Clinton D. Brown v. Earthboard Sports Usa, Inc. Hugh Jeffreys Jeffrey A. Vaughn Lincoln Financial Advisors Corporation, D/B/A Sagemark Consulting
Docket: 05-6317
Court: Court of Appeals for the Sixth Circuit; March 16, 2007; Federal Appellate Court
Clinton D. Brown, a wealthy businessman, invested in Earthboard Sports USA, a small California company, based on a misleading tip from financial advisor Jeffrey Vaughn, who suggested a large public company would acquire Earthboard on favorable terms. This acquisition was fabricated by Earthboard's president, Hugh Jeffreys, resulting in financial losses for Brown and other investors. Brown subsequently sued Earthboard, Jeffreys, Vaughn, and Vaughn's employer, Lincoln Financial Advisors Corp., alleging federal and state securities violations. The district court entered a default judgment against Earthboard and Jeffreys but granted summary judgment to Vaughn and Lincoln, ruling that Brown's claims under Kentucky's Blue Sky law were preempted by the National Securities Markets Improvement Act of 1996 due to a valid federal registration exemption. Additionally, the court found Brown failed to present adequate evidence for key elements of his securities fraud claim, specifically scienter and loss causation. Brown appealed, and the appellate court reversed the summary judgment against Vaughn but affirmed the ruling in favor of Lincoln. Earthboard had filed for a federal registration exemption under Rule 506 of Regulation D in 1999, allowing it to sell unregistered securities to accredited investors, but did not amend its filing or seek a new exemption before continuing to offer its securities until around 2003.
Brown operated a marketing firm from 1988 to 1999. In 1998, his accountant introduced him to Vaughn, a financial advisor at Lincoln, who sought to become one of Brown's investment advisors. Vaughn recognized Brown as a potential client, especially after learning Brown would receive a significant sum from the sale of his firm in 1999. Following the sale, Vaughn frequently contacted Brown, and they developed a social relationship, including golfing, attending games, and social events together.
In August 2001, Vaughn learned about Earthboard through a builder and was connected with its president, Jeffreys. Vaughn communicated with Jeffreys about a potential acquisition deal with VANS, a footwear company, which promised a substantial return on investment. Jeffreys offered Earthboard's shares at $1 each, while VANS shares were trading at approximately $12, implying a potential 1100% gain. Vaughn, possibly acting on insider information, invested heavily in Earthboard despite the dubious nature of the information, as Jeffreys had a criminal background for fraud.
Vaughn initially invested around $228,000, purchasing 100,000 shares on September 25, 2001, and was mistakenly sent an additional 100,000 shares, which were later rescinded. He subsequently introduced other investors, including Brown, and purchased an additional 99,000 shares on March 3, 2002, receiving 7,000 extra shares as a commission. By December 2002, he bought another 29,000 shares for $1 each.
Vaughn initiated a personal investment venture and sought participation from friends, including Brown, whom he contacted in late November or early December 2001. Vaughn expressed his desire to demonstrate his value as a financial advisor and introduced an investment opportunity related to a privately held company, Earthboard, which was about to be sold to publicly traded VANS. To enhance credibility, Vaughn falsely claimed to have a personal connection with Earthboard’s president, Jeffreys. He presented an investment opportunity at $6 per share, emphasizing urgency due to the imminent nature of the transaction and the potential for Brown to double his investment quickly.
Brown expressed interest, leading Vaughn to arrange for a subscription agreement to be faxed to him on December 5, 2001. Despite concerns raised by his financial advisors regarding Vaughn’s access to insider information about the unannounced deal, Brown chose to rely solely on Vaughn’s advice, perceiving it as a solid investment opportunity without conducting independent research on Earthboard.
Brown received the subscription agreement and wire transfer instructions directly from Earthboard, with Vaughn assisting in the process. An original share price of $1 was crossed out and replaced with $6, which Brown assumed indicated an increase due to the upcoming transaction. He did not request a Private Placement Memorandum, which was mentioned in the subscription agreement. On December 13, 2001, Brown sent a completed subscription form for 100,000 shares and wired $600,000 to Earthboard per Vaughn's instructions.
Vaughn and Brown had multiple discussions regarding their investments in Earthboard and the fluctuating price of VANS stock. Brown requested information from Vaughn about Earthboard, who subsequently sent him press releases, including one on January 9, 2002, announcing an agreement for Earthboard's stock to be acquired by a major footwear company, which Brown believed to be true. Despite Brown’s assumption that the merger was imminent and his discussions with Vaughn regarding whether to sell or hold VANS stock, Vaughn had not met with Earthboard's president by January 2002 and may not have conducted due diligence before soliciting Brown. Vaughn initially claimed to have met Earthboard's president in early 2001 but later corrected himself, indicating the meeting occurred in March 2002.
On February 28, 2002, with VANS shares rising to $14, Brown purchased an additional 40,000 shares of Earthboard for $6 each, signing a new subscription agreement that included clearer disclosures about the securities, which were unregistered and offered under Section 4(2) of the 1933 Securities Act. Brown asserted that he was an accredited investor and relied solely on his own investigations, yet he claimed he did not receive Earthboard's financial statements or other critical documents.
Meanwhile, Vaughn bought 99,000 shares of Earthboard on March 3, 2002, received 7,000 shares as a commission, and continued acquiring shares through various means, including a purchase from a neighbor in July 2003. Ultimately, the anticipated transaction never materialized, revealing the scheme as fraudulent.
Brown filed a complaint against all defendants in September 2003 and amended it in November 2004. On May 27, 2005, the district court issued a default judgment against Earthboard and Jeffreys for $840,000, holding them jointly and severally liable despite their likely inability to pay. However, on August 2, 2005, the court ruled in favor of Vaughn and Lincoln, stating that Kentucky Blue Sky law was preempted by federal securities regulations and that Brown could not establish loss causation or scienter against Vaughn. Consequently, the claim against Lincoln was dismissed. Brown subsequently filed a timely appeal.
The district court exercised federal question jurisdiction over Brown's federal claims under 28 U.S.C. § 1331 and supplemental jurisdiction over state claims under 28 U.S.C. § 1367(a), granting summary judgment based on federal law. The court's legal conclusions are reviewed de novo. Brown argues that the district court erred in ruling that federal law preempts his state Blue Sky law claims, specifically citing the National Securities Markets Improvement Act (NSMIA), which amended the 1933 Securities Act. NSMIA preempts state regulation of "covered securities," which are defined as securities exempt from federal registration under certain conditions. The parties disagree on whether Earthboard's 1999 filing qualifies for Rule 506 exemption; Brown contends that actual compliance with SEC regulation is necessary, while defendants argue that the intent to qualify for an exemption suffices. The district court sided with the defendants, asserting that the filing entitled it to federal preemption under NSMIA. However, there is a division among courts on whether actual qualification for a federal exemption is necessary for NSMIA preemption, with this case now aligning with those that require such qualification.
In Temple v. Gorman, 201 F.Supp.2d 1238 (S.D.Fla.2002), the court determined that Congress's passage of the National Securities Markets Improvement Act (NSMIA) broadly preempted state law regarding registration of securities. The plaintiffs argued that their state law claims were not preempted because the securities in question did not meet the requirements for exemptions under Rule 506. The court acknowledged this claim but emphasized that NSMIA's intent was to streamline regulation of national securities markets by designating federal authority as the exclusive regulator for national offerings. Thus, the court concluded that the securities were considered federal covered securities, regardless of actual compliance with Regulation D or Rule 506, due to being sold under those federal rules. Consequently, the court found that the state's Blue Sky law was preempted because the defendants purported to qualify for a legitimate federal exemption.
Subsequent cases have echoed Temple's reasoning; however, some courts have criticized it. The Alabama Supreme Court, in Buist v. Time Domain Corp, 926 So.2d 290 (Ala.2005), required defendants to prove that their securities genuinely qualified for a valid federal exemption under NSMIA. Several federal courts have supported this approach, asserting that the burden of demonstrating the applicability of the exemption lies with the defendants. One court specified that a security must indeed meet the criteria of a "covered security" for federal preemption to be valid, diverging from Temple’s broader interpretation. Overall, there is a division among courts regarding the extent of NSMIA's preemptive effect on state law, with some emphasizing the necessity of actual compliance with federal exemption criteria.
In Hamby v. Clearwater Consulting Concepts, the court criticized the Temple court's interpretation of a statute that purportedly allowed securities to qualify as exempt from registration based on a mere assertion of compliance with an exemption. The court emphasized that the statute does not support this interpretation and that Congress did not intend for a defendant to evade liability by claiming an exemption. The ruling reinforced that the statute is clear and unambiguous without needing to reference legislative history.
Further, in Grubka v. WebAccess, the court denied a motion for summary judgment based on defendants' claims of exemption under Regulation D, highlighting the existence of factual questions regarding their exemption status. The prevailing legal framework indicates that Congress has the authority under the Commerce Clause to regulate securities trading, which includes the potential to preempt state laws. However, the court pointed out that the National Securities Markets Improvement Act (NSMIA) does not contain broadly preemptive language; it restricts preemption to "covered securities." It clarified that Congress did not intend to preempt state laws concerning non-"covered" securities, and the SEC has established specific criteria for what constitutes a "covered security." Thus, NSMIA only preempts state securities registration laws for offerings that meet the SEC's defined criteria for "covered securities."
Appellees argue against adhering to the plain language of the statute, advocating instead for the use of legislative intent, which they and the district court have interpreted. The text cautions against relying on legislative history, emphasizing its potential for manipulation and misinterpretation. Legislative history may clarify ambiguous statutes, but cannot modify unambiguous statutory text. The court asserts that Congress must explicitly express any intention to preempt state Blue Sky laws, which it did not do. Consequently, the district court's ruling is reversed, affirming that NSMIA only preempts state securities registration for securities qualifying as "covered securities" under federal law.
The appellees further claim that Earthboard's 1999 offering qualifies for the Rule 506 exemption, invoking NSMIA preemption. The court notes that federal preemption is an affirmative defense, placing the burden of proof on the defendants. It references the necessity for a party claiming preemption to provide a substantial legal basis for their claim, which must not contradict the statutory language or be previously rejected by courts. The court concludes that the Union's argument regarding preemption, dependent on Davis' employment status, lacks sufficient evidence to demonstrate that Davis was an employee rather than a supervisor, thereby failing to meet the required burden of proof.
Successful assertion of federal preemption as an affirmative defense on summary judgment involves two key steps. First, the moving party must establish that federal preemption is relevant to the case's facts. Second, they must provide sufficient evidence to prove there is no genuine issue of material fact that contradicts the preemption claim. The first step is a legal determination, while the second involves mixed questions of law and fact. If the moving party fails to meet the burden in the second step, the issue must be resolved by the factfinder.
In the context of the case, the parties agree that the Earthboard offering was made under a 1999 registration exemption filing pursuant to Rule 506, which is relevant because the National Securities Markets Improvement Act (NSMIA) preempts state registration for securities qualifying under such exemptions. The moving party must demonstrate that there are no genuine issues of material fact regarding whether Earthboard's offering constitutes a "covered security."
Rule 506, established under Section 4(2) of the 1933 Securities Act, exempts certain limited offers and sales if specific conditions are met, including compliance with Rules 501 and 502, limiting the number of non-accredited investors to 35, and ensuring the integration of offers or sales within specified timeframes.
The appellees claim compliance with Rule 506, citing evidence that fewer than 35 non-accredited investors were involved, satisfying the numerosity requirement. However, they fail to adequately explain how sales occurring three years post-filing can be integrated with the original offering, indicating a genuine issue of material fact regarding the integration requirement under Rule 506.
Appellees have not provided evidence to support their claims regarding the mandatory requirements for supplying information to unaccredited investors or assessing their sophistication. The SEC's pending civil suit against Earthboard and Jeffreys highlights that the company unlawfully offered unregistered shares, failing to meet Rule 506 requirements. Specifically, Earthboard did not provide unaccredited investors with audited financial statements and did not ensure these investors possessed the necessary knowledge to evaluate investment risks. Consequently, a significant issue of material fact exists concerning whether the shares sold to Brown are "covered securities," which undermines the appellees' claims for NSMIA preemption and negates the granting of summary judgment.
Appellees' additional arguments for preemption are deemed weak. Vaughn cites Regulation D's preliminary notes, suggesting that an issuer can claim various exemptions even if they do not fully comply with Rule 506. However, noncompliance does not imply that an exemption under section 4(2) is available if it forms part of an evasion scheme. Vaughn also references Rule 508(a), which allows for minor deviations from Regulation D if made in good faith. Yet, the appellees failed to present evidence that Earthboard attempted to comply with Rule 506 or that any deviations were insignificant and made in good faith. Vaughn's argument regarding his liability as a seller under federal law is irrelevant to his liability under Kentucky law, especially since he agreed to his status as a federal seller for summary judgment purposes.
Vaughn's assertion that he was not a "seller" under Kentucky law is rejected. The reference he made to a Sixth Circuit opinion misinterprets its origin; that case, Excel Energy, Inc. v. Smith, involved a bankruptcy issue and did not allow for a review of state trial court findings on securities fraud liability. The state appellate courts dismissed the appeal due to timeliness, leaving the trial court's interpretation of Kentucky Revised Statutes Section 292.480 without significant precedential weight. Vaughn’s involvement in soliciting and selling shares, along with his admission of receiving a commission, indicates a more active role than a stockbroker who merely executes transactions, thus he is not entitled to summary judgment on the "seller" issue.
Lincoln's claim that Brown waived his Blue Sky claim by acknowledging the offering as private is incorrect. While the district court recognized that the exclusive federal cause of action for unregistered securities under the 1933 Securities Act lies in Section 12(a)(1), and that Section 12(a)(2) does not apply to private offerings, Brown’s original Section 12(a)(1) claim was deemed time-barred, and his Section 12(a)(2) claim failed due to his admission regarding the private nature of the offering. However, Brown's appeal focuses solely on the dismissal of his state claim. He argues that the Earthboard offering qualifies as unlawfully unregistered, which remains liable for state non-registration after NSMIA, and contends that the appellees did not demonstrate compliance with federal and state registration exemptions. The court agrees with Brown's position regarding the summary judgment motion.
Brown's acknowledgment that the Earthboard offering was private does not affect the state registration claim, leading to the reversal of the district court's summary judgment in that regard. Additionally, Brown is appealing the district court's summary judgment on his securities fraud claim under Section 10(b) of the 1934 Securities Exchange Act and a corresponding Kentucky statute. The essential elements for a securities fraud claim include: 1) material misrepresentation or omission, 2) scienter, 3) a connection to the purchase or sale of a security, 4) reliance, 5) economic loss, and 6) loss causation. Vaughn and Lincoln contest that Brown has established genuine disputes regarding the elements of scienter, reliance, and loss causation.
Scienter involves the intent to deceive or defraud, necessitating that the complaint presents facts supporting a strong inference that the defendant was aware a statement was false or misleading. A "totality of circumstances" test is applied to evaluate allegations of scienter, considering factors such as insider trading timing, discrepancies between internal and external reports, timing of statements in relation to inconsistent disclosures, bribery evidence, quick settlements of fraud allegations, neglect of current information, complex accounting disclosures, undisclosed interests of directors in stock sales, and self-serving motivations of defendants.
Scienter requires more than mere negligence; it must reflect an extreme deviation from ordinary care that presents a significant risk of misleading investors. Claims based on factual statements necessitate a showing of knowledge or recklessness on the part of the defendant.
Specific factual allegations indicating that a defendant disregarded warning signs revealing accounting errors may infer scienter. In a previous case, the court found that a professional broker exhibited reckless scienter by participating in a Ponzi scheme, losing money, and encouraging others to invest despite lacking detailed knowledge of the scheme. The court concluded the broker, due to his experience in reputable brokerage firms, should have known the scheme was fraudulent, establishing liability under anti-fraud securities laws.
In the current case, Brown argues that Vaughn's actions mirror those of the broker in the prior case, alleging that Vaughn solicited investors for Earthboard without conducting his own investigation and profited through commissions and discounted share purchases. The appellees counter that Vaughn was not a significant participant compared to the defendant in the previous case, emphasizing his belief in the investment's legitimacy due to supposed negotiations with VANS. However, the court finds that Brown has adequately alleged Vaughn's scienter, noting that Vaughn is a licensed securities professional aware of federal securities law prohibitions. Vaughn received a tip about a non-public merger negotiation involving Earthboard, which, if acted upon, would have violated securities laws. Instead of adhering to legal standards, Vaughn allegedly abused this insider information for personal gain, soliciting investments to enhance his reputation while profiting from the scheme.
Securities professionals act recklessly when they attempt to violate the law, and belief in the truth of a tip does not excuse such conduct, as it indicates intent to evade legal standards. Brown has adequately alleged Vaughn's recklessness and scienter based on several factors: (1) Vaughn misrepresented his relationship with Jeffreys to inflate the value of illicit information; (2) he conducted no due diligence regarding Earthboard's value, failing to uncover Jeffreys’ felony conviction before soliciting Brown; (3) the stock swap price was unreasonable; (4) he solicited purchases at six times his acquisition cost; and (5) he received an undisclosed commission from Earthboard despite not being its client or legally offering the securities. Vaughn's claim that proper due diligence was impossible does not mitigate his responsibility, as the value of non-public information lies in its secrecy, which is essential for capturing arbitrage profits. Illegally trading on confidential information undermines lawful market research and heightens fraud risk. Vaughn's victimization in this scheme does not absolve him of liability for passing the tip to others. The court determined Brown has sufficiently shown Vaughn's scienter to withstand summary judgment. However, the district court found that Brown did not adequately prove that his losses were caused by the defendants' actions, emphasizing the need for a causal link between misrepresentations and economic loss, akin to proximate cause in tort law.
Brown contends that the Earthboard-VANS merger was entirely fictitious and that Vaughn's reckless solicitation of investment based on this falsehood directly caused Brown's financial loss. Brown argues that Vaughn concealed critical information and made material omissions regarding the share purchase price, which misled him into believing the value was based on the merger's anticipated success. Evidence suggests that Vaughn's misrepresentations created an illusion of credibility, prompting Brown to invest. The court acknowledges that while inflated prices in fraud-on-the-market cases typically do not constitute economic loss, the unique context of a private offering may allow for such a claim. After the merger's falsehood was revealed, Brown's investment value significantly decreased.
The appellees argue that Brown could not reasonably rely on Vaughn's statements due to an integration clause in the subscription agreement, which waived claims of reliance on third-party advice. However, the court counters that a contextual analysis is necessary to determine whether Brown presented sufficient evidence of reasonable reliance to proceed beyond summary judgment. The court applies a recklessness standard to assess the context of reliance, indicating that the appellees' assertion oversimplifies the legal requirements for establishing reasonable reliance in this case.
Factors used to determine reasonable reliance in a non-insider context include the plaintiff's financial expertise, the presence of long-standing relationships, access to relevant information, fiduciary relationships, concealment of fraud, the opportunity to detect fraud, initiation or urgency of the transaction, and the specificity of misrepresentations. A blanket rule regarding non-reliance clauses would undermine the need for contextual analysis. Courts do not adopt a per se rule against recovery for deceit when such clauses are signed; instead, they consider the signing of the clause as part of the overall context of fraud. In the case at hand, Brown's reliance on a broker's tip was not deemed unreasonable, given the circumstances, allowing the claim to proceed to trial for a factual determination of reliance. Lincoln cannot be held secondarily liable for Vaughn's actions as it qualifies for the good faith safe harbor under the 1934 Act, having no actual knowledge of Vaughn's activities, and having prohibited unauthorized sales. No evidence suggested Lincoln failed to train its employees or endorsed Vaughn's conduct, and it did not materially aid the sale of the security. Brown's only evidence of Lincoln's involvement was Vaughn's use of the firm's office equipment.
Vaughn's use of the office fax machine does not indicate Lincoln's assistance, as there is no evidence requiring special permission for such use, similar to using an office telephone. Lincoln cannot be held vicariously liable for Vaughn's actions under any agency theory because Vaughn is an independent contractor without express or implied authority to engage in the solicitation or sale of Earthboard stock. He also lacked apparent authority, which is defined as the belief induced by the principal that the agent has authority, without actual conferred authority. Under Kentucky law, to hold a principal liable for an agent's unauthorized acts, it must be shown that the principal represented the agent as having authority for the specific transaction and that the plaintiff relied on this representation. Brown failed to provide sufficient evidence that Lincoln led him to believe Vaughn had the authority to participate in the Earthboard offering. Consequently, the district court's summary judgment in favor of Lincoln was upheld, while the judgment regarding Vaughn's claims was reversed and remanded for further proceedings. Additional notes mention Jeffreys' guilty plea for federal securities fraud and ongoing civil actions against him and Earthboard, as well as relevant state and federal statutes regarding securities regulation.
Pre-emption, as derived from the Supremacy Clause, is recognized as a federal issue. An "accredited investor" is defined as a person whose individual net worth exceeds $1,000,000, or whose annual income exceeds $200,000 for the last two years, or whose family income exceeds $300,000 during that period, with a reasonable expectation of maintaining such income. Regulation D, specifically 17 C.F.R. 230.501(e)(1)(iv), exempts accredited investors from the purchaser count, allowing a Rule 506 offering to include up to 35 non-accredited investors while having unlimited accredited investors. Non-accredited investors must possess sufficient knowledge and experience to evaluate the investment risks or must be reasonably believed by the issuer to meet this criterion.
Integration rules stipulate that all sales within a Regulation D offering must comply with its terms; offers made outside a six-month window before or after the offering are not integrated unless they are related to employee benefit plans. The term "offering" is not defined in the Act or Regulation D, and the decision on whether sales are integrated depends on specific facts and circumstances. Factors to consider include whether the sales are part of a single financing plan, involve the same class of securities, occur around the same time, involve the same type of consideration, and serve the same general purpose. The ruling allows for future summary judgment if additional evidence regarding federal preemption is presented. Finally, it is unlawful to use any means of interstate commerce to defraud.
Engaging in securities fraud is unlawful under both federal and state law, which prohibits making untrue statements of material fact, omitting necessary material facts, or engaging in deceptive practices in connection with the purchase or sale of securities. Vaughn's defense includes a claim that he met with Jeffreys and visited Earthboard's facility; however, inconsistencies in his deposition regarding the timing of these events raise a genuine issue of material fact regarding whether he conducted due diligence before soliciting a purchase from Brown. The court must view facts favorably to Brown for summary judgment purposes. Judge Rosen concurs with the majority on certain aspects, specifically that Brown's state registration claim is valid and that Lincoln Financial Advisors Corporation is not liable. However, he dissents on the reversal of summary judgment regarding Brown's securities fraud claim against Vaughn, arguing Brown has not sufficiently demonstrated reasonable reliance, which is essential for his claim. Judge Rosen emphasizes the importance of context in evaluating reliance, invoking precedents that consider the complexity of transactions and the parties' sophistication.
The majority opinion references various factors from Wright v. National Warranty Co. but fails to adequately analyze them, concluding that the non-reliance clause in the subscription agreement was insufficient to establish non-reliance. The author contends that Brown's claim of reliance is unreasonable, given that he is a sophisticated businessman with significant investment experience. Brown founded a marketing research firm sold for $22 million and had prior knowledge of private placements' risks. He consulted with legal and financial advisors before investing in Earthboard and acknowledged a lack of firsthand information from Vaughn, who merely relayed information from a third party. Brown had full access to information about Earthboard and did not pursue independent inquiries, which undermines his claim of reasonable reliance. Additionally, he signed a Subscription Agreement that explicitly warned of high investment risks and affirmed that he relied solely on his investigations. He also indicated his expertise in financial matters. The author cites precedent that holds securities fraud plaintiffs accountable for their statements in subscription agreements.
Securities law prohibits a party in a stock transaction from denying prior representations, meaning one cannot claim to have not relied on previous statements while seeking damages for those statements. Citing Carr v. CIGNA Sec. Inc., the plaintiff is bound by non-reliance statements within the subscription agreement. The record indicates that the plaintiff failed to demonstrate reasonable reliance, supporting the affirmation of the district court's summary judgment on the securities fraud claim. Although the district court did not address reliance, it was thoroughly briefed and argued. An appellate court can uphold a district court's decision for any valid reason, even if not considered by the lower court.
