The opinion of the court was delivered by: Michael A. Telesca United States District Judge
The Securities and Exchange Commission ("SEC") commenced this action against defendants Pittsford Capital Income Partners, L.L.C. ("Pittsford I"), Pittsford Income Partners II, L.L.C. ("Pittsford II"), Pittsford Income Partners III, L.L.C. ("Pittsford III"), Pittsford Income Partners IV, L.L.C. ("Pittsford IV"), Pittsford Income Partners V, L.L.C. ("Pittsford V"), Jefferson Income Partners, L.L.C. ("Jefferson") (collectively the "Pittsford Issuers"), Pittsford Capital, L.L.C. ("Pittsford Capital"), Pittsford Capital Mortgage Partners, L.L.C. ("PCMP"), Pittsford Capital Group, Inc. ("Pittsford Group"), (all of the foregoing parties collectively referenced at times as the ("Pittsford Entities"), Mark Palazzo ("Palazzo") and Edward Tackaberry ("Tackaberry")(collectively "defendants") and Communicate Wireless, L.L.C ("Communicate"), Monroe Wireless, L.L.C. ("Monroe Wireless") and Michael Latini ("Latini") (collectively "Relief Defendants"), alleging violations of Section 17(a) of the Securities Act, 15 U.S.C. § 77q(a), Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), and Exchange Act Rule 10b-5, 17 C.F.R. § 240.10b-5, arising out of the alleged use of investor funds for improper purposes by making secret loans, commingling investor funds without disclosure and other material misrepresentations and omissions.
On July 14, 2006 (the same day the complaint was filed), this Court granted the SEC's application for a temporary restraining order ("TRO") freezing the assets at issue pending a determination of its application for a preliminary injunction. In the same Order, Lucien A. Morin II, Esq., was appointed receiver (the "Receiver") to inter alia ascertain the financial condition of the defendants, prevent dissipation of defendants' assets, and preserve records. On July 24, 2006, the Court held a hearing on the SEC's application for a preliminary injunction. Palazzo and Tackaberry did not oppose the entry of the Preliminary Injunction. At the conclusion of the hearing, the Court granted the Order For Preliminary Injunction and Asset Freeze ("Preliminary Injunction"). The Court subsequently entered two orders in August and November 2006 relating to amending the Preliminary Injunction Order and Asset Freeze. On December 1, 2006, the Receiver filed a Preliminary Report of Receiver.
The SEC now moves this Court for an order granting summary judgment pursuant to Rule 56 of the Federal Rules of Civil Procedure against Palazzo and Tackaberry: (1) seeking a permanent injunction restraining Palazzo and Tackaberry from future violations of the anti-fraud provisions of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder; (2) ordering defendants, jointly and severally, to pay disgorgement in the amount of $11,725,294.82, plus prejudgment interest thereon calculated from June 17, 1996, based on their violations of the federal securities laws; and (3) imposing a third tier civil penalty against Palazzo and Tackaberry.
Defendants oppose the SEC's motion on the grounds that it lacks the required burden of proof to establish fraud by the defendants. According to defendants, the proof submitted by the SEC does not comply with the standard necessary for a party to establish a fraud claim in a motion for summary judgment, let alone at trial. Further, defendants argue that the SEC has ignored exculpatory evidence favoring defendants and continue to prosecute a significant claim that is contrary to undisputed evidence. Finally, defendants assert that certain claims argued in the motion for summary judgment include claims that were not asserted in the Complaint, yet the SEC did not amend the complaint to include these additional claims.
The Court has considered thoroughly all of the submissions the parties have made in connection with the instant motion. For the reasons set forth below, the SEC's motion for summary judgment is granted.
The following facts are undisputed except where specified otherwise.
Pittsford I was formed by Palazzo*fn1 and Tackaberry on May 22, 1996 as a New York limited liability company.*fn2 The Private Placement Memorandum ("PPM") dated June 17, 1996 for Pittsford I offered $2 million in unregistered promissory notes in forty $50,000 units. The Pittsford I promissory notes were to mature ten years from the date of issue.*fn3 However, after five years note holders could require Pittsford I to prepay subject to the availability of the company funds. The Pittsford I offering raised $2,001,250 from 56 investors. On April 16, 1997, Pittsford II was formed and the PPM offered $3 million in unregistered promissory notes that were sold in sixty $50,000 units. The Pittsford II notes matured five years from the date of issuance although Pittsford II "in its sole discretion" could extend the term of the notes an additional five years. In addition, it was a requirement that Pittsford II "use its best efforts" to redeem notes after five years "on a first come, first served basis." The principal amount became payable at maturity. Pittsford II offering raised $2,423,400 from 50 investors and returned $290,000 in principal to 11 investors.
On February 2, 1998, Pittsford III was formed and pursuant to the PPM, Pittsford III offered $3 million in unregistered promissory notes comprising sixty $50,000 notes. The notes were to mature in five years from the date of issue, although Pittsford II could extend the notes an additional five years "in its discretion." Moreover, it was a requirement for Pittsford III to "use its best efforts" to redeem notes after five years "on a first come, first served basis." The offering for Pittsford III raised $2,691,644.82 from 46 investors and returned $52,095.89 in principal to 11 investors. In the same year, Pittsford IV was formed and the PPM offered the same basic options for investors with the exception of the interest paid per year on the promissory notes.*fn4 The Pittsford IV offering raised $2,184,250 from 37 investors and returned $513,350 in principal to 12 investors.
In 1999, Pittsford V was formed and the PPM offered $3 million in unregistered promissory notes consisting of $50,000 Series B and Series C notes.*fn5 Pittsford V note holders may present their notes to the issuer for repayment of principal after one year, which Pittsford V would do but only if it had "sufficient funds." See App. Tab 9. The Pittsford V note holders, as opposed to the issuer, had the right to extend the maturity date an additional five years. The Pittsford V offering raised $4,339,750 from 62 investors and has returned $1,306,918.03 in principal to 22 investors and interest to 16 investors. On July 27, 2004, Palazzo signed a document that purported to extend the maturity of Pittsford I, II, III and V and also authorized Pittsford IV note holders to extend the terms of their Promissory Notes for an additional five years. While the document was signed in July 2004, it was dated as of July 10, 2002. Jefferson was formed on December 30, 2002 as a New York limited liability company. The PPM states that Jefferson offered $6 million in unregistered securities consisting of 120 Class B Units at $50,000 per Unit.*fn6 The Class B holders were entitled to redeem the Units after one year provided that Jefferson has "sufficient working capital and cash flow, which will be determined by [Jefferson] in its sole discretion." While the Jefferson offering raised $1,865,000 from 19 investors, it did not return any money to investors.
B. The Private Placement Memoranda
Each of the PPMs for Pittsford I through V and Jefferson indicate that their business would be to acquire and hold notes secured by mortgages on real property. For example, the PPM for Pittsford I stated in pertinent part that "[t]he Company shall engage in the business of acquiring and holding notes secured by mortgages on real property." Similar language is found on the other PPMs for Pittsford II through V and Jefferson. In essence, the PPM stated that investor funds would be used only to acquire notes secured by mortgages on real property. The PPM for Pittsford I, similar to the other PPMs, states that "Interest on the Notes will be paid from [Pittsford I's] operating capital" and "[p]rincipal on the Notes will be paid from the collection of the notes secured by mortgages held by [Pittsford I]." Accordingly, the PPMs for Pittsford I through V make clear that each of them was to keep its funds separate.
Defendants state that except for Jefferson's PPM, none of the other PPMs for Pittsford I through V specifically prohibited merger of the companies. In addition, the Operating Agreement of Jefferson stated that "[t]he Company's funds may not be commingled with the funds of any Manager, Member, Officer or any Affiliate thereof." Notwithstanding the language of these agreements, Pittsford III, IV and V merged into PCMP in August 2000. The note holders were not asked to provide their consent before the merger, even though a letter discussing the proposed merger stated that "[i]n order to merge the entities, the written majority consent of the members is required." In fact, James Jenkins of the Harter Secrest law firm, who represented Pittsford I through V in connection with the merger into PCMP, ge 7 of 34 never advised Palazzo and Tackaberry that the assets of one Pittsford Capital Income Partner could be used to pay off the liabilities of another, nor did either defendant seek advice from their attorneys regarding this issue.
Further, Palazzo and Tackaberry note that each PPM for Pittsford I through V and Jefferson stated that due to the nature of mortgage lending, the offerings were highly speculative and involved a high degree of risk. Accordingly, to qualify as an investor, a person not only had to be a person of high income or high net worth but he/she must essentially be a sophisticated investor. The SEC asserts however, that any cautionary language in the PPM did not disclose the risks that arose from Palazzo and Tackaberry's decisions to make millions of dollars in unauthorized loans, fail to disclose defaults and commingle funds.
Palazzo and Tackaberry eventually combined all the Pittsford Issuers bank accounts into the PCMP's M&T bank account in 2000 (hereinafter "PCMP's 101 Account"). This commingling of investor funds from the Pittsford Issuers occurred between January, 1999 through September 1999.*fn7 On March 20, 2000, Palazzo wrote investors that "as members and the manager of Pittsford Capital Mortgage Partners, LLC, we believe that it is in the best interests of the company and its other members to merge each of [Pittsford III, Pittsford IV and Pittsford V] with and into the Company. Once the [Pittsford V] offering is completed, we will begin the merger process to combine all of the 'Income Partner' companies into a single entity." See 7/14/06 Debella Decl. However, investors in the Pittsford Issuers were not informed that all the Pittsford Issuers' bank accounts had been merged into a single bank account. Moreover, Roehrig*fn8 stated that Jefferson loaned money based on real estate collateral and that when he solicited investors he told them that Jefferson would invest in real estate loans exclusively. In a letter from Palazzo to investors in September 2003, he stated that there had been a "'loan' of $980,000 from Jefferson ..., an affiliated mortgage fund, to PCMP." See 7/14/06 Debella Decl. Moreover, another letter in April 2005 from Palazzo to investors indicated that Jefferson lent PCMP $1.8 million.*fn9 See id. In sum, Pittsford III, IV, V and Jefferson transferred approximately $10,261,238 to PCMP's accounts.
D. Transfers of Funds to Communicate Wireless
In July 2003, Latini*fn10 initially approached Palazzo and Tackaberry for a loan to Communicate in the amount of $850,000 for use in acquisitions, inventory and working capital. The loan amount was increased $100,000 in August 2003. Meanwhile the only mortgage security providing collateral for the loan was given by Latini and his wife who executed a second mortgage in favor of PCMP on their residence for $100,000 on July 31, 2003.*fn11 In essence, the 2003 PCMP loan was secured by personal guarantees of Latini and a security agreement with Communicate. Communicate eventually repaid the loan to PCMP in February 2005. Upon repayment of the loan, Latini started negotiations with Palazzo and Tackaberry for a bridge loan to be used for funding of additional stores and expand their operations.*fn12
In February 2005, Palazzo (on PCMP's behalf) and Latini (on Communicate's behalf) executed a term sheet for recapitalization of Communicate whereby PCMP was to provide $2 million to Communicate. Notably, as a condition to the loan, both Palazzo and Tackaberry demanded that they each personally receive a 20% equity interest in Communicate. In addition, Palazzo and Tackaberry insisted that part of the recapitalization should include Communicate renting office space at 170 Office Park Way, the same location where PCMP had its offices. Due to this transaction, Palazzo became Communicate's Chief Financial Officer and Tackaberry became Communicate's Vice-President for Marketing.*fn13 In April 2005, Palazzo, on behalf of PCMP, signed a discharge of Latini's no-equity mortgage making PCMP's 2005 loan to Communicate unsecured by any mortgage. Moreover, on April 19, 2005, Palazzo, on behalf of PCMP, accepted and executed a Promissory Note from Communicate for $2,195,050.96 (the "April 19 2005 Note"). Communicate used funds from the April 19, 2005 Note to pay back a $1.3 million loan from M&T bank including interest payments and fees for extending the term of the promissory note.
Further, on July 13, 2005, Latini and Palazzo, on behalf of Communicate, signed a promissory note to PCMP, which was also executed by Tackaberry, on behalf of PCMP, for $2,472,000, which included additional loans, interest and fees from the $2,195,050.96 loan Communicate borrowed from PCMP on April 19, 2005.*fn14 It is noteworthy that Communicate never paid back any of the principal of the July 13, 2005 promissory note, only interest. Moreover, on September 6, 2005, Latini executed a Promissory Note to pay PCMP $52,960, which was accepted by Tackaberry on behalf of PCMP. The September 6, 2005 Promissory Note does not identify a mortgage, or any collateral, to secure PCMP's loan. During the same time in September, Communicate issued two stock certificates for PCMP, which were signed by Palazzo as President of Communicate*fn15 and Latini as Chief Executive Officer. In addition, on September 6, 2005, Tackaberry signed a "Pay-Off Confirmation Letter" on behalf of PCMP certifying that the conversion of PCMP's $2,472,000 loan into equity units, combined with a $115,960 payment of principal, constituted "payment in full of the total outstanding indebtedness and liabilities owed by Communicate" to PCMP. See App. Tab 62, at PITT 29542. Accordingly, Palazzo and Tackaberry exchanged for equity the money invested with PCMP to be used expressly for lending activity. Thus, there was no disclosure to PCMP's investors that their loans had been converted into equity in Communicate.*fn16 In total, from period 2003 to 2005, Palazzo and Tackaberry transferred $2,349,998.80 from PCMP's account to Communicate and Communicate transferred $1,545,257.38 to PCMP. However, Palazzo and Tackaberry never disclosed the loans to Communicate by PCMP to investors in the Pittsford Issuers.
The SEC has proffered undisputed evidence that Palazzo and Tackaberry did not inform any of the investors of the Pittsford Issuers that they loaned investor funds to Communicate and that those funds were not secured by a mortgage. In addition, Palazzo and Tackaberry did not disclose that they were equity owners and officers of Communicate. In fact, neither Palazzo nor Tackaberry informed Latini that they had told PCMP's investors or obtain their consent before making a loan to Communicate. Tackaberry also did not disclose the loan to Communicate to investors. Instead, in a letter to investors, Tackaberry stated that "a loan made last year to a local company left our fund very weak. They were unable to provide a repayment for monthly interest and principal and thus defaulted." See App. Tab 173, at 2. Further, Palazzo and Tackaberry did not disclose that Palazzo left PCMP to work at Communicate in spite of the fact that PCMP lent investors' money to Communicate.*fn17
Defendants argue that nothing in the PPM prohibits loans to companies in which Palazzo and Tackaberry held an interest since the PPMs specifically noted that defendants had conflicts of interest with the Pittsford Entities and through the defendants' affiliated companies.*fn18
Moreover, defendants argue that the Pittsford Entities made hundreds of loans over eleven years and only five (four while Palazzo was still affiliated with the entities) could be characterized as loans that were not secured principally by real estate mortgages.*fn19
E. Transfers of Funds to Monroe Wireless
When Roehrig sought a telecommunications franchise for Monroe, he filled out an application in which he stated "outside funding will provide capital for operations." Tackaberry informed him that the funding would come from PCMP. As a result, PCMP transferred funds four times to Monroe between March 2006 and May 2006. In March 2006, Tackaberry authorized two transfers from PCMP's 101 Account to Monroe totaling $50,000. In April 2006, Tackaberry signed a check drawn from PCMP's 101 Account made payable to Monroe in the amount of $100,000. Finally, in May 2006, Tackaberry signed another check drawn from PCMP's 101 Account to ...