The opinion of the court was delivered by: Denise Cote, District Judge
Plaintiff United States Securities and Exchange Commission ("SEC") has brought suit alleging that two individual defendants participated in a disclosure and accounting fraud scheme relating to transactions between Escala Group, Inc. ("Escala") and its parent company Afinsa Bienes Tangibles, S.A. ("Afinsa").*fn1
Escala and Afinsa are both in the collectibles market. Defendant Gregory Manning was Escala's chief executive officer and defendant Larry Lee Crawford was Escala's chief financial officer.
The complaint alleges that Manning and Crawford violated antifraud and reporting provisions of the federal securities laws by 1) failing to disclose the related party status of Barrett & Worthen, Inc. ("B & W"), which resulted in Afinsa's control of the Brookman Catalogue of stamp values, and by failing to disclose the revenues obtained by virtue of Afinsa and Manning's control of the catalogue; 2) falsely representing that several large stamp archives that Escala sold to Afinsa were sold at prices determined by reference to independent catalogues and appraisals when in fact Manning set the catalogue prices used and influenced the appraisals; and 3) falsely reporting a payment for business combination-related expenses as a sale of certain antiques.*fn2 The complaint seeks the following relief against Manning and Crawford: civil penalties, disgorgement of ill-gotten gains, an injunction permanently enjoining them from future violations of the federal securities laws, and an injunction barring them from serving as an officer or director of a public company.
On May 19, 2009, Manning moved to dismiss certain of the allegations and claims in the complaint, and on the same date Crawford moved to dismiss the complaint as against him. Both motions were fully submitted on June 24, 2009. For the following reasons, the motions are denied.
The following facts are taken from the complaint in this action, and are presumed to be true for the purposes of this motion. Only the facts necessary to the resolution of this motion are set forth below.
Escala is a global network of companies in the collectibles market, which includes stamps, coins, arms, and armor. Its common stock is registered with the SEC pursuant to Section 12(g) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78l(g), and its common stock was previously registered pursuant to Section 12(b). Escala's fiscal year runs from July 1 to June 30. Manning founded Escala, and served Escala in various capacities since its founding, including as Chairman of the Board of Directors, CEO, and President. Crawford is a licensed CPA who served as Escala's CFO and Executive Vice President and was a member of Escala's disclosure committee.
As of May 2006, 70% of Escala's outstanding common stock was owned by Afinsa, a private company organized under the laws of Spain. Escala and another Afinsa subsidiary were the exclusive suppliers of stamps to Afinsa. Afinsa's principal business was a stamp investment program, in which it sold investment contracts based on portfolios of stamps to investors in Europe. Afinsa offered investors a guaranteed fixed rate of return for the stamp investments and promised investors that it would find a buyer for the stamps at the original purchase price or would buy the stamps back itself at the end of the contract term; alternatively, the investors could invest their returns in more stamps.
The prices that Afinsa's investors paid for the stamp portfolios were equal to the values for the stamps published in stamp catalogues, but Afinsa purchased the stamps for a fraction of the catalogue values. When Afinsa repurchased stamps from the investors, the price was the catalogue price plus the guaranteed rate of return. Afinsa ceased operations in May 2006 when it was raided by Spanish authorities as part of a criminal investigation. The authorities allege that Afinsa was selling investors interests in portfolios of stamps that were overvalued or forgeries, and that the promised rate of return was paid from the investments of new investors in a pyramid or ponzi scheme.
A. The Escala/Afinsa Business Combination
In January 2003, after conversations initiated by Manning in April 2002, Escala and Afinsa signed a business combination arrangement. In the spring of 2003, before this transaction had closed, Manning examined the stamps in Afinsa's vault that were used for Afinsa's investment program, and he discovered that stamps with an estimated value of $200 to $300 million were forgeries. Afinsa confirmed this discovery in August 2003, and Escala entered into an agreement to become Afinsa's exclusive stamp supplier.
The business combination transaction closed in September 2003; Afinsa acquired shares of Escala's common stock such that it became the owner of 72% of Escala's outstanding stock, and Escala acquired Afinsa's other stamp supplier subsidiary. Manning completed this business combination with Afinsa without disclosing the discovery of the forgeries to others at Escala. Escala was under pressure as the exclusive supplier of stamps to Afinsa, because the operation of Afinsa's investment program required increasing numbers of investors, and therefore increasing numbers of stamps to sell.
B. The Brookman Agreement
Afinsa also wanted to be able to increase the catalogue prices of the stamps it was selling to investors, and therefore sought control of an existing international stamp catalogue. Discussions on this topic included Manning, and were occurring during the early stages of the Escala/Afinsa business combination negotiations. Manning suggested to Afinsa that it should enter into an arrangement with B & W, a company that owned the stamp catalogue known as the Brookman Catalogue, telling Afinsa: "I believe that a deal could be set up with [the current owners] staying on to run the entire operation . . . . We would have complete editorial control over the prices in the catalogue, but we can still use the current editors for the bulk of the work."*fn3 Manning negotiated with B & W on behalf of Afinsa to gain editorial control of the Brookman Catalogue.
On June 16, 2003, Afinsa and B & W signed the Brookman Agreement, which gave Afinsa "full and final editorial review and control of the content and form of each edition of the Brookman Catalogue published during the term of [the] agreement," including "final review of all pricing, the preparation and revision of all descriptions and the deletion and/or addition of material." The agreement was negotiated by Manning and drafted in-house at Escala. Crawford learned of the agreement while it was being drafted at Escala.
The Brookman Agreement also provided for non-disclosure of its contents. In October 2003, a representative of Afinsa thanked Manning for brokering the Brookman Agreement and reminded Manning that Afinsa's name "must not appear" in any Brookman Catalogue.
C. United Nations Archive
The United Nations philatelic archive ("UN Archive") consisted of artwork, imperforates, die proofs, and progressives pertaining to stamp issues and philatelic materials produced by the United Nations Postal Administration from 1951 to 2000. On May 12, 2003, a business acquaintance of Manning purchased most of the UN Archive at a public auction for $3.1 million. On June 1, 2003, Manning purchased the UN Archive from the acquaintance for $4.8 million.
On June 2, 2003, Manning sold most of the UN Archive to Afinsa for $6.4 million, payable in three equal installments. Manning had told Afinsa about the public auction of the UN Archive that was to occur during the Escala/Afinsa business combination negotiations. The June 2 transaction was booked in Escala's 2003 fourth quarter. The $6.4 million price was 8% of the Brookman Catalogue value of $80 million for the material.
Even before Escala had acquired the UN Archive material, Manning informed Afinsa of his plan to list the UN Archive material in the Brookman Catalogue at prices that were many times higher than the actual purchase prices. On June 2, 2003, the day of the sale of the UN Archive from Escala to Afinsa, Manning told Afinsa that the total catalogue value of the same may approach $150 million or more, and by June 4 he told Afinsa that the final catalogue value for the material would be about $180 million. Afinsa urged Manning to "go for even more," and by July 16, 2003, the total catalogue value of the UN archive material was over $215 million. Crawford knew that Manning set the initial values in the Brookman Catalogue for the UN Archive.
The values in the Brookman catalogue set by Manning also formed the basis for future Escala sales of UN stamp material to Afinsa. Escala obtained the "imperforates and progressive proofs" in April 2004 for $2.8 million. It then sold the material to Afinsa, booking revenue of approximately $11.8 million between December 2004 and July 2005. The sale prices to Afinsa were calculated as 15% of the $70 million catalogue value for the imperforates and progressive proofs; the catalogue value was derived by Manning from the UN catalogue values he and Afinsa set in the Brookman Catalogue. These transactions were booked in the second and third quarters of Escala's 2005 fiscal year.
D. The Washington Collection
In 1996, Escala purchased a collection of items for $1.2 million that was purported to have belonged to George Washington. In 1997, the collection was appraised at a value of $2 million. Escala could not sell the collection, however, and in June 2003 it wrote down the value of the collection to $96,000 pursuant to a company policy because the collection had not been sold. Both Manning and Crawford knew that the collection had not been sold, and Escala board members were asking why the collection was still on the company's books.
In October 2003, Escala re-characterized $500,000 of a reimbursement payment from Afinsa for business combination-related expenses as a first quarter sale of inventory for $500,000. The re-characterization of the $500,000 took place after the close of the fiscal year 2004 first quarter. The $500,000 purchase price greatly exceeded the carrying cost of the Washington Collection inventory, and the inventory was not completely delivered to Afinsa.*fn4 In addition, Escala's business combination-related expenses remained unpaid.
Specifically, on September 29, 2003, Escala invoiced Afinsa for $631,525 in business combination-related expenses, and Afinsa wired that amount to Escala on October 3, 2003. A few weeks later, Manning told Crawford that he had sold the Washington Collection to Afinsa for $500,000. Instead of creating a new invoice to bill Afinsa for this sale, Manning told Crawford to use a portion of the $631,525 previously received for business combination-related expenses to book the sale.
In order to do so, Crawford had to destroy a previously issued invoice and create a new one. Crawford instructed Escala's bookkeeper as follows: The invoice for $631,525 "should be destroyed and replaced with 2 invoices. That invoice was in error. Use the original invoice number for an invoice for $500,000. . . . [T]ype on the invoice 'Invoice for all components of the Washington Collection' . . . date the [invoice] no later than September 30." Crawford also told the bookkeeper to type a second invoice for $131,525 for business combination-related expenses and to give it the same date as the other invoice. He told the bookkeeper that "[t]hese bills are not to be sent to Afinsa; the bills have already been paid." On October 20, the bookkeeper responded by saying that "[t]he computer already assigned an invoice # and it cannot be used again . . . the Auditors already have all copies of billings to Afinsa as of last Thursday for the quarter . . . . What do you want me to do?" Crawford told the bookkeeper that same day to "do exactly what I asked you to do except make two new invoice numbers." Two new invoices were created and backdated to September 30, 2003.
Escala's 10-Q quarterly report for the first quarter of fiscal year 2004 (filed with the SEC on November 13, 2003) included revenues from the purported sale of the Washington Collection in the amount of $500,000 ($400,000 pre-tax net income). This amount was approximately 1.4% of Escala's first quarter ...