C. Securities Fraud Claims
Plaintiff argues that the New Jersey defendants are liable under various provisions of the federal securities laws for actions arising from their operation of Graystone. The Court will consider each theory in turn.
1. Fraud-Based Liability
Plaintiff argues that defendants' manipulation of the their unit offerings and the aftermarkets in common stock constitutes violations of section 10(b) of the Exchange Act and Rule lobs promulgated thereunder (fraud in connection with the purchase and sale of securities), section 17(a) of the Securities Act (fraud in connection with the offer and sale of securities), and section 15(c) of the Exchange Act and Rule 15cl-2 promulgated thereunder (fraud by brokers and dealers in connection with a transaction in or an attempt to induce the purchase or sale of securities). These activities also allegedly run afoul of Rule 10b-6.
a. Section 10 and Rule 10b-5 and Section 17(a) of the Securities Act Violations
Section 10(b) of the Exchange Act, which applies to buyers and sellers, makes it unlawful to "employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of any rule promulgated by" the SEC designed to protect the investing public. Gilmore v. Berg, 761 F. Supp. 358, 368 (D.N.J. 1991) (citing 15 U.S.C. § 78j(b)).
Section 17(a) applies to sellers only and proscribes similar conduct,
see Walck v. American Stock Exchange, Inc., 687 F.2d 778, 790 n.16 (3d Cir. 1982), cert. denied, 461 U.S. 942, 103 S. Ct. 2118 (1983); SEC v. Kimmes, 799 F. Supp. 852, 859, 860 (N.D. Ill. 1992), and section 15(c) and Rule 15cl-2 expressly extend liability for fraud to brokers and dealers.
There can be no dispute that the New Jersey defendants fall within the statutory definition of "broker." Section 3(4) of the Exchange Act directs that a broker is "any person engaged in the business of effecting transactions in securities for the account of others," 15 U.S.C. § 78c(4), activity which was the backbone of Graystone's operation. Thus, the question for the Court is whether the conduct of the New Jersey defendants satisfies the statutory prerequisites for fraud.
To succeed on a claim for liability under these provisions the Commission must show that: (1) defendants engaged in fraudulent conduct; (2) in connection with the purchase or sale of securities; (3) through the means or instruments of transportation or communication in interstate commerce or the mails, see 15 U.S.C. § 77q(a); id. § 78j(b); (4) with the requisite scienter. See Aaron v. SEC, 446 U.S. 680, 695, 100 S. Ct. 1945, 1955 (1980); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 196, 96 S. Ct. 1375, 1382 (1976). If misrepresentations or omissions are alleged, the facts misrepresented or omitted must be material. See Basic, Inc. v. Levinson, 485 U.S. 224, 232, 108 S. Ct. 978, 983 (1988). Plaintiff argues that defendants' market manipulations and the affirmative misrepresentations in their registration statements and prospectuses constitute violations of the federal anti-fraud statutes. The Court agrees.
At the outset the Court notes that the Commission has satisfied prongs two and three. The offering and sale of securities, from initial securities offerings to aftermarket trading, formed the basis of the New Jersey defendants' livelihood. See pages 3-5 supra. In addition, the evidence indicates that the New Jersey defendants relied on the means of interstate commerce to effect these transactions. Graystone headquarters in New Jersey maintained close contact with its branch offices, issuing price sheets and other directives through daily mailings, faxes and phone calls, Boyle at 24, 26, 55; Gallego at 12-13, 31-32; Torrey at 9, 10, 19, and clearing all trades through the New Jersey office. Gallego at 32; Mather at 16; Torrey at 10, 95.
Section 17(a) and clauses (a) and (c) of Rule 10b-5 contain "flat prohibitions of deceitful practices and market manipulations." United States v. Charnay, 537 F.2d 341, 350 (9th Cir. 1976), cert. denied, 429 U.S. 1000, 97 S. Ct. 527 (1976). Offenses falling within their purview include "any activities that falsely persuade the public that activity in an over-the-counter security is 'the reflection of genuine demand instead of a mirage.'" Kimmes, 799 F. Supp. at 859 (quoting SEC v. Resch-Cassin & Co., 362 F. Supp. 964, 975 (S.D.N.Y. 1973)), such as: (1) efforts of an acquiring group to artificially reduce a target company's stock price through organized large-block selling, see Charnay, 537 F.2d at 344; (2) the attempt of an underwriter of a convertible bond offering to deflate the stock price of the issuer by selling its stock short, see United States v. Regan, 937 F.2d 823, 829 (2d Cir. 1991), cert. denied, 112 S. Ct. 2273 (1992); and (3) the use of wash sales and matched orders to create the appearance of volume trading. See Edward J. Mawod & Co. v. SEC, 591 F.2d 588, 595 (10th Cir. 1979). Although more egregious because not limited to an isolated incident, Graystone's fraudulent scheme clearly falls within the scope of the prohibitions of section 17(a) and Rule 10b-5(a) and (c).
In essence, Graystone sought to gain control over the market in their house stocks by strongarming brokers and individual investors. To achieve this goal, the New Jersey defendants imposed mandatory resale rules on all unit offerings, sold specific quantities of common stock at predetermined prices and restricted investors' rights to alienate their shares by refusing to process sell tickets. See pages 4-7 supra.
Engaging in these activities with the added factor of nondisclosure also violates Rule 10b-5(b), since failing to reveal that the house stock prices were not the result of free market forces constitutes misrepresentations and omissions. See Charnay, 537 F.2d at 351. Further, the registration statements and prospectuses, which describe the unit offerings, but not the repurchase rule and the common stock distribution, provide an additional source of omissions and misrepresentations.
With respect to the misrepresentation and omissions claim, the Commission must show that defendants "lacked 'a genuine belief that the information disclosed was accurate and complete in all material respects.'" In re Phillips Petroleum Securities Litigation, 881 F.2d 1236, 1244 (3d Cir. 1989) (quoting McLean v. Alexander, 599 F.2d 1190, 1198 (3d Cir. 1970)). In the instant case, although the prospectuses described the offering of common stock and warrant units, the evidence demonstrates that the New Jersey defendants instead planned to execute a carefully devised two-tiered sales scheme.
To determine whether these misrepresentations and omissions are material, the Court must ask "if there is a substantial likelihood that a reasonable [investor] would consider it important in deciding" whether to purchase or sell the securities. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449, 96 S. Ct. 2126, 2132 (1976); Basic, 485 U.S. at 231, 108 S. Ct. at 983 (applying TSC Industries standard to section 10(b) claim). There can be no dispute that a reasonable investor contemplating participation in Graystone's unit offerings would have wanted to know of the attendant restrictions, which affected both the value and the liquidity of the investment. Indeed, the ability of common stock purchasers to sell their shares required the permission of Graystone as well as its continued existence. As the cascading bids for house stocks following Graystone's closing demonstrate, Mather at 75, Graystone provided the only market for these shares.
The Court also finds that there is no genuine issue with respect to the scienter element. Scienter refers to a mental state "embracing intent to deceive, manipulate or defraud." Hochfelder, 425 U.S. at 193 & n.12, 96 S. Ct. at 1381 & n.12. Recklessness also meets the scienter requirement. See Phillips Petroleum Securities Litigation, 881 F.2d at 1244. The evidence in the instant case, however, overwhelmingly indicates that the New Jersey defendants carried out their scheme intentionally.
The conscious nature of the scheme is evidenced by the New Jersey defendants' enforcement efforts. For example, resistance on the part of investors to repurchases of their units was met with orders to resell without the investors' permission. See page 5 supra. Labeled "new issue whores" these clients were barred from future issues. Further, to ensure compliance with their trading rules, the New Jersey defendants routinely threatened brokers and branch managers. See pages 5, 7 supra. The New Jersey defendants also ignored the advice of Graystone compliance officers, McGowan at 45-46, Mather at 34-35, actively concealing their activities from them. Mather at 15-16 (compliance officer asked to leave room when branch manager received calls from defendants Thomas Ackerly and Adams).
b. Rule 10b-6 violations
Aimed at market manipulations, Rule 10b-6 prohibits any person engaged in the distribution of securities from purchasing or bidding for the security until that person has completed his participation in the distribution.
See SEC v. Kimmes, 799 F. Supp. 852, 859 (N.D. Ill. 1992). A distribution includes "'the entire process by which in the course of a public offering the block of securities is dispersed and ultimately comes to rest in the hands of the investing public.'" R.A. Holman & Co. v. SEC, 366 F.2d 446, 449 (2d Cir. 1966) (quoting Lewisohn Copper Corp., 38 S.E.C. 226, 234 (1958)), cert. denied, 389 U.S. 991, 88 U.S. 473 (1967); Kimmes, 799 F. Supp. at 859. A distribution is triggered when the incentive to engage in manipulative conduct is first present. See SEC v. Burns, 816 F.2d 471, 476 (9th Cir. 1987) (quoting Exchange Act Release No. 18528 [1982 Transfer Binder]Fed. Sec. L. Rep. (CCH) P 83, 104 (Mar. 2, 1982)).
The Commission argues that the "purported offerings of units were shams, constituting only an intermediate stage in the actual distributions." Brief at 29. The structure of the offerings supports this characterization.
Graystone initially offered units comprised of common stock and warrants. Thereafter, through its mandatory resale rule, unit holders were required to sell their interests back to Graystone who then distributed the common stock. Graystone solicited investors who were willing to purchase both initial units and common stock, and if clients became uncooperative, the New Jersey defendants excluded them from future offerings. See page 4 supra. Allocations of initial units and common stock to the satellite offices were made jointly. See e.g., note 11 supra. Thus, the distribution in the instant case encompassed the sale of both the initial units and the shares of common stock.
As such, it is clear that the New Jersey defendants engaged in conduct proscribed by Rule 10b-6. Specifically, the record indicates that defendants solicited common stock purchases while engaged in the distribution of the units, see Boyle at 25-26; Mather at 90-91; Torrey at 24-31; Ware at 12-13, and bid for and reacquired the units before the distribution was complete. See Boyle at 20-21; Gallego at 8-13; McGowan at 39-40; Torrey at 18-19; Ware at 10-12.
3. Section 5 Violations
Plaintiff also seeks to hold the New Jersey defendants under the provisions of section 5 of the Securities Act for offering and selling securities in the absence of a registration statement. The Commission further accuses Thomas Ackerly of distributing a nonconforming prospectus.
(i) Section 5(a) and 5(c) Claims
Section 5(a) of the Securities Act of 1933 makes it unlawful for any person, either directly or indirectly, to sell a security in interstate commerce unless a registration statement is in effect as to that security. 15 U.S.C. § 77e(a). Section 5(c) extends this liability to those who offer to sell such securities. Id. § 77e(c).
To establish prima facie violations of these provisions of section 5, plaintiff must show that: (1) no registration statement was in effect as to the security; (2) defendants offered to sell or sold the security; and that (3) defendants used the means of interstate commerce in connection with the offer or sale. See SEC v. Spence & Green Chemical Co., 612 F.2d 896, 901 (5th Cir. 1980), cert. denied, 449 U.S. 1082, 101 S. Ct. 866 (1981); SEC v. Continental Tobacco Co., 463 F.2d 137, 155 (5th Cir. 1972). Once plaintiff has made this showing, the burden shifts to defendants to demonstrate that the securities were exempt from the registration requirement. See SEC v. Ralston Purina Co., 346 U.S. 119, 126, 73 S. Ct. 981, 985 (1953).
Because the Court found that Graystone offered and sold securities relying on the means of interstate commerce, see page 16 supra, these section 5 claims turn on the registration-statement element. Initially, the record indicates that Graystone filed registration statements for their offerings. However, this fact alone is not dispositive. Indeed, a registration statement is "effective only as to the securities specified therein as proposed to be offered." 15 U.S.C. § 77f(a); see First Multifund for Daily Income, Inc. v. United States, 221 Ct. Cl. 123, 602 F.2d 332 (Ct. Cl. 1979) (registration statement covers only initial offering of securities, not reoffering of those securities after issuer has redeemed them), cert. denied, 445 U.S. 916, 100 S. Ct. 1275 (1980).
The Court already has determined that the distribution contemplated and implemented by defendants included disbursement of the units in the initial offering and the shares of common stock. See page 21 supra. Defendants' registration statements covered offerings of "units" which consisted of shares of common stock and warrants to purchase additional common stock. See Mann Declaration, Plaintiff's Exhibit 1. However, once the units were sold, Graystone, through its mandatory resale rule, required unit holders to sell their interests back to Graystone. Graystone then distributed the common stock at predetermined, escalating tick prices. These distributions of common stock in the aftermarket were not registered.
(ii) Section 5(b) Claim
Section 5(b), designed to prevent conditioning of the market for upcoming offerings, prohibits transmittal of a prospectus that does not meet the requirements of section 10 of the Securities Act. 15 U.S.C. § 77e (b)(1). A prospectus includes any "notice, circular, advertisement, letter, or communication, written or by radio or television, which offer any security for sale." 15 U.S.C. § 77b(10). The term "offer" encompasses "every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value." Id. § 77b(3).
Section 10 requires that a prospectus contain the information provided in the registration statement in accordance with the schedule of section 77aa. 15 U.S.C. § 77j(a)(1). Schedule A requires, among other information, a balance sheet and a profit and loss statement of the issuer. 15 U.S.C. § 77aa(25), (26).
The Commission argues that the feature on W.I.N.E. that appeared in Speculators Magazine was a nonconforming prospectus. The article recommended W.I.N.E. as a good investment, depicted Graystone as a highly successful underwriter and concluded with "Call Graystone Nash" followed by the firm's address and phone numbers. See Plaintiff's Exhibit 14 at 2, 4.
The Court concludes that this story constituted an offer and therefore a prospectus. See 38 S.E.C. 882, 1959 WL 2717 at *3 (1959). Because it did not contain information required under section 77aa or a correct description of the nature of the offering, its publication and distribution, which occurred in advance of the effective date of the offering, Torrey at 47, was prohibited. Therefore, in causing its publication and dissemination to customers through Graystone's branch offices, Torrey at 48, Thomas Ackerly violated section 5(b) of the Securities Act.
Describing the conduct of the New Jersey defendants as "outrageous," the Commission asks the Court to enjoin defendants from future securities violations and to order disgorgement. The Court will review each remedy in turn.
1. Injunctive Relief
Section 20(b) of the Securities Act, in relevant part, provides:
Whenever it shall appear to the Commission that any person is engaged or about to engage in any acts or practices which constitute or will constitute a violation of the provisions of this subchapter, or of any rule or regulation prescribed under authority thereof, the Commission may, in its discretion, bring any action in any district court of the United States . . . to enjoin such acts or practices, and upon a proper showing, a permanent or temporary injunction or restraining order shall be granted without bond.
15 U.S.C. § 77t(b). Similarly, section 21(d) of the Exchange Act provides:
Whenever it shall appear to the Commission that any person is engaged or about to engage in acts or practices constituting a violation of any provision of this chapter, the rules or regulations thereunder, . . . it may in its discretion bring an action in the proper district court of the United States . . . to enjoin such acts or practices, and upon a proper showing a permanent or temporary injunction or restraining order shall be granted without bond.