The opinion of the court was delivered by: COTE
DENISE COTE, District Judge:
This case concerns a scheme through which the defendants reaped millions of dollars in profits at the expense of the American investor by creating active trading in the United States securities market without making the disclosures that were required for the benefit of the investing public by the Securities Act of 1933.
Specifically, in this action, which was filed on March 13, 1998, the Securities and Exchange Commission ("SEC") alleges that the defendants offered and sold securities of Electro-Optical Systems Corporation ("EOSC") in violation of the registration and antifraud provisions of the United States securities laws, codified at 15 U.S.C. §§ 77e ("Section 5") and 77q(a) ("Section 17(a)"), and 15 U.S.C. § 78j(b) ("Section 10(b)"). According to the SEC, the defendants defrauded the public -- primarily small, on-line investors -- of at least $ 5 million over the course of the scheme, the profits of which allegedly have been distributed among the defendants and relief defendants. In the underlying action, the SEC seeks, with respect to each of the defendants, a permanent injunction against future violations of the securities laws, and civil penalties, as provided for under 15 U.S.C. § 78u(d)(3).
The SEC also seeks disgorgement of all proceeds related to the scheme, plus pre-judgment interest, from all of the defendants and relief defendants.
Pending a resolution on the merits, the SEC seeks a preliminary injunction against the defendants and a continued freeze on their assets sufficient to satisfy whatever proceeds plus pre-judgment interest and civil penalties, if any, for which the defendants ultimately are found liable. The SEC also seeks a continued freeze on the assets and stock of the relief defendants that are traceable to the allegedly unlawful activities at the heart of this action.
On March 13, 1998, this Court issued a temporary restraining order (the "March 13 Order" or "TRO") which, inter alia, suspended trading by the defendants in EOSC stock; froze the assets of the defendants and the accounts of the relief defendants that contained EOSC stock or the proceeds from sales of the stock; ordered an accounting of the defendants' assets; and required the repatriation into the United States of all proceeds from the sales of EOSC stock by the defendants, to be deposited into the registry of the United States District Court for the Southern District of New York.
The March 13 Order also set forth an expedited discovery and briefing schedule for a preliminary injunction hearing, which was modified in subsequent conferences with the parties. By its own terms, the TRO provided that it would remain in effect "pending determination of the Commission's Motion for a Preliminary Injunction." The hearing, which was originally scheduled to begin on March 25, was put over to March 31 at the request of the defendants and the relief defendants who had appeared in the action, each of whom felt that they needed more time to prepare.
In the course of the hearing on the SEC's motion for preliminary relief, the SEC entered into stipulations with several of the defendants and relief defendants that modify the terms of the freeze order.
Three defendants also have reached agreements with the SEC disposing entirely of the SEC's motion for preliminary relief insofar as it concerns them. Namely, Cosimo Tacopino ("Tacopino"), the trader at Donald & Co. who placed many of the trades in EOSC shares at issue here, has consented to the Court's entry of a preliminary injunction against future violations of Sections 5, 17(a) and 10(b) against him, and has deposited a total of $ 352,279.14 in the Court's registry pending a resolution of this case. EOSC, the company whose stock is at issue in this case, has entered into an agreement with the SEC whereby the SEC has withdrawn its motion for preliminary relief against the company. Defendant Donald & Co. has entered into an agreement with the SEC providing for a sum of $ 233,811.07 to be deposited in the Court's registry pending a resolution of this matter and withdrawing the SEC's motion for a preliminary injunction as to this defendant.
Although all of the defendants have been served, many of them -- including all of the foreign defendants -- have failed to appear in this action. Defendant Thomas A. Hantges ("Hantges"); the Spanish entities, Customer Safety, S.L., Cambiarios, S.L., and Construcciones, S.L. (collectively "the Spanish entities"); and the Caribbean entities, Optimum Fund ("Optimum") and Agira Trading ("Agira"), were served but have not appeared. All of the relief defendants have been served, with the exception of the following individuals and entities: Kenneth Kehoe, Erin Martin, SHBL Associates Europe Ltd., Bernd Stieghorst ("Stieghorst"), Metropolitan Trade Finance Ltd., Jean-Pierre Neuhaus, and Carmillo Monastra. The Court does not consider the claims brought by the SEC against those relief defendants who have not been served.
The hearing on the SEC's motion for a preliminary injunction began on March 31, 1998 and continued through April 8, 1998. The Court took direct testimony in the form of affidavits from each of the following witnesses, who were also cross-examined at the hearing: Cameron Funkhauser, who works in the Department of Market regulation of the National Association of Securities Dealers ("NASD"); Galen O'Kane, an investor who bought EOSC shares through the internet; John Chachas, George Chachas' brother and a banker at First Boston; Richard Day ("Day"), the transfer agent for Curbstone Acquisition Corp. ("Curbstone") and EOSC; Ara Proudian ("Proudian"), the trader who bought shares pursuant to an order by Cavanagh on December 19; Jeffrey Bruss ("Bruss"), who prepared a stock report about EOSC in January 1998 for his internet publication, The Future SuperStock; and Richard Tucker, an expert on securities law offered by defendant Cavanagh. The Court also received the affidavits and cross-examination of defendants Thomas Cavanagh ("Cavanagh"), George Chachas ("Chachas"), Thomas Brooksbank ("Brooksbank"), and William Levy ("Levy"), and relief defendant Anthony Luttenberger. Chris Chaleki, an engineer at EOSC, also performed a demonstration of EOSC's product in Court and was subject to cross-examination, although he did not provide an affidavit in advance.
The Court has also received voluminous documentary evidence and deposition testimony in support of, and in opposition to, the SEC's motion. The Court has reviewed all of this evidence carefully, in addition to the legal briefing provided by counsel.
For the reasons set forth below, the Court finds that the SEC has made a proper showing that defendants Chachas, Brooksbank, Hantges, Levy, Cavanagh, U.S. Milestone ("Milestone"), Customer Safety, Cambiarios, Construcciones, Optimum, and Agira violated Section 5 of the Securities Act of 1933 ("the Securities Act"), and that these defendants may be found liable at trial for disgorgement of proceeds plus penalties for their violations. The Court finds that a preliminary injunction against future violations of Section 5 of the Securities Act is properly entered, however, only with respect to defendants Cavanagh, Milestone, Levy, Chachas, Customer Safety, Construcciones, and Cambiarios, as to each of whom the SEC has established a likelihood of repetition.
The SEC also has made a proper showing that defendants Cavanagh, Milestone, Customer Safety, Cambiarios, Construcciones, and Chachas violated Section 17(a) of the Securities Act and Section 10(b) of the Securities Exchange Act of 1934 ("the Exchange Act"), and that these defendants may be held liable at trial for disgorgement of proceeds and penalties associated with their violations. Because the SEC has demonstrated a likelihood of repetition as to Cavanagh, Milestone, Customer Safety, Construcciones, and Cambiarios, a preliminary injunction against future violations of Sections 17(a) and 10(b) is properly entered against these defendants.
To preserve the status quo pending a final determination of this matter, the Court extends the freeze order contained in the TRO, except with respect to those defendants and relief defendants, set forth above, with whom the SEC has reached agreements in lieu of, or modifying, the terms of the freeze order embodied in the TRO. As to those defendants and relief defendants, the terms of their agreements with the SEC shall remain in effect pending the final resolution of this case.
The scheme alleged by the SEC involves a broad cast of characters and a complicated series of events. In brief, the SEC alleges that a malevolent investment banker, Cavanagh, and his lawyer, Levy, approached a development stage company, WTS Transnational, Inc. ("WTS"), that had a dire need for capital. These two then set in motion a plan that had little to do with raising funds for WTS, but instead was designed to line their pockets. The scheme called for Cavanagh and his nominees to obtain for pennies a large block of shares of the company just as it merged with a public shell company.
Cavanagh and his nominees would then sell the shares into the public market at prices that they would help to inflate. The success of the scheme depended on the participation of the shareholders of the shell company, who would transfer to Cavanagh and his nominees their "affiliate" shares of the shell company.
The recitation of facts that follows sets forth more specific findings about the individuals and entities involved in this scheme and the sequence of events.
A. The "Cast of Characters"
WTS is a Massachusetts corporation with its principal place of business in Massachusetts. WTS was founded in 1990 by Charles Weaver ("Weaver"), a former employee of Texas Instruments and Honeywell, who is now 56 years old. According to the December 23, 1997 Form 8-K filed with the SEC ("December 23 8-K"), WTS
developed and [was] in the process of producing state-of-the-art fingerprint biometric systems for the information security and access control market segments . . . [that would] eliminate obnoxious and manifold passwords or personal identification numbers and replace them with biometric verification of the individual.
Weaver has invoked his Fifth Amendment privilege against self-incrimination and refused to testify in this lawsuit.
As of September 30, 1997, WTS had $ 10,000 in assets and $ 655,000 in current liabilities, including $ 359,000 in accounts payable and $ 172,000 in deferred compensation. The payroll and related expenses for the nine months ended September 30, 1997 was $ 31,000.
Milestone, a New York corporation, is an investment banking company specializing in Regulation S offerings.
Its principals are Cavanagh and Frank Nicolois ("Nicolois"), each of whom owns 50% of the company. In 1993, Cavanagh was fined $ 20,000 by the NASD and barred from association with any NASD member in any capacity for failure to provide testimony or to respond to NASD requests for information concerning transactions and activities in which he was involved while employed at a NASD member firm.
Since 1991, Levy has been Milestone's attorney and has structured and negotiated the terms of the Regulation S transactions in which Milestone has acted as a distributor. Levy is a securities attorney and the sole lawyer at the law firm of Levy & Levy, in Voorhees, New Jersey. He has on occasion brought corporate merger partners together, marrying a blank check company
with one that has an operating business.
In 1975, the Second Circuit affirmed the entry of a preliminary injunction against Levy for his participation in a securities fraud that bears remarkable similarities to the instant endeavor. See SEC v. Management Dynamics, Inc., 515 F.2d 801 (2d Cir. 1975). In that prior action, Levy brought together a shell and an operating company, participated in the review and issuance of two misleading communications to the public regarding the merged entity, and facilitated the offering of unregistered shares for sale that did not bear any restrictive legend when they should have. Levy's codefendants created a false appearance of greater interest in the stock of the company than was justified, resulting in an increase of the company's share trading price from 38 cents to as high as $ 6 within a six month period. See id. at 806. Levy was thereafter permanently enjoined from violating the antifraud and registration provisions of the same securities laws upon which the SEC is suing here. Id. at 809-10.
During the critical time at issue here, Cavanagh directed significant trading through Tacopino, a registered representative at Donald & Co., which is a registered broker-dealer in New Jersey. Tacopino has invoked his rights under the Fifth Amendment and refused to testify in this action.
Curbstone was a blank check or shell corporation that existed for the purpose of merging with a private company with business operations. Its officers and directors during the critical times at issue here were Chachas and Brooksbank.
Chachas is a corporate and securities lawyer with the two partner law firm of Wenthur & Chachas in La Jolla, California. The firm's clients are primarily small, privately-held corporations, for whom Chachas prepares private placement memoranda and files periodic reports. Chachas and Brooksbank were law school classmates and have been friends for the past 10 years.
Brooksbank is an attorney with Brooksbank & Associates in Las Vegas, Nevada. In 1990, Hantges, who is in the securities business and had at that time just attained control of Curbstone, brought Brooksbank into the company with him. Shortly thereafter, Brooksbank asked Chachas to prepare quarterly and annual reports for Curbstone, whose SEC filings were no longer current. Over the succeeding years, Chachas prepared corporate resolutions, drafted amended articles and by-laws, worked with auditors and prepared annual reports for Curbstone.
In early 1996, Brooksbank, Chachas, and Hantges decided to restructure Curbstone and to get it listed on an exchange. Chachas asked Jim Franklin ("Franklin"), a business acquaintance of Chachas from San Diego, for assistance in getting Curbstone listed.
On November 6, 1996, Curbstone filed an S-8 registration statement with the SEC that registered 3,500,000 shares. Day of ARTCO, Curbstone's transfer agent, issued certificates for the registered shares without any restrictive legend. Thereafter the shares were quoted on the NASD electronic quotation medium referred to as the OTC Bulletin Board. Four individuals, Chachas, Brooksbank, Hantges, and Franklin ("the Curbstone Management" or "Management Shareholders"), each held just under 25%, and together held 97.33% or 3,427,506 shares ("the Management Shares") of the Curbstone common stock as of late 1997. Each of the four Curbstone principals had invested approximately $ 6,000 in setting up and managing the company. It was their hope that from any merger they would collectively receive $ 125,000 for this collective investment of $ 24,000 as well as some stock in the new entity for long-term investment purposes.
By late 1997, Chachas and Brooksbank were the sole officers and directors of Curbstone. Throughout the course of the transactions at issue here, the Management Shares were treated as one block and all negotiations about the block were managed by Chachas. Thus, although only Brooksbank and Chachas held control positions at Curbstone, in the sense that they were officers and directors, the Court refers to the block of shares held by the four shareholders as the "Management Shares" because for all practical purposes they were one block under the control of Chachas.
1. Milestone agrees to raise equity for WTS.
WTS had an idea and needed cash in order to rent space in which it could produce what it called a "pre-production unit" that could be shown to potential customers.
Maier Lehman ("Lehman") introduced Cavanagh to WTS representatives at a meeting in New York City on July 15, 1997, that was attended by Lehman and two other persons involved in the search for financing for WTS, Michelle Weiss ("Weiss") and Ari Friedman ("Friedman"). After the merger, Cavanagh gave Lehman, Weiss, and Friedman unlegended
Curbstone stock as a "finder's fee" to compensate them for their roles in introducing Milestone to WTS. Not long after the July meeting, Milestone agreed to act as investment banker for WTS.
The initial understanding between WTS and Milestone is set out in a letter of intent "effective" September 22, 1997. Milestone represented that it is in the business of assisting corporations in raising equity capital through private placement of a company's stock. The letter described, inter alia, an intent to enter into an agreement whereby Milestone would have the exclusive right to raise $ 1 million in equity capital for WTS in a private placement offering in exchange for an aggregate of 30% of the WTS common stock, and after raising such funds would have a one year option to raise an additional $ 3 million for another 10% of the stock. It was expected that half of the $ 3 million, or $ 1.5 million, would be provided to WTS within five months of its receiving the initial investment of $ 1 million. Through this financing arrangement WTS indicated a willingness to give up 40% of its stock ownership in exchange for $ 4 million.
At this same time Milestone was looking for a shell into which WTS could be merged. Cavanagh asked Levy to locate such a candidate and Levy began to deal directly with WTS. Although Levy was retained by WTS as its counsel on December 12, and represented WTS at the time it was acquired by Curbstone, the initial dealings between Levy and WTS were far from smooth. By November 5, 1997, WTS's Weaver was complaining to Milestone about the status of negotiations with Levy. Specifically, the private placement memorandum that Levy had developed for WTS reflected WTS giving up 40% of its stock for a $ 1 million investment. While WTS believed that a finder's fee of 10% of the money raised was reasonable to compensate an investment banker for its work, it opposed giving up 10% of the company's equity as a finder's fee, particularly since there was an additional $ 2.5 to $ 3 million to raise after the first $ 1 million had been found. As described in the letter, Levy was pushing for a merger with a shell to coincide with the $ 1 million investment, although WTS's Weaver didn't understand that those events had to coincide.
The complaints about Levy continued. In a memorandum labelled "status of letter of intent," which responded to a proposed letter of intent sent by Levy to WTS on November 7, WTS complained vociferously to Milestone about Levy's proposal. WTS believed that its original understanding with Milestone was fair to all concerned. It contemplated that WTS would give up 40% of its equity in return for an investment of $ 4 million dollars, $ 3 million of which would be invested four to six months after the initial investment. WTS planned to use the first $ 1 million invested in the company to produce "preproduction units that demonstrate performance and actual production costs." With the "hardware" that would result from such work, WTS expected that Milestone would be able to find an investor to place the next $ 3 million into the company. Although the document is somewhat confusing on this point, it appears that WTS contemplated that Milestone would be compensated for its work by retaining that portion of the 40% in equity that Milestone did not require in order to entice the $ 4 million investment, or if Milestone did not use any of its own money, it would be entitled to a finder's fee of 10% and legal fees of 5%. Consequently, WTS expected to receive $ 850,000 of the first $ 1 million investment.
In contrast, Levy's proposal treated the investors, whom WTS considered a "key" ingredient to its success as a business, "almost [as] an after thought [sic]."
Levy wanted WTS to exchange 40% of its equity for $ 1 million and to give Milestone thereafter the right to raise an additional $ 3 million for an additional 600,000 shares, which Levy suggested should be priced at $ 5 per share. Under Levy's plan, 10% of WTS's equity would be used as a finder's fee for Milestone and the investment of $ 3 million would result in a market capitalization of $ 53 million. The author pointed out that a finder's fee of 10% was customary and that a market capitalization of $ 53 million was "astronomical at this stage." (Emphasis added.) WTS predicted that the next investor would "rachet" down the $ 5 per share price. In contrast, WTS estimated that the appropriate market capitalization at the point at which $ 1 million was invested was approximately $ 3.4 million, and after an investment of all $ 4 million, approximately $ 10 million.
Finally, a Letter of Intent effective November 13, 1997, was executed by Weaver and Nicolois on behalf of WTS and Milestone, respectively. Milestone agreed to use its best efforts to have Milestone or its clients advance to WTS $ 1 million as a note convertible into 30% of WTS's issued and outstanding common stock. It was also the intention of the parties that WTS would become a wholly-owned subsidiary of a publicly traded company before December 15, 1997, with WTS shareholders receiving 95% of the issued and outstanding capital of the new company and the shell's shareholders retaining 5%. Milestone would then convert its note and receive shares in the new entity "in proportion to its then ownership of WTS." The letter also required WTS to issue 6,054 shares (amounting to 10% of the entity's outstanding stock) to be registered in the name of Milestone, subject to repurchase by WTS or the new entity if Milestone failed to make an investment of $ 3 million in the stock of WTS or the new entity. It was contemplated that investors would purchase up to 5,000 shares of WTS for $ 3 million, with a $ 1.5 million investment being made by May 31, 1998, and the remaining $ 1.5 million invested by September 30, 1998.
On November 20, 1997, one week after the Letter of Intent was executed, Weiss and Friedman executed a consulting agreement in which Milestone "acknowledged" the consulting services they had rendered in connection with WTS and agreed to issue 150,000 shares of common stock to them in the event that WTS became a publicly traded company as a result of Milestone's efforts in full satisfaction for their consulting services.
2. Milestone secures a bridge loan.
As is apparent from the negotiations among Milestone, Levy, and WTS, WTS was in urgent need of $ 1 million. In November 1997, Cavanagh arranged with Stieghorst, a director of Optimum Fund, a Grand Cayman entity, for the Fund to make a $ 500,000 bridge loan to WTS, convertible into equity.
In December 1997, and contemporaneous with the acquisition described below, Milestone oversaw a $ 1 million offering of EOSC shares. Specifically, the Optimum Fund bridge loan was converted into 1,054,241 EOSC shares at a price of $ .47 per share, and Agira Trading, of the British Virgin Islands, also invested $ 500,000 for an identical number of shares at the same price per share. There is no evidence that these Regulation S shares have been sold since they were issued. Milestone was paid $ 100,000 by EOSC and $ 30,000 by the investors for these Regulation S offerings.
The December 23 8-K describes the bridge loan as follows:
Prior to Closing, WTS shall have caused the bridge loan in the amount of $ 500,000 to be converted to common stock of WTS or an additional 500,000 to be invested as equity, and further shall cause immediately following Closing to have an additional $ 500,000 to be invested and infused into Curbstone.
The "Material Liabilities of WTS" listed in the 8-K include "a bridge loan in the amount of $ 500,000 from Optimum Fund." There was no other description of the Regulation S transactions or the bridge loan in the December 23 8-K.
3. Levy finds Curbstone and structures the acquisition.
In November 1997, Levy selected Curbstone as the WTS merger partner. Levy had met Curbstone's Chachas earlier in 1997, when they were on opposite sides of another transaction in which an operating company represented by Levy merged into a shell owned by Chachas and Brooksbank. By late November, the Curbstone Management, that is its four principal shareholders, had agreed to pursue the transaction. Levy negotiated the terms of the transaction with Chachas, who kept the other three principal shareholders advised of the progress of the talks.
Chachas prepared a draft exchange agreement by marking up the agreement that Levy had used in the prior transaction in which Levy and Chachas had both been involved. According to the terms of the agreement, upon closing the Curbstone shareholders would hold no more than 5% of the fully diluted stock of the new company, i.e., 925,217 shares. The balance of the 3,521,876 shares of Curbstone would be cancelled. All of the WTS shares would be exchanged for 17,547,475 newly issued shares of Curbstone. This would allow WTS management to control the company, and give the Curbstone shareholders an investment opportunity in a company with an operating business. It was also agreed that the officers and directors of Curbstone would all resign and be replaced by WTS personnel. A November 25 draft Acquisition Agreement reflects these terms. This structure resembles the understanding between Weaver and Milestone reflected in the November 13 Letter of Intent, that is, that WTS would give up no more that 5% of its stock for a merger into a shell.
From the beginning of the negotiations, Chachas envisioned two separate payments to the Management Shareholders for their agreement to participate in the merger. As reflected in a document that he drafted in late November, he expected that the four Management Shareholders would receive $ 125,000 in cash and would be paid $ 1.2 million by "market makers" for 300,000 of their shares in the new company, priced in three equal units at between $ 3 per share to $ 5 per share.
By December 1, Chachas was requesting $ 125,000 in cash at the closing and $ 2.352 million within six weeks thereafter in return for the sale by the Curbstone Management of a majority of their shares in the new company.
On December 2, 1997, Chachas sent Levy what he characterized as "the only two acceptable alternatives" for closing and "our best and final effort." Under the first alternative, the Curbstone Management would be paid (1) $ 125,000 in cash at a closing on December 5, and (2) an additional $ 2.352 million in four installments between December 16, 1997, and March 13, 1998. The latter payment purchased 542,000 shares belonging to Curbstone Management. To insure performance by the purchasers, the Curbstone transfer agent would not release newly issued common stock to WTS or cancel the 2,596,659 shares of Curbstone common stock due to be cancelled until the first installment payment of $ 450,000 had been received, which was due no later than December 16. The second alternative contemplated an immediate payment of a "$ 10,000 no [sic] refundable deposit," as well as a December 16 closing, with the $ 125,000 in cash and first installment payment of $ 450,000 due at that time. The remainder of the 542,000 shares would be available for purchase in three installments spanning the time between December 16 and March 13, 1998. Under both proposals there would be no change in the Curbstone transfer agent until March 15, 1998, or until all the 542,000 shares had been acquired, whichever occurred first.
Following discussions with Levy on December 3, 1997, Chachas sent Levy a written outline of "the terms for the closing of the Curbstone/WTS acquisition." The acquisition agreement would be signed on December 4 and Curbstone Management would be paid $ 25,000 as a non-refundable deposit. The closing would occur no later than January 16, or
when the balance of the $ 125,000 is payable and the first round of 150,000 shares of Common Stock of Curbstone have [sic] been purchased from the Curbstone shareholders at a net of $ 3.00 per share and full payment has been received.
The remainder of the 542,000 shares would be made available for purchase in blocks of shares at monthly intervals running to April 17, on which date the final 92,000 shares would be available for purchase at $ 6 per share.
Under this agreement, the transfer agent could be changed after 30 days.
The latter sales of 392,000 shares are in the nature of a call option agreement, with the Curbstone Management having no direct control over the exercise of the options.
Over December 2 and 3, Chachas and Levy finally agreed on the following payments to Curbstone Management in exchange for their agreement to acquire WTS:
1) a $ 25,000 non-refundable payment, which Levy sent to Chachas on December 8;
2) a $ 100,000 payment for the sale of 2,563,000 Curbstone Management Shares described below, which payment Levy sent to Chachas on December 12;
3) the purchase of 150,000 Curbstone Management Shares for $ 450,000, or $ 3 per share, for which payment was made on December 12;
4) An oral agreement that Milestone had an option to purchase in the following three rounds the following Curbstone Management Shares: 150,000 shares at $ 4 per share by February 13, 1998; 150,000 shares at $ 5 per share by March 13, 1998; and 92,000 shares at $ 6 per share by April 17, 1998.
As this list indicates, Chachas, Cavanagh, and Levy decided that the vast majority of the Curbstone Management Shares would not be cancelled. Instead, they arranged a sale for $ 100,000 of 2,563,000 of the shares that had been slated for cancellation. Although Chachas at first understood that the shares were to be transferred to Milestone, he was later informed that the certificates for the shares were to be issued in the names of three Spanish clients of Milestone ("the Spanish Shares"). Although Chachas presents this arrangement simply as a means by which Curbstone Management could get $ 100,000 for shares that otherwise would have been cancelled, this critical decision substantially changed the entire transaction, and was essential to the fraud. It afforded Milestone, and those associated with it, the means to profit enormously from the fraud while giving absolutely nothing of value to WTS. Indeed, the arrangement radically transformed the terms of the merger, in that it would no longer be true that all but 5% of the shares of the new entity would be traded for WTS stock.
As a result of the decision not to cancel over 2.5 million of the Management Shares, not 5%, but approximately 16% of the EOSC stock was held by Curbstone shareholders or those to whom they sold. In any event, both Milestone and Curbstone Management now had a strong motive to create a market price for the new entity that would allow them to sell the shares covered by the call option agreement and the Spanish Shares for a significant profit. As Brooksbank frankly recognized at the hearing with respect to the option agreements, "if we were going to make any money [out of the merger] this was where it was going to happen." On December 5, Levy sent Chachas by telefax a revision of the exchange agreement that reflected the decision that there would be no cancellation of the Curbstone Management Shares.
4. Chachas and others execute the "December 5, 1997" stock exchange agreement ("Exchange Agreement") between WTS and Curbstone.
The Exchange Agreement, which bears the date December 5 on its cover, but was executed by Chachas and Brooksbank on December 8, contains the following terms.
Curbstone would deliver to the WTS shareholders 15,488,120
shares of authorized, but previously unissued unregistered shares of Curbstone in exchange for all of the issued and outstanding shares of WTS owned by the WTS shareholders. The Exchange Agreement included the representation that those shares given in exchange for the WTS stock had not been registered and would be issued with a restrictive legend. The Agreement further represented that the authorized capital stock of Curbstone consisted of 3,521,876 shares of stock issued and outstanding prior to the Closing. The Closing was to be held on or prior to January 16, 1998.
On December 5, Chachas and Brooksbank executed a corporate resolution authorizing Day to issue 17,596,601 restricted shares, which included the 15,488,120 shares described in the final Exchange Agreement as well as 2,108,481 shares divided between Agira and Optimum.
Of the 15,488,120 restricted shares to be issued, 500,000 shares were to be issued to Levy, and 2,108,481 were to be issued to Milestone. The certificates for all of these shares were to be delivered to Levy. In addition, the transfer agent was instructed to cancel 33,659 shares of Curbstone held by Curbstone shareholders. As a consequence of the December 5 resolution, there were 21,084,818 issued and outstanding shares of Curbstone. As described below, however, these instructions were not sent to Day until after the Curbstone Management had received $ 575,000 in cash.
5. The Spanish Shares move from Curbstone into the market.
Cavanagh contends that the 2,563,000 Curbstone Management Shares purchased for $ 100,000 were sold to three clients of Vicente Tur Ortola, an attorney whom Cavanagh had met in Spain in June 1996.
According to Cavanagh, Tur Ortola represents groups of investors who want to invest in U.S. publicly traded corporations. While Cavanagh contends that he told Levy in late November that some Milestone clients wanted to purchase Curbstone stock, both Levy and Cavanagh deny negotiating the terms of the transaction between Chachas and Tur Ortola. On the other hand, it is undisputed that Chachas never spoke to Tur Ortola and dealt for all practical purposes solely with Levy. In any event, I find that Cavanagh, through Levy, negotiated these sales with Chachas.
Chachas structured the sale of the Spanish Shares so that it appeared to occur on December 18, immediately after the closing of the acquisition. He fully recognized that, if sold before the closing, these shares were indisputably "control shares." Relying on the fact that the shares had been registered initially in 1996 under an S-8, the Purchase Agreements for the sale of the Spanish Shares drafted by Chachas (there were three identical agreements except for the name of the purchaser) represented that the shares "have been registered securities and will be free of restrictive legend upon delivery." The Agreements further provided that Chachas would hold the shares until "all conditions for the Closing of the Agreement for Exchange of Stock between Curbstone and WTS . . . have been satisfied . . . ." The Purchase Agreements also included a provision that the Curbstone Management Shareholders had the right to repurchase the shares at the same price for which they had sold them, in the event that the Closing of the acquisition of WTS by Curbstone was completed on or before January 16, 1998. The Purchase Agreements also contained "representation and warranties" by the purchasers, discussed at greater length below, which provided that the purchasers were accredited investors and had no present agreements to resell the shares.
Chachas provided the Purchase Agreement to Levy with blanks for the number of shares and total purchase price, the name of the purchaser and the date of purchase.
It appears that Levy faxed the Purchase Agreements to Milestone on December 5; that Milestone's Nicolois faxed the Agreements to "Vincent Tur" on December 10; and that three such agreements were executed on December 11 on behalf of purchasers, and returned. Chachas contends that he signed the Agreements on December 19.
Although there are three separate agreements, each for the purchase of one-third of the Spanish Shares, it is apparent that the purchase of the entire block was controlled by a single entity.
Moreover, as is evident from the date on the account opening statement at Donald & Co., Cavanagh laid the groundwork for reselling these shares into the American securities market on December 11, that is, even before the shares had been paid for.
On December 12, Milestone sent the cash -- $ 100,000 -- for purchasing the 2.563 million Spanish Shares to Chachas' escrow account from its escrow account at Levy's law firm. Thus, the Spanish Shares were purchased at a price of less than four cents per share, specifically, $ .39.
In a twice-underlined instruction to Day on December 17, Chachas ordered Day to issue 2,353,217 shares to the three Spanish entities "without legend." On December 18, 1997, the stock certificates were issued and sent to Levy. Chachas understood that it was important to both Levy and Cavanagh that any shares sent to Milestone or its clients be unlegended shares. In documents prepared by Chachas as early as November, Chachas indicated to Levy that 3,510,027 of the 3,521,876 issued Curbstone shares were "free trading" shares. Chachas was acutely aware that there were severe restrictions on the sale of Curbstone Management Shares if sold by affiliates or persons in control of Curbstone. According to Chachas, so long as the Curbstone Management Shares were sold after the acquisition, and thus after the four Curbstone Management Shareholders were no longer affiliates or in control of the corporation's operations, the stock could be sold without any restrictions on its being traded in United States securities markets. Among the steps Chachas took to make it appear that the sale of Spanish Shares did occur after the acquisition, were (1) inserting language in the Purchase Agreement making the delivery of the shares contingent on the acquisition; (2) holding the $ 100,000 paid for the shares in an escrow account until after the acquisition; (3) executing virtually all of the documents associated with the acquisition prior to sending instructions to Day to transfer the Spanish Shares; and (4) issuing instructions to Day directing him to issue the unregistered Curbstone shares to WTS (which were exchanged for the WTS shares and thus effected the merger) prior to transferring the 2,353,217 Curbstone Management Shares to the three Spanish entities.
Levy was fully familiar with Chachas' rationalization that taking the above-described steps would justify the sale of the Curbstone Management Shares without any legend restricting their resale. He testified at the hearing that he conveyed to Cavanagh Chachas' own legal conclusion that the Spanish Shares were "free trading" shares, as well as his concurrence in that judgment. Cavanagh in turn contends that he was entitled to and did rely upon Levy's legal opinion that the Spanish Shares were free trading shares. In any event, all three men knew that the purchase of unlegended Spanish Shares was an essential part of the acquisition of WTS by Curbstone, and that at the time those shares were committed to be sold, and were paid for, they were owned by men who controlled the decision as to whether Curbstone would acquire WTS.
Between December 24 and 26, the Spanish Shares as well as other EOSC shares were deposited into trading accounts at Donald & Co. The 2,713,000 shares so deposited constituted at least 77% of the "market float," that is, 77% of the 3,521,876 shares that were available for trading in the public market. Beginning in late December 1997, Tacopino began systematically liquidating these shares.
When these shares are combined with the remaining 392,000 shares tied up by the Option Agreement and the 200,000 shares held by Curbstone Management under a lock-up agreement, Cavanagh controlled approximately 95% of the market float prior to liquidation.
6. The acquisition is completed.
On December 12, Levy wire transferred to Chachas $ 550,000, representing the $ 100,000 payment for the purchase of the 2,563,000 Spanish Shares and $ 450,000 for Milestone's exercise of the first round of options to purchase 150,000 shares. In connection with that first amount of money, Levy wrote that the $ 100,00 was wired "to complete the sale of 2,563,000 shares as of December 1, 1997," (emphasis added) the date Chachas had inserted into the agreement to purchase the Spanish shares. Chachas distributed the $ 550,000 among the four Management Shareholders on December 19. Chachas tendered his resignation as an officer and director of Curbstone on December 12 and wrote to Levy:
It is my understanding that the agreement between Curbstone and WTS has been fully executed and thus this transaction is closed . . . . As I indicated previously I will be glad to edgarize
and file the 8-K if you need my assistance.
On December 16, 1997, Milestone signed the agreement dated November 20, 1997, that Weiss and Friedman -- who had introduced Milestone to WTS -- had sent to Milestone on November 21, 1997. Pursuant to this document, Milestone agreed to convey 150,000 shares of EOSC to the two individuals as full payment for their consulting services.
During this period of time, Chachas obtained a CUSIP number for the new company and was notified that the company would bear the OTC trading symbol of EOSC. On December 16, he confirmed with Levy the appropriate division among the three Spanish entities of the "2,563,000 Free trading [shares] purchased for $ 100,000." On December 17, 1997, Chachas sent by overnight mail instructions to Day to issue new stock and to cancel and transfer existing stock.
On December 18, Chachas and Brooksbank, acting as the "entire Board of Directors," executed a corporate resolution appointing four WTS employees as directors, accepting their own resignations as officers, and appointing in their stead five WTS employees as officers. On that same day, Day acted on the instructions that Chachas had sent him, completing both the acquisition and the sale of the Spanish Shares.
7. December 19, 1997 trading moves the EOSC stock price to over $ 5 per share.
On December 19, at about 10:22 a.m., before there had been any public announcement of the acquisition, Cavanagh called Proudian, a trader at Alexander, Wescott & Co., and told him to buy 500 shares of EOSC at $ 7 per share for his client, Optimum Fund.
Proudian called Donald & Co, placed the order, and made the trade. A trade at $ 7 per share reflected a market capitalization for EOSC of $ 140,000,000. As recently as November, the President of WTS ...