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S.E.C. v. CHESTER HOLDINGS

February 19, 1999

SECURITIES AND EXCHANGE COMMISSION, PLAINTIFF,
v.
CHESTER HOLDINGS, LTD., ET AL., DEFENDANTS.



The opinion of the court was delivered by: Barry, District Judge.

      OPINION

The Securities and Exchange Commission ("SEC" or "plaintiff") has brought this civil enforcement action against Chester Holdings, Ltd., formerly known as Aqua Buoy Corporation ("Aqua Buoy"); Joseph Pignatiello; Constance Pignatiello; and Christopher Werner ("Werner"). On August 20, 1997, a final order of permanent injunction was entered by consent against Chester Holdings. In addition, on October 8, 1998, a final order of permanent injunction was entered by consent against Christopher Werner. The only defendants who remain in this case are, therefore, Joseph and Constance Pignatiello (collectively as "defendants") and the SEC now moves for summary judgment against each of them. For the following reasons, this court will grant the SEC's motion.

I. STATEMENT OF FACTS

Aqua Buoy was formed in December 1988 and, on June 19, 1989, merged with Seek Ventures, Inc., a company then registered with the SEC. Exh. 13*fn1 at 12. From 1989 to 1994, Aqua Buoy's securities were registered with the SEC pursuant to Section 12(g) of the Securities Exchange Act of 1934 and its common stock was traded over the counter on NASDAQ. Exh. 53 at 14-15.*fn2

Joseph Pignatiello founded Aqua Buoy and was its first CEO, President and Chairman of the Board of Directors. Exh. 1 ¶ 6, Exh. 2 ¶ 6. He resigned as President in July 1990 and as CEO and Chairman in May 1991 but continued on as Director of International Marketing. Id.; Exh. 10 at 3; Exh. 6 at 82-83. Constance Pignatiello, Joseph's wife, was Aqua Buoy's Secretary and Treasurer from June 1989 to July 1990, President from July 1990 to February 1992, and a director from June 1989 to February 1992. Exh. 1 ¶ 7; Exh. 3 ¶ 7. Her parents were also directors of Aqua Buoy. Exh. 17 at 28. Werner was Aqua Buoy's Controller from January 1989 to April 1991, Exhs. 1, 2, 3 ¶ 8, its Secretary-Treasurer from July 1990 to February 1993, and its Chief Financial Officer and a director from April 1991 to February 1993. Exh. 17 at 28; Exh. 46 at 31.

This action revolves around the following five acquisitions by Aqua Buoy in 1991:(1) manufacturing equipment acquired from Aqua Buoy International, Inc. ("ABI"); (2) Leven Oaks, a hotel and restaurant retirement facility in California; (3) a commercial building in Michigan acquired from H & R Corporation ("H & R"); (4) certain assets of Lord Jeff Knitting Company, Ltd. ("Lord Jeff"), a bankrupt sweater manufacturer; and (5) equipment, trademarks and trade names acquired from Pearson Yachts Corporation ("Pearson"), a bankrupt boat manufacturer.

On March 15, 1991, Aqua Buoy acquired from ABI the manufacturing equipment, along with the necessary trademarks and patents, to produce the Aqua Buoy Flotation Aid ("ABI acquisition"). Exh. 17 at 7.

Mitchell, Londer & Company ("Mitchell Londer") was Aqua Buoy's independent auditor and supplied an Independent Auditor's Report dated July 19, 1990 to accompany Aqua Buoy's 1990 10-K statement for the fiscal year ending June 30, 1990 ("1990 10-K"). Exh. 13 at F-1, F-2. Monty Lamirato ("Lamirato"), an accountant at Mitchell Londer, was the audit manager for Aqua Buoy. Exh. 21 at 10. On February 28, 1991, Joseph Pignatiello wrote to Londer, described the upcoming ABI acquisition, and stated, inter alia, that:

  1. We are purchasing the manufacturing facility for
  $1,353,000 which is $153,000 in cash and 300,000
  shares of restricted 144 stock at $4.00 per share.

Exh. 23 at 1. Lamirato testified that he informed Joseph Pignatiello that Aqua Buoy's $4.00 per share valuation of the 300,000 shares of unregistered common stock issued in connection with the ABI acquisition, did not comply with Generally Accepted Accounting Principles ("GAAP"). Exh. 21 at 49-51. Lamirato explained to Joseph Pignatiello that because the shares of Aqua Buoy's common stock were publicly trading at between $1.00 and $1.50 per share at the time of the ABI acquisition,*fn3 and because Rule 144 stock is restricted stock that cannot be immediately sold, the 300,000 shares should be valued at approximately 25-50% less than $1.00-$1.50 per share. Exh. 21 at 46-51, 56-58. Lamirato also explained that Mitchell Londer "would not certify and opine upon the value that [Aqua Buoy] was placing on the transaction." Exh. 21 at 47. On April 15, 1991, Aqua Buoy terminated Mitchell Londer as its independent auditor. Exh. 21 at 51; Exh. 22 at 2.

Notwithstanding Lamirato's comments, Aqua Buoy issued a press release on March 3, 1991 ("March 3, 1991 Press Release"), prepared by Joseph Pignatiello and signed by Constance Pignatiello, Exh. 6 at 129, which stated that the ABI assets were acquired for $1,353,000 in cash and equity. Exh. 15. As was more specifically delineated in Aqua Buoy's 10-Q statement for the quarter ending March 31, 1991 filed with the SEC on April 29, 1991 ("March 1991 10-Q"), the $1,353,000 was in the form of a promissory note for $153,000 and 300,000 shares of Aqua Buoy unregistered stock valued at $4.00 a share. Exh. 19 at 10. Aqua Buoy also represented the value of the ABI acquisition as $1,353,000 in its 10-K statement for the fiscal year ending June 30, 1991 ("1991 10-K"). Exh. 17 at 7-8. Finally, the SEC asserts, and defendants do not deny, that the 1991 Annual Report to Shareholders ("1991 Annual Report") and a press release dated July 27, 1991 announcing the 1991 10-K ("July 27, 1991 Press Release") listed Aqua Buoy's total assets as $7,538,609 which included the valuation of the ABI acquisition at $1,353,000. Exh. 41; Exh. 40.

On May 8, 1991, Aqua Buoy purchased Leven Oaks, a retirement facility in California ("Leven Oaks acquisition"). Exh. 17 at 8. Aqua Buoy issued a press release on May 13, 1991 ("May 13, 1991 Press Release"), prepared by Joseph Pignatiello and reviewed by Constance Pignatiello, Exh. 11 at 19-20, which stated that Leven Oaks was purchased for $1,940,000. Exh. 26. As was specified in Aqua Buoy's 1991 10-K, the $1,940,000 represented $1.2 million and 146,000 shares of unregistered common stock valued at $5.00 per share. Exh. 17 at 8. The quoted market price of Aqua Buoy common stock on May 8, 1991 was $1.50 per share. Exh. 27. The SEC asserts, and defendants do not deny, that the 1991 Annual Report and the July 27, 1991 Press Release announcing the 1991 10-K listed Aqua Buoy's total assets as $7,538,609 which included the valuation of the Leven Oaks acquisition at $1,940,000. Exh. 41; Exh. 40.

Next, on June 10, 1991, Aqua Buoy acquired 100% of the shares of H & R whose sole asset was a commercial building located in Michigan ("H & R acquisition"). Exh. 17 at 9. Aqua Buoy issued a press release on July 21, 1991 ("July 12, 1991 Press Release"), prepared by Joseph Pignatiello and reviewed by Constance Pignatiello, Exh. 6 at 178, which stated that it had acquired the H & R building which had an "M.A.I. appraised value of $2.75 million, in exchange for shares of [Aqua Buoy's] unregistered shares of stock [and Aqua Buoy] will assume approximately $590,000 in debt as part of the agreement." Exh. 33. Aqua Buoy's 1991 10-K reported that the $2.75 million represented Aqua Buoy's assumption of $490,000 in a first mortgage plus the issuance of 433,000 shares of Aqua Buoy unregistered common stock valued at $5.00 a share. Exh. 17 at 8.

In July 1991, before Aqua Buoy filed its 1991 10-K statement, Lamirato reviewed a draft of the 10-K for the purpose of Mitchell Londer reissuing its opinion concerning Aqua Buoy's financial statements for the year ending June 30, 1990. Exh. 24, Exh. 21 at 83-87. On July 25, 1991, Lamirato sent a letter to Werner regarding Aqua Buoy's proposed 1991 10-K statement ("July 25, 1991 Letter"). Exh. 24. In that letter, Lamirato stated:

  8. We assume you will be able to support a common
  stock value of $4-5 per share used in acquiring
  various businesses when the free trading price of the
  Company's common stock never exceeded $2.88.

Exh. 24 at 2, ¶ 8.*fn4 Neither Joseph nor Constance Pignatiello contest Werner's assertion that they saw the letter. Exh. 11 at 68.

Werner then faxed a letter to Lamirato which responded to Lamirato's concerns and stated with respect to paragraph eight:

  8. According to counsel, the price for which we
  traded shares of stock is to our advantage and the
  price is substantiated by the acceptance of the buyer
  to trade his equity at that level. Each owner has
  signed a subscription agreement drawn up by counsel
  which states all of the risk factors and that each
  owner is aware that he could lose his entire
  investment.

Exh. 42 at 1, ¶ 8. Joseph Pignatiello drafted this paragraph of the letter. Exh. 11 at 75.

In response, Lamirato sent another letter to Werner on July 26, 1991 which further commented on paragraph eight by stating:

  Comment # 8: We assume you and your current
  accountants have reviewed the SEC guidelines for
  valuing stock.

Exh. 43 at 1. Werner distributed the letter to both Joseph and Constance Pignatiello. Exh. 11 at 80.

Notwithstanding the above correspondence, Aqua Buoy's 1991 10-K reported the H & R acquisition at $2,750,000 which included, in part, 433,000 shares of Aqua Buoy unregistered common stock valued at $5.00 a share. Exh. 17 at 8. In addition, the SEC asserts, and defendants do not deny, that the 1991 Annual Report and the July 27, 1991 Press Release announcing the 1991 10-K listed Aqua Buoy's total assets as $7,538,609 which included the valuation of the H & R acquisition at $2,750,000. Exh. 41; Exh. 40.

On September 27, 1991, Aqua Buoy acquired Lord Jeff, a bankrupt sweater manufacturer. Exh. 60. On October 29, 1991, Aqua Buoy filed its 10-Q statement for the quarter ending September 30, 1991 ("September 1991 10-Q") which had been prepared by Joseph Pignatiello and Werner and signed by Constance Pignatiello. Exh. 11 at 162-63. The September 1991 10-Q highlighted increases in total assets and shareholder equity of $15,380,745 and $14,151,745, respectively, between June 30, 1991 and September 30, 1991. Exh. 59 at 3. The $14-15 million increase was attributed primarily to the Lord Jeff acquisition. Exh. 1 ¶ 27; Exh. 2 ¶ 27; Exh. 3 ¶ 27.

Aqua Buoy's $14-15 million valuation of Lord Jeff was principally based on a payment of $85,000 in cash to Lord Jeff's unsecured creditors and the issuance of four million shares of Aqua Buoy stock valued at $3.50 per share. Defs.' Br. at 11;*fn5 Exh. 61 at 2-3; Exh. 7 at 455. The four million shares were purportedly distributed in the following way: (1) 1.5 million shares to Lord Jeff creditors, including 125,000 shares held in escrow to compensate for any royalty shortfalls; (2) 1.5 million shares to Robert Hoy, President of Lord Jeff; (3) 500,000 shares to Landmark Financial Corp., an investment bank; and (4) 500,000 shares to Constance Pignatiello. Exh. 7 at 455-56; Exh. 12 at 20; Exh. 61 at 2-3.

Aqua Buoy also issued a press release on October 29, 1991 ("October 29, 1991 Press Release"), prepared by Joseph Pignatiello, Exh. 7 at 77-78, announcing the financial results for the quarter ending September 30, 1991. It compared Aqua Buoy's total assets in 1991 of $22,919,354 to $448,097 in 1990. The increase was due to the ABI, Leven Oaks, H & R and Lord Jeff acquisitions.

Finally, Aqua Buoy acquired Pearson for "cash and stock" and issued two press releases on October 21, 1991 ("Pearson Press Releases"), prepared by Joseph Pignatiello and reviewed by Constance Pignatiello, Exh. 7 at 247-48, announcing the acquisition. Exhs. 74, 75. In January 1992, Aqua Buoy filed an 8-K with the SEC which was prepared by Werner, reviewed by Joseph Pignatiello and signed by Constance Pignatiello ("Pearson 8-K"). Exh. 7 at 267-68; Exh. 77 at 2. The Pearson 8-K stated that Aqua Buoy had acquired Pearson for $1,250,000 in cash and stock ($250,000 cash and 173,077 shares of unregistered Rule 144 stock). Exh. 77 at 2.

On November 5, 1991, Ed O'Connell ("O'Connell"), a partner at the accounting firm of Wiss & Company ("Wiss"), wrote to Werner, with copies sent to Joseph Pignatiello, regarding the Lord Jeff acquisition. Exh. 60.*fn6 In his letter, O'Connell stated that the September 1991 10-Q "must be amended" in order to recompute the value of the Lord Jeff acquisition. Exh. 60 at 1. The Lord Jeff acquisition should have been recorded at 1,375,000 shares at $3.50 per share (totaling $4,812,000) to unsecured Lord Jeff creditors, royalties to unsecured creditors "collateralized" by 125,000 shares, $85,000 cash to unsecured creditors, $254,000 cash to administrative claims, and 17,000 shares to landlord at $3.50 per share (totaling $60,000). Exh. 60 at 1. Thus, he concluded, the Lord Jeff assets should have been valued at $5,649,000 instead of $14-15 million. Exh. 60 at 1. He stated, "I'm really lost as to where the balance of the four million shares are that [Joseph Pignatiello] said were paid for Lord Jeff." Exh. 60 at 2.

On November 13, 1991, O'Connell wrote to Joseph Pignatiello regarding the accounting for the Lord Jeff acquisition and stated that the September 1991 10-Q Statement should be "revised." Exh. 61 at 3. O'Connell explained:

  the fair value for [the Lord Jeff Acquisition]
  (approximately $4,958,000 using the values in the
  Disclosure Statement, plus contingent consideration
  of up to $438,000) should be considered as part of
  the Company's investment in (or advance to) Lord
  Jeff.

Exh. 61 at 2. This "fair value" included $85,000 cash, 1,375,000 shares of common stock valued at $3.50 per share, 125,000 shares to compensate for royalty shortfalls, and 17,000 shares to the landlord to pay for back rent. Exh. 61 at 2. As for the remaining two and a half million shares that Aqua Buoy had reported as part of the transaction, O'Connell stated:

  We understand that additional shares were issued by
  the Company of which 1,000,000 were, or are to be,
  issued to investment bankers for finder's fees and
  consulting services directly related to the
  acquisition. We understand there is no documentation
  as to the nature of these services. To the extent
  that financing or equity underwriting are involved,
  these costs should be classified as deferred
  financing costs or reductions to paid-in-capital.
  In addition, we understand that 1,500,000 shares
  were, or are to be, issued to Mr. Hoy or Lord Jeff.
  The purpose of this issuance appears outside of the
  requirements for the Company to acquire Lord Jeff.
  Further, we understand that some of these shares are
  to be re-issued to employees of Lord Jeff. Since
  these shares do not represent payment for Lord Jeff's
  obligations, they apparently relate to future
  compensation.

Exh. 61 at 2.

On December 12, 1991, O'Connell wrote to Joseph Pignatiello regarding the 1991 10-K and certain documents relating to, inter alia, the ABI, Leven Oaks and H & R acquisitions. He opined that the shares of restricted unregistered Aqua Buoy common stock in each of acquisitions should have been valued at between approximately $0.63 and $1.10 per share. Exh. 25 at 3. This opinion was reached because between January 1, 1991 and March 31, 1991, the mid range of low and high bids for the shares was $1.25 per share and between April 1, 1991 and June 30, 1991, it was $2.19 per share. Therefore, after a 50% discount due to restrictions on marketability, a $0.63 value should have been used for third quarter acquisitions and a $1.10 value for fourth quarter acquisitions. Id.

More specifically, O'Connell opined that the ABI assets should have been valued at $342,000 instead of $1,353,000 as reported in the 1991 10-K. Id. at 3. This figure was based upon an estimated fair market value of $189,000 for Aqua Buoy's common stock valued at $0.63 per share. Id.

In addition, O'Connell stated that the Leven Oaks acquisition should have been valued at $1,380,000 instead of the $1,940,000 reported in the 1991 10-K. Id. at 2. This valuation was based upon an estimated fair market value of $172,000 for Aqua Buoy's common stock valued at $1.10 per share. Id.

Finally, O'Connell informed Joseph Pignatiello that the H & R facility should have been valued at $1,061,300 as opposed to $2,750,000 as reported in the 1991 10-K. Id. This finding was based on an estimated fair market value of $476,300 for Aqua Buoy's common stock valued at $1.10 per share. Id.

O'Connell also recommended that an investment banker be engaged to precisely value the debt and equity securities as well as those issued in connection with the Lord Jeff acquisition. Id. at 3. He then concluded that, based on the above, the 1991 ...


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