RESPONSE TO AARON TSAI’S OBJECTIONS TO THE
ORDER OF THE MAGISTRATE JUDGE REGARDING THE
CRIME-FRAUD EXCEPTION TO THE ATTORNEY-CLIENT PRIVILEGE
UNITED STATES DISTRICT COURT
FOR THE SOUTHERN DISTRICT OF OHIO
EASTERN DIVISION
:
Securities and Exchange Commission, :
:
Plaintiff, : CIVIL ACTION
: CASE NO. C2-03-326
:
v. : Judge Holschuh
: Magistrate Judge Abel
Sierra Brokerage Services, Inc., et al. :
:
Defendants. :
:
RESPONSE TO AARON TSAI’S OBJECTIONS TO THE
ORDER OF THE MAGISTRATE JUDGE REGARDING THE
CRIME-FRAUD EXCEPTION TO THE ATTORNEY-CLIENT PRIVILEGE
Jarett B. Decker
Tracy W. Lo
Attorneys for Plaintiff
U.S. Securities & Exchange Commission
175 West Jackson Boulevard
Suite 900
Chicago, Illinois 60604
(312) 353-7390 (tel)
(312) 353-7398 (fax)
TABLE OF CONTENTS
I. INTRODUCTION..................................................................................................... 1
II. ARGUMENT............................................................................................................. 4
A. THE ORDER IS NOT CLEARLY ERRONEOUS OR CONTRARY TO LAW................... 4
B. THE MAGISTRATE USED THE CORRECT LEGAL STANDARD IN DETERMINING
THAT THE CRIME-FRAUD EXCEPTION APPLIED........................................................... 6
1. The Magistrate Judge Understood and Correctly Applied the Elements
Required to Prove the Crime-Fraud Exception........................................................ 7
C. THE MAGISTRATE PROPERLY DENIED TSAI’S REQUEST FOR ANOTHER
HEARING....................................................................................................................... 10
1. There is no Right to a Hearing in the Sixth Circuit ....................................... 10
2. Tsai Was Amply Heard by Evidence and Argument ...................................... 11
D. THE MAGISTRATE JUDGE CORRECTLY APPLIED THE “PROBABLE CAUSE”
STANDARD .................................................................................................................... 13
E. TSAI’S USE OF NAÏVE NOMINEES TO DISGUISE HIS OWNERSHIP AND CONTROL
OF SHARES SHOWS THAT NO EXEMPTION TO REGISTRATION APPLIES .................... 16
1. Using Naïve Nominee Shareholders for MAS XI........................................... 19
2. Continuing Control Over MAS XI Shares...................................................... 21
3. Sales from Oblivious “Shareholders” to Michael Markow............................ 22
4. Tsai’s Benefit from the Sale of MAS XI Shares ............................................. 23
F. TSAI VIOLATED SECTION 5 BY GIFTING SHARES TO CREATE AN APPEARANCE
OF A BROAD SHAREHOLDER BASE WHILE MISREPRESENTING AND FAILING TO
DISCLOSE HIS PURPOSE............................................................................................... 25
G. CONNECTION TO INTERSTATE COMMERCE WAS ESTABLISHED........................ 31
H. THE ORDER COVERS SCHLENKERT COMMUNICATIONS REGARDING LEGAL
OPINION LETTERS FOR ALL MAS ACQUISITION COMPANIES ................................... 33
III. CONCLUSION ................................................................................................... 36
I. INTRODUCTION
In this case, the SEC presented Magistrate Judge Abel with abundant evidence
that the defendant Aaron Tsai used nominee “shareholders” and sham corporate
“directors,” including two patients in a partial hospitalization program for the mentally
disabled, to conceal his ownership and control of shares in 101 shell companies that he
created. He got the nominees to sign hundreds of blank stock powers that they did not
understand, and then used the powers to move shares in and out of their names as he
pleased, for his own benefit. The “shareholders” did not know how many shares they
supposedly had, or in which of the 101 companies, or when Tsai would sell the shares, or
to whom, or for how much, and some of them did not have the mental capacity to
understand what shares in a corporation are. Meanwhile, Tsai had numerous false
documents filed with the National Association of Securities Dealers (“NASD”) and the
SEC representing that the shares were received, owned, controlled, and transferred by
independent shareholders.
For example, in a sworn SEC filing, Tsai described one mental health patient who
suffers from Borderline Intellectual Functioning and Schizo-Affective Disorder as a
“corporate director” and “accredited investor,” and represented that she was awarded
shares in one of his companies for her “services” as director; she later supposedly decided
to transfer most of “her” shares to others. However, the patient’s mental-health case
manager has testified in this lawsuit that the patient would not be able to understand what
a “corporate director” is. And by Tsai’s own admission, he decided how many of “her”
shares would be transferred, to whom, and for how much. The patient was one of the five
largest “independent shareholders” in the company at issue in this lawsuit, MAS
2
Acquisition XI (“MAS XI”), and “her” holdings were the source of one fifth of all the
shares at issue in this lawsuit.
Tsai’s purpose, in this fraudulent scheme orchestrated over several years, was to
make it appear that ownership of the shares was dispersed and beyond his control as the
issuer, because the Securities Act of 1933 and other related regulations strictly limit the
number of shares that controlling management of the issuing corporation may sell
without registering the shares. Ultimately, in Tsai’s scheme, the shares would be
transferred in fraudulent “reverse mergers” and then dumped onto public markets such as
the Over the Counter Bulletin Board (“OTCBB”) without registration. For MAS
Acquisition XI, as the Magistrate Judge found, Tsai made $250,000 from the sale of
shares in the names of the nominees.
In an effort to provide what the Magistrate Judge called “window dressing” for
his fraudulent scheme (See Transcript of October 8, 2004 Hearing (“Transcript”), at p.
131), Tsai sought to obtain legal opinion letters, for dissemination to regulators at the
NASD and others, representing that the shares in his various shell companies were held
independently from management and eligible for public trading.1 Tsai engaged a South
Florida lawyer named Arthur Schlenkert, whose only services were in connection with
the opinion letters that Tsai sought for public dissemination. The SEC subpoenaed
1 Tsai’s overall scheme is most fully described in PLAINTIFF SEC’S RESPONSE TO SUBMISSIONS
BY AARON TSAI AND MICHAEL MARKOW AS TO CRIME-FRAUD EXCEPTION (CORRECTED)
(Doc. #76), as well as in the February 14, 2005 Order of the Magistrate Judge (Doc. #85). One of Tsai’s
associates in his machinations with the shell companies, J.T. Lin, is now in federal prison for his conduct in
connection with one of Tsai’s companies, and four others—from a brokerage firm in Brooklyn—pleaded
the Fifth Amendment in this lawsuit when questioned about their assistance to Tsai in helping make shares
of his companies tradable on the OTCBB. Tsai himself pleaded the Fifth Amendment in investigative
testimony, but later provided testimony in both the investigative stage and in this lawsuit, in which he either
conceded or failed to contest (repeatedly claiming that he “did not recall”) most aspects of his scheme.
(Doc. #76, at pp. 6-10, 13-14, 18-19).
3
Schlenkert, who then claimed in letters to the SEC that at least one (unsigned) opinion
letter submitted to the NASD on his letterhead was a draft, for which he never received
back-up documentation and whose filing he never authorized. Four months of motion
practice ensued before the Magistrate Judge over whether Tsai’s communications with
Schlenkert were protected by privilege or confidentiality.
To establish the crime-fraud exception to privilege and confidentiality, the SEC
presented transcripts of deposition and investigative testimony from more than a dozen
witnesses; offered documentary evidence, including extensive filings by Tsai with the
NASD and the SEC; and took Tsai’s deposition while the motion practice was pending,
later submitting substantial portions of the transcript to the Magistrate Judge, together
with extensive briefing. (Docs. #59, 63, 73-76, 84). Tsai himself presented the
Magistrate Judge with two of his own affidavits and two from his counsel; excerpts from
the testimony of a half-dozen witnesses; documents; and extensive briefing. (Docs. #62,
65, 70, 79). (The transcript from Tsai’s deposition was also available for Tsai’s later
filings, but he chose not submit any portion of his five hours of sworn testimony for
consideration.)
During the motion practice from early September to later December 2004, the
Magistrate Judge invited and received further briefing and evidence from any co-
defendants who wished to weigh in on Tsai’s behalf (because most of them face related
counts under the Securities Act of 1933). (Docs. #69, 78). Magistrate Judge Abel also
held a three-hour court hearing on October 8, 2004. Ultimately, the Magistrate Judge
issued forty-five pages of rulings in two Orders, dated November 23, 2004 (Doc. #72)
and February 14, 2005 (Doc. #85), setting forth findings and holding that the crime-fraud
4
exception to the attorney-client privilege and confidentiality applied to Tsai’s dealings
with Schlenkert.2
Tsai seeks reversal, claiming that the Magistrate Judge should have held more
hearings and that the Magistrate Judge’s fact-findings are clearly erroneous, because they
conflict with Tsai’s contentions in his affidavits and briefs. (Docs. #87, 88). However, in
his submissions to this Court, Tsai does not even mention most of the extensive
evidentiary record that has accumulated. Indeed, the nature of Tsai’s conduct, including
his false regulatory filings and exploitation of naïve and in some cases seriously mentally
ill people as unwitting tools in his complex fraudulent maneuvers, goes completely
unrecognized in his pleadings to this Court. We respectfully submit that a party seeking
reversal of a Magistrate Judge’s Order as “clearly erroneous” should at least acknowledge
the evidence that was presented against him. Tsai’s motion for reconsideration is
unfounded and should be denied.
II. ARGUMENT
A. The Order is not Clearly Erroneous or Contrary to Law
A district court shall only reverse a magistrate judge’s order relating to a nondispositive
matter where it has been shown that the order is “clearly erroneous or contrary
to law.” 28 U.S.C. § 636(b)(1)(A) (1988); Fed.R.Civ.P. 72(a). A finding is “clearly
erroneous” only if the reviewing court is “left with the definite and firm conviction that a
mistake has been committed.” Easley v. Cromartie, 532 U.S. 234, 242 (2001); Hood v.
Midwest Savings Bank, 2001 WL 327723, at *2 (S.D. Ohio March 22, 2001). Where
there are two permissible views of evidence, a finding of one of those views over another
2 The Order of February 14, 2005 is hereinafter “the Order,” while collectively the November and February
Orders are hereinafter “Orders.”
5
cannot be clearly erroneous. Anderson v. City of Bessemer City, 470 U.S. 564, 574
(1985). Furthermore, “[t]he question is not whether the finding is the best or only
conclusion that can be drawn from the evidence, or whether it is the one which the
reviewing court would draw. Rather, the test is whether there is evidence in the record to
support the lower court’s finding, and whether its construction of that evidence is a
reasonable one.” Geiger Brothers Mechanical Contractors v. Lockheed Martin Utility
Services, 2000 WL 1456916, at *1-2 (S.D. Ohio Sept. 19, 2000) (citing Heights
Community Congress v. Hilltop Realty Corp., 774 F.2d 135, 140 (6th Cir. 1985). A
district court can only find a magistrate judge’s order “contrary to law” if the magistrate
judge has “misinterpreted or misapplied applicable law”. Hood, 2001 WL 327723, at *3.
Given this highly deferential standard of review, a magistrate judge is “afforded broad
discretion in resolving discovery disputes and reversal is appropriate only if their
discretion is abused.” Derthick v. Bassett-Walker Inc., 1992 WL 249951, at *8
(S.D.N.Y. Sept. 23, 1992). Therefore, a party seeking to overturn a magistrate judge’s
order bears a heavy burden. Lyondell-Citgo Refining LP v. Petroleos De Venezuela,
S.A., 2004 WL 3019767, at *2 (S.D.N.Y. Dec. 29, 2004).
Most of Tsai’s arguments to this Court can be easily rejected because they simply
ignore or misconstrue the “clearly erroneous” standard. For example, Tsai asserts that
“[t]he Magistrate Judge’s findings and conclusions appear on pp. 20-22 of the Order” of
February 14, 2005, and then, in his arguments, ignores all unfavorable evidence not
contained in those two pages of the Magistrate Judge’s 45 pages of rulings, and
repeatedly argues that the Magistrate Judge’s ruling is insufficiently supported by, or
contrary to, the evidence. (Doc. #88, at p. 7).
6
That approach is profoundly misguided and unhelpful. First, the Magistrate Judge
specifically cites much more evidence in his two rulings than in just the two pages that
Tsai seizes upon. Second, and more importantly, the Magistrate Judge is not required to
include every fact that supports his conclusions in his written rulings; the proper question
in deciding whether to uphold his decision is whether “there is evidence in the record to
support the lower court’s finding. . . .”3
For reasons more fully stated below, Tsai has failed to show that the Magistrate’s
order was clearly erroneous or contrary to law. Accordingly, the Order should stand.
B. The Magistrate Used the Correct Legal Standard in
Determining That the Crime-Fraud Exception Applied
Tsai argues that the Magistrate Judge erroneously equated the elements of the
crime-fraud exception with the elements of a violation of Section 5 of the Securities Act
of 1933, which generally makes it unlawful to offer or sell securities without registration.
15 U.S.C. §77(e). He points out that the crime-fraud exception only applies if a client
engages an attorney with the intent of furthering a crime or fraud and asserts that since a
Section 5 violation does not require scienter (i.e. fraudulent intent), Section 5 therefore
cannot serve as the “crime or fraud” underlying the crime-fraud exception. Tsai fails to
acknowledge that while a civil Section 5 violation does not require scienter, one can
certainly violate Section 5 willfully or with fraudulent intent, and to do so is a federal
felony. 15 U.S.C. §77x. Indeed, an abundance of facts in the record, and the Magistrate
Judge’s express findings, show that Tsai engaged in a willful and fraudulent scheme to
3Tsai takes issue with the fact that Magistrate Judge Abel did not make findings as to various supposedly
“disputed factual contentions.” The Magistrate Judge was not required to make findings on all conceivable
facts, which would be a pointless burden, especially where the record is so vast. See M.P. Kenes, Inc. v.
Technicote, Inc., 1993 WL 488420, at *2 (N.D. Ill. Nov. 24, 1993). The only findings required are those
sufficient for a “clear understanding of the basis of the decision.” Tri-State Petroleum Corporation v. Saber
Energy, Inc., 845 F.2d 575, 580 (5th Cir. 1988).
7
violate Section 5, and that he sought legal opinion letters from attorney Schlenkert as
“window dressing” to further that scheme.
1. The Magistrate Judge Understood and Correctly Applied the
Elements Required to Prove the Crime-Fraud Exception
The language in the Order confirms that Magistrate Judge Abel understood the
elements of a “prima facie case of fraud” in the crime-fraud context. The Order
specifically states in two separate places that, “the government must make a prima facie
showing that a “sufficiently serious crime or fraud occurred… Collis, 128 F.3d at
321.”(emphasis added)(Doc. #85, Order at pp. 13, 22). Nowhere in the Order does it say
that the S.E.C. must make a prima facie showing only that an inadvertent Section 5
violation occurred. The Order also states, “[t]he inquiry of this Court is whether Tsai’s
communications to Schlenkert were made ‘in furtherance of a crime or fraud.’” (Doc.
#85, Order at p. 14). Furthermore, the Magistrate Judge “concluded that the SEC has
made a prima facie showing that the crime-fraud exception is applicable to Schlenkert’s
communications.” (Doc. #85, Order at p. 22). The Magistrate Judge thus knew and cited
the appropriate standard to apply in reaching his decision.
a. The Magistrate Judge Found Crime and Fraud
The Orders contain ample findings setting forth a clear understanding of the basis
for deciding that the crime-fraud exception applied, and other evidence of record
overwhelmingly supports that conclusion. Tsai does not mention these findings, which
show that Tsai acted willfully when he violated Section 5 (which is a crime), and instead
only mentions the findings necessary to prove a Section 5 violation in general. The Order
states as follows:
8
The SEC has made a sufficient showing at this stage that Tsai controlled
the initial 5 shareholders and that the additional 28 shareholders were nominees
also controlled by Tsai. As the deposition testimony demonstrates, the
“shareholders” were unaware that they had stock and were directors. They were
unaware that they sold their shares. Tsai’s control is also demonstrated by his use
of the blank stock powers that he had the “shareholders” sign. As the deposition
testimony shows, the 5 initial shareholders did not even understand what the
blank stock powers were. The SEC has established a prima facie case that when
the stock was transferred to the 5 initial shareholders, they remained controlled by
Tsai. Therefore, the stock in the hands of these shareholders were securities in the
hands of issuers, and their transactions were not exempted from the registration
requirements.
Further, Tsai’s argument that the “gifts” to the initial 5 shareholders were
not distributions is unpersuasive. As already stated, the SEC has made a prima
facie showing that these transactions were for value and not gifts.
Tsai’s argument that the transfers of the shares to the additional 28
shareholders are exempted is also unpersuasive. The SEC has made a prima facie
showing that Tsai had control over the shareholders. These shareholders were not
“non-affiliates” as they remained “issuers” defined as “any person…controlled by
the issuer, or any person under direct or indirect common control with the issuer.”
15 U.S.C. §§ 77(b)(a)(11), 77d(1). (Doc. #85, Order at p. 21).
These findings leave no doubt that Tsai violated Section 5 not by accident, but
through a fraudulent scheme to disguise his control of shares. That conclusion is further
buttressed by the evidence, specifically noted by the Magistrate Judge, of Tsai’s
exploitation of unsophisticated and mentally disabled people, one of whom he claimed, in
sworn SEC filings, was a “corporate director” and “accredited investor,” even though
undisputed evidence shows that she has Borderline Intellectual Functioning and does not
know what a corporate director is, or what shares of stock are worth, or what the blank
stock powers that Tsai had her sign would signify. (Doc. #85, Order at pp. 4-5).
Finally, at the October 8, 2004 hearing, the Magistrate Judge stressed that Tsai not
only was involved in selling unregistered shares, but made false representations to the
NASD about the status of the shares: “[T]he fraud is in representing to the NASD that
9
these stocks can be traded without registrations, and that the facts asserted by the issuer
support that exception to the general rule that the stock has to be registered, that’s the
fraud.” (Transcript, at p.132). That finding, too, is supported by ample evidence of
record that Tsai told the NASD that the supposed “shareholders” transferred their shares
on their own, when they did not even know that they supposedly owned the shares, and in
reality Tsai transferred the shares using blank stock powers. (Doc. #85, Order at pp. 5-6).
b. Findings Show Connection Between Tsai’s Communications
With Schlenkert and Tsai’s Intent to Violate Section 5
The Magistrate Judge also carefully considered the second prong of the crimefraud
showing that the SEC was required to make, namely that the SEC had to establish
that Tsai’s communications with Schlenkert furthered the violation. (Doc. #85, Order at
pp. 13, 22). The SEC submitted ample evidence showing how Tsai unlawfully arranged
for shares of MAS stock to be sold on the open market, and how the legal opinion letters
he sought from Schlenkert served as “window dressing” in furtherance of the fraud (to
use the Magistrate Judge’s term). To enable shares to trade on the OTCBB, Tsai had to
get clearance from the NASD. The NASD had concerns relating to several of Tsai’s
MAS companies and required opinion letters from an attorney stating that the shares were
publicly tradable. The evidence showed that Tsai’s only purpose in retaining Schlenkert
was for the opinion letters and the point of the opinion letters was to get the MAS shares
approved for trading without filing a registration statement under Section 5, and to create
a veneer of legality over the scheme. (Doc. #62, Tsai First Decl., at pp. 3-8, ¶¶7-13; Doc.
#59, First Decker Decl., at Ex. M). The Magistrate Judge agreed: “I have concluded that
the SEC has made a prima facie showing that the crime-fraud exception is applicable to
Schlenkert’s communications.” (Doc. 85, Order at p. 22).
10
The Magistrate Judge elaborated on his reasoning that Tsai retained Attorney
Schlenkert to further crime or fraud in his statements made at the hearing conducted on
October 8, 2004, during which both sides presented arguments relating to the crime-fraud
exception. Mr. DePetris, Tsai’s counsel, made the argument that the opinion letter from
Attorney Schlenkert merely stated the law and that Schlenkert did not delve into the
underlying facts, as the facts came directly from Tsai. (Transcript, at p. 127). Mr.
DePetris argued, “a shell company with zero assets is not going to be able to go out and
afford to retain an eminent law firm to write a thorough analysis of the securities law.
That wasn’t at issue here.” (Id. at p. 128). The Court stated, “Doesn’t that make the
fraud argument all that much more compelling?” (Id. at p. 129). The Court further
stated, “You can’t do it without the window, because the fraud can’t be committed
without the window dressing, the way you are arguing it. You are arguing that the
attorney opinion letter is just giving black letter law is window dressing, but you can’t
commit the fraud unless you get the letter.” (Id. at p. 130). The Court again stated, “He
couldn’t commit the fraud unless you had the letter.” (Id. at p. 131). These statements by
the Magistrate Judge make it clear why he concluded, and correctly so, that the
Tsai/Schlenkert communications relating to the opinion letter furthered crime and fraud
and that the SEC made a prima facie showing of a criminal or fraudulent violation of
Section 5 by Tsai.
C. The Magistrate Properly Denied Tsai’s Request for Another Hearing
1. There is no Right to a Hearing in the Sixth Circuit
Tsai argues that the Magistrate Judge erred in not allowing Tsai yet another
hearing on the crime-fraud issue and states that the Magistrate Judge should have adopted
11
positions supposedly taken by the Third Circuit and Eighth Circuit in apparent disregard
of Sixth Circuit precedent. That argument is incorrect because (1) no evidentiary hearing
is required in the Sixth Circuit; and (2) Tsai in fact had exhaustive opportunities to
present “evidence and argument,” as some other Circuits have deemed necessary to
invoke the crime-fraud exception.
In the Sixth Circuit, no hearing is necessary to apply the crime-fraud exception
in a civil case. Royal Surplus Lines Ins. Co. v. Sofamor Danek Group, Inc., 190 F.R.D.
505, 517 n.10 (W.D. Tenn. 1999). The Court in Royal Surplus Lines rejected the
argument that a party defending the privilege must be allowed a court hearing, rejecting
Third Circuit precedent that supposedly held the contrary. Id. Furthermore, as more
fully set forth below in Section D, the standard in the Sixth Circuit for applying the
exception is “probable cause,” so the Court need not accept or weigh opposing evidence
at all; the Court need only determine whether the SEC has made its prima facie showing
to invoke the exception. In Re Antitrust Grand Jury, 805 F.2d 155, 167-68 (6th Cir.
1986)(trial court did not err “in not considering the entire evidentiary record” in finding
crime-fraud exception applied, because only probable cause was required). The
Magistrate Judge afforded Tsai far more opportunities to be heard, through evidence and
argument, than the Sixth Circuit precedent requires.
2. Tsai Was Amply Heard by Evidence and Argument
In analogous circumstances outside the crime-fraud context, the Sixth Circuit has
repeatedly stressed that a court need not waste judicial resources on an evidentiary
hearing where it determines, in its discretion, that a hearing would serve no useful
purpose. See e.g., Ohio National Life Insurance Company v. United States, 922 F.2d
12
320, 327 (6th Cir. 1990)(defendant’s request for evidentiary hearing denied because
defendant had ample opportunity to present evidence and suggested no other evidence it
would present at hearing except for testimony from its agent); Gould v. Sullivan, 131
F.R.D. 108, 113 (S.D. Ohio 1989)(evidentiary hearing unnecessary where parties
submitted adequate materials and arguments); Proctor & Gamble Cellulose Company v.
Viskoza-Loznica, 33 F.Supp.2d 644, 651 (W.D. Tenn. 1998)(evidentiary hearing
unnecessary where parties provided several briefs with supporting affidavits, even where
the court had to resolve mixed questions of law and fact).
Tsai’s argument that he has received inadequate due process is unfounded,
regardless of which Circuit’s standards are applied. Tsai submitted four affidavits from
himself and his counsel; relied in his arguments on another affidavit from his codefendant
Michael Markow, as well as Markow’s own briefing; submitted testimonial
excerpts from half a dozen witnesses; had an opportunity to clarify anything he chose at
his deposition, conducted while the motions were pending; submitted dozens of pages of
briefing through his counsel; and had the benefit of three hours of in-court hearings on
October 8, 2004. The Magistrate Judge worked hard to give all parties a fair say.4
The Magistrate Judge denied Tsai’s belated request for yet another hearing, first
made in December, stating that, “This Court believes that further oral argument on this
issue would not serve any meaningful purpose except to further delay a decision on this
4 Indeed, a hearing could not generate substantial additional evidence beyond what has already been
submitted by the parties and reviewed by the Court. Tsai has been arguing all along that he legitimately
gifted his shares to five “former directors,” that he did not own or control the shares of the five “former
directors,” and that the five former directors legitimately owned “their” shares for over two years, thus
satisfying the Rule 144 exemption from registering the shares. As such, Tsai argues that he did not commit
a crime or fraud (or a violation of Section 5 for that matter), and therefore, his communications with
Schlenkert could not be for the purpose of committing a crime or fraud, as none existed. All of these five
“former directors” are located in Evansville or Bloomington, Indiana and reside beyond the 100-mile reach
of the Court’s subpoenas. As such, their testimony can only be presented through depositions, not live
testimony, under FRE 804(b)(1)—as it already has been.
13
issue.” (Doc. #85, Order at p. 22). The Magistrate Judge had good reason for making
this decision based on the extensive opportunities he had already provided for evidence
and argument, and his conclusion that no more was needed is not clearly erroneous.
Indeed, Tsai has never pointed to any specific piece of evidence important to the
resolution of crime-fraud that he has not already presented, or could not have already
presented with reasonable diligence. Discovery has now closed, and Tsai did not notice a
single deposition, nor request an expedited transcript of any deposition in this case. The
notion that the Magistrate Judge was required to keep waiting for some unspecified new
evidence, or give Tsai new bites at the apple, is specious. Tsai’s argument that he needed
an additional hearing to present “rebuttal evidence” ignores the months of opportunities
he was given—and took—to present his rebuttal evidence. He suffered an adverse ruling
because the evidence is against him, not because he had no chance to defend himself.
D. The Magistrate Judge Correctly Applied the “Probable Cause”
Standard
In Clark v. U.S., 289 U.S. 1 (1933), the Supreme Court held that the attorneyclient
privilege will not apply where there is a prima facie showing of fraud. Id. at 14.
The Court defined a prima facie showing as a “case sufficient to satisfy the judge that the
light should be let in.” Id. The Supreme Court further held, “[t]o drive the privilege
away, there must be ‘something to give colour to the charge’; there must be ‘prima facie
evidence that it has some foundation of fact.’” Id. at 15 (citing O’Rourke v. Darbinshire,
A.C. 581, 604 (1920)). Fifty-five years later, the Supreme Court was again presented
with the definition of prima facie in the crime-fraud context, albeit in a footnote. See
U.S. v. Zolin, 491 U.S. 554, 565 n.7 (1989). The Court noted that there has been
14
confusion over the phrase “prima facie case” as used by the Court in Clark to describe the
showing needed to defeat the privilege. The Court in Zolin, however, did not further
clarify the phrase as it was not the subject of its review.
Circuit courts, including the Sixth Circuit, have consistently held that a “prima
facie case” in the crime-fraud context, in keeping with the spirit of Clark, amounts to a
showing of probable cause (or various other verbal formulations that are equivalent to
probable cause). In a thorough analysis of the Clark reasoning, the Sixth Circuit defined
“prima facie case” as probable cause to believe a crime or fraud was committed. See In
Re Antitrust Jury, 805 F.2d 155, 166 (6th Cir. 1986). That level of proof requires that “‘a
prudent person have a reasonable basis to suspect the perpetration of a crime or fraud.’”
Id. (citing In Re Grand Jury Subpoena Duces Tecum Dated September 15, 1983, 731
F.2d 1032, 1039 (2d Cir. 1984)). In arriving at this standard, the Sixth Circuit stated that,
“t is the most objective definition of what we believe the Supreme Court meant when it
stated that the government must present evidence to give ‘colour to the charge.’” Id.
Furthermore, the Court noted that this standard is the one formulated in other circuits. Id.
In 1997, the Sixth Circuit reiterated that “[t]o satisfy its prima facie showing, the
evidence presented by the government must be such that ‘a prudent person [would] have
a reasonable basis to suspect the perpetration of a crime or fraud.’” U.S. v. Collis, 128
F.3d 313, 321 (6th Cir. 1997). A Third Circuit case describes and adopts the consensus
view of the Circuits that probable cause (or various virtually identical tests) is the correct
standard, in a civil case as much as in a criminal one. Haynes v. Liggett Group, Inc.,
975 F.2d 81, 95 (3d Cir. 1992) (in civil case, adopting “probable cause” standard and
noting that the Second, Fifth, Seventh, Eleventh, and D.C. Circuits all agree that the
15
crime-fraud exception requires that “a prudent person have a reasonable basis to suspect
the perpetration or attempted perpetration of a crime or fraud, and that the
communications were in furtherance thereof”).
Tsai reaches all the way to a lonely opinion from a lower court in the Northern
District of California in an effort to find some precedent to avoid the probable-cause
standard, citing Laser Indus., Ltd. v. Reliant Tech. Inc., 167 F.R.D. 417, 427-430 (N.D.
Cal. 1996). After analyzing the various interpretations of the standard of “prima facie
case”, the Court in Laser Indus. determined that Fed.R.Evid. 104(a) should dictate the
standard. Id. at 436. Rule 104(a) states that “‘[p]reliminary questions concerning…the
existence of a privilege…shall be determined by the court…’” Id. The Laser Indus.
Court noted that in making a determination under Rule 104(a), courts generally use a
preponderance of the evidence standard. Id. (emphasis added). The Court then held that
the standard to apply when considering whether the crime-fraud exception applies is
whether “it is more likely than not that the party resisting the disclosures sought or used
legal advice to commit or to try to commit a crime or fraud.” Id. at 441. The Court in
Laser Indus. admitted that Rule 104(a) is almost never considered by appellate courts in
the crime-fraud context, but it nonetheless relied on that Rule to formulate its own
standard of “prima facie case”. Id. at 436.
That anomalous formulation from Northern California is not precedent in this
District or this Circuit, and Magistrate Judge Abel certainly did not commit any clear
error in failing to apply it.5 See Daugherty v. Campbell, 935 F.2d 780, 784 (6th Cir.
5 In his objections, Tsai cites Bourjaily v. U.S., 483 U.S. 171, 175-76 (1987), a Supreme Court case, as well
as U.S. v. Short, 790 F.2d 464, 468 (6th Cir. 1986) and U.S. v. Enright, 579 F.2d 980, 983-86 (6th Cir.
1978), two Sixth Circuit cases, to support his claim that when courts consider preliminary questions under
Rule 104(a), they apply a preponderance of the evidence standard. First, these cases have nothing
16
1991)(“the law of our circuit requires us to look first to decisions of the Supreme Court,
then to decisions of [the Sixth Circuit] and other courts within our circuit, and finally to
the decisions of other circuits”). Further, it would make no sense to require a showing of
preponderance of the evidence to allow discovery under the crime-fraud exception,
because that is the same standard that will determine the outcome of the full case at trial;
it would mean that a party must win its case before it may obtain discovery. The Sixth
Circuit has never endorsed such an absurd requirement.
E. Tsai’s Use of Naïve Nominees To Disguise His Ownership and Control
of Shares Shows that No Exemption to Registration Applies
Tsai claims that “the SEC has not cited a single case in support of the proposition
that Tsai’s [allegedly] limited authority over the 250,000 shares gifted to the 33
shareholders somehow defeats the exemption from registration under either the safe
harbor provisions of Rule 144(k) or the provisions of §4(1) of the [1933] Act. . .” (Doc.
#87, at Ex. A, p.15). In fact, the SEC cited and discussed a number of cases for exactly
that proposition, and they were in turn cited in the Magistrate Judge’s Order, yet Tsai
does not mention them or attempt to distinguish them; as with adverse facts, he ignores
them. Furthermore, his claims of only “limited authority” over the shares are contrary to
the Magistrate Judge’s findings and to the evidence of record.
whatsoever to do with the crime-fraud exception. Second, Tsai argues that the probable cause standard for
the crime-fraud exception in Collis, a Sixth Circuit criminal case, does not apply in this civil case. Tsai’s
argument that the Magistrate Judge should have rejected a standard applied in a Sixth Circuit crime-fraud
case because it was a criminal case, and instead relied on unrelated Sixth Circuit criminal cases that have
nothing to do with the crime-fraud exception, makes no sense. In 1986, in Antitrust Jury, the Sixth Circuit,
in a thoroughly reasoned opinion, identified the standard involved in a prima facie showing in the crimefraud
context, the same year that the Sixth Circuit analyzed Rule 104(a) in Short and eight years after
discussing the preponderance of the evidence standard under Rule 104(a) in Enright. Nowhere did the
Sixth Circuit even mention Rule 104(a) when deciding Antitrust Jury. Clearly, it did not believe that the
standard associated with Rule 104(a) had any place in a crime-fraud exception analysis.
17
Section 5 of the Securities Act of 1933 generally requires that securities cannot be
offered or sold without registration. 15 U.S.C. §77(e). Section 4(1) of the Securities Act
provides an exemption from registration requirements for sellers who are not “an issuer,
underwriter, or dealer,” where an issuer includes “any person controlling or controlled by
the issuer, or any person under direct or indirect common control with the issuer.” 15
U.S.C. §§ 77b(a)(11), 77d(1). Further, SEC Rule 144(k), 17 C.F.R. §230.144(k), allows
sales of stock without registration by a shareholder who is “not an affiliate of the issuer,”
either at the time when he received the securities or within three months of the sale, as
long as the shareholder has held the stock at least two years from the time when he
received the stock from the issuer or an affiliate of the issuer.
Section 4(1) and Rule 144 are precisely the kinds of exemptions that can be
fraudulently abused by an issuer (or affiliate of an issuer) who places stock in the name of
nominees but continues to exercise control. Therefore, periods during which stocks are
nominally in the hands of outside shareholders, while the issuer or an affiliate continues
to exercise control, “cannot be used to calculate the two year computation” under Rule
144, and sales from such nominees must be treated as sales by the issuer for purposes of
Section 4(1). In Matter of Charles F. Kirby et al., 2000 WL 1787908, at *14 (SEC
Release No. ID-177) (December 7, 2000).
In Kirby, the principal of an issuer had his restricted stock put into the names of
nominees, including several “trusting neighbors” who belonged to his church. Id. at *5-
6. He had one of the “trusting neighbors” sign “twelve to eighteen blank stock powers
and other legal documents at [the principal’s] request without understanding the
significance of the documents.” Id. The principal then “moved stock in nominee names
18
without their knowledge.” Id. The SEC administrative law judge held that sales by these
nominee shareholders must be treated as sales by the issuer, and were therefore unlawful
without registration. Id. at *9 (“These nominees assumed [the principal’s] legal status as
issuers.”) Furthermore, anyone buying from these nominees in order to resell the shares
was deemed “an underwriter” and would also be liable upon resale. Id. On appeal, the
SEC affirmed the ALJ’s finding of Section 5 liability and held that the conduct was
“egregious” and warranted heavy sanctions. In Matter of Kirby, et al, 2003 WL 71681, at
*8, *11 (SEC Release No. 8174) (January 9, 2003) (Section 4(1) exemption did not apply
because the principal “orchestrated the transfer of [one nominee’s] stock to [another
nominee] without consideration. He also controlled the disposition of the stock held in
[the second nominee’s] name.”)
Numerous other precedents recognize that registration requirements are violated
where the issuer or an affiliate arranges holding and sale of shares in the name of
nominees who are not truly independent, in order to disguise the actual control of the
shares. In Matter of Timothy J. Brannon, 1998 WL 214280, at *2 (S.E.C. Release No.
7533) (May 4, 1998) (Commission found that respondent was a mere nominee of the
principal for the issuer because he “never had control of the S-8 shares issued to him, and
did not know. . . how much of the stock he would be able to keep, that amount being
determined entirely by [the principal].”); In Matter of New Allied Development Corp.,
1996 WL 683705, at *7 n. 28 (SEC Release No. 37990) (November 26, 1996) (sufficient
evidence that principal of issuer controlled nominee shares where he directed their
movements and received proceeds from their sale); In Matter of Art H. Beroff, 2002 WL
46861, *2-*3 (SEC Release No. 8054) (January 14, 2002) (nominees were considered to
19
be the same as the issuer, and therefore Section 5 was violated in sales from nominees,
where the nominees received the shares without paying for them, executed blank stock
powers that were used for transfer, and shares were transferred at the direction of a
promoter for the issuer).
1. Using Naïve Nominee Shareholders for MAS XI
Here, the Magistrate Judge had ample evidence to find, as he did, that Tsai used
nominees to conceal his control of unregistered securities, just as in the cases cited above.
April C. (“Ms. C.”) is one of five alleged “corporate directors” and “accredited investors”
of MAS XI, and was the supposed holder of one-fifth of the MAS XI shares that were
later “given” to other shareholders, then sold to Michael Markow, and then dumped on
the public markets without registration. MAS XI was founded in October 1996, and
coincidentally in that same month Ms. C. was hospitalized in connection with her
Borderline Intellectual Functioning and “Schizo-Affective Disorder,” a condition closely
related to schizophrenia, which involves hearing voices and also has a mood component.
(Doc. #75, Lo Third Decl., Ex. A at pp. 9-10, 22, and 30).
Since October 1996, Ms. C. has been either hospitalized, living in a group home,
or receiving intensive medication, supervision, and care as a diagnosed SMI (Seriously
Mentally Ill) person. (Id. at pp. 7, 21-22, 24). She receives social security disability
payments because of her incapacity, but the monthly payments do not go directly to her.
(Id. at pp. 31, 52-53). Instead, the checks go to her caregiver, the Center for Behavioral
Health in Bloomington, Indiana, which pays her rent and other bills. (Id. at p. 29). If Ms.
C. wishes to obtain access to any part of the modest social security payments herself, she
discusses it with her case manager in the Seriously Mentally Ill program, Natalie
20
Hawkins. (Id. at pp. 20, 29). Ms. Hawkins recently testified that Ms. C. would not be
able to understand what a corporate director is; would not be able to understand what
shares of stock are worth; and would not be able understand legal documents, such as
stock powers, that transfer ownership of shares. (Id. at pp. 34-35). Further, Ms. Hawkins
testified that Ms. C.’s limitations would be obvious to anyone who knew her:
Q And would her limitations be obvious to people that know her?
A Yes. I would -- in my opinion, most definitely. In meeting with her,
sometimes she presents as what I would say childlike and very sweet and
pleasant, sometimes difficult. She's a wonderful woman. But mostly I would say
unaware, childlike, naive in some cases, and that's when I feel like we need to
discuss, talk about possible consequences of her actions to try to get her to
understand what may or may not happen.
(Id. at pp. 33-34). The SEC pointed out to Tsai at his recent deposition that he named
Ms. C. as a corporate director, accredited investor, and major shareholder in sworn SEC
filings, and asked him, “From your interactions with her, do you have any knowledge as
to whether or not she understands what a corporate director is?” His answer: “I don’t
know.” (Doc. #75, Lo Third Decl., Ex. B. at p. 93).
The Magistrate Judge also had testimony from the four other people (David Carra,
Charles Roberson, Stephen Lee, and Rich Hemmer) whom Tsai claims are former
“directors” of MAS XI, allegedly received 50,000 shares each in 19976 (as well as shares
in many other Tsai companies), and then allegedly gave most of “their” MAS XI shares
6 Tsai has admitted that he falsely stated in an SEC filing that MAS XI had three directors at the time of its
founding, when in fact he was the only one. (Id. at pp. 51-52). He says it was an oversight. (Id.) There is
probable cause to believe that sometime after April 16, 1999, Tsai fabricated the claim that he had given
the five “former directors” 50,000 shares each in 1997, in order to make it appear that the two-year
Rule144 holding period had been satisfied for “their” shares. Tsai made no mention of the gift of 50,000
shares to each of them in an SEC filing on April 16, 1999 (mentioning only that they had received 100
shares each from the company), and first mentioned the 50,000 share “gifts” in an SEC filing two months
later that sought identical information. (Id. at pp. 69-70). When asked why he did not mention the 50,000
share “gifts” in the earlier SEC filing, Tsai testified, “I don’t recall.” (Id. at p. 70).
21
away in August of 1999 (when “their” shares were supposedly dispersed to 33 new
holders). All four said they were never directors of any of Tsai’s companies, did not
know they had supposedly received 50,000 shares in MAS XI in 1997, and did not know
that they supposedly later gave away most of these shares. (Doc. #59, SEC’s
Memorandum in Support of Motion for Declaration, at pp. 4-5).
2. Continuing Control Over MAS XI Shares
Tsai admitted that it was his idea to approach Kensington Capital Corp., a
Brooklyn brokerage, to initiate the Form 211 process to allow certain shares of MAS XI
to become tradable on the OTCBB, even though the “vast majority” of shares that would
become tradable supposedly belonged to the five former directors. (Doc. #75, Lo Third
Decl, at Ex. B, pp. 83-84). Tsai conceded that Kensington relied on him for the
information they supplied to the NASD in the Form 211 process, and had no other source
of information for the filing (other than public filings). (Id. at p. 97). Kensington Capital
kept Tsai apprised of its progress in the 211 process, for both MAS XI and other MAS
Acquisition companies (Id. at p. 98).
During the Form 211 process for MAS XI, the NASD raised concerns about the
concentration of shares in the (supposed) hands of only five people. (Id. at p. 105). In
response, Tsai testified that he “found more shareholders” and arranged for transfers to
them in August 1999. (Id.) Tsai claimed that he obtained permission for these transfers
from the five former directors, but conceded that they did not know to whom their shares
were going and did not know how many of their shares would be transferred. (Id. at p.
122). Further, Tsai conceded that he does not “know whether they had a clear
understanding of how many shares they owned in MAS XI” at the time, and he “does not
22
recall” whether the five knew which company he was talking about when he allegedly got
their permission for transfer. (Id. at pp. 116, 122).
By his own admission, Tsai decided how many shares each transferee would
receive, on a “more or less arbitrary” basis. (Doc. #75, Lo Third Decl., at Ex. B, p. 108).
Some transferees received as few as 600 shares, while others received as many as 9,000.
(Id. at p. 219). There were 28 transferees, and the original five “directors” kept some of
their shares, so the shares allegedly ended up in the hands of 33 people in all. (Id. at p.
121).
3. Sales from Oblivious “Shareholders” to Michael Markow
It was the shares from these 33 people that were later sold to the defendant
Michael Markow in February 2000 (and then used in March 2000 in the market
manipulation on the OTCBB that the SEC alleges in this case). Representative witnesses
from among the 33 people have testified that they did not know that they supposedly later
sold shares to Michael Markow, and did not know that the $100 checks they received in
the mail were for MAS XI shares. (Doc. #73, Lo Second Decl., at Exs. C-J). Tsai claims
that each of the 33 people expressly agreed to the sale, but admitted that at the time when
the 33 allegedly agreed to sell their shares to Markow, “most of them” did not know that
MAS XI, a shell company, had already entered into an agreement to merge with
Bluepoint Linux Software Company, or even that their shares had been approved by the
NASD to trade on the OTCBB. (Doc. #75, Lo Third Decl., at Ex. B, pp. 227-28). Thus,
by Tsai’s own admission, these shareholders did not know that they were selling, or what
they were supposedly selling.
23
4. Tsai’s Benefit from the Sale of MAS XI Shares
In his investigative testimony, Markow testified clearly and no fewer than three
times that he paid in excess of $253,000 for shares from the alleged selling shareholders,
with $250,000 of the payment going to Tsai and $100 each (totaling $3,300) going to
each of the 33 supposed selling shareholders. Here is the first instance:
Q: Does this document represent that you are gathering up $250,000 to pay to
Aaron Tsai to buy shares of Bluepoint, as opposed to buy shares from the shareholder is
what they’re talking about?
A: I bought shares from the shareholders. I sent money to Tsai. He told me
which shareholders to go to get the shares. I sent them money also.
Q: So the money that you used to buy the shares, some of it went to Tsai and
some of it went directly to the shareholders?
A: That’s correct.
Q: How much went to Tsai?
A: I believe $250,000.
Q: And how much went to the shareholders?
A: Three, four thousand dollars.
Q: Why did some of the money, most of the money got to Tsai and a fraction
of it go directly to shareholders?
A: He told me he would take care of them.
Q: What did that mean?
A: He identified certain shareholders to go to, a pretty lengthy list. I did not
know what the relationship or what the situation was, and he told me which
shareholders to send money to and the balance to him and he would take care of it.
(Doc. #75, Lo Third Decl., at Ex. C, pp. 69-70).7
7 All of the movements of shares in and out of the names of supposed “shareholders” were part of a
continuous scheme to disguise Tsai’s beneficial ownership and control. The fact that Tsai ultimately got
98.7% of the proceeds from the sale of the shares that had been moved first to five and then to 33 supposed
24
And later in the testimony, Markow again confirmed that the $250,000 was for
the shares from the 33 “holders”:
Q: And you wrote [quoting from document]: “By tomorrow, the $250,000
will be cleared, and I will have a cashier’s check issued and send you a copy by fax.”
What does this letter represent?
A: It represents that I will send him $250,000 for—to purchase my shares,
and we will be—that’s what it represents.
Q: Okay. Why is the $3,000 or $4,000 not included in this letter?
A: Because I didn’t send the $3,000 to $4,000 to him.
Q: Did you keep him apprised of when you did send the $3,000 to $4,000 to
the other shareholders? That’s where you sent it, right?
A: Yes.
Q: Did you—and you let Aaron Tsai know when you did that?
A: I communicated with him about it, yes.
(Id. at p. 84).
And later Markow for a third time confirmed that the $250,000 and the $3,300 in
individual payments were all for the shares he received from the 33 people:
Q: Did it strike you as odd that 33 people each were willing to sell for $100?
A: I did not believe they were selling for $100.
Q: That’s because Tsai was going to take the $250,000 and take care of that
as you put it, right?
A: In terms, yes.
shareholders helps show that he was the real beneficial owner all along; it helps prove the fraud that Tsai
intended from the outset with his “gifts.”
25
(Id. at p. 100).8 Thus, Tsai received $250,000, or about 98.7% of the total proceeds of
the sales to Markow from the “shareholders.”
F. Tsai Violated Section 5 By Gifting Shares to Create an Appearance of
a Broad Shareholder Base While Misrepresenting and Failing to
Disclose His Purpose
Even if Tsai had not continued to control the puppet strings over shares that he
supposedly gifted, his scheme to create the appearance of a broad shareholder base
through gifts, and thereby help his companies to go public without registration, violated
Section 5 and was fraudulent. In the Matter of Capital General Corp., 1993 WL 285801
(S.E.C. Release No. 7008) (July 23, 1993). In Capital General Corp., the SEC sanctioned
an individual named Yeaman and his company, Capital General, for a scheme “devised
by Yeaman to create public companies without registration under the Securities Act and
then transfer control of the public companies to promoters for a fee. . . .” Id. at *5.
Yeaman and Capital General created 69 shell companies and distributed shares in those
companies, typically in allotments of 100 shares each, to numerous people “ostensibly as
gifts.” Id. No registration statements were in effect when the shares were distributed. Id.
Even after the gifts of shares, Yeaman and Capital General still owned the
majority of shares in the companies. Id. Yeaman later transferred control of these
companies to promoters or private companies in exchange for fees totaling $750,000, and
assisted with filings with the NASD to enable the shares of these companies to be
publicly traded on the Over the Counter Bulletin Board, as well as other venues. Id. In
8 In his deposition, Tsai conceded that each of the 33 people received $100 from Markow, regardless of
whether they allegedly “sold” 600 shares or 9,000 shares. (Doc. #75, Lo Third Decl., at Ex. B, pp. 219-
220). Thus, the price per share that they received varied from $.17, or 17¢ per share, to $.01, or 1¢ per
share. (Id.) Tsai testified in his investigative testimony that “I don’t know if I mentioned to them exactly
how much the buyer is going to pay.” (Doc. #75, Lo Third Decl., at Ex. D, p. 75). In other words, Tsai
concedes that the purported sellers may never have been told what they would get for “their” shares.
26
Form 10 filings with the SEC, Yeaman “failed to disclose the purpose of the gifts [of
shares], to create a ‘public’ company, control of which Yeaman intended to transfer for a
fee, so that Capital General actually received value in the distributions.” Id. The
Commission rejected the argument that the distributions of gifted shares were not sales
and therefore were exempt from registration, because the giver received a benefit (in the
form of increasing its chances of making the company public and selling control of the
company for a fee) by making the gifts:
Yeaman and Capital General Attempted to evade the registration requirements of
the Securities Act by purporting to rely on the theory that since the shares were
distributed as “gifts,” no sales occurred. However, the fact that recipients may
not have provided direct monetary consideration for the shares does not mean that
there was not a sale or offer for sale for the purposes of Section 5. . . . Capital
General’s distributions of securities constituted a ‘sale’ within the meaning of
the Securities Act since the distributions were dispositions for value. Here,
value accrued to Capital General and Yeaman by virtue of the creation of a
public market for the issuer’s securities, and the fact that, as a public
company, the issuer could be sold for greater consideration.
Id. at *10.
The Commission emphasized that in determining whether the issuer receives
value from a distribution of supposedly gifted shares, the issuer’s whole course of
conduct and goals must be considered:
[T]he analysis must include the entire transaction—the distribution of the issuer’s
shares, and subsequent change in control of the issuer—to determine whether
value was received from the distribution. The distributions of the Capital General
subsidiaries were undertaken to create a public market in the subsidiaries’ stocks
while avoiding registration of the shares with the Commission under the
Securities Act, and to permit Capital General and Yeaman to offer the issuers as
public companies. . . . [T]he shares were distributed not for eleemosynary
[charitable] purposes. Rather, the shares were distributed so that control of the
issuer could be transferred by Yeaman for significant value following the
distribution. No independent business purpose for these distributions exists. . . .
Capital General and Yeaman retained a control position in the shells after the
stocks were gifted, the value of which has increased due to the creation of a public
trading market for the securities. . . . Capital General’s purpose in distributing the
27
shares is further evidenced by Yeaman’s efforts in attempting to create trading
markets for the securities of the subsidiaries, in assisting broker dealers in filing
NQB applications [similar to the current NASD Form 211], and later filing the
Form 10 registration statements.
Id. at *11.9
Here, Aaron Tsai has admitted under oath that he engaged in a “gifting” scheme
to create public companies without registration, for his own benefit, substantially
identical to the one described in Capital General. While Yeaman created 69 shell
companies and gifted shares in them, in hopes of later transferring control for a fee, here
Tsai created, by his own admission, 101 shell companies, including MAS III, MAS VIII,
MAS X, and MAS XI. (Doc. #75, Lo Third Decl., at Ex. B, p. 25). They all had the
purpose of being merged with a private company. (Id. at pp. 25-26).
Tsai admitted that his purpose in arranging for gifts of shares was to benefit
himself by helping create a public company. For example, Tsai explained his reasons for
the supposed gifts of 50,000 shares each to “former directors” in his investigative
testimony on March 25, 2002:
Q: Why did you give these five former Directors 50,000 shares of your stock?
A: Because we need shareholders so we can try to take the company public
later on.
Q: How does that work?
A: All I knew at the time was that you need more shareholders, so, and so I
decided to do that transaction.
Q: Does that have something to do with Rule 144 when you say that you need
more shareholders?
9 Capital General is a seminal opinion discussed, for example, in Hazen, LAW OF SECURITIES REGULATION,
§5.1 n.19 (2002). Yeaman was later convicted of multiple felonies in connection with his scheme. U.S. v.
Yeaman, 194 F.3d 442 (3d Cir. 1999).
28
A: Yes.
(Doc. #75, Lo Third Decl., at Ex. D, pp. 30-31).
Further, with the “gifts” he arranged in the summer of 1999 from the five former
“directors” to 33 others, Tsai conceded that the gifts benefited him and the company:
Q: Did you benefit in any way by making these arrangements for the transfer
of shares from Roberson, Carra, Carlisle, Lee, and Hemmer to others?
A: No.
Q: Why did you do it then?
A: To further the purpose of the company.
Q: Would that benefit you to further the benefit of the company?
A: Yes.
Q: Okay. How did transferring the shares from these five individuals to the
other listed people further the purposes of the company of MAS XI?
A: Because the purpose of the company is to become publically [sic] traded.
(Doc. #75, Lo Third Decl., at Ex. B, p. 110-111).
Tsai, like Yeaman, cannot claim any legitimate business or charitable purpose for
his gifts of shares. His sole purpose, by his own admission, was to create the appearance
of a shareholder base sufficient to go public, and thus increase his potential proceeds
from promoters. Tsai and his holding company MAS Capital, like Yeaman and Capital
General, retained majority ownership of his companies after the “gifts” and would only
pass control upon merger, for an appropriate profit, as Tsai described in his investigative
testimony. (Doc. #75, Lo Third Decl., at Ex. D, pp. 63-64). Tsai, like Yeaman, did not
29
disclose in SEC filings the purpose behind his gifts of shares.10 See, e.g., Doc. #59, First
Decker Decl. at Ex. A (Form 10 SB/A discloses gifts of shares but does not disclose their
purpose to create appearance of independent shareholder base). Tsai, like Yeaman, also
enlisted broker dealers to seek permission from the NASD for shares, including “gifted”
shares, to trade on public markets, such as the OTCBB, as previously discussed. Thus,
even setting aside the evidence that Tsai was always the beneficial owner of supposedly
gifted shares, his “gifting” benefited him and his company, and thus constituted a sale
requiring registration.
In sum, there is ample probable cause that Tsai violated Section 5, and made
numerous willful false statements and material omissions in doing so, in SEC filings and
elsewhere, as described above and in prior filings. Thus, the Magistrate Judge correctly
found crime and fraud sufficient to trigger the crime-fraud exception.
In an effort to justify his conduct, Tsai seizes upon cases that have nothing to do
with a fraudulent scheme such as his, complete with false regulatory filings and
exploitation of impaired people. For example, Tsai cites a case in which an affiliate of an
issuer disclosed to the SEC that he intended to make a gift of shares, for a genuine
charitable purpose, to a foundation on whose Board he sat, where he would continue to
have influence over disposition of the shares as a Board member; asked for clearance to
do so, and was assured that the SEC would take no enforcement action under Section 5.
BMC Software Inc., SEC No-Action Letter, 1991 SEC No-Act. LEXIS 991 (August 14,
10 Indeed, Tsai falsely reported in SEC filings that the purpose of issuing 100 shares each to Ms. C. and the
other four “directors” of MAS XI was “compensation” for their service as directors, but then admitted in
his deposition that Ms. C, Hemmer, and Lee performed no services whatsoever, and he “does not recall” if
Roberson or Carra performed any services. (Doc. #75, Lo Third Decl., at Ex. B, pp. 91-92). Tsai did not
disclose his purpose for his further gifts of 50,000 shares each to these same people, other than to report
that the “gifts” were to supposed “former directors,” thus suggesting that it had something to do with their
“services” or status. (Doc. #59, First Decker Decl. at Ex. A).
30
1991). From that Tsai argues that his own continuing control over shares he supposedly
gave away does not violate Section 5 and was not fraudulent. But Tsai has admitted that
his purpose for the “gifts” was not charitable, but part of a continuous and systematic
effort to enable a public distribution of shares for his own benefit; he received 98.7% of
the proceeds from sale of shares in MAS XI that he had supposedly given away; the
“recipients” of his gifts did not know how many shares they supposedly received, in
which MAS companies, to whom they were later transferred, or how much was paid; and
Tsai, unlike the party in BMC, falsified sworn regulatory filings, for example telling the
SEC that shares were provided to “directors” for their “services,” when they did not
perform services, did not know they were directors, and, in one case, did not have the
capacity to know what a corporate director is.
Likewise, Harmony Trading Corp. 1999 WL 1059812 (SEC No-Action Letter)
(November 12, 1999) does not suggest that Tsai’s situation involves “a legitimate legal
dispute, not fraud,” as Tsai would have it. In that case, the SEC roundly rejected an
issuer’s request to distribute shares in a shell company for little or no consideration
because of the SEC’s concern “over circumstances where, after a company is formed
without either substantial capital or the prompt commencement of business, but in
proximity to the company’s efforts to have its securities traded in the public markets, its
closely-held securities are transferred to significant numbers of persons. In situations of
this kind, resales of such securities in claimed reliance on Rule 144 raise questions
whether the transfers involve an evasive scheme to avoid registration under the Securities
Act of 1933.” Id. at 7. The issuer in that case honestly disclosed its intentions to the SEC,
sought permission, and was rebuffed. Here, Tsai falsified regulatory filings to disguise
31
what he was doing and exploited vulnerable people to help further and conceal his
scheme, and through his deception succeeded in the unlawful distribution on public
markets. His conduct was willful and fraudulent.
G. Connection to Interstate Commerce Was Established
Magistrate Judge Abel specifically found that the interstate commerce
requirement for a Section 5 violation was met. (Doc. #85, Order at p. 20). Tsai argues
that “[t]he SEC did not present evidence and argue that interstate means were used in
connection with the transfers of stock to five initial holders in January 1997 (or the
subsequent transfers to 28 additional shareholders)” in February 2000. That argument is
both incorrect and waived.
In Plaintiff’s Response to Submissions by Aaron Tsai and Michael Markow as to
Crime-Fraud Exception, filed with the Magistrate Judge, the SEC asserted that it was
“undisputed” that means of interstate commerce were used in connection with the offer
and sale of the shares, giving as an example evidence of the use of mails to get $100
checks to the 33 nominee shareholders in February 2000. (Doc. #76, at pp. 9, 13 n.7).
Tsai never disputed that fact in his subsequent briefings and never argued to the
Magistrate Judge that the interstate commerce requirement was not satisfied, so the
objection is waived.
Even if it were not waived, Tsai has not shown that the Magistrate Judge’s finding
that interstate means were used in the scheme to trade unregistered stock was clearly
erroneous. The SEC presented evidence showing, and the Magistrate Judge found, that
Tsai’s supposed “gifts” to “corporate directors” (who were not really directors) in 1997,
and his transfer of shares from them to 28 others, and the supposed sales from all 33 of
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them to defendant Michael Markow in February 2000, were all part of a continuous
scheme to disguise Tsai’s ownership, control, and benefit from the sale of shares. The
SEC was only required to show probable cause that means of interstate commerce were
used at some point to further the overall scheme. See Aquionics Acceptance Corporation
v. Kollar, 503 F.2d 1225 (6th Cir. 1974)(interstate transportation of a stock certificate
some months after a sale was for the purpose of consummating the sale and sufficient
basis for federal jurisdiction); Wright v. Downs, 1992 WL 168104 (6th Cir. July 17,
1992)(sufficient to implicate a defendant who did not directly use any instrument of
interstate commerce if another defendant used an instrument of interstate commerce).
Stephen Lee, one of the “former directors,” received MAS XI stock certificates in
the mail. (Doc. #59, First Decker Decl., at Ex. E, p. 26). In addition, Tsai himself
introduced a memorandum from Yongzhi Yang and Francois Goelo, two of the
defendants in the case, to Michael Markow, another defendant in the case, stating,
“attached are copies of the memo and cashier checks drawn on Wells Fargo Bank
expressed mailed to all sellers of free trading shares in MAS Acquisition XI Corp.”
(Doc. #65, Declaration of Ronald E. DePetris Dated October 4, 2004, at Ex. 1). With his
own exhibit, Tsai shows that interstate couriers were used in furtherance of the scheme.
Further, interstate commerce was also used when Tsai mailed letters back and forth with
Kensington Capital and the NASD in the Form 211 process and ultimately in having the
shares approved for public trading on the open market. (Doc. #59, First Decker Decl. at
Exs. G, H, I, M, N and O).
33
H. The Order Covers Schlenkert Communications Regarding Legal
Opinion Letters for All MAS Acquisition Companies
Tsai argues that “the scope of the Magistrate Judge’s Order is limited to the Tsai-
Schlenkert communications with respect to the September 1999 opinion letter regarding
MAS XI shares.” (Doc. #87, at p. 13). The Order says otherwise. The Magistrate Judge
specifically granted the SEC’s Motion (Doc. #59), holding that “Defendant Aaron Tsai’s
claims of attorney-client privilege or confidentiality are waived or do not apply.” (Doc.
#85, Order at p. 23). The SEC’s Motion (Doc. #59) was not limited to MAS XI, but
specifically included all information in Arthur Schlenkert’s letters to the SEC of July 9
and July 10, 2004, and the attached email from Schlenkert to Tsai, dated November 1,
1999, in which Schlenkert refused to work further with Tsai and told Tsai that “if you can
find a lawyer who writes legal opinions out of thin air, I would suggest you get him to do
the opinion ASAP.” (Doc. #59, First Decker Decl., at Ex. S). The Schlenkert letters and
email refer in general to Schlenkert’s work for Tsai in connection with legal opinion
letters for the various MAS Acquisition companies, not just to MAS Acquisition XI, and
include specific references to MAS XI, MAS VIII, Surgilight (the successor to MAS III),
and Kensington Capital Corp. (the Brooklyn brokerage firm that handled NASD filings
for a number of the MAS Acquisition companies). (Id.)
The Magistrate Judge had ample evidence that MAS XI and Tsai’s other MAS
Acquisition companies were similar, and similarly fraudulent. Tsai created, by his own
admission, 101 shell companies, including MAS III, MAS VIII, MAS X, and MAS XI.
They all had the purpose of being merged with a private company. (Doc. #75, Lo Third
Decl., at Ex. B, pp. 25-26). To obtain “shareholders” for all of them, Tsai used people he
34
found around Evansville, Indiana and Henderson, Kentucky. (Id. at pp. 28-29). Tsai
concedes that some people were asked to become shareholders in multiple MAS shell
companies at the same time. (Id. at p. 29). By Tsai’s admission, new “shareholders” for
all the companies were not provided with stock certificates or “anything in writing to
show how many shares they would have in particular MAS Acquisition companies.” (Id.
at p. 31).11 When asked whether April C., the mental health patient with Borderline
Intellectual Functioning, and the other four purported “directors” of MAS XI, were
shareholders in all 101 companies, Tsai replied, “I don’t recall.” (Id. at pp. 33-34). Tsai
admitted in investigative testimony that some of the “directors” of MAS XI were
purported “directors” of more than ten other MAS companies. (Doc. #75, Lo Third
Decl., at Ex. D, p. 50). When asked whether he ever learned from discussions with the
“shareholders” that “any of these individuals did not know how many shares they held in
MAS Acquisition companies,” Tsai replied, “I don’t recall.” (Doc. #75, Lo Third Decl, at
Ex. B, p. 32). Tsai was asked whether, “from your dealings with them, do you know if
those people kept track of how many MAS Acquisition companies they had shares in?”
His answer: “I don’t know.” (Id. at p. 35).
As is typical with those who seek to fraudulently evade registration requirements
by using nominees, Tsai collected signatures on blank stock powers, which gave him the
ability to control movement in and out of the names of his nominees. Indeed, one
witness, Ersal Susar, said Tsai had him sign more than 100 blank stock powers for
various “MAS” companies. (Doc. #73, Lo Second Decl., at Ex. G, pp. 29-30). When
asked whether he had Susar sign 100 stock powers, Tsai replied, “I don’t recall.” (Doc.
11 Tsai claimed in sworn SEC filings that “[c]ertificates in such form as may be determined by the board of
directors shall be delivered, representing all shares to which shareholders were entitled.” (Id. at p. 63)
(emphasis added). That was false. (Id. at pp. 65-66).
35
#75, Lo Third Decl., at Ex. B, at p. 41). Once Tsai had obtained signed stock powers, by
his own admission, he did not need any further documentation to move shares out of the
names of the “shareholders.” (Id. at p. 42). Tsai has conceded that he obtained the stock
powers with the intent that they might be used even years after they were signed to effect
transfers. (Id. at pp. 44-45). Thus, the Magistrate Judge was not clearly erroneous in
granting the SEC’s motion, finding crime-fraud with respect to the communications
between Tsai and Schlenkert about opinion letters for the various MAS companies. (See
also detailed discussion of MAS III, MAS VIII, and MAS X in prior SEC pleadings at
Docs. #59 and 63).
Finally, contrary to Tsai’s suggestion, the Magistrate Judge did not fail to address
whether there should be a remedy such as suppression for Schlenkert’s supposed
breaches of the rule of confidentiality, or reserve ruling on that issue for a later time.
(Doc. #87, at p. 14). Rather, the Magistrate Judge expressly granted the SEC’s motion
for a finding that rules of “privilege and confidentiality have been waived or do not
apply” based on the crime-fraud exception. (Doc. #85, Order at p. 23). That means that
privilege and confidentiality never attached to Tsai’s communications with Schlenkert.
E.g., In Re Grand Jury Subpoena, 731 F.2d 1032, 1038 (2d Cir. 1983) (“Whereas
confidentiality of communications and work product facilitates the rendering of sound
legal advice, advice in furtherance of a fraudulent or unlawful goal cannot be considered
‘sound.’ Rather advice in furtherance of such goals is socially perverse, and the client's
communications seeking such advice are not worthy of protection.”); Laser Indust., Ltd.
v. Reliant Tech., Inc., 167 F.R.D. at 438 n. 34 (“In theory, establishing the crime/fraud
exception does not cause the ‘loss’ of the privilege; rather, after the requisite showing, the
36
law concludes that the privilege never attached in the first place.”) Crime-fraud is an
exception to privilege and confidentiality, not a doctrine of waiver. Therefore, the
protections never applied. Tsai’s repeated requests for a “remand” on various issues
would only lead to further rounds of pointless arguments to the Magistrate Judge and then
new rounds of appeals to this Court, in a cycle that Tsai seems to wish to perpetuate.
III. CONCLUSION
Tsai has not shown that the Magistrate Judge’s order is clearly erroneous or
contrary to law. Accordingly, the Order should stand.
Respectfully submitted,
/s/ Jarett B. Decker
Jarett B. Decker
Tracy W. Lo
Attorneys for Plaintiff
U.S. Securities & Exchange Commission
175 West Jackson Boulevard
Suite 900
Chicago, Illinois 60604
(312) 353-7390 (tel)
(312) 353-7398 (fax)
Dated: March 22, 2005
Local Counsel:
Mark D’Allesandro
OH Bar Number 0019877
A.U.S.A.
Southern District of Ohio
303 Marconi Blvd.
2nd Floor
Columbus, OH 43215
CERTIFICATE OF SERVICE
I hereby certify that on Tuesday, March 22, 2005, I electronically filed Plaintiff Securities
and Exchange Commission’s Response to Aaron Tsai’s Objections to the Order of the
Magistrate Judge Regarding the Crime-Fraud Exception to the Attorney-Client Privilege
with the Clerk of the Court using the CM/ECF system which will send notification of
such filing to the following parties:
Peter B. Shaeffer, Esq.
30 N. LaSalle St., Suite 2140
Chicago, IL 60602
Bruce O. Baumgartner, Esq.
Gina A. Berado, Esq.
Baker & Hostetler, LLP
3200 National City Center
1900 East Ninth Street
Cleveland, OH 44114
Irving M. Einhorn, Esq.
1710 10th Street
Manhattan Beach, CA 90266
Ronald E. DePetris, Esq.
DePetris & Bachrach, LLP
240 Madison Avenue
New York, NY 10016
Phillip W. Offill, Jr., Esq.
Godwin Gruber, LLP
Renaissance Tower
1201 Elm Street, Suite 1700
Dallas, TX 75270
And I hereby certify that I have mailed by Federal Express on March 22, 2005, a copy of
the foregoing to the following non CM/ECF participants:
Sierra Brokerage Services, Inc., pro se
c/o Jeffrey A. Richardson, President
4378 Hickory Wood Drive
Columbus, OH 43220
Jeffrey A. Richardson, pro se
4378 Hickory Wood Drive
Columbus, OH 43220
2
Jerome B. Armstrong, pro se
528 S. Union Street
Burlington, VT 05401
/s/Tracy W. Lo
Tracy W. Lo
One of the Attorneys for Plaintiff
Securities and Exchange Commission
175 W. Jackson Blvd
Suite 900
Chicago, IL 60604-2615
Phone: (312) 353-7390
Facsimile: (312) 353-7398
Email: lot@sec.gov |
