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Securities and Exchange Commission v. Fernando J. Espuelas

March 3, 2011


The opinion of the court was delivered by: Richard J. Holwell, District Judge:


This is third motion to dismiss in this enforcement action by the Securities Exchange Commission ("SEC") against former executives of StarMedia Network, Inc. ("StarMedia" or the "Company") for accounting fraud. The SEC alleges violations of Sections 10(b), 13(a), 13(b)(2)(A), and 20(e) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. §§ 78j(b), 78m(a), 78m(b)(2)(A), and 78t(e); and Rules 12b-20, 13a-1, 13a-13, 13b2-1, and 13b2-2 thereunder, 17 C.F.R. §§ 240.12b-20, 240.13a-1, 240.13a-13, 240.13b2-1, and 240.13b2-2. This Court initially dismissed many of the SEC's claims against several defendants but found that the SEC's original complaint stated claims against defendant Peter M. Morales. See SEC v. Espuelas, 579 F. Supp. 2d 461 (S.D.N.Y. 2008) ("Espuelas I"). The SEC filed an amended complaint and, with a few exceptions not relevant here, denied a motion by defendants other than Morales to dismiss the claims against them. See SEC v. Espuelas, 698 F. Supp. 2d 415 (S.D.N.Y. 2010) ("Espuelas II"). Now before the Court is a motion by Morales for judgment on the pleadings as to the claims against him on the ground that the content of the amended complaint vitiates the basis on which the Court denied his motion to dismiss the original complaint. For the reasons set forth below, the motion is denied.


The SEC's original allegations are set forth in the Court's prior opinions in Espuelas I and Espuelas II, familiarity with which is assumed. The following allegations are relevant to disposition of the instant motion and taken as true for that purpose. See Harris v. Mills, 572 F.3d 66, 71 (2d Cir. 2009).

StarMedia was an Internet portal focused on Spanish- and Portuguese-speaking markets. (Am. Compl. ¶ 24.) Defendant Morales served as Controller and Vice President, Finance for StarMedia from June 1998 through November 2001. (Id. ¶ 22.)*fn1

In 2000, StarMedia experienced a steady decline in its stock price, "in part because of a general decline in Internet advertising revenues." (Id. ¶ 37.)

The SEC alleges that, in response to the decline in revenues, StarMedia developed a series of schemes to falsely inflate and improperly recognize revenue through three types of transactions, referred to by the SEC as (1) base book; (2) incremental revenue; and (3) contingent transactions. (Am. Compl. ¶ 1.) In late 2001, StarMedia restated its financial statements to correct the accounting for these transactions. (Am. Compl. ¶ 3.) The allegations against Morales relate to the incremental revenue transactions. However, because Morales essentially contends that the SEC has conflated its theories regarding the base book and incremental revenue transactions, discussion of both kinds of transactions is warranted.

A. The Base Book Transactions

The essence of the base book transactions was reciprocal advertising sales. In April 2000, StarMedia acquired AdNet S.A. de C.V. ("AdNet"), "a leading Mexican Internet search portal and Web directory", from its shareholders, the media companies Grupo MVS, S.A. de C.V. ("MVS") and Harry MAller Publicidad, S.A. de C.V. ("HMP"). (Id. ¶ 25.) Prior to this acquisition, MVS, HMP, and AdNet had an agreement whereby MVS and HMP would purchase internet advertising from Adnet and AdNet would buy advertising from MVS and HMP in the same amount. (Id. ¶ 31.) Because AdNet was obligated to pay MVS and HMP exactly what MVS and HMP paid AdNet, neither party generated any cash revenue on the transactions. (Id. ¶ 33.) However, the services that MVS and HMP purchased from AdNet pursuant to this arrangement accounted for 60% of AdNet's revenue. (Id. ¶ 31.) In acquiring AdNet, Star Media agreed to continue the arrangement and to retain defendant Walther Maller, whose family owned HMP, as President of AdNet to maintain the relationships between MVS, HMP, and AdNet. (Id. ¶¶ 32-33.)

StarMedia reported revenue from advertising sales to MVS and HMP in late 2000 and the first two quarters of 2001. (Id. ¶¶ 31, 33, 39, 52, 72, 86, 103.) The SEC alleges that, because MVS and HMP purchased advertising in exchange for receiving an identical dollar amount in purchases by AdNet, accounting for sales to MVS and HMP as equivalent to cash revenue was improper. Indeed, StarMedia later wrote off more than 90 percent of the revenue it had previously reported from the transactions. (Id. ¶¶ 3, 43-45.)

B. Incremental Revenue Transactions

The incremental revenue transactions occurred in the fourth quarter of 2000 and

the first two quarters of 2001, and all defendants allegedly took part in them. (Id. ¶¶ 4, 57--71, 88--93, 104.) These transactions were similar to the base book transactions in that they involved transfers of money from StarMedia, through AdNet, to MVS and HMP in amounts equal to advertising purchased by MVS and HMP from AdNet. However, whereas the SEC alleges that the base book transactions involved reciprocal purchases of advertising,the SEC alleges that the incremental revenue transactions involved an agreement to purchase unspecified "services" from HMP and MVS. (Am. Compl. ¶ 65.) Indeed, the SEC merely alleges that "MVS and HMP purchased the ad space in exchange for StarMedia's promise to provide them with funds in an amount equal to the advertising purchases." (Id. ¶ 4.)

StarMedia management developed these transactions in late 2000 after it learned that revenues would fall significantly short of both internal and analyst expectations. (Id. ¶ 57.) To fill the gap, StarMedia management decided to leverage Maller's family connections with MVS and HMP to increase revenue. (Id. ¶¶ 57, 59.) On November 29, 2000, Maller sent an e-mail to Steven J. Heller, StarMedia's CFO and Morales's superior, in which Maller diagrammed what would come to be called the "incremental revenue" transactions: StarMedia would make capital contributions to AdNet; AdNet would use the funds to purchase $3.2 million in "services" from HMP and MVS; and HMP and MVS would direct the purchase of $3.2 million in advertising from AdNet purportedly on behalf of HMP and MVS clients. (Id. ¶¶ 60, 62.) Some of these clients were unaware of the purchases, while others knew but did not care because it was MVS and HMP who were actually paying for the advertising. (Id. ¶ 65.).

Morales was "not involved in the negotiations of the incremental revenue transactions." (Id. ¶ 70.) Rather, Morales "learned about the scheme from Heller" at some time between November 29 and December 4, 2000. (Id.) The SEC alleges that "Heller first told Morales about the incremental revenue transactions" and "also told him the planned accounting treatment for them," namely, "that StarMedia would recognize all revenue from the transaction in the fourth quarter but defer recognition of the expenses related to the offsetting, purchased services until the quarter in which the services were utilized." (Id.) "Morales initially did not agree with this treatment" and "told Heller that the transactions appeared to be barter transactions and should be classified and recorded as such." (Id.) However, after Heller assured Morales that Heller would take care of any issues raised by the company's auditors, "Morales relented" and on December 4 at Heller's direction, "approved the wire transfer of $345,000 from StarMedia directly to HMP", a payment that "provided the initial funds used to capitalize the incremental revenue transactions." (Id. ¶ 71.) Morales also later transferred $950,000 to HMP after the close of the first quarter of 2001 "for advertising purchased pursuant to the incremental revenue transactions in that quarter" and, at the close of the second quarter, "directed the transfer" of $517,500 from StarMedia to AdNet and "knew that the funds were to be paid to HMP as part of the incremental revenue agreement." (Id. ¶¶ 93, 105.)

In reports to the SEC, StarMedia recognized and recorded $3.2 million in revenue in the fourth quarter of 2000, $2.6 million in revenue in the first quarter of 2001, and $2.6757 million in revenues in the second quarter of 2001 from the incremental revenue transactions. (Id. ¶¶ 67-68, 87, 103-104.) However, in November 2001, StarMedia "wrote off the entire amounts previously reported as revenue." (Id. ¶ 4.) The SEC ...

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