S.E.C. v. M & a West, Inc.

• Decision Date: 12 August 2008
• Docket Number: No. 06-15165.,06-15165.
• Citation: 538 F.3d 1043
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellee, v. M & A WEST INC.; Scott L. Kelly; Salvatore Censoprano; Zahra R. Gilak; Frank Thomas Eck, III, Defendants, and Stanley R. Medley, Defendant-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

538 F.3d 1043

SECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellee, v. M & A WEST INC.; Scott L. Kelly; Salvatore Censoprano; Zahra R. Gilak; Frank Thomas Eck, III, Defendants, and Stanley R. Medley, Defendant-Appellant.

No. 06-15165.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted November 6, 2007.

Filed August 12, 2008.

Irving M. Einhorn and Patricia G. Bell, Law Offices of Irving M. Einhorn, for the appellant.

Brian G. Cartwright, General Counsel, Jacob H. Stillman, Solicitor, Hope Hall Augustini, Senior Litigation Counsel, Tracey A. Hardin, Senior Counsel, Securities and Exchange Commission, for the appellee.

Appeal from the United States District Court for the Northern District of California; Vaughn R. Walker, District Judge, Presiding. D.C. No. CV-01-03376-VRW.

Before: SIDNEY R. THOMAS, RICHARD C. TALLMAN, and SANDRA S. IKUTA, Circuit Judges.

Opinion by Judge THOMAS; Partial Concurrence and Partial Dissent by Judge IKUTA.

THOMAS, Circuit Judge:

This case arose from the activities of M & A West, Inc. ("M & A West"), which, as the district court aptly stated, "can fairly be described as a sham incubator for startup companies." The Securities and Exchange Commission ("SEC") brought a civil law enforcement action against defendant/ appellant Stanley Medley and five co-defendants. This appeal concerns the charges against Medley only. Medley was charged with violating Section 5 of the Securities Act of 1933 ("the Act"), 15 U.S.C. § 77e, for selling unregistered securities. On summary judgment, the district court held that Stanley was an underwriter under Section 2(11) of the Act, 15 U.S.C. § 77b(11), and therefore not exempt from Section 5's registration requirements under Section 4(1), 15 U.S.C. § 77d(1). The court also imposed remedies in the form of a five-year injunction, civil penalties, disgorgement and pre-judgment interest. On appeal Medley argues, as he did before the district court, that he acted in reliance on Rule 144(k), 17 C.F.R. § 230.144(k),¹ a safe harbor under which persons are deemed not to be underwriters as the term is used in Section 2(11).

We conclude that the district court properly held that Medley was an underwriter, and therefore not exempt from the registration requirements. We also conclude that the district court did not err in ordering that Medley disgorge all profits, with interest, he obtained from these transactions. However, we conclude that genuine issues of material fact precluded the entry of summary judgment as to the imposition of the civil sanctions—specifically, the second-tier penalties and the five-year injunction. We therefore vacate the summary judgment on civil sanctions and remand for an evidentiary hearing.

I

The claims against Medley arise from a series of "reverse merger" transactions. A reverse merger is a transaction in which a privately-held corporation acquires a publicly-traded corporation, thereby allowing the private corporation to transform into a publicly-traded corporation without the necessity of making an initial stock offering. Often, and in the three reverse mergers at issue here, the public corporation is a shell company with minimal assets and liabilities and no actual operations. To effect the reverse merger, the shell public corporation will exchange its treasury stock for all outstanding shares of the privately-held corporation. In consideration, the controlling shareholders of the shell public corporation transfer a majority of their shares to the owners of the private corporation. After the transaction, the newly merged public corporation will assume the identity and name of the former private company. Thus, the private corporation is transformed into a publicly traded company, without going through the complicated process of an initial stock offering.

Since 1992, Medley has been in the business of assisting private corporations to become publicly-traded corporations through reverse merger transactions. Medley would identify a suitable public shell company into which the private company would merge, advise the private company, coordinate the transaction with both parties, and assist with the paperwork involved in such a transaction.

In the transactions at issue here, Medley assisted his co-defendants in arranging reverse mergers for three privately-held companies: M & A West and two of its subsidiaries. Medley helped to seek out public shell companies that were willing to enter into a reverse merger. Medley then prepared the documentation for the merger and acted as a conduit for the negotiations.

The owners of the shell companies used in these transactions were compensated largely through the retention, and eventual sale, of a small portion of the stock in the newly-merged entities. Medley was compensated for his work through both a cash fee and a block of shares in the newly-merged company. Medley and the former shell owners all entered into "lock-up" agreements allowing the immediate sale of a small portion of their shares, with the remaining shares becoming eligible for sale in blocks every month for the following six months.

A The VirtualLender Transaction

The first reverse merger involved M & A West Financial, Inc., a wholly-owned subsidiary of M & A West. During the merger process, M & A West Financial, Inc. was known as Virtuallender.com, Inc. ("VirtualLender"). Medley was hired in late 1998 or early 1999 to assist with arranging a reverse merger for VirtualLender. Medley identified Golden Chain Marketing, Inc. ("Golden Chain"), as a suitable public shell company for a reverse merger and prepared the documentation for the reverse merger.

The transaction was accomplished in a "Reorganization and Stock Purchase Agreement" on February 4, 1999. Under this agreement, Golden Chain and/or its shareholders transferred 95% of the outstanding Golden Chain shares to VirtualLender or its assigns, in exchange for all of the outstanding shares of VirtualLender. Golden Chain then changed its name to VirtualLender.

As part of Medley's compensation, he received 100,000 shares in VirtualLender.² Medley and the former Golden Chain shareholders signed lock-up agreements for the shares they retained. Medley was also paid $50,000 in cash. Within seven months of the merger, Medley sold a portion of his VirtualLender stock to the public for a profit of approximately $208,000. Within the next nine months, Medley sold additional shares to the public for a profit of approximately $10,800. No registration statement was filed for these sales.

B The M & A West Transaction

The second reverse merger involved M & A West itself and Buffalo Capital IV, Ltd. ("Buffalo Capital"), a public shell company. In April 1999, Medley prepared documents and helped facilitate a reverse merger between M & A West and Buffalo Capital. This transaction was accomplished through a two-step structure in which two separate agreements were set to close on the same day.

Under the "Reorganization and Stock Purchase Agreement," dated April 19, 1999, all of the shares of M & A West were transferred to Buffalo Capital. In exchange, M & A West and/or its assignees received 69% of the outstanding Buffalo Capital stock, including both existing shares and new shares issued from Buffalo Capital's treasury. The agreement specified that Medley was to receive 110,000 of the existing common shares from Buffalo Capital's shareholders "[a]t the closing." The agreement also provided that, on the closing date, Buffalo Capital's officers and directors would be replaced by Scott L. Kelly, an officer of M & A West. Buffalo Capital then changed its name to M & A West, Inc.

Under the separate "Stock Purchase Agreement," dated April 20, 1999, Medley and the M & A West shareholders agreed to purchase the existing shares specified in the "Reorganization and Stock Purchase Agreement" from the Buffalo Capital shareholders for $2,983. The sale was expressly contingent on the closing of the Reorganization Agreement between Buffalo Capital and M & A West. Both Agreements were scheduled to close on April 26, 1999.

Medley received 110,000 shares of stock from the officers, directors, and shareholders of Buffalo Capital. As before, Medley and the former Buffalo Capital shareholders signed lock-up agreements. Medley was also paid $75,000 in cash. Within eleven months of the merger, Medley had sold shares of this stock to the public for a profit of $547,139. No registration statement was filed.

C The Digital Bridge Transaction

The third transaction involved the reverse merger of Digital Bridge, Inc. ("Digital Bridge"), a privately-owned M & A West subsidiary, into Black Stallion Management, Inc. ("Black Stallion"), another public shell company. This merger also utilized a two-step structure. The "Reorganization and Stock Purchase Agreement" was dated January 21, 2000 and set to close on January 31, 2000. This agreement provided for the issuance of 20,000,000 new shares from Black Stallion's corporate treasury to the Digital Bridge shareholders in exchange for the outstanding Digital Bridge stock. The agreement also provided for the replacement of the current Black Stallion officers and directors with Digital Bridge shareholders by the closing date. After the closing, Black Stallion changed its name to Digital Bridge.

The Reorganization Agreement contained a "condition subsequent" clause which assumed the future closing of Stock Purchase Agreements between M & A West shareholders, including Medley, and Black Stallion shareholders, in order to effectuate the purchase of Black Stallion stock.³ Under the clause, if the selling shareholders "fail[ed] to satisfy their obligations" of the stock purchase agreements, Digital Bridge and Black Stallion retained the right to unwind the Reorganization Agreement without penalty.

The Stock Purchase Agreements, referenced in the condition subsequent clause, were dated January 31, 2000 and scheduled to close that same day, which was...