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From Securities Regulation Daily, April 9, 2015

Judgment against firm that aided scam by touting fake contract sticks

By Matthew Garza, J.D.

A judgment against a public relations firm that hyped a fake Department of Homeland Security contract for a client’s product was affirmed after a second look at the application of Securities Act Section 17(a) to a party not considered the “maker” of the fraudulent statement. The court held that Supreme Court’s decision in Janus Captial Group v. First Derivative Traders did not apply to Section 17(a), and obtaining money by means of any untrue statement under Securities Act 17(a)(2) encompasses a broader range of conduct than “making” such a statement as defined in Rule 10b-5 (SEC v. Big Apple Consulting USA, Inc., April 9, 2015, Siler, E.).

The investor relations firm Big Apple Consulting USA promoted a microcap company named CyberKey Solutions, Inc. that sold USB drives that could be protected with encryption software. The SEC said Big Apple acted with both actual knowledge and severe recklessness by touting a fictitious $25 million contract with the Department of Homeland Security dreamed up by CyberKey, in violation of Securities Act Section 17(a), Exchange Act Section 20(e), and other provisions of the securities laws.

Big Apple did nothing to confirm the authenticity of the contract. The fake contract, which the court called a “game changer,” contained a number of obvious inconsistencies. The Department of Homeland Security was referred to only on the cover page and page headers, but within the document, the State of Connecticut was referred to as the purchaser, with the mailing address and email of Connecticut’s purchasing contact listed multiple times. Big Apple also drafted press releases touting the first $4.2 payment allegedly delivered for the USB drives.  When questioned about the cash-starved company’s $6K checking account, CyberKey’s CEO explained dubiously that the contract was “front-loaded,” and the company would make its money “on the back end.” The CEO, James Plant, was convicted and sentenced to 97 months in federal prison, but the SEC also pursued Big Apple Consulting for its role in the fraud. The district court decision was covered in Securities Regulation Daily on April 2, 2013.

Background. The SEC originally charged the investor relations firm with violations of Exchange Act Section 10(b) and Rule 10b-5, but after the Supreme Court’s decision in Janus clarified that a person or entity that merely prepares or publishes a fraudulent statement does not “make” the statement, the SEC amended the complaint to charge the firm under Exchange Act Section 20(e) with aiding and abetting CyberKey’s fraud, among other claims.

Of the four claims asserted against the firm, the SEC was granted summary judgment on three, and one claim under Securities Act Section 17 went to trial. The jury convicted, but Big Apple appealed, arguing that the Janus decision extends to 17(a) liability. The Eleventh Circuit disagreed.

Securities Act 17(a). The court pointed out that Rule 10b-5 borrows much of its language from Securities Act Section 17(a), but 17(a) subsections (1) and (3), which strongly resemble 10b-5 subsections (a) and (c), do not use the word “make” or even address misstatements. “The court in Janus interpreted what it means to “make” a misrepresentation under subsection (b) of Rule 10b-5. Thus, any attempts by the defendants to import the Court’s narrow holding to the entirety of §17(a) is untenable on its face,” the court wrote. “The reality remains,” said the court, that even a person like the mutual fund investment adviser in Janus, who is not the “maker” of a fraudulent statement, could still be liable as a primary violator of Rule 10b-5(a) and (c).

The court said its holding was “solidified” by the fact that Janus was an action brought under the implied private right of action under Rule 10b-5, and Securities Act 17(a) contains no similar private right of action. The court therefore did not have the same concern about expanding a judicially-created private cause of action.

Exchange Act 20(e). The court next rejected the investor relation firm’s argument that the SEC needed to prove that they had “actual knowledge” of CyberKey’s and Plant’s violations of Exchange Act Section 10(b) and Rule 10b-5 in order to be found liable under Exchange Act Section 20(e), which prohibits knowingly providing substantial assistance to securities violations. Severe recklessness should not suffice to establish scienter for a 20(e) aiding and abetting claim, Big Apple argued. But 20(e) does not contain the phrase “actual knowledge,” said the court, nor does it define the term “knowingly.”

Looking to the legislative history, the court concluded that it was clear that Section 20(e) was enacted to negate the Supreme Court’s 1994 decision in Central Bank of Denver v. First Interstate Bank of Denver, which cast doubt on the SEC’s ability to pursue aiding and abetting claims under Section 10(b). The Dodd-Frank Act added to 20(e) the phrase “or recklessly” to satisfy the scienter requirement in aiding and abetting cases, which Big Apple argued showed that prior to Dodd-Frank, actual knowledge was required. Again, the Eleventh Circuit disagreed, saying that concerns about retroactive application are not implicated when an amendment that takes effect after the initiation of a lawsuit is deemed to clarify, rather than to substantively change, the law. Ultimately, the district court did not err when it found that severe recklessness was sufficient to constitute acting “knowingly” under 20(e), held the court.

The court also rejected an argument that the district count incorrectly included a jury instruction about “deliberate ignorance” and failed to include language that focused on the defendant’s subjective beliefs. There was more than sufficient evidence to warrant a deliberate ignorance instruction, the court concluded.

The case is No. 13-11976.

Attorneys: Theodore Weiman for the SEC. Mark C. Kaley, pro se. Carl Francis Schoeppl, Jr. (Schoeppl & Burke, P.A.) for Big Apple Consulting USA, Inc. and MJMM Investments, LLC.

Companies: Big Apple Consulting USA, Inc.; MJMM Investments, LLC

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