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July 15, 2004.

THOMAS CAVANAGH, et al., Defendants. CROMLIX, LLC, et al., Relief Defendants.

The opinion of the court was delivered by: DENISE COTE, District Judge


This securities fraud action grew out of a "pump and dump" scheme engineered by William Levy ("Levy"), Thomas Cavanagh ("Cavanagh") and Frank Nicolois ("Nicolois"). After entry of a preliminary injunction in 1998, the action was stayed for an extended period of time during a criminal investigation and prosecution of Levy, Cavanagh and Nicolois for false statements made in connection with this litigation. With the conclusion of the criminal proceedings, this civil litigation has resumed and the Securities and Exchange Commission ("SEC") now brings a motion for summary judgment against those defendants who have not settled this litigation.*fn1

  The SEC seeks entry of judgment against Cavanagh, Nicolois, their company U.S. Milestone ("Milestone"), Thomas Brooksbank ("Brooksbank"), James Franklin ("Franklin"), and Thomas Hantges ("Hantges") for violation of Sections 5(a) and (c) ("Section 5") of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77e(a) and (c). It also seeks judgment against defendants Cavanagh, Nicolois and Milestone for violation of Section 10(b) ("Section 10(b)") of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b); Rule 10b-5 thereunder ("Rule 10b-5"), 17 C.F.R. § 240.10b5; and Section 17(a) ("Section 17(a)") of the Securities Act, 15 U.S.C. § 771(a). Finally, the SEC seeks judgment against relief defendants Karen Cavanagh, Beverly Nicolois, their jointly-owned company Cromlix, LLC ("Cromlix"), and Edward Kaufer ("Kaufer"). For the following reasons, the motion for summary judgment is granted.

  Procedural History

  On March 13, 1998, the SEC filed this action, alleging that certain defendants offered and sold securities of Electro-Optical Systems Corporation ("EOSC") in violation of the registration and anti-fraud provisions of the securities laws. The SEC asserted that the defendants had defrauded the public — principally small, on-line investors — of millions of dollars. That same day, a temporary restraining order was issued which, inter alia, suspended trading by the defendants in EOSC stock and froze the assets of defendants and the accounts of relief defendants that contained EOSC stock or the proceeds from the sales of the EOSC stock.

  A preliminary injunction hearing ("Hearing") ran from March 31 to April 8. For the reasons explained in an Opinion of April 20, a preliminary injunction was issued. SEC v. Cavanagh, 1 F. Supp.2d 337 (S.D.N.Y. 1998) ("April 20 Opinion"). The April 20 Opinion found that the SEC had shown a substantial likelihood of success in proving that Cavanagh, Levy, Milesone, three companies described herein as the Spanish Nominees, George Chachas ("Chachas"), Brooksbank, Hantges, the Optimum Fund and Agira Trading violated Section 5. The Court entered a preliminary injunction against Levy, Cavanagh, Milestone, Chachas, and the Spanish Nominees, and freeze orders against all of these defendants. The April 20 Opinion found that the SEC had shown a substantial likelihood of success in proving that Cavanagh, Milstone, Chachas and the Spanish Nominees had violated Sections 17(a) and 10(b). Levy and one relief defendant appealed. The injunction was affirmed on appeal. SEC v. Cavanagh, 155 F.3d 129 (2d Cir. 1998).

  In October 1998, the action was stayed at the request of, among others, defendants Cavanagh, Nicolois, Milestone, Levy and relief defendants Karen Cavanagh and Beverly Nicolois due to a criminal investigation. On March 13, 2003, Cavanagh and Nicolois requested that the stay be lifted since no prosecution had begun. They argued that the civil action be dismissed because of the "long, detrimental" stay. In fact, a sealed indictment had been returned on February 26, 2003.

  At a conference on March 27, 2003, the defendants' motion to dismiss was scheduled. On April 4, Cavanagh and Nicolois learned of their indictment and requested a reimposition of the stay.*fn2 On April 22, the Court denied their request in light of the defendants' stated intention to move to dismiss the action because of the length of the stay. Although they made no offer to forego that motion if a stay were reimposed, the defendants never filed the motion. On February 11, 2004, following the close of discovery, the SEC moved for summary judgment as to those defendants with whom it has not already settled.

  Defendants Cavanagh, Nicolois, their wives (who are named as relief defendants), and their company Milestone, oppose summary judgment. They rely on their attorney's affidavit, on a Rule 56.1 Statement that contests relatively few of the 157 paragraphs in the SEC's Rule 56.1 Statement, and on excerpts from the record created at the Hearing. Cavanagh, Nicolois and Milestone do not contest that a fraud occurred. They argue principally that they relied on the advice of their attorney, Levy, and that the SEC has not sufficiently shown their scienter to establish a violation of Sections 17(a) and 10(b).

  Defendants Franklin and Brooksbank also agree that the public was defrauded. They argue, however, that the SEC has failed to show that it is entitled to summary judgment since there are questions of fact as to whether Franklin and Brooksbank's sales of shares were exempt from registration under one of three possible exemptions.

  In the event summary judgment is granted, defendants Cavanagh, Nicolois, and Milestone do not object to the relief sought by the SEC. Defendants Hantges, who concedes liability under Section 5, Franklin, and Brooksbank do object to the relief sought. Relief defendants Karen Cavanagh, Beverly Nicolois, Cromlix, and Kaufer only contest the underlying liability of the defendants, but not the relief sought against them.


  The following facts are undisputed, unless otherwise noted. A summary of the scheme precedes a more detailed description of the evidence. WTS Transnational, Inc. ("WTS") was a small development stage company with a dire need for capital. Cavanagh, Nicolois, and their investment banking firm Milestone, agreed to raise money for WTS. Levy, an attorney, prepared many of the legal documents and conducted many of the negotiations on behalf of Cavanagh, Nicolois and Milestone. They located a blank check or shell corporation called Curbstone as the vehicle to take WTS public.

  At the time that WTS merged with Curbstone through a reverse stock acquisition, Levy, Cavanagh, Nicolois, Milestone, and three offshore companies (the Spanish Nominees) with whom they were associated as described below, obtained for pennies per share a large block of shares of the new public company, renamed EOSC. There was no public disclosure of this transfer of shares or of the fact that this group now controlled virtually all of the public float of EOSC. The Spanish Nominees, Cavanagh and Nicolois resold the shares into the public market after Cavanagh, Nicolois and others had taken the steps described below to inflate the price for the EOSC shares to over $5 per share.

  Curbstone was owned by four partners, including Brooksbank, Franklin, and Hantges (collectively, the "Curbstone Management Group"). The fourth partner, Chachas, was the person principally responsible for the negotiations with Levy and the Milestone group. The four Curbstone partners were paid in cash and in EOSC shares for their sale of Curbstone. They each profited handsomely from these transactions, including through an option agreement that gave them the opportunity to sell their shares at prices ranging from $3 to $6 over the course of the months following the merger. With this overview, a more detailed description of the chronology of events follows.

  WTS, a private company, was trying to develop optical fingerprint recognition technology. It needed money to do so. Charles Weaver ("Weaver"), the President of WTS, met Cavanagh and Nicolois in July 1997. Milestone, a company owned by Cavanagh and Nicolois, agreed to procure financing for WTS. Cavanagh and Nicolois told Weaver that they had $4 million in off-shore accounts that there were willing to invest in the company through a private placement.

  On September 22, WTS and Milestone executed a letter of intent that allowed Milestone the exclusive right to raise $1 million in equity capital for WTS in a private placement offering in exchange for 30% of the WTS stock, and after raising such money, a one year option to raise an additional $3 million for another 10% of the stock. In total, WTS agreed to give up 40% of its stock for $4 million.

  Meanwhile, Levy began to search for a public shell company to merge into WTS. Levy first informed Weaver of this fact in November 1997, when he told him that "an investor" wanted a public company. Levy asserted that WTS must become public before the investor would give it money. Levy also tried to change the terms of the investment. He wanted WTS to give up 40% of its stock for a $1 million investment. Weaver immediately complained to Nicolois. Weaver specifically complained that Levy's plan for a $5 per share follow-on investment would result in an "astronomical" market capitalization of $53 million. According to Weaver, a market capitalization of approximately $3 million following a $1 million investment, or $10 to $15 million following a $4 million investment was more appropriate.

  On November 13, Weaver and Nicolois executed a Letter of Intent. 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 and then to raise an additional $3 million in funds for WTS. WTS would become a wholly owned subsidiary of a publicly traded company before December 15, with WTS shareholders receiving 95% of the issued and outstanding capital of the new company and the shell's shareholders retaining 5%.

  After the execution of the letter of intent, Cavanagh caused the Optimum Fund, a Grand Cayman entity over which Cavanagh had control, to make a $500,000 bridge loan to WTS, less fees. The bridge loan was convertible into equity.

  Meanwhile, Levy selected a shell company, Curbstone. Throughout the negotiations that followed, the shares owned by the Curbstone Management Group were treated as one block.*fn3 Chachas was authorized to negotiate the merger with WTS. Chachas envisioned two payments modeled on an earlier transaction, the Capital Advisors Acquisition Corporation ("Capital Advisors") transaction, that he had negotiated with Levy. As reflected in contemporaneous documents, Chachas expected that the Curbstone Management Group would receive $125,000 in cash and $1.2 million through "market makers" for 300,000 shares in the new company ("Curbstone Management Shares"), priced in three equal units of between $3 to $5 per share.

  Levy acted as counsel for both Milestone and WTS in the negotiations with Chachas. Draft term sheets specified that the Curbstone Management Group was to provide "free trading" Curbstone stock. On December 2, Chachas sent Levy what he characterized as the only two acceptable alternatives for closing the reverse merger and "our best and final effort." Under the first alternative, the Curbstone Management Group would be paid (1) $125,000 in cash at a closing on December 5, and a further payment of $2.352 million in four installments between December 16 and March 13, 1998. The latter payment was for the purchase of 542,000 shares in the new company owned by the Curbstone Management Group. 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 at the time of the merger until the first installment payment of $450,000 had been received, which was due no later than December 16.

  The second alternative presented by Chachas included an immediate payment of a non-refundable $10,000 deposit, with the balance of the $125,000 in cash and a first installment payment of $450,000 due at a December 16 closing. The remainder of the 542,000 Curbstone Management Shares would be available for purchase in three installments spanning the time between December 16 and March 13, 1998. Under both alternatives, there would be no change in the Curbstone transfer agent until March 15, 1998, or until all of the 542,000 shares had been acquired, whichever occurred first.

  On December 3, Chachas sent Levy a written outline of the terms reflecting their further discussions. They finally agreed on the following:
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 shares controlled by the Curbstone Management Group, 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, which payment was also made on December 12.
4) An oral agreement that Milestone had three options to purchase the Curbstone Management Shares as follows: 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.
5) A lock up agreement in which the Curbstone Management Group agreed not to sell an additional 200,000 shares they held until March 15, 1998.
  Under this agreement, the vast majority of the shares held by the Curbstone Management Group would not be cancelled. Instead, they would be sold for $100,000 on December 12. The sale of these shares made the market fraud possible. Chachas understood at first that the shares were being purchased by Milestone. After the agreement for the sale was entered, however, he was told that for the first time that the share certificates were to be issued in the names of three Spanish companies: Cambiarios S.L. ("Cambiarios"), Construcciones Solariegas, S.L. ("Construcciones"), and Customer Safety, S.L. ("Customer Safety") (collectively, the "Spanish Nominees"). Chachas understood the Spanish Nominees to be clients of Milestone. No member of the Curbstone Management Group spoke to the Spanish Nominees or performed any due diligence regarding them. The Curbstone Management Group asserts that it relied solely upon representations contained in the Purchase Agreements described below, which stated that the purchasers were accredited investors and had "no present agreements" to resell the shares.

  As a result of selling the approximately 2.5 million shares to the Spanish Nominees, it was no longer the case that all but 5% of the shares of the new entity would be traded for WTS stock. Rather, Milestone and those associated with it held 16% of the EOSC stock, and this stock constituted the vast majority of the EOSC stock that was issued without a restrictive legend and was thus available to be sold to the public.

  Chachas and Brooksbank for Curbstone, and Weaver for WTS, executed the Exchange Agreement ("Exchange Agreement"). The Exchange Agreement bears the date December 5, and provides that 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. It represents that the Curbstone shares given to WTS in exchange for the WTS stock had not been registered and would be issued with a restrictive legend. It states that the authorized capital stock of Curbstone consisted of 3,521,876 shares of stock issued and outstanding prior to the closing. It provides that the closing would be held on or before January 16, 1998. Weaver and WTS were not informed of the sale of the shares to Milestone and the Spanish Nominees.

  On December 8, Levy wired Chachas $25,000 — the non-refundable purchase fee. It was paid by Milestone through the client escrow account that Levy maintained for Milestone. None of this money came from or was reimbursed by the Spanish Nominees.

  On December 5, Chachas faxed to Levy a single form of a purchase agreement for the purchase of the 2,563,000 shares. Levy faxed the form to Milestone that day, and Nicolois, after consulting with Cavanagh, filled in the names and addresses of the Spanish Nominees, the number of shares, the price per share and dated the agreements December 1, 1997. With the transaction split into three units no one purchaser owned over 5% of the EOSC stock, thereby avoiding the Section 13(d) reporting requirements under the Exchange Act. After consulting again with Cavanagh, Nicolois faxed the purchase agreement to Tur Ortola in Spain on December 10. Tur Otola executed at least the agreement for Cambiarios. On this same date, Brooksbank and Chachas executed a corporate resolution directing the transfer agent to issue and cancel the shares for the WTS/Curbstone transaction. They sent the form to the agent on December 18.

  On December 11, the three purchase agreements ("Purchase Agreements"), dated as of December 1, and executed on behalf of the Spanish Nominees, were faxed to Milestone's offices. Each of the Spanish Nominees was a newly formed entity. With this purchase, the Spanish Nominees acquired the entire 2.5 million share block for $.039 per share. The Purchase Agreements included the representations by the Curbstone Management Group that the shares "have been registered securities and will be free of restrictive legend upon delivery," and 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 did not encompass the shares to be acquired under the option agreement.

  During this time, Cavanagh and Nicolois were preparing for the resale into the public market of the shares sold to the Spanish Nominees. They called a broker, Cosimo Tacopino ("Tacopino") at Donald & Co., and advised him that they would soon receive a large Curbstone/EOSC stock position and that he would have to make a market in EOSC so that they could liquidate the position. On December 11, Cavanagh and Nicolois told Tacopino that they would be sending Donald & Co. "Express Forms" to open accounts for the three Spanish Nominees and one for another Spanish company called Inversora Dactilar ("Inversora"). Nicolois filled out the new account applications for the Spanish Nominees and faxed them to Donald & Co. Tacopino spoke to no other representative of the Spanish Nominees prior to opening these accounts. Cavanagh and Nicolois instructed Tacopino to use these accounts to liquidate EOSC stock upon its receipt.

  When Chachas wrote Levy on December 12, to advise him that the agreement between Curbstone and WTS had been fully executed in his opinion and that the transaction had closed, Levy wired Chachas $550,000, representing $100,000 for the sale to the Spanish Nominees of the 2.5 million share block, and $450,000 for the exercise of the first round of options under the option agreement. The money was sent from the Milestone escrow account and not from the Spanish Nominees. Levy immediately sent Chachas a Closing Memorandum noting that the "prerequisites have been fulfilled (except certain schedules, shareholder lists and certain signatures which should all be delivered to you by Tuesday)," December 16. On December 19, Chachas distributed the $550,000 among the four members of the Curbstone Management Group, as well as the sum earned through a parallel acquisition negotiated between Levy and the Curbstone Management Group.

  At this same time, Milestone was managing a $1 million offering of EOSC shares purportedly under Regulation S. First, a bridge loan from the Optimum Fund was converted into 1,054,241 EOSC shares at a price of $.47 per share. Then Agira Trading ("Agira"), a British Virgin Island company that Cavanagh and Nicolois controlled, purportedly invested $500,000 for an identical number of shares at the same price per share.

  On December 16, Chachas wrote to Levy to confirm the division among the Spanish Nominees of "2,563,000 Free trading [shares] purchased at $100,000." Chachas obtained a CUSIP number and was notified that the company would bear the OTC trading symbol of EOSC.

  On December 17, Chachas instructed Curbstone's transfer agent American Registrar and Transfer Company ("ARTCO") to issue 17,596,601 new Curbstone shares; cancel Curbstone stock certificates representing 33,659 shares; transfer record ownership of 2,563,000 shares to the Spanish Nominees, reissue the certificates to them "WITHOUT LEGEND", send the certificates to Levy; and forward an updated shareholder list to Chachas. (Emphasis in original.) Richard Day ("Day"), the president of ARTCO, completed these tasks within two hours because of Chachas' desire that it be done as quickly as possible. Day shipped the certificates to Levy on December 18. That afternoon, Chachas and Brooksbank, acting as the "entire Board of Directors" of Curbstone executed a corporate resolution accepting their own resignations as officers and directors, and appointing in their stead WTS employees as officers and directors. The transfer agent also sent 500,000 shares to Levy, 2,108,481 shares to Milestone, and 857,081 shares to Inversora Dactilar, S.L., a Spanish entity that Cavanagh indicated would provide additional financing for EOSC.

  On December 19, Cavanagh told Tacopino that the WTS/Curbstone deal had been completed and to start making a market in EOSC stock. No public announcement had yet been made about the creation of EOSC. Tacopino was told by the head of compliance at Donald & Co. that the market had to set the price of EOSC stock. Quotes on the NSAD bulletin board consist of bid and ask prices. The former is the price at which a market maker is willing to buy; the latter is the price at which a market maker is willing to sell. At 9:56 a.m., Tacopino posted an initial Donald & Co. quote of $.50 bid and no ask price. Within ten minutes, Cavanagh called Tacopino and said that he wanted the bid price to be at or above $5, and that Tacopino had to keep the market price at or above $5 per share. Tacopino told Cavanagh that he was not permitted to raise the bid price until a street order or participation from other market makers justified it. Cavanagh assured Tacopino that there would be plenty of orders coming. Cavanagh and Nicolois assured Tacopino that "they would be constantly bringing in buying whether through other brokerage firms, PR firms" or otherwise.

  Cavanagh immediately placed a buy order with Ara Proudian ("Proudian") at Alexander Westcott to buy 500 shares of EOSC at $7 per share through the account of the Optimum Fund.*fn4 Cavanagh insisted that the order be at $7 over Proudian's objection that that was out of line with the current market price. (A share price of $7 reflected a market capitalization for EOSC of $140,000,000.) When Proudian placed the order with Tacopino at $7, Tacopino's only response was "sold." Since Donald & Co. did not yet have any EOSC stock in its inventory, the sale created a short position in Donald & Co.'s proprietary trading account. Cavanagh and Nicolois had told Tacopino that the accounts of the Spanish Nominees would be available to him to cover his short position at or above $5 per share.

  Based on this sale, at 10:21 to 10:22 a.m., Tacopino changed the Donald & Co. bid to $5 and ask to $7. A second trade in EOSC occurred at 10:53 a.m. Jean-Pierre Neuhaus ("Neuhaus"), an associate of Cavanagh and Nicolois, placed the order through the account of Banca del Gottardo in Zurich, Switzerland Cavanagh and Nicolois later gave Neuhaus 130,000 EOSC shares for free out of the Construcciones account.*fn5

  A third trade of EOSC stock occurred at 11:13 a.m. A Milestone client named Bernd Stieghorst, with Cavanagh's participation, placed an unsolicited order to buy 2,500 shares at or about $5 ½ Tacopino did not charge either Stieghorst or Cavanagh any commission on the transaction. Cavanagh and Nicolois later gave Stieghorst 70,000 EOSC shares for free.*fn6

  A fourth trade of EOSC stock occurred at 2:10 p.m. Chachas placed a market order for 100 EOSC shares through the e-trade account owned by Chachas and Brooksbank in the name of Dillon Trading. The order was filed at $5 7/8. When Cavanagh and Nicolois called Tacopino later on December 19 to inquire about the EOSC trading for the day, they expressed disappointment and Cavanagh assured Tacopino that he "would be sending in buy orders and there would be other retail firms getting involved, and the stock should trade heavily." Levy's secretary and the boyfriend of Nicolois' daughter later placed orders; they sold their stock for a profit in February. After the close of the market on December 19, Curbstone made its first public announcement of the WTS acquisition. The announcement was reported on the business wire. The announcement included the following:
Curbstone Acquisition Corp., a public company, Friday announced that it had completed the acquisition of 100 percent of the stock of WTS Transnational Corp., a privately held company, in exchange for the original issuance of 15,488,120 shares of Curbstone common stock. Curbstone has changed its name to Electro-Optical Systems Corp. The Bulletin Board symbol has been changed to "EOSC." The directors and officers of Curbstone have resigned and have elected the directors and officers of WTS to succeed them.
The announcement did not disclose the sale of stock to the Spanish Nominees, the existence of the option and lock-up agreements between Milestone and the Curbstone Management Group, that there were over 20 million shares of Curbstone issued and outstanding, or that 3.5 million shares of purportedly free-trading Curbstone stock, virtually the entire market float of Curbstone, was under the control of Cavanagh and Nicolois. The market float is the shares allegedly available for trading in the public market.

  On December 23, Chachas filed a Curbstone Form 8-K, the document on which a registered company reports a change in control. Levy, as the attorney for the merger had responsibility for this filing, but had asked Chachas to do it. Chachas asserts that he consulted with Levy regarding the contents, but Levy denies that. Among other things, the Form 8-K did not disclose the sale of shares to the Spanish Nominees, the option agreement, the lock-up, or the transfer of stock to Levy and to Milestone. It represented that no broker was associated with the transaction and that no fee had been paid to a broker despite the substantial payments to Cavanagh and Nicolois. The public was not advised that the market float consisted of millions of shares and that it was controlled by Milestone and those associated with Milestone.

  Between December 24 and 26, the shares for the Spanish Nominees were deposited into trading accounts at Donald & Co. Cavanagh and Nicolois soon began directing the distribution of about one million of these shares to twenty-nine friends, relatives and business associates. In this connection, Cavanagh and Nicolois ordered the opening of eight new customer accounts at Donald & Co. to receive some of this stock. These accounts included those of various relief defendants including Cromlix.*fn7 Cavanagh and Nicolois caused 100,000 EOSC shares to be transferred into the Cromlix brokerage account.*fn8 Cavanagh and Nicolois told Tacopino that these transfers represented their compensation on the deal. Tur Ortola also told Tacopino that this stock was the compensation due Cavanagh and Nicolois on the EOSC deal. All orders to transfer stock and proceeds originated with Milestone in New York; none of the orders came from Spain.

  Between December 19, and early March 1998, Tacopino, who controlled nearly the entire float of EOSC stock, kept the price above $5 per share despite heavy sales after January 16 of the shares originally sent to the Spanish Nominees. Tacopino believed that if he allowed the price to go above $5 to $6 his ability to sell would have ended. In this range, however, he was able to sell a continuous stream of shares. With rare exceptions, Tacopino liquidated the stock by trading "from the short side." This was the pattern he had followed in about 40 to 50 prior "Reg S" deals on which he had worked with Cavanagh and Nicolois. By selling short, he avoided the risk of a drop in price. Cavanagh and Nicolois had daily conversations with Tacopino about how the stock was trading and how he was liquidating the dozen or so accounts that they controlled. They told him which accounts should be used to cover each day's short positions.

  In late December, Tacopino sold 102,100 shares from the Cambiarios account at the direction of Cavanagh and Nicolois for $555,260.07. In January 1998, at their direction, Tacopino sold 724,900 shares through the Cambiarios account for net proceeds of $3,775,704.03.

  On January 9, 1998, Cavanagh told Tacopino "that there would be good things happening" in the EOSC stock and he should be long, not short, on the stock. Tacopino went from a position of 16,000 shares short to 27,000 shares long. Nicolois told Tacopino during a visit to Nicolois' house that the "good news" was that a public relations firm would be making a buy recommendation to its clients. This recommendation was arranged by Maier Lehmann ("Lehmann").*fn9

  On January 12, an internet publication called The Future Superstock released its choice of EOSC as the "Stock Pick of the Year for 1998." It set a price target of $15 to $18 per share over the next three months to a year. That prediction assumed a market capitalization of $378,000,000 for a company that had received an investment of approximately $1 million from outside investors and that did not yet have a prototype that Weaver felt he could show to potential customers. That very day Weaver wrote an internal memorandum expressing concern about the unwarranted "hype" of the stock and stating that he would rather not say anything yet. "We do not have a product that we can show today. We will in about four months."

  In late January, Ari Friedman approached David Pollack ("Pollack"), the president of ADL Data Systems, Inc. ("ADL"), about the possibility of distributing EOSC's fingerprint identification units. ADL provides software services to the health care industry. On January 29, Levy faxed Pollack the first draft of a press release which referred to an ADL purchase order. Pollack told Levy that this purchase order did not exist and that he did not intend to execute a blanket purchase order. Pollack insisted that any commitment to EOSC had to be conditioned on receiving a working unit that would satisfy him. Levy then faxed a draft letter detailing a proposed joint venture. Pollack and Weaver signed the letter, which refers to an attached purchase order that did not exist. It reads in part:
As per my negotiations with your agent, enclosed please find our Purchase Order for 1,000 units of your Fingerprint Identification system. These units are to be delivered to our office soon after we've had the opportunity to test your evaluation units and price will be finalized prior to shipment.
  On January 30, EOSC issued a press release that Levy dictated to EOSC employee George Clarke ("Clarke"). When Clarke learned that there was no purchase order from ADL he ordered Levy to remove the reference to a purchase order from the press release. Levy insisted that investors needed the reference to a purchase order. Clarke crossed out the word "purchase" on the draft press release and told Levy that he could issue it. Neither Clarke nor Weaver saw the final version of the press release until long after it was issued. It read in part:
[EOSC] a public company, announced today that it received a Purchase Order from ADL Data Systems, Inc., a leading system integrator and software provider to the nursing home and health care industry, for an initial order of 1,000 Finger Print Verification Units for an undisclosed price. The Purchase Order and accompanying Letter of Agreement state that upon the successful evaluation and testing of these units initially with selected ADL nursing home clients, ADL agrees to market additional units in a joint venture with EOSC to national health care sources. ADL estimates that the first year of the joint venture following the test placement could result in the sale of a minimum of 15,000 units.
(Emphasis supplied.)

  Meanwhile, Chachas and Cavanagh discussed the exercise of the second option. On February 23, 1998, Chachas ordered the transfer of 150,000 EOSC shares owned by the Curbstone Management Group to Construcciones. The Construcciones brokerage account at Donald & Co. received the shares on February 24. This transfer was the exercise of the second tranche of the option agreement and required a payment of $4 per share. The $600,000 payment came from the Construcciones account at Donald & Co. via the Levy & Levy Trust Account for Milestone ("Trust Account"). Construcciones wired the money to the Trust Account on February 10, 1998, and on that same day the Trust Account posted the receipt of the $600,000. On February 12, the Trust Account sent Chachas $600,000.*fn10 An amended Form 8-K was filed by Levy on February 18. EOSC had fired Levy for failing to correct statements in the December 23 Form 8-K about who had agreed to serve as EOSC Directors. After Cavanagh threatened EOSC with a loss of financing if it did ...

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