UNITED STATES DISTRICT COURT
WESTERN DISTRICT OF TEXAS
WACO DIVISION
)
SECURITIES AND EXCHANGE COMMISSION, )
) CASE NO.
Plaintiff, )
)
v. )
)
GREAT WHITE MARINE AND RECREATION, INC., )
and A. COLIN SMITH, )
)
Defendants, )
)
KENNETH URSREY, )
)
Relief-Defendant. )
)
MEMORANDUM IN SUPPORT OF COMMISSION'S
APPLICATION FOR TEMPORARY RESTRAINING ORDERS;
ORDER DIRECTING AN ACCOUNTING; ORDER APPOINTING TEMPORARY
RECEIVER AND FOR ORDER EXPEDITING DISCOVERY
PHILLIP W. OFFILL, JR.
VICTORIA F. PRESCOTT
RONDA J. BLAIR
Attorneys for Plaintiff
SECURITIES AND EXCHANGE
COMMISSION
801 Cherry Street, 19th Floor
Fort Worth, TX 76102
(817) 978-6450
Fax No.: (817) 978-2700
UNITED STATES DISTRICT COURT
WESTERN DISTRICT OF TEXAS
WACO DIVISION
)
SECURITIES AND EXCHANGE COMMISSION, )
) CASE NO.
Plaintiff, )
)
v. )
)
GREAT WHITE MARINE AND RECREATION, INC., )
and A. COLIN SMITH, )
)
Defendants, )
)
KENNETH URSREY, )
)
Relief-Defendant. )
)
INTRODUCTION
The Securities and Exchange Commission (“Commission”) seeks emergency injunctive and other equitable relief, to immediately halt the unlawful distribution of unregistered Great White Marine and Recreation, Inc. (“Great White”) securities by the company and its promoter and control person, A. Colin Smith (“Smith”). Ancillary to this injunctive relief, the Commission seeks instanter relief to prohibit Great White, Smith and relief-defendant Kenneth Ursrey (“K.Ursrey”), Smith's son-in-law, from dissipating funds or assets acquired from the defendants' unlawful activities; the appointment of a receiver pendente lite for Great White, to marshal and hold its assets for the benefit of the company's investors; and a repatriation order requiring Great White, at the instruction of the receiver pendente lite, and Smith to return funds and assets held outside the jurisdiction of this Court. Additionally, the Commission seeks an order expediting discovery, and prohibiting the defendants from destroying or secreting any of their business records, to permit discovery in anticipation of a preliminary injunction hearing.
As detailed in the Commission's pleadings, and supported by the evidentiary materials provided herewith, since early 1998, Great White and Smith have taken at least $10.8 million from sales of Great White's unregistered securities, in a massive, unlawful distribution. All of their sales efforts, conducted directly and indirectly, through nominees and shills, have relied on fraudulent public releases and other widely disseminated promotional materials, including postings to the company's Internet website, and false, misleading and incomplete statements set out in the company's recent Commission filings. Moreover, Smith has misappropriated at least $3.5 million of the funds raised in Great White's fraudulent distribution.
The Commission seeks to bring to an end to Great White and Smith's scheme, and to safeguard the funds and assets they have obtained through their unlawful activities. Emergency consideration is required because these defendants' fraudulent activities, and their unlawful distribution of Great White securities, are ongoing, and because absent immediate action, it is unlikely the Commission can recoup any of the funds or assets they have taken, for the benefit of their shareholder/victims.
FACTS
The facts set out in the Commission's Complaint are incorporated by reference as if set out here verbatim. Certain of these facts all of which are supported by the Declaration of Ronda J. Blair attached hereto should be emphasized.
This case involves a nationwide, ongoing unregistered distribution of the securities of Great White, whose common stock is quoted by several Commission-registered broker-dealers on the OTC Bulletin Board (“OTC BB”). Great White, acting under the direction and control of Smith, its president and chief executive officer, has obtained at least $10.8 million from its distribution of approximately 10 million shares of unregistered stock in the public market through various nominees and intermediaries, and from sales of other securities, including securities potentially convertible into a controlling interest in Great White. Since Great White's stock was initially quoted on the OTC BB in January 1998, the number of shares in the “public float” has increased from approximately 1 million to nearly 13 million as the result of Smith's and the company's scheme to evade the securities registration requirements, and their unlawful distribution of the company's shares.
Moreover, this public distribution has continued even as the Commission has conducted its investigation into this matter. Smith recently opened three new brokerage accounts in the name of his son-in-law and three-year-old grandson, and has deposited Great White shares in at least one of those accounts. And, just days after testifying before the staff in May 1999, Smith sold 83,000 shares of Great White stock for over $174,000 through an account he set up in the name of his son-in-law, and deposited the proceeds into his personal bank account and to purchase vehicles for himself and his wife. In fact, the Commission has traced a total of $3.5 million in proceeds from stock sales directly to Smith, much of which is unaccounted for at this time. Given his activities over the past 18 months, and the fact that he has profited it seems evident that Smith plans to sell additional unregistered Great White shares into the public market.
As part of his distribution and sales effort, Smith has flooded the market with Great White's promotional information, including supposedly independent “tout” pieces featuring Great White, press releases and a Great White Internet web site, which contained false and misleading information about the company's financial condition and business prospects and the number of issued and outstanding shares of Great White stock. Among other things, these promotional materials misrepresented the company's revenues and earnings, made false claims as to the company's business relationships with at least one supplier, misrepresented and failed to disclose Smith's misappropriation of funds obtained from the company's securities offerings, and made false and misleading claims as to the number of shares Great White had issued. These promotional activities were bolstered by Great White's specious “dividend” payment in 1998, at a time when the company had insufficient surplus, much less revenue, to make such a payment, and which was paid directly from funds obtained from investors,
In furtherance of this fraudulent scheme, in an apparent attempt to tout and legitimize Great White, Smith recently filed a Form 10-SB with the Commission containing false and misleading financial information, which he permitted to become effective, by operation of law, on June 10, 1999, after being notified by the Commission that such registration statement did not comply with critical disclosure requirements. Specifically, the registration statement contained 1997 and 1998 financial statements audited by two different Mexican auditors. As to the year-end 1997 financial statement, the auditor, and all of the documents to support his audit, have inexplicably disappeared. Smith altered the June 30, 1998, financial statement by attaching footnotes and subsidiary schedules prepared by yet another accountant, to give the false impression that the financial statements were complete, and that the audit report complied with Generally Accepted Auditing Standards. Finally, during the past month, Smith fired Great White's most recent accountant and simultaneously engaged another—the company's fourth auditor in the past year.
NEED FOR ANCILLARY EQUITABLE RELIEF
Based upon the Commission's investigation to date, it appears that Smith has orchestrated, and he and Great White are conducting, a wide-ranging, fraudulent distribution of Great White's shares to the public, and that much of the money raised through the unlawful sales of the company's shares has been misappropriated for Smith's personal benefit.
Simply put, Great White operates as Smith's alter ego: There is little, if any, recognition of corporate formalities in the company's business, and Smith, as Great White's president and chairman, controls its board of directors. Smith casually and continually uses, indeed, misappropriates, Great White's funds and assets, using money from the company's shareholders for his personal expenditures separate and apart from any legitimate compensation program. Finally, the accounting and recordkeeping systems Smith has designed for Great White do not permit any means of audit or oversight; while the company maintains a general ledger, most other records of original entry routinely kept in the ordinary course of business, such as cash receipt and disbursement journals, revenue and sales journals, and shareholder ledgers, are not available.
Great White's and Smith's bookkeeping failures, and their actions in hindering the Commission's investigation, as summarized in note 2 herein, also demonstrate the urgent need for emergency relief. As set out in the Blair Declaration, and irrefutably in correspondence from Great White's and Smith's counsel, the defendants' actions in delaying or refusing to cooperate in the Commission's lawful investigation border on obstruction of justice. The defendants have failed to produce documents called for by clearly worded administrative subpoenas, and have failed to provide promised explanations of transactions or other matters have not been forthcoming. Most importantly, the company has refused to make its auditors available for questioning, and Smith has disobeyed a validly issued administrative subpoena, by refusing to provide relevant testimony.
The defendants have not been good shepherds of the funds entrusted to them by the investing public, and have worked to conceal their breaches of fiduciary duty (which in this case constitute violations of the securities registration and anti-fraud provisions of the federal securities laws), to Great White and its shareholders in the instance of Smith, and to shareholders in the instance of Great White. Unless a receiver pendente lite is appointed for Great White, and all of the defendants' and the relief-defendant's available assets are immediately frozen, investors face even greater losses.
ARGUMENTS AND AUTHORITIES
A. Securities Registration Violations – Sections 5(a) and (c)
of the Securities Act of 1933
Sections 5(a) and (c) of the Securities Act prohibit the offer and sale of securities in interstate commerce unless an effective Securities Act registration statement is on file with the Commission. The Commission can establish a prima facie case for a violation of Section 5 by a showing that: (1) no registration statement was in effect or had been filed as to the securities; (2) the defendants, directly or indirectly, sold or offered to sell the securities; and (3) the sale was made through the use of the interstate facilities or the mails. SEC v. Spence & Green Chemical Co., 612 Fed 896, 901-02 (5th Cir. 1980);.SEC v. Continental Tobacco Co. of S.C., 463 F.2d 137, 155 (5th Cir. 1972).
Once the Commission establishes a prima facie violation, the defendants assume the burden of proving that the securities offered qualified for a registration exemption. SEC v. Ralston Purina Co., 346 U.S. 119, 126 (1953); Doran v. Petroleum Management Corp., 545 F.2d 893, 899 (5th Cir. 1977), aff'd. on appeal after remand, 576 F.2d 91 (1978). The exemptions provided by statute, rule or regulation are construed narrowly, and courts properly require persons claims exemptions from registration to comply with both the spirit and the letter of the law. SEC v. Murphy, 626 F.2d 633, 641 (9th Cir. 1980); see also, Ralston Purina, 346 U.S. at 126 (determination as to whether exemption is available turns broadly on whether the class of offerees are among class of persons that the registration process is intended to protect). Under the facts of this case, no such exemptions are available.
As set out in the Commission's Complaint, Great White and Smith distributed the company's securities in three ways: First, Smith opened brokerage accounts in his name and in the name of various nominees, including relief-defendant K.Ursrey, deposited shares issued by the company to himself or these persons into these accounts, and then directed the sales of these shares into the public market. Hundreds, if not thousands, of unsuspecting investors across the United States purchased these shares in routine brokerage transactions, without knowing that they were dealing with a control person of the issuer. Second, Smith arranged putative private placements of Great White's stock, directly or through intermediaries, knowing that, in nearly every instance, the purchasers intended to immediately sell these restricted shares directly into the OTC marketplace. Third, Smith sold convertible securities, usually debentures or similar debt instruments, or warrants, again in putative private transactions, knowing that the purchasers intended to immediately convert these securities into Great White stock, and immediately sell these restricted shares directly into the OTC marketplace.
While the analysis for each method differs somewhat, none of Great White's or Smith's transactions and none of the subsequent resales or sales of converted securities by purported private placement purchasers qualify for an exemption.
Smith, as a control person and affiliate of Great White for purposes of Securities Act Rule 144 [17 C.F.R. § 230.144], a “safe harbor” provision under Section 4(1) of the Securities Act, could only offer or sell his Great White shares (i) by filing a Securities Act registration statement, or (ii) complying with the requirements of Securities Act Rule 144. No Securities Act registration statement was (or is) in effect for any of Great White's shares, and Smith's offer and sale of his 1.1 million Great White shares through nominee accounts did not meet the requirements of Rule 144: There was a complete dearth of accurate information in the marketplace. Smith failed to satisfy the one-year holding period prior to commencing sales, in that he acquired his ownership interest in Great White in late 1997, and sold shares throughout 1998 and 1999. Furthermore, Smith's sales far exceeded the volume limitations, which permit a control person to sell, during any three month period after the original one-year holding period has expired, the greater of 1% of the total number of shares outstanding or the average weekly volume during the prior four-week period. Finally, Smith failed to file a Form 144 with the Commission, which would have notified the public that he was selling shares in the company he controlled.
The intrastate offering exemption of Section 3(a)(11) of the Securities Act is unavailable to any offeree or seller because Great White, Smith, and the putative private placement purchasers have offered and sold the company's securities nationwide, through broker-dealers who have provided quotes nationwide through the OTC BB. Furthermore, much of the money raised was, apparently, spent outside of Texas, Great White's “residence” for purposes of the exemption.
Section 4(1), which exempts “transactions by any person other than an issuer, underwriter, or dealer” is not applicable. The exemption is not available to Great White, as the “issuer” pursuant to Section 2(a)(4) of the Securities Act, or Smith, in that he controlled Great White and is thus an “affiliate of the issuer” for purposes of Section 2(a)(11) of the Securities Act. Nor is the exemption available to any of the private placement purchasers, since all the securities, were offered and sold either by Great White or Smith, and were purchased with a “view to distribution”; so that each of the putative private placement purchasers was an “underwriter” under the Section 2(a)(11) of the Securities Act. See, Quinn and Co. v. SEC, 452 F.2d 943, 946 (10th Cir. 1971), cert. denied, 406 U.S. 957 (1972); SEC v. North American R. & D. Corp., 424 F.2d 63, 72 (2d Cir. 1970).
None of Great White's transactions are exempt under the private placement exemption contained in Section 4(2) of the Securities Act. The applicability of the private placement exemption turns on four factors: (1) the number of offerees and their relationship to each other and to the issuer; (2) the number of units offered; (3) the size of the offering; and (4) the manner of the offering. Doran, 545 F.2d at 899.
The most important of these factors is the number of offerees and their relationship to the issuer. Id, 545 F.2d at 900. Because Great White and Smith sold these shares knowing that the purchasers did not purchase these securities with investment intent, but instead with the intent to immediately sell their stock into the public market, they were conducting a public solicitation. See, Swenson v. Engelstad, 626 F.2d 421, 427 (5th Cir. 1980) (persons who are known will be purchasing from the private placement purchasers considered offerees for purposes of Section 4(2) exemption claim), citing, Katz v. Amos Treat & Co., 411 F.2d 1046 (2d Cir. 1969) (Knowledge that purported private placement purchaser was relying on funds obtained from resale of securities contrary to reasonable belief that purchaser had investment intent in purchasing. Id., at 1054); see also, SEC v. Mono-Kearsage Consolidated Mining Co., 167 F.Supp 248, 252 (D. Utah 1958) (holding that the private placement exemption does not apply when the “purchaser” are reselling shares for the benefit of the issuer).
Additionally, because all of Great White's and Smith's distribution activities were predicated on their fraudulent dissemination of false, misleading and incomplete information, none of the offerees – whether the putative private placement purchasers or the public market – had meaningful access to the manner of information necessary to make an investment decision. Spence & Green, 612 F.2d at 902; Doran, 545 F.2d at 903-04; see also, Lawler v. Gilliam, 569 F.2d 1283, 1289 (4th Cir. 1978) (issuer of fraudulent securities not entitled to Section 4(2) exemption because he probably would provide false data). Clearly, when Great White and Smith set out to effect a distribution of the company's shares through these surreptitious means, they established the investing public-at-large as the “particular class of persons” requiring the protection that the registration provisions of the Securities Act provide. Ralston Purina Co., 346 U.S. at 127; Continental Tobacco Co. of S.C., 463 F.2d at 158 (5th Cir. 1972).
The Section 4(2) exemption is unavailable to Smith or the private placement purchasers for their sales into the market because a) the exemption can only be claimed by issuers; and b) because they sold in market transactions, through a public solicitation effected, in part, by Commission-registered brokers quoting Great White's shares in the OTC BB.
The various “safe harbor” exemptions under Regulation D [17 C.F.R. § 230.501] are also unavailable to Great White. The exemptions provided by Rules 505 and 506 are unavailable because investors have not been furnished with financial statements or other information required to be contained in a registration statement filed under the Securities Act, as required by Rule 502(b)(2). And, in view of the prevailing law in the 5th Circuit, as set out in Swensen, the actual offerees for Smith's personal and nominee sales, and Great White's putative private placements consist of the investing public, and the total number of purchasers is certainly several hundred, if not several thousand, none of whom have been qualified as accredited investors; these numbers, and the failure to qualify investors, should render any claim of a Rule 505 or Rule 506 “safe harbor” laughable. Furthermore, neither Rule 504 nor Rule 505 is unavailable because Great White has sold more than $5 million worth of securities within one year.
B. Antifraud Violations - Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder.
The antifraud provisions contained in the Securities Act and the Exchange Act are applicable to any fraudulent transaction involving the offer, sale or purchase of securities, where the jurisdictional means are used. In order to prove a violation under Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act, the Commission must prove the existence of a fraudulent scheme, or the misrepresentation or omission of a material fact. The term "scheme" here means the same as when used in the mail fraud statues: A plan reasonably calculated to deceive. Information is deemed material upon a showing that there is a substantial likelihood that the omitted or misstated facts would have assumed significance in the investment deliberations of a reasonable investor. Basic, Inc. v. Levinson, 485 U.S. 224, 240 (1988) (Section 10(b) of the Exchange Act); Steadman v. SEC, 603 F.2d 1126, 1130 (5th Cir. 1979) (Section 17(a) of the Securities Act).
Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder also require a showing of scienter in order to establish liability. Aaron v. SEC, 446 U.S. 680, 697 (1980); Steadman, 603 F.2d at 1134. The Fifth Circuit, as well as other circuits, has held that proof of severe recklessness will satisfy the scienter requirement. See Shivangi v. Dean Witter Reynolds, Inc., 825 F.2d 885, 889 (5th Cir. 1987); Broad v. Rockwell International Corp., 642 F.2d 929, 961 (5th Cir.) (en banc), cert. denied, 454 U.S. 965 (1981).
Liability under Sections 17(a)(2) and 17(a)(3) of the Securities Act can be established by a showing of mere negligence. Aaron v. SEC, 446 U.S. at 967; SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963); Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992).
Great White and Smith, violated the anti-fraud provisions of the federal securities laws by making false, misleading or incomplete statements of material facts concerning, among other things, their intended uses -- or misuse by conversion or misappropriation -- of investors' funds, including the use of investors' funds to make a specious “dividend” payment, that was nothing more than a Ponzi-type inducement for additional investments ; Great White's financial condition, specifically including its sales and revenues; the “audited” condition of the company's financial statements; and the total number of shares the company had issued and outstanding. These misrepresentations and omissions were material since the facts would be substantially likely to influence the investment decision of reasonably prudent investors. See generally Basic v. Levinson, 485 U.S. at 231-32; see also Sinay v. Lamson & Sessions Co., 752 F. Supp. 828, 833 (N.D. Ohio 1990) (Profitability and the basis for projections are of "paramount" importance, especially when the returns are disproportionate to comparable opportunities.)
The defendants' activities also demonstrate requisite scienter: They alone knew that Great White's true financial condition and business prospects were misrepresented; that Great White would use new investors' funds to pay for Smith's personal expenses and a specious “dividend”; that Great White's financial records were a disaster, and that the “audited” financial statements were unreliable; and that Great White had issued millions of shares for distribution into the public market, and that Smith himself sold at least 1.1 million of these shares. Because the defendants knew they were misrepresenting material facts to investors, they acted with scienter. See generally Aaron v. SEC, 446 U.S. 680 (1980). Furthermore, the defendants' concealment of their bad acts, and willfully attempts to hinder and obstruct an investigation into their violative activities, all the while continuing to conduct a fraudulent distribution of securities, should be strong evidence of their intent to deceive.
B. The Commission Has Made a Proper
Showing to Obtain the Relief Requested
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