UNITED STATES DISTRICT COURT 10/11/207
NORTHERN DISTRICT OF ILLINOIS
EASTERN DIVISION
SECURITIES AND EXCHANGE COMMISSION, )
)
Plaintiff, )
) Civil Action No.
vs. ) 03C-1507
)
MICHAEL J. PIETRZAK and MAURICE W. ) Judge Grady
FURLONG, )
)
Defendants. )
________________________________________________)
SEC’S REPLY TO DEFENDANTS’ RESPONSE TO THE SEC’S MOTION TO IMPOSE PERMANENT INJUNCTIONS, DISGORGEMENT, PREJUDGMENT INTEREST, CIVIL PENALTIES, OFFICER-DIRECTOR BARS AND PENNY STOCK BARS AGAINST FURLONG AND PIETRZAK, AND TO ENTER FINAL JUDGMENT AGAINST THEM
The SEC, in response to the Court’s order of October 3, 2007, hereby files its reply brief which sets forth “the legal authorities it will rely on in reply to the points raised in the defendants’ response brief.” See Court’s Order 10/3/2007. The bulk of the legal authority relied upon by the SEC is set forth in its brief supporting its motion filed with the Court on August 27, 2007, which except for certain points of reply, will not be repeated in this reply.
The defendants have alleged various factors, that they contend are mitigating in nature, which the Court should consider in imposing final judgment against Furlong and Pietrzak. These “factors,” among other things, include self-serving contentions that Furlong and Pietrzak “reinvested” money received from their stock sales during the fraud back into the company; that they did not override CFO Berry and Auditor McGhie in preparing the balance sheet and responding to the SEC; and that the defendants did not “cut and run” from the SEC’s investigation, but rather “engaged it in a dialogue with the aim of resolving complex accounting issues.” See Response Brief, pp1-2. The “factors” that the defendants ask the Court to adopt as mitigating are either irrelevant or are
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essentially contrary to the conclusions of the jury verdict in this case, and should be disregarded.
The jury’s responses to the verdict interrogatories indicated that it found fraud, against both defendants, on every category of assets that HCCA recorded on its balance sheet between 1996 and 2001. Further, the jury found fraud in virtually all press releases that the defendants caused HCCA to issue between 1996 and 2001. This scheme was a “pump and dump” whereby the defendants issued false “good news” press releases to pump the stock price, which they then often followed with large sales of their personal HCCA stock. It was Furlong and Pietrzak who consistently benefited from the fraud, at the expense of other shareholders. It is abundantly clear from Furlong’s and Pietrzak’s trial testimony that they lived essentially, over the 3½ year period of the fraud, from their personal stock sales in HCCA. During the fraud, they were dumping stock on an unsuspecting public based upon information that they released in the marketplace, which they knew to be false. From the jury’s verdict (including its responses to the verdict interrogatories), no other reasonable conclusion can be reached. To that end, there are no real mitigating “factors” that this Court should consider in imposing final judgment against the defendants.
I. INJUNCTIVE RELIEF
The defendants contest the entry of a permanent injunction, and contend that the injunction against them “should be limited to a reasonable period of time.” See Response Brief, p. 3. The case of SEC v. Holschuh, 694 F.2d 130 (7th Cir. 1982) provides guidance to this Court as to the considerations for the entry of a permanent injunction. In Holschuh, the Seventh Circuit held that in an action for a statutory injunction, the Court, in predicting the likelihood of future violations, must assess the totality of the circumstances surrounding each defendant and his violation, including such factors as the gravity of the harm caused by the offense; the extent of the defendant’s participation and the degree of his scienter; isolated or recurrent nature of infraction and likelihood that the defendant’s customary business activities might again involve him in such transaction; the defendant’s recognition as to his own culpability; and the sincerity of his assurances against future violations. Id. at 144.
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Notwithstanding the fact that Furlong and Pietrzak have failed to cite any legal authority to support a time limited rather than permanent injunction, this is a case where egregious circumstances exist, and a permanent injunction is more than warranted. For example, Furlong is a long time recidivist with securities violations going back to 1988. He has been previously enjoined by a federal court against further securities laws violations, and has also been ordered to cease and desist from various securities laws violations in at least four (4) states. Furthermore, Furlong has admitted that during the scheme, and for years prior, he has not paid income tax on any of his income derived from the fraud. The HCCA scheme was not an isolated incident of securities fraud, but a multiyear scheme which indicates a predilection for a continuing fraud. As to Pietrzak, he pled guilty to a misdemeanor in Illinois for aiding and abetting others in connection with the misapplication of bank funds, and has also admitted that for much of the period of the HCCA fraud, he failed to file tax returns or failed to pay taxes on his earnings. Both defendants make much ado about their 4/22/2005 resignations as HCCA board members. However, this fact is of little import to the entry of a permanent injunction. First, their resignation occurred more than four (4) years after the period for which they were sued by the SEC in this fraud. Secondly, their resignation is of little import to the likelihood of future violations, as the defendants do not need the corporate vehicle of HCCA (or its successors) to engage in further securities fraud—they can simply buy another shell corporation and start a fraud all over again. For both Pietrzak and Furlong, this was a calculated scheme over a long period of time. Moreover, neither of the defendants has admitted wrongdoing in this matter. Finally, as to their promise to never again serve as an officer or director of another public company, they could simply change their minds tomorrow. The public is not protected in this case, without the entry of a permanent injunction.
II. DISGORGEMENT
The Court’s recent order concluded that it had considered the authorities cited by the SEC in its motion, and has ruled that the case authority supported the SEC’s position that Furlong and Pietrzak should not be given any set-off on disgorgement for alleged business expenses, or “reinvestment” against the SEC’s claim for disgorgement. See Court’s Order 10/3/2007. The SEC alleged, and proved, that HCCA’s assets were
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fraudulently recorded. The defendants argue that the SEC “changed its mind” on how assets should be recorded, and that they should have some set off on disgorgement for the period of time prior to a clear direction from the SEC to remove assets. It related primarily to the real estate assets. That the SEC “changed its mind” on how assets should be recorded, was an argument advanced by the defendants at trial. However, that argument was one which the jury soundly rejected. It is readily apparent from the verdict interrogatories, which found fraud as to all of HCCA’s assets, that the jury held the defendants, as officers and directors of HCCA, responsible for the bookings of the various assets in HCCA’s financial statements. Any attempt to carve down the period of disgorgement based upon this theory is wholly unsupported by the jury verdict or by the law on disgorgement. Not surprisingly, the defendants offer no case or statutory authority to support their bald contention that the Court should narrow the calculation of disgorgement in this manner. Their argument is without merit.
The defendants contend that brokerage commissions paid by Pietrzak and Furlong should be deducted from the disgorgement they are ordered to pay. See Response Brief, p. 5. It is arguably discretionary with the Court as to whether brokerage commissions should be deducted from disgorgement, and some indirect authority exists on that point. SEC v. Bocchino, 2002 WL 31528472 (S.D.N.Y. 2002); Litton Industries v. Lehman Brothers Kuhn Loeb, Inc. 734 F. Supp. 1071, 1077 (S.D.N.Y. 1990). While this Court should note that Litton is not an SEC enforcement action, but is rather a tender offer case between private parties, the Court in that case reasoned that direct transaction expenses such as brokerage commissions could be deducted from disgorgement. There is no case law which compels this Court to deduct brokerage commissions in this case. Litton provides little authority for this Court, on this issue. In fact, the more compelling consideration is that while Furlong and Pietrzak argue that the Court should allow them credit for commissions they paid, they have failed to offer any proof as to a calculation, by percentage or otherwise, which would establish that they in fact paid sales commissions, when they sold their HCCA stock between 1997 and June 30, 2000. Given their complete silence on the amount of brokerage commissions they contend should be deducted, the Court should disallow this deduction for failure to prove commissions allegedly paid.
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III. PREJUDGMENT INTEREST
On the issue of prejudgment interest, Furlong and Pietrzak contend that interest should be disallowed because prejudgment interest in this case “would not be used to compensate investors, but would be paid to the U.S. Treasury.” See Response Brief, p. 6. This misses the point entirely on the issues of both disgorgement and prejudgment interest. Without question, although disgorgement can be used to reimburse investors, the purpose of disgorgement is not to reimburse defrauded investors, but rather is a method based in equity to force a defendant to give up the amount by which he was unjustly enriched—and it is therefore unlike an award for damages. SEC v. First Jersey Securities, Inc., 101 F.3d 1450, 1475 (2d Cir. 1996). The decision whether to grant prejudgment interest and the rate used if such interest is granted are matters left to the district court’s broad discretion. Id. at 1476. Furthermore, in deciding whether an award of prejudgment interest is warranted, the Court should consider that in an enforcement action brought by a regulatory agency, the remedial purpose of the statute takes on special importance. As set forth in First Jersey at 1476, when the SEC itself orders disgorgement, the interest rate it imposes is generally the IRS underpayment rate, which essentially reflects what it would have cost to borrow the money from the government, and therefore reasonably approximates one of the benefits that the defendants derived from the fraud. Courts have therefore approved the use of the IRS underpayment rate in connection with disgorgement. SEC v. Drexel Burnham Lambert, Inc., 837 F.Supp. 587, 612 n.8 (S.D.N.Y. 1993), affirmed 16 F.3d 520 (2d Cir. 1994), cert. denied 513 U.S. 1077, 115 S.Ct. 724, 130 L.Ed.2d 629 (1995); SEC v. First Jersey Securities, Inc., 101 F.3d 1450, 1476 (2d Cir. 1996). Further, the law supports the conclusion that prejudgment interest should be paid for the entire period from the time of the defendants’ unlawful gains to the entry of the judgment. Indeed, even where litigation was protracted through some fault of the SEC, defendants have been held plainly to have had the use of their unlawful profits for the entire period, and given the remedial purpose of the statute, the goal of depriving culpable defendants of their unlawful gains has been upheld on appeal. SEC v. First Jersey Securities, Inc., 101 F.3d 1450, 1477 (2d Cir. 1996). Whether Furlong and Pietrzak used the funds to pay living expenses, or to gamble, or to “reinvest” in HCCA as they self-servingly contend, they nonetheless have had free use of
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the disgorgement proceeds for a decade. Prejudgment interest is appropriate for the entire period of 10 years because to do otherwise would amount to interest free use of those ill-gotten gains over that decade.
IV. PENNY STOCK BAR
Contrary to the defendants’ assertion, the SEC is not asking the Court to retroactively apply the statute authorizing penny stock bars. The SEC is asking the Court to issue a penny stock bar based upon the Court’s inherent equitable powers. Federal courts possess broad equitable powers to impose ancillary relief upon individuals who violate the federal securities laws. SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1103 (2d Cir. 1972) (“Once the equity jurisdiction of the district court has been properly invoked by a showing of a securities law violation, the court possesses the necessary power to fashion an appropriate remedy.”) Therefore, this Court should use its equitable powers to impose penny stock bars against Furlong and Pietrzak, thereby providing protection to the public. In SEC v. Posner, 16 F.3d 520 (2d Cir. 1994), the 2d Circuit upheld a district court’s order that imposed O&D bars on the defendants even though the conduct occurred before the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Pub. L. No. 101-429, 104 Stat. 931 (“Remedies Act”), added O&D bars to the available statutory remedies in securities laws. Rather than decide whether the Remedies Act applied retroactively, the 2d Cir. upheld the district court because it had used its equitable powers as an alternate basis for imposing the bar. Id. at 521. Similarly, this court should impose penny stock bars on Furlong and Pietrzak using its own equitable powers.1 A person participating in an offering of penny stock includes one who engages “in activities with a[n] . . . issuer for purposes of the issuing, trading, or inducing or attempting to induce the purchase or sale of, any penny stock.” §20(g)(2) of the Securities Act and §21(d)(6)(B) of the Exchange Act.
Furlong and Pietrzak violated §17(a) of the Securities Act and §§10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5 and 13b2-1 thereunder and aided and abetted
1 Section 603 of the Sarbanes-Oxley Act amended §20 of the Securities Act and §21(d) of the Exchange Act to provide federal courts with statutory authority to bar an individual from participating in an offering of penny stock. The SEC seeks penny stock bars against Furlong and Pietrzak even though their conduct took place prior to the enactment of the Sarbanes-Oxley Act.
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violations of §§13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-11 and 13a-13 thereunder by, inter alia, filing several false and misleading reports and registration statements from 1996 through 1999, publishing false and misleading press releases and a letter to shareholders, and fraudulently selling their HCCA stock. During those years, HCCA stock was a penny stock, because its price was less than $5, its net tangible assets were negligible, and it had no revenues. See §3(a)(51)(A) of the Exchange Act and Rule 3a51-1(g). As officers of HCCA, Furlong and Pietrzak conducted a registration of HCCA’s stock on Form 10-SB and issued periodic reports, press releases and a letter to shareholders, thereby engaging in activities with HCCA for purposes of trading of its stock, or inducing or attempting to induce the purchase or sale of its stock. Therefore, the defendants' violations occurred while they were participating in an offering of penny stock. See In re Charles D. Ledford, Securities Exchange Act Release No. 41941 (September 29, 1999), 1999 SEC LEXIS 2029 (corporate officer barred for involvement in issuer’s false and misleading press releases); In re Lynn K. Ross, Securities Exchange Act Release No. 39041 (September 10, 1997), 65 S.E.C. Docket 0987 (Oct. 7, 1997) (corporate officer barred for involvement in issuer’s false and misleading periodic reports and book and records).
V. OFFICER AND DIRECTOR BARS
As to the officer and director bars sought by the SEC against Furlong and Pietrzak, they contend the bars should be time limited, and that the standard has to be “substantial unfitness” rather than “unfitness.” See Response Brief, pp 8-9. Even if using the “substantial unfitness” standard, the evidence strongly suggests permanent O&D bars are appropriate in this case. Courts generally consider six factors when making a “substantial unfitness” determination: “(1) the ‘egregiousness’ of the underlying securities law violation; (2) the defendant’s ‘repeat offender’ status; (3) the defendant’s ‘role’ or position when he engaged in the fraud; (4) the defendant’s degree of scienter; (5) the defendant’s economic stake in the violation; and (6) the likelihood that misconduct will recur.” E.g., SEC v. Patel, 61 F.3d at 141 (2d Cir. 1995). Courts may consider some of these factors, all of them, or additional factors. Id. at 141.
Analysis of these factors demonstrates that O&D bars against Furlong and Pietrzak are appropriate. Their violations were egregious; they were and remained officers of a public company until at least April 2005; they acted with high degrees of 7
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scienter; they had a large economic stake in their violations (Furlong and Pietrzak raised $3,452,823 and $1,296,720, respectively); and their flagrant violative conduct suggests likelihood of recurrence. Moreover, Furlong is a recidivist who was previously enjoined by the SEC in 1988 and was subjected to cease-and-desist orders by 2 states in 1977 and 2 states in 1994. Bars are needed to prevent Furlong and Pietrzak from ever acting as officers and directors of a public company in the future. As to their self-serving promises at trial that they will never serve as officers or directors of a public company in the future, absent a bar, they can change their minds tomorrow, acquire yet another shell entity, and start the fraud over again. O&D bars are essential in this case to protect the public from these defendants.
VI. CIVIL PENALTIES
As to civil penalties, Furlong and Pietrzak ask that the Court not impose one in this case, because they contend they put more into HCCA than they received from their fraudulent sales of the company’s stock. See Response Brief, p. 10. The statute authorizes the imposition of a civil penalty equivalent to the ill-gotten gains received by the defendant, or in the alternative $110,000 per violation.
The defendants contend that the Court should consider their inability to pay in granting any civil penalty, and cite the case of SEC v. Parks, 222 F. Supp. 2d 1124, 1134 (N.D. Ill 2002), (which has incorrectly cited by the defendants as SEC v. Gorsek). The holding in Parks is that inability to pay may be considered to some extent in the determination to order defendants to pay a civil penalty at a certain amount. The case makes the distinction between the more and less culpable of the defendants, but concludes it appropriate to award civil penalties as to both defendants. However, in this case, the Court should consider two factors. First, Furlong and Pietrzak were both essential parts of the fraudulent scheme. They both signed financial statements of HCCA; both served as officers and directors of HCCA; both interfaced with the internal accounting people on various assets the jury found to be fraudulent; and both profited from their sales of HCCA stock during the period of the fraud. Secondly, the financial statements submitted by Pietrzak and Furlong are of little value as to their true net worth, because they are not executed as true and correct before a notary public who witnessed their swearing, and cannot amount to a proper declaration pursuant to 28 U.S.C. §1746,
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because they were not executed in conformity with the requirements of that statute. Given the testimony of the defendants at trial, which was soundly rejected by the jury with its verdict, this Court should justifiably be circumspect of essentially unsworn, self serving statements of low net worth by two men who are not in bankruptcy, but who otherwise sold voluminous amounts of HCCA stock during the fraud. Their credibility is less than forthcoming, and should be viewed with great skepticism. Moreover, Furlong and Pietrzak have lived for the past decade off funds that were derived not the result of any product they produced or sold. Rather, their funds were derived from the printing and selling of HCCA stock. Given their work histories, health, and relative youth, there is a substantial likelihood that these defendants will again come into money in the future. To that end, the Court should not allow them to avoid a substantial civil penalty today, based upon a claimed inability to pay, where they will likely be able to pay that civil penalty in the future. Courts are frequently comfortable with a one-time civil penalty under the federal securities laws, against each defendant, in an amount equal to the gross amount of pecuniary gain as to that defendant. See SEC v. Interlink Data Network of Los Angeles, Inc. et al., 1993 WL 603274 (C.D. Cal. 1993); Fed. Sec. L. Rep. P 98,049.
RESPECTFULLY SUBMITTED,
/s/Edward G. Sullivan
Edward G. Sullivan
Senior Trial Counsel
/s/William P. Hicks
William P. Hicks
Regional Trial Counsel
COUNSEL FOR PLAINTIFF
SECURITIES AND EXCHANGE COMMISSION
3475 Lenox Road, N.E. Suite 1000
Atlanta, Georgia 30326
(404) 842-7612
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CERTIFICATE OF SERVICE
I hereby certify that the foregoing SEC’S REPLY TO THE DEFENDANTS’ RESPONSE TO THE SEC’S MOTION AND BRIEF TO IMPOSE PERMANENT INJUNCTIONS, DISGORGEMENT, PREJUDGMENT INTEREST, CIVIL PENALTIES, OFFICER-DIRECTOR BARS AND PENNY STOCK BARS AGAINST FURLONG AND PIETRZAK, AND TO ENTER FINAL JUDGMENT AGAINST THEM was served by ECF filing with the Court, which automatically notifies counsel, on this 11th day of October, 2007, upon the following:
Keith E. Roberts, Esq.
Robert S. Marcott, Esq.
Roberts & Associates, P.C.
104 East Roosevelt Road, Suite 202
Wheaton, IL 60187
/s/Edward G. Sullivan
Edward G. Sullivan
Senior Trial Counsel
Counsel for Plaintiff
Securities and Exchange Commission
3475 Lenox Road, N.E., Suite 1000
Atlanta, Georgia 30326
(404) 842-7612
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