S.E.C. v. Cavanagh

Decision Date10 April 2006
Docket NumberDocket No. 04-5422-CV(CON).,Docket No. 04-5402-CV(L).,Docket No. 04-5708-CV(CON).,Docket No. 04-6363-CV(CON).
Citation445 F.3d 105
PartiesSECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellee, v. Thomas Edward CAVANAGH, U.S. Milestone, Frank Nicolois, Karen Cavanagh, Beverly Nicolois, Cromlix, LLC, and Thomas A. Hangtes, Defendants-Appellants, Electro-Optical System Corp., George Chachas, Thomas R. Brooksbank, The Estate of William N. Levy, deceased, by and through his executrix, Marlene Levy, Optimum Fund, Agira Trading, Customer Safety, S.L., Cambiares, S.L., Construcciones Solariegas, S.L., Cosimo Tacopino, Maier S. Lehman, James E. Franklin, Donald & Co. Securities Inc., SHBL Associates Europe Ltd., Joseph Falco, Martin Hodas, Bernd Stieghorst, Erin Martin, Ana P. Lopez, Tamar Lehman, Metropolitan Trade Finance Ltd., Tim Timlin, Carmillo Monastra, Eugene Stricker, Arthur De Acutis, Jean-Pierre Neuhaus, Kenneth C. Kehoe, Antonio V. Borotto, Anthony S. Luttenberger, Shlomie Zarchy, Florida Pension Fund Inc., Inversoa Dactiler, S.L., Edward C. Kaufer, The Owners of Account No. 13601, and Baja Ltd., Defendants.
CourtU.S. Court of Appeals — Second Circuit

Paul A. Batista, New York, NY, for Defendants-Appellants Thomas Cavanagh, Frank Nicolois, U.S. Milestone Corp., Beverly Nicolois, Karen Cavanagh, and Cromlix, LLC.

Thomas R. Brooksbank, Phoenix, AZ, pro se.

Gregory J. Sherwin, Fields, Fehn & Sherwin, Los Angeles, CA, for Defendant-Appellant Thomas A. Hantges.

Melinda Hardy, Assistant General Counsel (Giovanni P. Prezioso, General Counsel, Richard M. Hurnes, Associate General Counsel, Philip J. Holmes and Wm. Smith Greig, Senior Counsel, on the brief), United States Securities and Exchange Commission Washington, DC, for Plaintiff-Appellee.

Before: CARDAMONE, CABRANES, and POOLER, Circuit Judges.

JOSÉ A. CABRANES, Circuit Judge.

These consolidated cases1 concern a "pump-and-dump" securities fraud scheme whereby certain defendants artificially inflated a company's stock price, sold high, and left investors holding nearly worthless shares when the price plummeted to a realistic value. Other defendants allegedly benefitted unjustly from the opportunity to buy shares at nominal prices and then to sell at inflated prices. The Securities and Exchange Commission ("SEC") instituted this enforcement action, alleging that defendants had violated federal securities laws by failing to register shares and by committing fraud. The SEC moved for summary judgment, which the United States District Court for the Southern District of New York (Denise Cote, Judge) granted. On appeal, defendants contend that the District Court's action was erroneous on several grounds, none of which we find meritorious. In this opinion, we consider two of the defendants' arguments in greater detail: (1) that the District Court should have allowed defendants to benefit from an exemption to the federal securities registration requirements2 and (2) that the District Court exceeded its authority in granting equitable disgorgement of defendants' ill-gotten profits.

Because the District Court correctly found that the claimed exemptions do not apply to defendants' actions, and because the remedies imposed by the District Court did not exceed its equity powers, we affirm.

BACKGROUND

We assume familiarity with our previous opinion related to this matter, see SEC v. Cavanagh, 155 F.3d 129 (2d Cir.1998) ("Cavanagh II"), and the opinions of the District Court, see SEC v. Cavanagh, No. 98 Civ. 1818(DLC), 2004 WL 1594818 (S.D.N.Y. July 16, 2004) ("Cavanagh III"); SEC v. Cavanagh, 1 F.Supp.2d 337 (S.D.N.Y.1998) ("Cavanagh I"), and recount only those facts necessary for the resolution of the issues presented. The facts below are drawn from the complaint of the SEC and the Cavanagh III opinion of the District Court.

WTS Transnational, Inc. ("WTS"), a Massachusetts corporation that was developing a fingerprint-verification system, required additional financing to continue its operations. As of September 30, 1997, WTS had no revenue, $655,000 in current liabilities, and only $10,000 in assets. It had yet to produce a prototype of its fingerprint verification system, which remained unpatented.

Defendants Thomas Cavanagh and Frank Nicolois, who operated an investment banking company called U.S. Milestone ("USM"), agreed to arrange financing for WTS. They located a shell corporation, Curbstone Acquisition Corp. ("Curbstone"), which had essentially no assets but which had registered approximately 3,500,000 shares with the SEC.3 Curbstone's principals — including defendants George Chachas, Thomas Brooksbank, Thomas Hantges, and James Franklin — owned nearly all of Curbstone's shares. Cavanagh, Chachas, and defendant William Levy, USM's legal counsel, worked out a reverse stock acquisition, whereby Curbstone would acquire WTS, and WTS's management would replace Curbstone's.4 The resulting merged entity was to be renamed Electro-Optical Systems Corporation ("EOSC").

WTS and Curbstone entered into a Stock Exchange Agreement ("EA") dated December 5, 1997.5 The EA was signed on Curbstone's behalf on December 8, 1997 and on WTS's behalf between December 2 and 16, 1997. Under the EA, WTS shareholders exchanged all outstanding shares of their company for newly issued shares of Curbstone, thereby "reverse merging" the closely held WTS into the publicly traded Curbstone. The newly issued shares bore a "restrictive legend" that imposed limitations on the ability of the former WTS shareholders to trade their new Curbstone shares. The EA contained options provisions, whereby Curbstone shares would be purchased from the individuals comprising Curbstone management, and so-called "lock-up" provisions preventing those individuals from otherwise selling Curbstone shares until March 15, 1998, two months after the January 16, 1998 deadline the EA set for the closing of the reverse merger.6

The challenged transactions relevant to this appeal occurred on three distinct occasions. First, in late December 1997, Cavanagh and others arranged for the sale of Curbstone shares to third-party Spanish companies controlled by them, which the District Court referred to as the "Spanish Nominees." After the transaction contemplated by the EA closed on December 18, 1997, the USM defendants directly or indirectly controlled nearly all the freely tradable shares of EOSC, the entity created by the merger of Curbstone and WTS. Cavanagh and Nicolois intentionally inflated EOSC's share price by purchasing small lots of EOSC shares at high prices, issuing false and misleading press releases, and using the Spanish Nominees to regulate the supply of EOSC shares in the market. Second, in February 1998 the USM defendants exercised their options pursuant to the EA and transferred additional shares to the Spanish Nominees; they later sold these shares via the Spanish Nominees to the unsuspecting public. Cavanagh also distributed, often without receiving consideration, hundreds of thousands of shares to friends, relatives, and associates. Third, in mid-March 1998, Brooksbank and Franklin sold additional shares they owned, after the SEC began its investigation and contacted certain defendants. When the share price subsequently plummeted to its actual value, innocent shareholders — mostly individual investors — suffered total losses which the SEC estimates at over $15 million.

The SEC filed this civil enforcement action in the District Court on March 13, 1998 alleging violations of the registration and antifraud provisions of the federal securities laws. Defendants included the alleged ringleaders of the scheme (Cavanagh, Nicolois, and USM), as well as members of Curbstone management whose negligence was essential to the scheme's success (Chachas, Brooksbank, Hantges, and Franklin), and several "relief defendants,"7 principally recipients of gratuitous EOSC stock. The SEC sought disgorgement of the EOSC stock in question and all proceeds from sales of that stock.8 On the SEC's motion, the District Court entered a preliminary injunction on April 20, 1998 prohibiting further trading of EOSC stock, enjoining defendants from future violations of federal securities laws, and freezing the assets of defendants and relief defendants to the extent of their profits from trading in EOSC stock. See Cavanagh I, 1 F.Supp.2d at 386-87. We affirmed the preliminary injunction on appeal. Cavanagh II, 155 F.3d at 131. Thereafter the SEC moved for summary judgment. In a comprehensive opinion dated July 15, 2004, the District Court granted the SEC's motion. Cavanagh III, 2004 WL 1594818, at *1.

The District Court found that Cavanagh, Nicolois, and USM violated antifraud and registration requirements of securities laws — namely Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933 ("1933 Act"), 15 U.S.C. §§ 7.7e(a), e(c), q(a), and Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) — and permanently enjoined them from further violations. The District Court also imposed civil penalties upon these three defendants of $1,000,000 each and ordered that they disgorge to the District Court all profits obtained in connection with their scheme, a combined total of $15,564,863.02, "plus interest less any disgorgement amounts actually paid by other defendants and relief defendants." The District Court maintained jurisdiction for the purpose of overseeing the final judgment "and any plan of distribution of disgorged funds to victims of the fraud."

With respect to defendants Brooksbank, Hantges, and Franklin, the District Court found that these defendants violated registration requirements of Sections 5(a) and 5(c) of the 1933 Act and imposed civil penalties of $125,000 each, instituted a permanent injunction barring further violations, and ordered disgorgement to the District Court of a combined total of $889,275, plus interest.9

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