004, R at. 122.) At the end of 1999, the company had total net sales of $23,027.
Shenzen Sinx is an English translation of the company's Chinese name. At some point before the reverse merger with MAS XI, the company changed its English name to BluePoint Linux Software Co., Ltd. as this name was a more accurate translation. (See Yang Dep. 52:16-53:16, Feb. 28, 2002, Pl.'s Mem. Supp. Ex. 12, July 20, 2005.) For clarity, the Court will consistently refer to the pre-merger private Chinese operating company as Shenzen Sinx irrespective of the when this name change occurred.
As a consultant for Shenzhen Sinx, Yang sought out a public shell corporation with which the company could merge. (Yang Dep. 46:12-19, Dec. 1, 2004.) Yang was introduced to Markow through Defendant François Goelo, a resident of the Cayman Islands whom Yang had met through Internet sites related to investing. (Goelo Dep. 12-14, May 24, 2004, R. at 118.) Goelo has described Markow as a "professional" in completing reverse mergers. (Id. at 14:4-20.) Through the execution of a "Plan and Agreement of Reorganization," MAS XI and Shenzhen Sinx on January 7, 2000 agreed to a reverse merger of the two companies. (Plan and Agreement of Reorganization, Pl.'s Mem. Supp. Ex. 30, July 20, 2005.) Markow states that he facilitated the reverse merger between MAS XI and Shenzhen Sinx by identifying the shell corporation, overseeing the creation of the share exchange agreement, and lining up market makers for the merged corporation's stock, as well as engaging in other coordination activities. (Markow Dep. 103:12-16, Mar. 1, 2002, Pl.'s Mem. Supp. Ex. 6, July 20, 2005.)
On the day that the merger agreement was executed, MAS XI effected a 15-for-1 forward stock split such that at the time of the merger, MAS XI had 20 million shares of common stock outstanding. (BluePoint Linux Software Corp. Form 8-K at 2 (Feb. 18, 2000), Pl.'s Mem. Supp. Ex. 32, July 20, 2005.) Per the merger agreement, the directors of Shenzen Sinx received 15.5 million of these shares, which were restricted as to resale, as consideration for delivering all of the Chinese company's shares of common stock to MAS XI. (Plan and Agreement of Reorganization art. I, §§ 1.01 to 1.02; see BluePoint Linux Software Corp. Schedule 14f-1 at AT000295 (Feb. 18, 2000), Pl.'s Mem. Supp. Ex. 39, July 20, 2005.) Thus, after the merger was completed, Shenzen Sinx was a wholly-owned subsidiary of MAS XI with MAS XI controlled by the former directors of Shenzen Sinx. (See Schedule 14f-1 at AT000294-AT000295.) MAS XI changed its name to BluePoint Linux Software Corp. ("BluePoint") on February 17, 2000. (Id. at AT000294.)
At some point later, Yang received 500,000 of these restricted shares from the directors as compensation for his role in finding a reverse merger candidate in North America. (Yang Dep. 54:9-56:2, Dec. 1, 2004.) These shares were never sold and are not relevant to the violations alleged by the SEC.
The merger agreement does not provide for any transactions involving the 4.5 million shares that reflect the difference between the 20 million shares outstanding and the 15.5 million shares delivered to the former directors of Shenzen Sinx. After the 15-for-1 forward split on January 7, 2000, 3.75 million of the shares were held by Tsai's 33 friends and acquaintances. (MAS Acquisition XI Corp. Transaction List (Feb. 24, 2000), Pl.'s Mem. Supp. Ex. 27, July 20, 2005.) Coincident to the reverse merger, Tsai arranged for the sale of the shares held by the 33 shareholders using stock power forms signed by the shareholders. (Tsai Dep. 77, Mar. 25, 2002.) The parties offer differing accounts of this transaction.
As discussed above, Tsai had originally gifted 250,000 shares of MAS XI to the five "former directors." These 250,000 shares were distributed to an additional 28 of Tsai's friends and acquaintances. The 15-for-1 forward split increased the number of shares held by Tsai's friends and acquaintances from 250,000 to 3.75 million.
By February 7, 2000, Markow had received just under $250,000 in wire transfers from Yang, Luo, and Goelo. (Wire Transfers from Goelo, Yang, and Luo, Pl.'s Mem. Supp. Ex. 34, July 20, 2005.) Goelo sent $91,250 and Yang and Luo both sent $79,365. (Id.) Yang and Goelo both testified that the $250,000 that Markow received was the price to obtain the shares from the 33 MAS XI shareholders. (Yang Dep. 30-31, Feb. 28, 2002, Pl.'s Mem. Supp. Ex. 12, July 20, 2005; Goelo Dep. 21-23, May 24, 2004.) Markow sent a cashier's check dated February 8, 2000 in the amount of $250,000 to Tsai. Markow originally testified that the $250,000 that he collected from Yang, Luo, and Goelo was payment for his work in completing the transaction and that the $250,000 that he sent to Tsai was payment to acquire the 3.75 million shares held in the names of the 33 shareholders. (Markow Dep. 56-57, 69, 74, Mar. 1, 2002.) Markow now contends, as does Tsai, that the $250,000 that Tsai received from Markow was Tsai's finder's fee. (Markow Dep. 136, Dec. 3, 2004; Markow Decl. ¶ 2, Nov. 12, 2004, attached to Defs.' Br. Opp'n, Nov. 12, 2004.) Tsai testified that the $250,000 was compensation for his role in the reverse merger. (Tsai Dep. 19-20, Mar. 25, 2002.)
Tsai delivered the 3.75 million shares held by the 33 shareholders to Markow in certificate form, along with stock power forms signed by the shareholders. (Id. at 107:24-108:6.) Afterwards, Markow sent a $100 check, dated February 14, 2000, to each of the 33 shareholders for payment of their shares, regardless of the number of shares that they held. (Markow Dep. 97:10-98:19, Mar. 1, 2002.) At the time that they signed the stock power forms, the 33 shareholders did not know how much money that they would receive for their shares. (Tsai Dep. 75:4-14, Mar. 25, 2002.) Tsai has acknowledged that most of the shareholders were not aware of the merger of MAS XI and Shenzen Sinx at the time that their shares were transferred to Markow. (Tsai Dep. 227:11-228:20, Oct. 19, 2004.)
After receiving the 3.75 million shares from Tsai, Markow had the stock certificates in the names of the 33 shareholders cancelled and had new certificates issued in the names of 14 new shareholders. (Letter from Markow to Signature Stock Transfer (Feb. 22, 2000), Pl.'s Mem. Supp. Ex. 41, July 20, 2005.) These 14 shareholders were Yang, Luo, family members of Yang and Luo, Goelo's then-girlfriend, and entities controlled by Yang, Luo, Goelo, and Markow. (Id.) Of the 3.75 million shares of BluePoint held by the 14 new shareholders, 2.43 million were deposited into accounts at Defendant Sierra Brokerage Services, Inc. ("Sierra"). (See Helpingstine Decl. ¶¶ 17, 24, 34, 41, Pl.'s Mem. Supp. Ex. 1, July 20, 2005.)
C. Alleged Price Manipulation
The SEC alleges that Yang, Luo, Goelo, Markow, and the entities that they control (collectively, the "Promoter Defendants"), together with Sierra and Sierra traders Richard Geiger and Jeffrey Richardson, engaged in a scheme known as a "pump and dump" whereby the Promoter Defendants and the Sierra traders artificially inflated the price of BluePoint stock, sold their shares when the price was high, and profited millions of dollars. To facilitate the scheme, the SEC asserts that the Promoter Defendants promoted the stock on Internet message boards related to investing and through emails to individual investors. These messages provided information about BluePoint, indicated that the float (the shares that could be publically traded) was tightly controlled, apprised recipients of the day on which trading would commence, and advised as to what the opening price of the stock would be. The SEC contends that the Promoters disseminated this information to increase the demand for the stock.
Trading of BluePoint stock on the Over-the-Counter Bulletin Board began on Monday, March 6, 2000. The initial trading in BluePoint involved the Promoter Defendants. Before trading began, Geiger committed Sierra to purchasing 100,000 shares from Yang. (Geiger Dep. 34:20-35:6, Jan. 29, 2002, Pl.'s Mem. Opp'n Ex. 2, Aug. 15, 2005.) Sierra bought these shares from Defendant K J Consulting, a corporation controlled by Yang, at 9:46 a.m. for $6 per share. (Sierra Order Tickets for BluePoint (Mar. 6, 2000), Pl.'s Mem. Supp. Ex. 57, July 20, 2005.) More trades followed, and the price of BluePoint quickly surged, reaching a price of $21 per share by 10:28 a.m. (Trade Inquiry Report 5, Rosen Decl. Ex. 2, July 18, 2005, R. at 120-3.)
The SEC alleges that the Promoter Defendants and Sierra structured transactions that allowed them to set the initial price of the stock. The transactions also allegedly increased demand for the stock, which influenced the price of the stock. Further, the SEC asserts that the Promoter Defendants controlled the float and that this allowed them to dominate the market on the first day of trading. Finally, the Promoter Defendants allegedly had an understanding to not sell their shares, and this control of the supply kept the price of the stock from falling during the early days of trading of BluePoint.
Defendants deny that they engaged in any efforts to manipulate the price of BluePoint stock; instead, they maintain that the undisputed facts establish that they did not interfere with the forces of supply and demand of BluePoint stock. They argue that there was significant demand for shares of BluePoint and that other market participants were responsible for the price surge on the first day of trading. Defendants also state that Sierra did not dominate or control the volume of shares sold on the market such that it was able to artificially increase the price of BluePoint stock.
II. Relevant Procedural History
Baker Hostetler LLP represented both Markow and Global Guarantee from the inception of this action until the Court granted its motion to withdraw as counsel in its Order of February 17, 2006. (R. at 156.) In this Order, the Court directed both Markow and Global Guarantee to retain new counsel and have counsel enter an appearance within thirty days. The Court also ordered the Clerk to serve a copy of the order on both Markow and Global Guarantee. By March 27, 2006, neither Markow nor Global Guarantee had responded to the Court's February 17 Order. By that date, the Court had noticed that the docket reflected that S. Lee Terry Jr. represented Markow and Global Guarantee but that Terry had neither made an appearance nor moved for admission to the bar of the Southern District of Ohio pro hac vice. The Court ordered Terry to make an appearance and file a motion for admission to the bar of the Souther District of Ohio pro hac vice within eleven days if he intended to represent Markow and Global Guarantee. (R. at 165.) Terry never did either.
Markow was given the alternative of filing within thirty days a notice of his intention to represent himself. As Global Guarantee is a corporation, it could not appear through an agent or representative other than a licensed attorney, and it therefore had to retain new counsel if it wished to further defend itself in this action.
The copies for both Markow and Global Guarantee were sent to the following address: 900 Country Village Road, Westlake Village, CA 91362-5630. On February 27, 2006, Baker Hostetler LLP filed a Notice of Service (R. at 159) informing the Court that it had served copies of the Court's Order on Markow and Global Guarantee via email on February 23, 2006. Additionally, Baker Hostetler LLP certified that it served the Notice of Service on Markow and Global Guarantee via email and had also sent a copy to Markow and Global Guarantee at the following address via U.S. mail: 1230 Calle Suerte, Camarillo, CA 93012.
A copy of the Court's March 27, 2006 Order was sent to both Markow and Global Guarantee at 900 Country Village Road, Westlake Village, CA 91362-5630.
On April 26, 2006, the Court entered a Show Cause Order regarding the Markow Defendants' failure to respond to the Court's February 17 Order. (R. at 170.) Markow and Global Guarantee were ordered to show cause within eleven days why default should not be entered against them for failing to defend in the action. Unlike the Court's orders of February 17 and March 27, there is no indication on the docket that the April 26, 2006 Show Cause Order was served on either Markow or Global Guarantee. The Markow Defendants contend that they never received the Show Cause Order.
As evidence of them not receiving the Show Cause Order, Defendants point to the Court's docket entry number 172, dated May 2, 2006. This docket entry is irrelevant, however, as to whether Markow and Global Guarantee received the Show Cause Order. Docket entry 172 informs that the Court's March 27, 2006 Memorandum Opinion and Order, regarding Defendant Aaron Tsai's motion for sanctions against the SEC, that had been mailed to Global Guarantee was returned as undeliverable. Although the docket does not reflect whether either Markow or Global Guarantee received the Show Cause Order, the Markow Defendants do not assert that they did not receive copies of the Court's two previous orders dated February 17, 2006 and March 27, 2006.
Because the Markow Defendants failed to respond to both the April 26, 2006 Show Cause Order and the Court's Order of February 17, 2006, the Court directed the Clerk to enter default against both defendants on May 16, 2006. (R. at 175.) The Clerk entered the default the same day. (R. at 176.)
The docket shows that both the Court's Order directing the Clerk to enter default and the Entry of Default were mailed to Markow and Global Guarantee at 1230 Calle Suerte, Camarillo, CA 93012.
Markow's son, Ari L. Markow, filed notices of appearance on behalf of Global Guarantee and Markow on June 9, 2006 and June 12, 2006, respectively. (R. at 178, 179.) Then, on July 7, 2006, Markow filed a notice of his intention to proceed pro se. (R. at 180.) The Markow Defendants are currently represented by Buckingham, Doolittle Burroughs, LLP, who submitted the Markow Defendants' Motion to Set Aside Entry of Default.
Markow's notice listed his address as 1230 Calle Suerte, Camarillo, CA 93012.
III. Markow Defendants' Motion to Set Aside Entry of Default
A. Standard for Motion to Set Aside Entry of Default
Rule 55(c) governs setting aside an entry of default or a default judgment. The standard for setting aside an entry of default is not as strict as that for setting aside a default judgment. Waifersong, Ltd. v. Classic Music Vending, 976 F.2d 290, 292 (6th Cir. 1992). Rule 55(c) provides that the Court may set aside an entry of default for good cause shown. In contrast, the Court may only set aside a default judgment in accordance with Rule 60(b). Because a default judgment has not been entered against Defendants, they need not demonstrate the existence of one of the specific "reasons" listed in Rule 60(b), such as excusable neglect; instead, they need only show good cause. Nevertheless, though the standards differ, the factors that the Court considers in each situation are the same:
(1) Whether the plaintiff will be prejudiced;
(2) Whether the defendant has a meritorious defense; and
(3) Whether culpable conduct of the defendant led to the default.United Coin Meter Co. v. Seaboard Coastline R.R., 705 F.2d 839, 845 (6th Cir. 1983) (quoting Feliciano v. Reliant Tooling Co., 691 F.2d 653, 656 (3d Cir. 1982)); accord Waifersong, 976 F.2d at 292 (citing United Coin Meter, 705 F.2d at 845; 10 Charles A. Wright et al., Federal Practice and Procedure §§ 2692, 2694 (1983)).
The district court enjoys considerable latitude under the good cause standard of Rule 55(c). United Coin Meter, 705 F.2d at 846;Victoria's Secret Stores v. Artco Equip. Co., 194 F. Supp. 2d 704, 717 (S.D. Ohio 2002). A strong preference for trial on the merits limits the court's discretion, however, and the district court's decision on a motion to set aside a default may be reversed even absent a "glaring abuse" of discretion. Victoria's Secret Stores, 194 F. Supp. 2d at 717 (citing Shepard Claims Serv., Inc. v. William Darrah Assocs., 796 F.2d 190, 193 (6th Cir. 1986)).
Because of the strong preference for trial on the merits, all ambiguities or disputed facts should be construed in a light most favorable to the defendant, and any doubt should be resolved in favor of setting aside an entry of default so that the case may be decided on its merits. INVST Fin. Group, Inc. v. Chem-Nuclear Sys., Inc., 815 F.2d 391, 398 (6th Cir. 1987) (quoting Jackson v. Beech, 636 F.2d 831, 838 (D.C. Cir. 1980)); Union Coin Meter, 705 F.2d at 846 (quoting Rooks v. Am. Brass Co., 263 F.2d 166, 168 (6th Cir. 1959)). That being said, the Court is not required to take as true any fact stated by the party moving to set aside the default; the Court may discredit unbelievable testimony. See Waifersong, 976 F.2d at 291.
Although the culpability of the defendant's conduct that resulted in the default is outcome determinative when seeking to set aside a default judgment, the same is not true in deciding a motion to set aside an entry of default. See Waifersong, 976 F.2d at 292-93. The factors of the Union Coin Meter test must be balanced. Victoria's Secret Stores, 194 F. Supp. 2d at 717 (citing Waifersong, 976 F.2d at 292; United Coin Meter, 705 F.2d at 846).
B. Application
The Markow Defendants argue that they have shown good cause for setting aside the entry of default considering the factors of theUnited Coin Meter balancing test. They contend that they are not culpable for the default because since February 17, 2006 Markow has dealt "with various medical challenges that have severely hindered [his] ability to focus on the pending litigation" (Markow Aff. ¶ 5, Sept. 6, 2006), they have a meritorious defense to the SEC's allegations as articulated in their pending motion for summary judgment, and the SEC will not be prejudiced if the default is set aside because discovery has been completed and any delay in the proceedings will not result in any loss or harm to the SEC. The Court will discuss these arguments within the framework of United Coin Meter. 1. Culpable Conduct of the Defendants
As president of Global Guarantee, Markow is solely responsible for responding to litigation filed against the corporation. (Markow Aff. ¶ 3, Sept. 6, 2006.) The Markow Defendants state that Markow's medical challenges also resulted in Global Guarantee being unable to comply with the Court's orders.
The Markow Defendants argue that Markow's health issues constitute "excusable neglect" under Rule 55(c); however, the excusable neglect standard is inapplicable here. "[I]t is not necessary that conduct be excusable to qualify for relief under the `good cause' standard of Rule 55(c)." Shepard Claims Serv., Inc. v. William Darrah Assocs., 796 F.2d 190, 194 (6th Cir. 1986). "`When the issue is one of whether to set aside an entry of default so that the "good cause" standard of Rule 55(c) is applicable, it is not absolutely necessary that the neglect or oversight offered as reason for the delay in filing a responsive pleading be excusable.'" Id. (quoting Broglie v. Mackay-Smith, 75 F.R.D. 739, 742 (W.D. Va. 1977)). Thus the Markow Defendants need not show excusable neglect for the first factor of United Coin Meter to weigh in their favor; they need to show that no culpable conduct on their part led to the default.
The Court considers the first factor of United Coin Meter in the general context of whether the defendant is deserving of equitable relief. Waifersong, 976 F.2d at 292. "A party's conduct is culpable if it `display[s] either an intent to thwart judicial proceedings or a reckless disregard for the effect of its conduct on those proceedings.'" Williams v. Meyer, 346 F.3d 607, 613 (6th Cir. 2003) (quoting Amernational Indus. v. Action-Tungsram, Inc., 925 F.2d 970, 978 (6th Cir. 1991)).
Although listed as the third factor in United Coin Meter, most courts consider the defendant's culpability first because this factor is outcome-determinative when the defendant is seeking to set aside a default judgment
The Markow Defendants assert that they are not culpable for failing to respond to the Court's orders of February 17, 2006 and April 26, 2006 because Markow was suffering from "debilitating health issues" that did not permit him to respond. In support, the Markow Defendants have provided a sworn affidavit from Dr. Mark Hyman, Markow's primary care physician since 2001. (Hyman Aff. ¶ 6.) Dr. Hyman offers the following account of Markow's medical history.
Prior to 2001, Markow was diagnosed with cervical degenerative disc disease. (Id. ¶ 9.) Markow was involved in an accident in early 2001 that caused severe injuries including several herniated discs and pinched nerves; the accident also exacerbated Markow's cervical degenerative disc disease. (Id.) Consequently, Markow had surgery to fuse three of his vertebrae together. (Id. ¶ 10.)
Markow had knee surgery performed in both 2004 (right knee) and 2005 (left knee) to repair damaged cartilage. (Id. ¶¶ 11, 14.) After both procedures, Markow developed avascular necrosis, "a disease resulting from the temporary or permanent loss of the blood supply to the bones." (Id. ¶¶ 12, 15.) The avascular necrosis in Markow's knees caused debilitating pain and required him to undergo artificial knee replacement surgery for both knees. (Id. ¶¶ 13, 16.)
In late 2005, Markow was still experiencing pain in his neck as a result of the 2001 accident. (Id. ¶ 17.) In January 2006, Markow was again diagnosed with degenerative disc disease of the cervical vertebrae; additionally, he was diagnosed with several ruptured discs. (Id. ¶ 18.) Markow was ordered to attend hematological examinations for several months to determine if he could undergo surgery on his neck. (Id. ¶¶ 19-20.) Markow was experiencing "excruciating and debilitating pain in his neck" during the time in which Markow was having these examinations. (Id. ¶ 21.) Markow's condition caused him to become despondent and depressed. (Id. ¶ 23.) In February 2006, Markow "began taking psychotropic medications in an effort to manage panic attacks and to combat serious emotional problems with which he was dealing because of his physical issues." (Id. ¶ 22.) Markow took a variety of psychotropic medications from March 2006 through September 2006. (Id. ¶ 24.) These drugs had a number of "serious potential side effects including but not limited to suicidal thoughts or actions, racing thoughts, seizures, lethargy, mental confusion, slurred speech, hallucinations, and fatigue." (Id. ¶ 25.) During the same time period, Markow was also prescribed several medications to relieve pain, including morphine. (Id. ¶ 26.)
Markow underwent surgery to alleviate his neck pain in June 2006, but the surgery was unsuccessful. (Id. ¶ 29.) This left Markow even more depressed. (Id.) In August 2006, Markow was diagnosed with a severe spinal cord injury, which Dr. Hyman stated would require surgery. (Id. ¶ 30.)
Dr. Hyman concluded as follows:
[T]he combination of the prescribed medications at the dosage levels at which [Markow] was required to take the medications have negatively affected his frame of mind and ability to communicate effectively. . . . Markow's physical and mental health issues have severely affected his cognitive abilities and impaired his mental performance. . . . Markow's physical and mental health, coupled with the variety and dosages of medication he was taking, would have made it almost impossible for Mr. Markow to function as he had functioned prior to his extensive illness.
(Id. ¶¶ 32-34.)
The Markow Defendants argue that their failure to respond to the Court's orders was the result of Markow's medical condition during 2006. As such, they contend that no culpable behavior on their part led to the entry of default that followed as a consequence of their failure to respond. The Markow Defendants point to Rooks v. American Brass Co., 263 F.2d 166 (6th Cir. 1959), for the rather uncontroversial proposition that serious illness that prevents a party from timely responding to an order of the Court is excusable neglect. Rooks involved a defendant moving to set aside a default and a default judgment. Id. at 167. Thus, in that case, the stricter standards of Rule 60(b) applied. The court held that the defendant's meningitis, "which was the main factor in defendant's receiving no notice of the action," constituted excusable neglect, id. at 168, one of Rule 60(b)'s reasons for granting relief from a default judgment. The difference in procedural posture between the instant case andRooks in no way weakens the Markow Defendants' reliance on that case. As serious illness that prevents a party from timely responding to a court's order satisfies Rule 60(b)'s more strict standard of excusable neglect, it must therefore follow that the same type of serious illness is not culpable conduct on the part of the defendant under Rule 55(c)'s lesser standard of good cause.
Culpable behavior does not exist when a defendant cannot grasp the seriousness of the proceedings. See Burrell v. Henderson, 434 F.3d 826, 833-34 (6th Cir. 2006) (Default judgment set aside when the defendant's failure to grasp the seriousness of the situation was not entirely her fault. The district court abused its discretion in declining to set aside the default judgment.). Markow's serious illness and the side effects of medications prescribed to him, as described by Dr. Hyman, evidence, to some extent, an inability on Markow's part to understand the seriousness of this Court's orders of February 17, 2006 and April 26, 2006. Dr. Hyman's assessment supports Markow's statement that his medical condition "severely hindered [his] ability to focus on the pending litigation." (Markow Aff. ¶ 5, Sept. 6, 2006.)
The SEC argues that even if Markow suffers from the illnesses described in Dr. Hyman's affidavit, Markow was perfectly capable of complying with the Court's orders. Markow became the Chairman and Chief Executive Officer ("CEO") of Pride Business Development Holdings, Inc. ("Pride") no later than December 9, 2005. (Press Release, Pride, Pride Business Development Holdings, Inc. Announces New Chairman of the Board of Directors and Chief Executive Officer (Dec. 9, 2005), Helpingstine Decl. Ex. I, Oct. 5, 2006.) Between the Court's Order of February 17, 2006 and the Entry of Default on May 16, 2006, Pride issued at least nine press releases. (Helpingstine Decl. Ex. J, Oct. 5, 2006.) All of the press releases included a statement from Markow. (Id.) During the same time period, Markow certified and signed at least two of Pride's SEC filings. (Id. Exs. F-G.) Neither the press releases nor the SEC filings make mention of Markow's health issues.
The press releases are dated March 20, March 22, March 23, April 10, April 12, May 2, May 3, May 4, and May 9, 2006.
The SEC contends that Markow made nine SEC filings during the this time period, but the SEC has provided the Court with only six Pride filings, and of these six only two were signed by Markow between February 17, 2006 and May 16, 2006. Markow certified one Form 10-QSB on February 23, 2006 and another on March 23, 2006. (Helpingstine Decl. Exs. F-G, Oct. 5, 2006.) Markow also certified Pride SEC filings on February 15, May 31, July 14, and August 22, 2006. (Id. Exs. C-E, H.)
The evidence presented by the SEC shows that Markow held the title of CEO and Chairman of the Board of Directors of a corporation and that during 2006 he made statements that were included in press releases by the corporation and signed some of the corporation's SEC filings. It is not known to what extent Markow himself personally prepared the press releases and the documents to which he affixed his signature, but none of these somewhat routine activities involved litigation, the court system, or the legal significance and consequences of a failure to respond to a show cause order. According to the medical evidence, which is not disputed, "Mr. Markow's physical and mental health, coupled with the variety and dosages of medication he was taking, would have made it almost impossible for Mr. Markow to function as he had functioned prior to his extensive illness." (Hyman Aff. ¶ 34.) The fact that Markow, with a reduced physical and mental condition, appeared able to conduct some business activities does not necessarily mean that he was physically and mentally able to recognize and fully appreciate the legal consequences of what was occurring in this lawsuit. While the SEC's argument certainly has some weight, the Court must resolve this dispute in the light most favorable to the Markow Defendants and any doubt must be resolved in favor of setting aside an entry of default so that the case can be decided on the merits. INVST Fin. Group, 815 F.2d at 398 (quoting Jackson, 636 F.2d at 838). Construing the evidence in the light most favorable to the Markow Defendants, their explanation for not responding to the Court's orders is not so unbelievable that the Court may completely discredit it. Cf. Waifersong, 976 F.2d at 291 (Court discredited testimonies by defendants that they were not served with notice of the action because they contradicted the process server's testimony and the return of service and the defendants' testimonies were "rife with inconsistencies, improbabilities, and contradictions.").
The Court determines that the Markow Defendants' failure to comply with the Court's orders was not a result of reckless disregard for the effect of their conduct on this case. Accordingly, culpable conduct on the part of the Markow Defendants did not lead to the entry of default.
2. Meritorious Defense
"In determining whether a defaulted defendant has a meritorious defense, `likelihood of success is not the measure.'" United Coin Meter, 705 F.2d at 845 (quoting Keegel v. Key West Caribbean Trading Co., 627 F.2d 372, 374 (D.C. Cir. 1980)). "[I]f any defense relied upon states a defense good at law, then a meritorious defense has been advanced." Id. (citing Rooks, 263 F.2d at 169).
The SEC alleges in its Complaint that the Markow Defendants violated several securities laws. Specifically, they are said to have (1) sold unregistered securities in violation of the Securities Act of 1933, (2) failed to report their beneficial ownership of a common stock as required by the Securities Exchange Act of 1934, and (3) engaged in price manipulation and other conduct that operated as a fraud upon buyers and sellers of securities in violation of both acts.
A defendant need not show a defense to every claim brought against it for the second factor of the United Coin Meter test to weigh in its favor. The defendant need only show that it "has a meritorious defense." A defense is meritorious if "there is some possibility that the outcome of the suit after a full trial will be contrary to the result achieved by the default." Williams, 346 F.3d at 615 (quoting INVST Fin. Group, 815 F.2d at 398-99). As discussed below, the Court determines that the Markow Defendants possess a meritorious defense to the claims predicated on fraudulent activity. As such, the Court finds it unnecessary to determine whether meritorious defenses exists for the other claims.
Section 17(a) of the Securities Act of 1933 makes it unlawful for any person, directly or indirectly in the offer or sale of any securities
(1) to employ any device, scheme, or artifice to defraud, or
(2) to obtain money or property by means of any untrue statement of 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) of the Exchange Act of 1934 makes it unlawful for any person, directly or indirectly
(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, or any securities-based swap agreement . . ., 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). And Rule 10b-5, promulgated under the authority of this statutory provision, makes it 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.
Liability under section 17(a)(1), section 10(b), and Rule 10b-5 cannot exist in the absence of scienter on the part of the defendant. Aaron v. SEC, 446 U.S. 680, 691, 697 (1980). "Scienter" refers to a mental state that embraces "an intent on the part of the defendant to deceive, manipulate, or defraud." Id. at 686 n. 5. "[C]onduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities" is manipulative. Ernst Ernst v. Hochfelder, 425 U.S. 185, 199 (1976). Because scienter is a mental state, proving its existence with direct evidence is often difficult. Scienter may be established by the trier of fact, however, by drawing inferences from the facts of the case, including the defendant's conduct and knowledge. See, e.g., Meadows v. SEC, 119 F.3d 1219, 1226-27 (5th Cir. 1997); see also In re Pagel, Inc., Exchange Act Release No. 22280, 33 S.E.C. Docket 1003, 1985 WL 548387, at *3 (Aug. 1, 1985).
In the Sixth Circuit, the requisite scienter may also be established by showing that the defendant acted with recklessness — "highly unreasonable conduct which is an extreme departure from the standards of ordinary care." SEC v. George, 426 F.3d 786, 792 (2005) (quoting Mansbach v. Prescott, Ball Turben, 598 F.2d 1017, 1025 (6th Cir. 1979)); accord SEC v. Blavin, 760 F.2d 706, 711 (6th Cir. 1985).
The SEC contends that the Markow Defendants' conduct related to the acquisition and distribution of shares of BluePoint stock shows that they controlled the supply of BluePoint shares, coordinated communications promoting the shares, and arranged for trades to set the initial price and create momentum. This conduct, it argues, illustrates the Markow Defendants' intent to manipulate the price of BluePoint stock and satisfies the fraud provisions' scienter requirement. In their pending Motion for Summary Judgment and their Memorandum in Opposition to the SEC's Motion for Partial Summary Judgment, the Markow Defendants argue that they did not possess the requisite scienter to support a finding that they manipulated the price of Bluepoint in violation section 10(b), Rule 10b-5, and section 17(a)(1). Specifically, they assert that their trading activity does not show an intent to tamper with the free forces of supply and demand or a conscious disregard for the effect that their conduct would have on the market. They contend that the price surge was caused by other market participants and, although their trades represented a substantial portion of the total volume of shares traded on March 6, 2000, the facts do not show that they acted intentionally or recklessly to influence the price of BluePoint stock.
This defense is good at law because if the Markow Defendants lacked the scienter to manipulate the price of BluePoint, as they argue the facts demonstrate, the SEC's claims based upon violations of section 10(b), Rule 10b-5, and section 17(a)(1) will fail. The possibility of this outcome is certainly different than if default judgment is entered against them on these claims. Thus, the Markow Defendants possess a meritorious defense and the second factor of United Coin Meter weighs in favor of them.
3. Prejudice to the Plaintiff
Delay, in itself, is not sufficient to constitute prejudice to the plaintiff. INVST Fin. Group, 815 F.2d at 398 (quoting Davis v. Musler, 713 F.2d 907, 916 (2d Cir. 1983)); United Coin Meter, 705 F.2d at 845 (citing Keegel, 627 F.2d at 374). Instead, prejudice to the plaintiff exists only if a delay will "`result in the loss of evidence, create increased difficulties of discovery, or provide greater opportunity for fraud and collusion.'" INVST Fin. Group, 815 F.2d at 398 (quoting Davis, 713 F.2d at 916).
Any delay caused by setting aside the entry of default will not create any increased difficulties of discovery because discovery in this case has already been closed. Additionally, the SEC has not asserted that setting aside the default would result in the loss of any evidence.
The SEC does argue, however, that it will be prejudiced because "the longer this litigation continues the more opportunity the Markow Defendants have to commit further fraud." The SEC points to Pride's Form 10-KSB SEC filing certified by Markow May 31, 2006 in furtherance of this argument. The completed form states that "[d]uring the last five years, no officers or directors have been involved in any legal proceedings, bankruptcy proceedings, criminal proceedings or violated any federal or state securities or commodities laws or engaged in any activity that would limit their involvement in any type of business, securities or banking activities." The SEC contends that by deliberately concealing the existence of this action, Markow is deceiving potential Pride investors regarding the corporation's financial viability.
The SEC's argument lacks merit. First, contrary to the SEC's position, the existence of this action does not make the statement in the filing false. The SEC seems to focus on the "no officers or directors have been involved in any legal proceedings" portion of the statement while ignoring the modifying language at the end of the statement. Properly construed, the statement informs that no officers or directors of Pride have been involved in any legal proceedings that would limit their involvement in any type of business, securities, or banking activities. The statement, accordingly, is not false because there has been no order or judgment in this action — or any other action of which the Court is aware — that limits Markow's ability to engage in business, securities, or banking activities.
Second, the SEC is mistaken that Markow has deliberately concealed the existence of this action so as to deceive the investing public. "Regulation S-B is the source of disclosure requirements for `small business issuer' filings under the Securities Act of 1933 . . . and the Securities Exchange Act of 1934. . . ." 17 C.F.R. § 228.10(a). Under this regulation, a corporation must disclose certain legal proceedings "material to an evaluation of the ability or integrity of any director, person nominated to become a director, executive officer, promoter or control person of the small business issuer." Id. § 228.401(d). Only two of the four legal "events" for which the regulation requires disclosure could possibly apply to this action:
. . . Being subject to any order, judgment, or decree, not subsequently reversed, suspended or vacated, of any court of competent jurisdiction, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities or banking activities; and
. . . Being found by a court of competent jurisdiction (in a civil action), the Commission or the Commodity Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended, or vacated.Id. § 228.401(d)(3)-(4). Neither of the above "events" has occurred in connection with this action. Thus, Pride was not required to disclose this action in its Form 10-KSB SEC filing. If Pride had no duty to disclose the existence of this action, Markow cannot be said to be deceiving the public by not including this action in Pride's Form 10-KSB.
Because there is no indication that any delay will result in any greater opportunity for Markow to engage in fraudulent activity, the Court finds that the SEC will suffer no prejudice if the motion to set aside the entry of default is granted. The third factor of United Coin Meter therefore weighs in favor of the Markow Defendants.
IV. Conclusion
IT IS SO ORDERED.
GRANTED. DENIED.