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December 27, 2012

LITIGATION AND ENFORCEMENT FRAUD AND MANIPULATION-Cal App: Convictions for Registration Violations Did Not Require Knowledge That Promissory Notes Were Securities

By John M. Jascob, J.D.

The California Court of Appeal has held that convictions for the crime of selling unqualified securities did not require the state to prove that the defendant knew that the promissory notes at issue were securities. In People v. Butler, the defendant claimed that the trial court had committed error by failing to instruct the jury that it was required to find that he knew or should have known the notes were securities as an element of the crime of selling unqualified securities under Section 25110 of the California Corporate Securities Law of 1968. The appellate court rejected this contention, however, concluding that proof that a defendant knew he was selling a security is not an element of Section 25110. (People v. Butler, December 21, 2012, Ikola, J.).

The appellate court acknowledged the California Supreme Court's ruling in People v. Salas (2006), where the state high court held that a seller who believes reasonably and in good faith that a security is exempt is not guilty of the crime of unlawful sale of an unregistered security. The appellate court noted, however, that the Salas court was not presented with the issue of whether a defendant must have guilty knowledge that the financial product at issue is a security. Rather, the Salas court only dealt with the issue of whether a violation of Section 25110 required the defendant to know whether the thing he sold was not exempt from registration. Moreover, two subsequent California appellate cases, People v. Frederick (2006) and People v. Cole (2007), have declined to hold that a defendant's knowledge of whether an investment contract is a security is an element of a securities offense. In view of these cases, therefore, the Court of Appeal concluded that proving that a defendant knew he was selling a security is not an element of Section 25110 or any other securities offense under California law. At most, the appellate court stated, a lack of knowledge that one is dealing in a security provides an affirmative defense to Section 25110.

The appellate court also rejected the defendant's assertion that many of his convictions for making material omissions in violation of Section 25401 were not supported by substantial evidence. The defendant argued that he was being punished for "simple nondisclosure" for any count in which the evidence showed that he did not make any communications to the alleged victims other than the promises contained in the securities. According to the defendant, additional disclosures were not needed because he made no statement of material fact. The appellate court held, however, that a false promise to repay an investor in the future could constitute an untrue or misleading statement of material fact under Section 25401.

In cases involving pyramid schemes or Ponzi schemes in which money from investors is either being used to pay interest owed to other investors or is being siphoned off to enrich principals before the underlying business is profitable, the appellate court reasoned, promises to investors to pay interest and return principal are inherently either false or misleading. Accordingly, the defendant's promises to repay principal and interest on promissory notes were misleading in the absence of disclosures about the nature of his business enterprises and his prior history of fraud involving elderly investors.

The appellate court found that the record contained substantial evidence that the defendant promised to pay investors 12 percent interest and return their principal. Even assuming that the evidence was insufficient for the jury to conclude that these were "false promises," the appellate court stated, there was substantial evidence in the prosecution's case-in-chief that the defendant did not make sufficient disclosures to the victims to make his statements not misleading. The testimony of victims who recalled the communications that were received from the defendant and his colleagues, along with the consistent absence of any written disclosures in the files of defendant or any of the victims, provided substantial evidence that the defendant consistently omitted material facts to all of the victims.

The Court of Appeal also rejected the defendant's assertion that the trial court erred by failing to instruct the jury that it needed to find the defendant knew his omissions were material. The appellate court held that any error was harmless because it was impossible to believe that the jury would have found that the defendant did not know his omissions were material at the same time it found beyond a reasonable doubt that he knew he made misleading omissions. Rather, the record contained overwhelming evidence establishing that: (1) the supposed safe investments marketed by the defendant to elderly, unsophisticated investors were extremely risky; and (2) the defendant withheld obviously material information that would have allowed his investors to see they should not trust him with their assets.

Boyce & Schaefer and Laura Schaefer for Jeffrey Gordon Butler. Kamala D. Harris, Attorney General, Dane R. Gillette, Chief Assistant Attorney General, Julie L. Garland, Assistant Attorney General, Barry Carlton and Teresa Torreblanca, Deputy Attorneys General, for the People of the State of California.

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