The opinion of the court was delivered by: CONNER
This case involves yet another skirmish in the long-running battle between the Securities and Exchange Commission (the "SEC" or the "Commission") and defendant Raymond L. Dirks ("Dirks"), a well-known, if controversial, securities analyst. In February of 1982, the SEC commenced this action seeking to enjoin Dirks, defendant Michael C. Scott ("Scott") and three other defendants from further violations of Section 17(a) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77q(a), Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b) and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5. The Commission alleges that defendants committed such violations by causing the securities of Cayman Islands Reinsurance Corporation, Ltd. ("Cayman Re") to be sold pursuant to a materially misleading prospectus. According to the complaint, defendants affirmatively misrepresented in the prospectus that: (1) Cayman Re would invest the proceeds of the offering primarily in liquid, fixed income securities; (2) Cayman Re would manage its own portfolio of investments; and (3) Cayman Re would enter the reinsurance business. The SEC further alleges that the prospectus was materially misleading because it failed to disclose that (1) there was a pre-existing agreement between Cayman Re and John Muir & Co. ("Muir"), the underwriter of the Cayman Re offering in which Dirks was a limited partner at the time, to invest as much as $2.5 million of the proceeds of the offering in speculative securities recently underwritten by Muir; (2) there was a plan to invest the remaining proceeds in a Canadian real estate venture (the "Marsta Cessions transaction"); (3) Scott, Cayman Re's chief executive officer, had been convicted of fraud, which adversely affected Cayman Re's ability to obtain a reinsurance license in the Cayman Islands; and (4) during the prospectus delivery period approximately $1.6 million of Cayman Re's proceeds from the offering were invested in new equity securities that had been underwritten by Muir, thus resulting in a duty to amend the prospectus to disclose this material use of the proceeds.
Before trial, the SEC resolved its claims against three of the defendants by stipulation and order.
Dirks, however, has vigorously contested the Commission's allegations both at the trial, which was conducted by this Court without a jury, and in his post-trial submissions. Despite his aggressive defense, Dirks did not testify during the case but instead relied on his Fifth Amendment privilege against self-incrimination, as did Scott during pretrial discovery. Although the SEC presented its evidence against Scott at trial, he chose not to appear for the proceedings or to file post-trial papers. He has, however, indicated to the Court that he disputes the accuracy of the Commission's allegations.
This Opinion incorporates the Court's findings of fact and conclusions of law, Rule 52, F.R.Civ.P. For the reasons set forth below, I conclude that Scott violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 and accordingly should be permanently enjoined from future violations thereof. The Court also finds that Dirks violated those antifraud provisions of the securities laws but declines to issue an injunction against him because of the SEC's failure to establish a reasonable likelihood that he will commit future violations. In explaining these conclusions, the Court will first review generally the evidence adduced at trial concerning the Cayman Re offering. Following that background discussion, the Court will then set forth separate conclusions concerning the individual defendants based on the admissible evidence as to each. Finally, the Court will detail the various considerations that justify the granting of equitable relief against Scott and the denial of such relief against Dirks.
Cayman Re is the embodiment of an idea developed by William E. Thompson ("Thompson") and others to incorporate an offshore reinsurance company that would be capitalized through a public offering in the United States. Reinsurance is a segment of the insurance business in which an insurer who has accepted a risk then passes a portion of that risk to another company, a procedure not unlike that of a bookie laying off his bets. Thompson and the other founders put up the initial capitalization of $100,000 and Cayman Re was incorporated on June 26, 1979 under the laws of the Cayman Islands.
Even before the company was incorporated, Thompson approached Muir about underwriting Cayman Re's initial public offering. Thompson, who served as Cayman Re's chairman of the board, testified that Muir was selected because that brokerage house had recently underwritten a new issue for Aneco Reinsurance Co. Ltd. ("Aneco"), which the Cayman Re principals believed was similar in concept to their own project. Specifically, Thompson understood that Dirks had been involved in the Aneco underwriting and thus his initial discussions and correspondence about Muir's involvement with Cayman Re were with Dirks.
During the spring of 1979, Thompson and Dirks developed the preliminary plans for the offering and negotiated the terms on which Muir would be retained as underwriter.
Ultimately, on August 22, 1980, Cayman Re and Muir executed a letter of intent under which Muir would underwrite $12 million of Cayman Re securities on a firm commitment basis. As then contemplated, the arrangement involved the issuance of 1,750,000 shares at $7.50 per share. Thompson signed the letter of intent on behalf of Cayman Re and John S. Sullivan, a general partner, executed the document for Muir.
In addition to developing plans for the underwriting itself, Thompson and the other Cayman Re principals also worked closely with Muir in establishing the company's investment objectives for the underwriting proceeds. The initial draft prospectuses, which Thompson prepared and sent to Dirks, stated that Cayman Re would invest these funds in liquid, fixed income securities. At one of the early meetings concerning the investment strategy, however, Dirks suggested that Cayman Re invest a portion of the proceeds in equity securities and that Muir, because of its track record, be retained as investment adviser in connection with such equity acquisitions. After some consideration, Cayman Re accepted this proposal at a January 10, 1980 meeting in Muir's offices, which was attended by Thompson, Dirks, Robert Sterling ("Sterling"), a Muir employee, P. Bruce Wright ("Wright") and Gerald Freedman ("Freedman"), partners in Trubin Sillcocks Edelman & Knapp ("Trubin Sillcocks"), legal counsel to Cayman Re for the underwriting. During that meeting Thompson announced Cayman Re's decision to have Muir manage a portion of the proceeds. The remaining funds, Thompson reported, were to be invested by two other managers, J. Henry Schroder and Continental Illinois Bank. In a January 14, 1980 memorandum to the Cayman Re principals,
Thompson summarized the events of the January 10 meeting and gave the following report on the investment situation:
It became obvious that one factor key to the completion of this project was allowing Muir to in fact have a part of our portfolio for investment.
I was glad to have been able to say that in our Cayman directors meeting we decided to give a portion ($3-5 million) of our funds to the other two managers, allowing for Muir to have a portion. We told Muir they could invest some of our funds from the beginning. No figure was discussed, but I would hope no more than 15-25% would be under their management (see management of investment funds memorandum accompanying this memo).
They agreed that their portion would also fall under Continental Illinois' custodial management account, so that we can be rendered a master account once a month.
Despite his statement to the Cayman Re principals that the Muir investment was "key" to the completion of the offering, Thompson testified at trial that Dirks never stated to him that Muir's retention as investment adviser was a necessary precondition to its participation in the underwriting. Nevertheless, after Cayman Re decided to invest a portion of the proceeds with Muir, a series of meetings was held to develop the investment guidelines. At one of these meetings, held on March 4, a disagreement arose between the Cayman Re principals and Sterling, who was working on the investment side of the project for Muir. In attendance at the meeting were Thompson, Wright, Freedman, Dirks, Sterling, Paul V. Miller ("Miller"), Cayman Re's president, and Henry Rothman ("Rothman") of Booth Lipton & Lipton ("Booth Lipton"), Muir's legal counsel for the underwriting. Sterling took the position that Muir, as investment manager, should be bound only by very loose guidelines. He insisted that the sole restriction placed on Muir by the prospectus should be the statement that Muir would do its best to maximize results. Not surprisingly, the Cayman Re principals objected to this vague language and turned to Dirks to resolve the matter. Dirks agreed that concrete investment guidelines were necessary and told Sterling that his position was "crazy." Dirks basically agreed with Thompson's proposed guidelines, which Wright listed in a March 4 conference memorandum:
There was discussion as to the investment guidelines which would be imposed on John Muir & Co., as follows:
(a) No investments would be placed with companies with less than $25 million in assets.
(b) Only securities of companies traded on the New York Stock Exchange, the American Stock Exchange and the NASDQ could be invested in.
(c) No more than $300,000 would be invested in any one issue, and no more than 10% of any new issue would be invested in.
(d) John Muir & Co. would strive to keep the turnover of the fund under 50% unless unrealized profits made such a position unsound.
Mr. Thompson then asked Mr. Dirks what types of securities he would be investing in and whether there would be investment in companies listed on the American and New York Stock Exchanges. Mr. Dirks said that half of the assets utilized would be listed companies such as Travelers, etc., i.e., insurance and financial companies, and that half would probably be over the counter issues, again concentrating on insurance and financial issues.
Despite the consensus on the preliminary investment guidelines, the Cayman Re principals continued to be dissatisfied with Sterling's attitude toward the project. They voiced this concern to Dirks and asked him to allow someone else to work on the deal from the investment end. Dirks agreed to the change and Sterling was removed from the project.
In its preliminary prospectus, filed with the Commission on April 11, 1980, Cayman Re disclosed that Muir would invest one-third of the proceeds "to optimize the total return thereon through a combination of capital appreciation and current income." Plaintiff's Ex. 204B at 19. The prospectus further revealed Muir's investment guidelines, which substantially comported with those agreed on at the March 4 meeting. After reviewing the registration statement, the Commission sent a comment letter to counsel regarding the sufficiency of the disclosure. The comment letter, a copy of which was sent to Dirks by Rothman, stated, inter alia, that the prospectus should detail more specifically the potential conflicts of interest and should make clear that the investment advisers would earn substantial fees regardless of the success of their investment strategies.
Sometime around the first part of May 1980, John Peterson ("Peterson") became actively involved in selling the underwriting for Muir. In a May 9, 1980 memorandum to the Cayman Re principals, Thompson described Peterson as Muir's "top sales person" and stated that he would be in charge of the account.
Thereafter, plans were made for Cayman Re's "dog and pony show," a trip made by certain of the principals and representatives of the underwriter to various cities in order to woo large investors. The Cayman Re "show" took place during the first part of June and was staffed by Peterson and Nancy Rochford ("Rochford") on behalf of Muir. Thompson testified that while the trip was in progress, Peterson called Dirks to report on their efforts to sell the underwriting. For his part, Dirks made "due diligence" trips for Cayman Re to London and to the Cayman Islands.
Although Thompson was optimistic after the road show that Cayman Re would go public during the summer of 1980, Dirks called Thompson and Miller in July to recommend restructuring the underwriting. Because market conditions were soft for insurance stocks, Dirks proposed that the offering be reduced from $12 million to $6 million, and that it be sold in units consisting of one share of common stock and one warrant at a unit price of $1. Thompson testified that after Dirks promised to oversee the offering personally, Cayman Re reluctantly agreed to the changes.
Even as restructured, however, the underwriting did not move forward. In early September, Dirks telephoned Thompson to tell him that there were still problems with market acceptance of the issue. Dirks suggested that he bring in a group of Canadian investors who could purchase up to 60 per cent of the offering. Thompson responded to this proposed change by Telex asking Dirks to proceed with the underwriting without the Canadians. Thompson believed that the delay caused by bringing in the new principals would merely complicate the already protracted efforts to take the company public.
On September 15, Thompson and Miller attended a meeting at Muir's office to discuss Dirk's proposal and to meet Scott, who purportedly represented the Canadian investors. Also present at the meeting were Dirks, Peterson, legal counsel for both Cayman Re and Muir and Murray Frank ("Frank"), Muir's designee to the Cayman Re board of directors. After Dirks introduced Thompson and Miller to Scott, the rest of the meeting was spent discussing Scott's background and his ideas on the Cayman Re project. Scott stated that he had extensive experience in the insurance field and mentioned that he had been a consultant to several Canadian insurance companies and to Muir.
What Scott failed to mention, however, was his 1961 fraud conviction in Canada for diverting $172,931.53 from the Canadian Shield General Insurance Company while he was its president. During the meeting, Scott expressed his opinion that the legal fees incurred by Cayman Re were too high and that there was too much dilution by insiders. Moreover, Scott stated that because he had substantial experience as a portfolio manager, none of the investment managers, including Muir, would be needed.
Although the discussions were continued the following day, there was no immediate decision made concerning the Canadians' involvement. One week later, however, Thompson wrote Scott stating that Cayman Re had approved certain of his proposals. Despite Scott's entry into the Cayman Re project, apparently no due diligence inquiry was ever conducted into his background. Wright understood that Rothman would investigate the Canadians although Rothman claims not to recall any conversations with Wright concerning due diligence with respect to Scott.
On September 24, 1980, Cayman Re filed Amendment No. 2 to its registration statement. After the SEC indicated that it had no further comments on the filing and was prepared to declare it effective, Thompson sent an October 1 telegram to the other Cayman Re principals announcing that the offering was imminent. The offering was again delayed, however, when Scott requested further changes in its terms. On October 17, Wright circulated a memorandum to Thompson, Miller and the other Cayman Re principals stating that Scott and the other Canadian investors were insisting that they be allowed to add enough directors to the board to give them control and that Scott be named chief executive officer ("CEO") of Cayman Re. Wright, who apparently learned of these demands in a conference call with Scott, Sterling and Peterson, further stated that Scott wanted to discontinue the investment management contracts so that he could handle investment of the proceeds. This proposal, one of Scott's original ideas, had not been adopted earlier.
The Cayman Re principals acquiesced in these changes and Wright incorporated them in a draft of Amendment No. 3 to the registration statement. The revised draft (1) identified Scott as CEO; (2) identified seven new directors, including Scott, to be added to the existing six-director board; (3) stated that Cayman Re would manage its own investment portfolio; and (4) listed seven Canadian residents as having indicated their interest in purchasing a substantial amount of the Cayman Re stock. However, one of these individuals, A. J. Reynolds Mastin ("Mastin") testified at trial that he had decided prior to the filing of the Amendment against investing in Cayman Re and had notified Peterson of that decision. See note 7, supra.
On November 18, the Cayman Re board met in Toronto and approved all of the changes incorporated in the Amendment. Thereafter, Scott became CEO while Miller was moved to the position of chief operating officer. The board also resolved to terminate Cayman Re's investment management contracts with Muir and the other two managers.
After approval by the board, Amendment No. 3 was filed with the Commission, which declared it effective on December 17, 1980. The day before, however, Thompson received a phone call from Peterson, who insisted that Thompson place an additional order for the Cayman Re units once the offering began. According to Thompson, Peterson stated that he had to agree to purchase an additional 150,000 units before Muir would go forward with the offering. Thompson, who stated that he could not afford such a purchase, called Dirks to tell him that he was being pressured to buy additional units. Dirks responded by asking Thompson what he could afford and when Thompson stated that he could handle another 75,000 units, an order for that amount was placed in his name.
The final prospectus was declared effective on December 17 and Muir immediately began selling the units. Prior to the effective date, Muir received an opinion letter from Trubin Sillcocks stating that the law firm had no reason to believe that the prospectus contained any false or misleading statements. This opinion, which Trubin Sillcocks reaffirmed on December 29, the day the offering closed, was never withdrawn.
The prospectus states that "the Company expects that the net proceeds of this offering will be invested principally in liquid, fixed income securities. . . ." Plaintiff's Ex. 224B at 17. The prospectus further provides that
the Company's initial investment objectives will be to maintain liquidity and preserve its capital while optimizing the total return thereon through a combination of current income and, to a lesser extent, capital appreciation. To these ends, the Company intends to invest its funds primarily in short-term (not more than six months), fixed income debt securities of major corporate, bank and governmental issuers both within and without the United States.
Id. at 23. With respect to investment managers, the prospectus discloses that
the Company may retain one or more investment managers, possibly including the Underwriter, from time to time after the Closing Date to provide it with investment management advice, for which the Company will pay fees or commissions. . . . The amount and type of any compensation to be paid to the Underwriter will be subject to negotiations if and when it is so retained by the Company.
It soon became clear, however, that a sizeable portion of the proceeds was destined not for conservative investment but for purchases of seven new issues underwritten by Muir. On December 28, one day prior to the closing of the offering, Scott and Miller met in Miller's New York hotel.
According to Miller's testimony,
Scott told him during that meeting he was being pressured by Dirks and Peterson to buy additional stock and that Dirks was warehousing 1,000,000 Cayman Re shares that could not be sold. Scott also told Miller that he had made compromises with Dirks, which included buying other Muir stocks with Cayman Re's proceeds. Miller, however, never discussed these "compromises" directly with Dirks.
The following day Scott began to elaborate further on the nature of these "compromises." Scott, Miller, Thompson and Roger Corbin ("Corbin"), another of Cayman Re's directors, met at a pre-closing breakfast. Thompson testified that during the meeting Scott disclosed that he was considering a purchase on behalf of Cayman Re of up to $2.5 million worth of Muir-underwritten securities. According to Thompson, Scott stated that he had discussed these proposed purchases with Dirks, although Scott did not say when or where the discussions took place.
Thompson testified that he believed that Scott brought the matter up to seek the others' opinions as to the "prudence" of such a move. The group did discuss specific stocks, including Brady Energy and Basic Earth Sciences, but there was no testimony concerning the principals' reaction to the proposed investments.
Later that morning Cayman Re received approximately $4.8 million in net proceeds at the closing, which was attended by Scott, Miller, Thompson, Corbin, Freedman, Wright, Rothman and Peterson. Conspicuous in his absence was Dirks, who apparently was out of town during late December.
After the closing was completed and the Muir contingent had departed, Thompson asked the Cayman Re attorneys to remain so that Scott could tell them about the stock purchases. At this point, the testimony of those present at the meeting varies somewhat. Freedman, one of Cayman Re's attorneys, testified that Scott stated that he had made a commitment to Dirks to acquire certain equity securities. Wright similarly testified that some kind of commitment had been made to Muir, at Muir's request, to purchase certain securities. Thompson and Miller, on the other hand, testified that the post-closing discussion centered on the possibility that Scott would make the investments in compliance with Muir's request. In particular, Miller testified that there was no mention of an agreement or commitment to make the purchases, unlike his discussion with Scott on the preceding day.
Upon hearing of Scott's plans for the proceeds, Freedman and Wright advised the principals, including Scott, against the purchases on the ground that they might be inconsistent with the language of the prospectus. Freedman reiterated this advice in a letter to Scott dated December 29 and suggested that if the purchases were made against ...