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SECURITIES AND EXCHANGE COMMISSION v. COATES

April 6, 2001

SECURITIES AND EXCHANGE COMMISSION, PLAINTIFF,
V.
GEORGE J. COATES, INDIVIDUALLY AND D/B/A COATES PRECISION ENGINEERING, LTD., COATES ENTERPRISES, LTD., COATES INTERNATIONAL LICENSING LTD., AND GEORGE J. COATES 1991 FAMILY PARTNERSHIP, L.P., AND COATES INTERNATIONAL, LTD., DEFENDANTS.



The opinion of the court was delivered by: Motley, District Judge.

  OPINION AND ORDER

In this securities fraud action brought under the Securities Act of 1933 ("the Securities Act") and the Securities Exchange Act of 1934 ("the Exchange Act"), the Securities and Exchange Commission ("the Commission" or "the SEC") brings this motion for summary judgment seeking (i) a finding that George J. Coates ("Coates") violated Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), and Rule 10b-5 thereunder, 17 U.S.C. § 240.10b-5, and (ii) an order requiring Coates to pay civil penalties under the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, 15 U.S.C. § 78u(d) ("the Remedies Act"). Coates claims that no civil penalties should be assessed against him. For the following reasons, this court GRANTS the Commission's motion in part and denies it in part and DENIES Coates' motion.

I. BACKGROUND

A. Procedural History

On July 22, 1994, the Commission filed a complaint against defendants, alleging, among other things, that they violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by making false and misleading statements to investors in connection with the sale of Coates International, Ltd. ("CIL") securities. See Pl.'s R. 56.1 Stm't ¶ 1.*fn1 The Commission sought a permanent injunction, disgorgement, and civil penalties against defendants pursuant to the Remedies Act. See id. ¶ 3. On July 22, 1994, the court, upon application made by the Commission on the same date, granted the Commission interim relief, including an asset freeze as to both Coates and CIL and the appointment of a temporary receiver for CIL. See id. ¶¶ 3, 112. The temporary receiver was directed to take possession of the assets of CIL, to operate the business, and otherwise to maintain the status quo. See July 10, 1996 Opinion and Order at 2-3. In violation of this order, Coates' wife subsequently withdrew $25,000.00 from their joint bank account. See id. ¶ 113.

On February 21, 1995, the court entered two final consent judgments as to Coates and CIL ("Coates Judgment" and "CIL Judgment") that settled this matter, except for the issue of civil penalties against Coates. See id. ¶¶ 5, 6. The consent judgments permanently enjoined Coates and CIL from violating Sections 5(a), 5(c) and 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5. See Pl.'s Mem. Supp. Summ. J. at 5. The consent judgments also required Coates and CIL to disgorge certain funds and other assets. See id. The extent of the defendants' obligations to disgorge funds depended, in part, on the results of a registered rescission offer to certain purchasers of CIL stock. See id. The CIL Judgment discharged the temporary receiver and, instead, named him as Special Master of CIL, with specific responsibilities including assisting in CIL's compliance with the consent judgments. See July 10, 1996 Opinion and Order at 3.

The Coates Judgment froze all of Coates' assets other than certain salary. See Pl.'s R. 56.1 Stmt. ¶ 114. The day after issuing the Coates Judgment, Coates transferred his patents relating to the Coates System to his son, Gregory Coates, in exchange for one dollar, in violation of the asset freeze. See id. ¶ 115. Paragraph XI of the Coates Judgment stated that the court reserved judgment as to the issue of civil penalties against Coates and set forth certain factors for the court to consider in determining whether civil penalties are warranted. See id. ¶ 6.

The consent judgments permanently enjoined Coates and CIL from violating federal securities laws and called for the disgorgement of certain funds and assets. See id. ¶ XX. The CIL Judgment required that CIL make a registered offer ("rescission offer") to all persons who purchased CIL stock from CIL or Coates from April 24, 1990 to February 21, 1995, the date of the rescission offer. Coates and CIL were required to pay the amounts due to the rescinding shareholders. See Pl's R. 56.1 Stm't ¶ 117. Prior to the distribution of funds to rescinding shareholders, the Special Master was to propose, subject to approval and order of the court, a plan of distribution. See id. ¶ 118.

Without seeking the court's prior approval, Coates and CIL solicited and obtained money from some of its remaining shareholders, placed that money in a bank account outside of the Special Master's control, and used that money to pay some of the rescinding shareholders. See id. ¶ 119. The rescission offer has been fully implemented, with only thirty-two shareholders electing to receive cash in exchange for their CIL stock. See id. ¶ 116. The total amount due to the rescinding shareholders was $1.27 million plus interest at the annual rate of five percent. See id. ¶ 116. Of the total amount due, $900,000 had been invested by two shareholders. See Def.'s R. 56.1 Stmt. ¶ 119B.

The CIL Judgment required that CIL file a registration statement with respect to the rescission offer by July 21, 1995. CIL's registration statement was twice amended, and on November 13, 1995, the Second Amended Registration Statement was declared effective. See Pl.'s R. 56.1 Stmt. ¶¶ 9-10. Coates signed the Second Amended Registration Statement on CIL's behalf in his capacity as, among other things, president, principal executive officer, and a director of CIL. See Pl.'s Mem. Supp. Summ. J. at 6.

The proceedings in this case were initially before Judge Wood who oversaw the defendants' conduct after the entry of the consent judgment as well as the funding of the rescission offer. Judge Wood entered multiple rulings some of which appear in the following court orders: (1) Opinion and Order dated July 10, 1996, (2) Opinion and Order dated August 19, 1996, (3) Order dated August 20, 1996, and (4) Order dated September 9, 1996. See Pl.'s R. 56.1 Stmt. ¶ 12.

In the August 19, 1996 Order, the court rejected a request by Coates that he not be ordered to relinquish tangible assets to satisfy his obligation to fund payments to the rescinding shareholders unless a sale of his intangible assets (i.e. his CIL stock) failed to generate the required amount of cash, and held as follows:

In light of the bad faith that Coates has demonstrated throughout this litigation as set forth in this order and in my previous orders in this matter — see, e.g., [August 1994 Order] (describing withdrawal of $25,000 from Coates' bank account by Coates' wife after Coates had been informed of temporary restraining order issued by this court freezing his assets) — I order Coates to transfer title to his automobiles and his Rental Property to the Special Master on or before August 26, 1996.

See id. ¶ 120. In this order, the court also required Gregory Coates to transfer the patents back to Coates on or before August 26, 1996 and required Coates to transfer the patents to the Special Master on August 27, 1996. See id. ¶ 121. In the August 20, 1996 Order and the September 1996 Order, the court extended the deadlines for performance of the transfers to September 10, 1996. See id. ¶¶ 122, 123. The September 1996 Order also required Coates to transfer title to all of his automobiles to the Special Master on or before September 10, 1996. See id. ¶ 123. The transfers of the patents and automobiles did not take place on or before September 10, 1996. See id. ¶ 124. Untimeliness aside, Coates complied with every order of the court. See Def.'s R. 56.1 Stmt. ¶ 124B.

The rescission offer process concluded in July 1997. On July 15, 1997, Judge Wood entered an order detailing the conditions under which the Special Master would be discharged. See July 15, 1997 Order. The July 15, 1997 Order also appointed the Special Master to be Escrow Agent for the sole and limited purpose of holding the escrow sum which consisted of the interest payments still owed to two of the rescinding shareholders. See id. On July 31, 1997, Judge Wood entered an Order Vacating Restraints Against George J. Coates. In this order, the restraints imposed in Paragraph VII of the Coates Judgment were vacated; however, the terms of all prior orders including the Coates Judgment were not altered. See July 31, 1997 Order.

In an order dated August 8, 1997, Judge Wood denied defendants' request that they should be relieved of their obligation under the CIL Judgment and subsequent court orders to pay interest to the Quintas Trust and Rainer Heubach, two of the rescinding shareholders. See August 8, 1997 Order. The interest is in an escrow account under the auspices of the Escrow Agent, the former Special Master. See id. By order dated August 15, 1997, Judge Wood denied a motion by defendants to reconsider her August 8, 1997 order; however, she granted a stay of the August 8, 1997 order to pay interest until a final decision was issued on the summary judgment motion regarding civil penalties. See August 15, 1997 Order.

This case was subsequently transferred from Judge Wood to Judge Motley on October 30, 1998. The pending motions were argued orally on November 19, 1998.

B. Factual History

Coates founded CIL in October 1991. See Pl.'s R. 56.1 Stmt. ¶ 13. Coates is the inventor of the Coates System, a spherical rotary valve system for use in piston driven internal combustion engines. See id. ¶ 16. CIL's business is entirely dependent on the activities of Coates, who at times has been CIL's president, chairman, chief executive officer, and controlling stockholder. See id. ¶ 15. From CIL's inception through November 1, 1995, the Coates System has been the only actual or potential source of operating revenue for CIL. See id. ¶ 19. During the period subject to the rescission offer, Coates and CIL sold a total of 478,350 shares of CIL stock at prices of $5, $10, $20, and $30 per share for a total of $6,578,000 in gross proceeds. See id. ¶ 14.

1. EPA Emissions Standards

All new motor vehicles or new motor vehicle engines for sale in the United States intended for road use, including those with engines equipped with the Coates System, are subject to Environmental Protection Agency ("EPA") emissions standards and are required to pass a series of tests known as the Federal Testing Procedure or "FTP" tests. See id. ¶¶ 20, 22; see also 40 C.F.R. § 86.090-5. Included in the regulations governing the emissions testing component of the FTP tests is a requirement that emissions tests be conducted using a machine known as a chassis dynamometer ("dynamometer"). See Pl.'s R. 56.1 Stmt. ¶ 21; see also 40 C.F.R. § 86.135. Prior to July 1994, CIL never received a Certificate of Conformity from the EPA stating that engines modified with the Coates System were in compliance with applicable federal emission standards. See Pl.'s R. 56.1 Stmt. ¶ 25. Before July 1994, the EPA never conducted any emissions tests or other tests involving the Coates System or vehicles associated with the Coates System, CIL, or Coates. See id. ¶ 26.

Engines modified with the Coates System technology were tested in February and August 1990 and February 1991 at Compliance and Research Services, Inc. ("Compliance"), an independent motor vehicle emissions testing contract laboratory recognized by the EPA. See id. ¶ 27. The tests performed at Compliance indicated emission levels of pollutants that were substantially higher than the maximum emission levels permitted under EPA regulations. See id.; see also Pl.'s Ex. 2, CIL Second Am. Registration Stmt. ("Reg.St.") at 26. The Compliance tests were performed using a dynamometer, a machine required under federal regulations to be used for independent emission testing. See Pl.'s R. 56.1 Stmt. ¶¶ 21, 28. Coates received the results of the Compliance tests and was aware of the EPA emissions standards. See id. ¶¶ 29, 32.

CIL disseminated two documents dated December 6, 1991 to CIL stockholders and other potential investors regarding a private offering of CIL's Series A Preferred Stock ("December 1991 Offering"). See id. ¶ 33. These documents were titled "Confidential Private Offering Memorandum" and "Confidential Information Memorandum." Coates testified at his deposition that he personally provided Deloitte & Touche, the preparers of the December 1991 memoranda, with the information contained therein. See id. ¶ 35. The Confidential Information Memorandum stated that the Coates System modified "engine, under an internally supervised test, far surpassed the emission standards imposed by the [EPA]." Id. ¶ 38. It further stated that the "Coates engine emits significantly lower levels of pollutants than a conventional engine" and listed comparisons between the federal emissions standard and the Coates System in a chart entitled "Comparative Analysis":

Exhaust Federal Coates Improvement Emissions Standard System
CO (%) 1.2 .2 84% HC (ppm) 220 97 56%

Pl.'s Ex. 10, Confidential Info. Mem. at 13. However, the testing that produced the figures listed above was not performed at an independent motor vehicle emissions testing contract laboratory recognized by the EPA. The tests were performed at a CIL facility using a machine other than a dynamometer. See Pl.'s R. 56.1 Stmt. ¶ 40. Additionally, neither memoranda referenced above disclosed anything about the 1990-91 Compliance test results, which stated that the emissions levels of a Coates System engine were substantially higher than the maximum levels permitted by the EPA. See id. ¶ 41.

In a letter to CIL stockholders and other potential purchasers of CIL stock dated March 24, 1992, Coates wrote:

[O]ur first official independent emission test has indicated the lowest emissions in the world. . . . Further testing with the EPA is continuing and should be completed within six weeks depending on the schedules.

Pl.'s Ex. 7, Larkin Decl. Ex. A, March 24, 1992 Letter. The letter also contained a solicitation to purchase additional CIL stock. See id.; see also Pl.'s R. 56.1 Stmt. ¶ 45.

Similarly, in a letter to CIL stockholders and other potential purchasers of CIL stock dated March 26, 1992, Coates wrote:

The results of our first independent emissions test have demonstrated that our design produces the lowest level of pollutants in the world. In fact, we have eliminated some of the most harmful emissions completely. . . . With further EPA testing going as scheduled, this phase of evaluation should be finished within six weeks.

Pl.'s Ex. 8, Carter Decl. Ex. A, March 26, 1992 Letter. The letter also contained a solicitation to purchase additional CIL stock. See id.; see also Pl.'s R. 56.1 Stmt. ¶ 49.

2. Harley-Davidson

1. The reliability/durability of the current rotary valve trains systems for both ...

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