Court: District Court, S.D. New York; January 5, 2015; Federal District Court
A default judgment has been sought by the Securities and Exchange Commission (SEC) against eight defendants involved in a fraudulent scheme related to the penny-stock company Biozoom, formerly known as Entertainment Arts, Inc. The company, incorporated in Nevada in 2007, initially claimed to design leather bags but was later sold in entirety to Medford Financial Ltd. in 2009, which, in turn, sold all shares to Le Mond Capital in 2012. Sara Deutsch, affiliated with both Medford and the defendants, became the new president of Biozoom.
From January to May 2013, each defendant opened accounts at U.S. broker-dealers, falsely claiming to have acquired 15,685,000 shares of Biozoom stock through private transactions with original investors, when in fact, all shares had been acquired by Medford years prior. They misrepresented the amount paid for these shares, totaling $84,260. Following a rebranding to Biozoom and a promotional campaign claiming to have developed a groundbreaking medical device, the stock price surged above $4 per share. The defendants then sold 14,078,406 shares without SEC registration, generating $33,421,062 in proceeds. Subsequently, seven defendants attempted to wire approximately $15,990,000 of these proceeds to foreign accounts before the SEC suspended trading in Biozoom stock on June 25. The Court acknowledges the SEC’s entitlement to default judgment but has reservations regarding the proposed remedies.
On July 3, 2018, the Commission initiated action against the defendants, leading to a temporary restraining order that froze their Biozoom shares. A preliminary injunction was later stipulated and ordered, requiring defendants to respond to the complaint by August 26. Defendants' counsel, McLaughlin, Stern, LLP, withdrew on September 11, 2013, and the motion was not opposed by the Commission. A scheduling order was issued on December 17, 2013, setting a response deadline of February 3, 2014, with a warning of potential default judgment for non-compliance. Defendants missed this deadline but were granted a 30-day extension after Brafman, Associates replaced McLaughlin, Stern. Brafman then also withdrew, and the Clerk certified the defendants' default on May 15, 2014. The Commission filed a motion on June 4, 2014, which was served according to prior stipulations. Communication ensued with Juan Ignacio Prada, an Argentinian lawyer claiming to represent the defendants, who requested the ability for some defendants to respond pro se. The Court clarified that while individual defendants could represent themselves, they could not be represented by foreign counsel in a U.S. action. Despite this, the defendants did not follow up nor respond further. The discussion section highlights that Rule 55 of the Federal Rules permits default judgment against parties who fail to defend. The defendants, despite having two law firms represent them, did not respond to the complaint for over ten months, despite multiple extensions and warnings about default judgment.
Defendants' prolonged inaction justifies the imposition of a default judgment, leading to an acceptance of the complaint's well-pleaded allegations of liability, excluding damages. While damages must be independently established through sufficient evidence, a court may conduct a hearing or rely on detailed affidavits and documentary evidence. The SEC submitted the Sachar Declaration, which sufficiently supports the remedies sought, negating the need for an evidentiary hearing, though the entry of final judgment is delayed to allow the SEC to address prejudgment interest.
The established facts indicate that defendants violated Section 5 of the 1933 Act, which mandates the registration of securities prior to sale. The SEC must demonstrate (1) the absence of a registration statement, (2) the offer or sale of securities, and (3) the use of interstate communications. The defendants were found to have sold unregistered Biozoom shares using international emails and instant messages without claiming any applicable exemptions, thus establishing a prima facie case of violation.
Regarding remedies, the SEC seeks a permanent injunction, disgorgement of illegal sale proceeds, disgorgement of prejudgment interest, and civil penalties equivalent to the proceeds. A permanent injunction is warranted under Section 20(b) of the 1933 Act, considering factors such as the likelihood of future violations, the defendants' liability for illegal conduct, the degree of scienter, and whether past conduct was systematic rather than isolated. These factors collectively support the need for a permanent injunction against the defendants.
Defendants exhibited scienter by misleading their American broker-dealers about the source of their Entertainment Art stock, suggesting coordinated wrongdoing. This manipulation poses significant risks to unsuspecting investors, prompting the Commission's request for an injunction.
The concept of disgorgement, aimed at removing the benefits gained through securities law violations, is well-established in enforcement actions. The SEC contends that failing to require disgorgement would undermine the deterrent effect of its actions. The amount to be disgorged should reasonably approximate the profits connected to the violations, with any uncertainties falling on the wrongdoers. The Commission seeks to recover proceeds from the defendants’ illegal sales, with calculations based on the difference between the amounts received for shares and the amounts claimed to have been paid.
The court agrees with the Commission’s calculations for some defendants, including Goldman, Baggatin, Ferrari, and Tavella, while noting discrepancies for others like Blaya and Ficicchia, where the proposed amounts exceeded actual net proceeds due to commissions and fees. The recalibrated figures match the allegations in the complaint.
Disgorgement of prejudgment interest is also permissible, aimed at depriving defendants of the benefit of illicit gains over time. The Second Circuit typically supports calculating this interest at the IRS underpayment rate, reflecting borrowing costs from the government. However, a recent decision limited the availability of prejudgment interest for funds frozen by the government, acknowledging challenges raised by defendants regarding such awards.
The Circuit acknowledged the defendant's argument regarding the awarding of prejudgment interest on disgorgement amounts, stating that such interest is discretionary for the period during which a defendant utilized illegal profits. However, if the defendant's assets are frozen due to government enforcement actions, awarding prejudgment interest on those assets is inappropriate since the defendant has been denied access to them during the freeze period. The Commission requested prejudgment interest starting July 1, 2013, but the court had issued a worldwide freeze on the defendants' relevant assets on July 3 and 17, 2013. The SEC did not provide evidence of any violation of the freeze orders or details on the returns from the frozen assets. Consequently, the court could only order disgorgement of actual returns on frozen assets without specifying the amounts. The court will defer judgment to allow the Commission to determine the actual returns, and if proven, those amounts may be included in the final judgment. If the Commission demonstrates a violation of the asset freeze by the defendants, it may renew its request for disgorgement of prejudgment interest on the frozen funds at the IRS underpayment rate.
Under Section 20(d) of the Securities Act, the court has jurisdiction to impose civil penalties for statutory violations, which can take three tiers based on the severity of the violation. The highest tier requires evidence of fraud or reckless disregard for regulations that resulted in substantial losses or risks to others. While the statute outlines maximum penalties, it grants the district court discretion to determine the actual penalty amount based on various factors, including the egregiousness of the conduct, the degree of intent (scienter), the impact on others, the frequency of the conduct, and the defendant's financial condition.
The Commission aims to impose penalties on each defendant equal to their gross pecuniary gain from selling Biozoom shares, seeking civil penalties ranging from approximately $2.0 million to $6.2 million per defendant. However, the Commission provides no specific rationale for the proposed penalty amounts, only citing that courts typically impose penalties equivalent to a defendant's earnings and asserting that the defendants engaged in an unregistered securities distribution without investors' knowledge. This lack of detailed argumentation is insufficient for justifying multi-million-dollar fines. While civil penalties are deemed appropriate to address the defendants' illegal actions, the Commission fails to clarify the defendants' roles in the Biozoom scheme—whether they orchestrated it, were merely participants, or acted under influence. The absence of this information leaves critical questions unanswered. A third-tier penalty is deemed justified due to the defendants' culpable conduct and the significant investor losses incurred. However, the maximum penalties are not imposed due to the lack of proportionality to the defendants' culpability. Ultimately, civil penalties of $160,000 are awarded against each defendant.
The Commission's motion for a default judgment is granted, but judgment entry is deferred to allow the Commission to provide additional information regarding the amount of prejudgment interest to be disgorged, which is due by January 23, 2015. The eight parties named as "Selling Defendants" are noted, while Mariana Graciarena and Fernando Loureyro, who have settled with the Commission, are excluded from findings in this opinion. There is a discrepancy between the total proceeds alleged in the complaint ($33,997,152) and a table listing proceeds totaling $33,421,062, which reflects different calculation methods for four defendants. The court finds the lower calculation to be correct for the purpose of this case.
The Commission's proposed order includes permanently barring defendants from participating in penny stock offerings, supported by 15 U.S.C. 77t(g). The proper purchase price cited is $6,765. The recalculation method for four defendants aligns with SEC staff calculations for other defendants as detailed in the complaint and the Sachar Declaration. Previous case law (Razmilovic) is referenced, indicating a need for clarification on whether frozen funds apply to disgorgement and prejudgment interest. Here, it’s established that the frozen funds are subject to disgorgement. The SEC’s rules suggest that the IRS underpayment rate may not apply to certain frozen funds, allowing for a potential lower rate of prejudgment interest for funds in escrow.
The Commission also noted that authorities in Belize and Cyprus have frozen the defendants’ assets, but this claim references out-of-Circuit decisions with questionable relevance due to a lack of factual similarity. Defendants' reported professions include various roles such as music producers, marketing specialists, and a delicatessen owner, with no direct relevance to the findings of the case.
