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From Securities Regulation Daily, April 4, 2013

Sanctions Upheld for Registration, Disclosure Violations in Reverse Merger

By Lene Powell, J.D.

The Court of Appeals for the Sixth Circuit upheld a decision by the lower court granting summary judgment to the SEC in a civil enforcement action for securities registration and disclosure violations relating to a reverse merger. The appellate court found that the defendant should have registered the securities and disclosed his beneficial ownership, and that an order of permanent injunction was appropriate (SEC v. Sierra Brokerage Services, Inc., April 4, 2013, Batchelder, A.).

Background. Aaron Tsai was the CEO, president, and treasurer of MAS Acquisition XI Company, a shell company that underwent a reverse merger and sold shares to the public on the Over-the-Counter Bulletin Board (OTCBB) in March 2000. Tsai was "no neophyte" to the securities industry, having formed over 100 shell companies and been a registered representative of multiple brokerage firms.

To prepare MAS XI for clearance on the OTCBB, Tsai used 33 initial shareholders of MAS XI, including five "former directors"; he later admitted that either they did not perform any services or he could not recall if they did. Following a rejection of the initial filing by NASD, Tsai transferred shares from the five directors to the 28 additional shareholders, friends, and acquaintances, using stock powers that the shareholders had signed in advance. After NASD approved the filing, Tsai completed a reverse merger with Bluepoint, and Bluepoint shares began trading on the OTCBB.

The SEC filed a civil enforcement against 12 defendants, including Tsai, alleging that they had violated Sections 5(a) and (c) of the Securities Act, which require that securities be registered before they can be sold or offered for sale. The SEC also charged that Tsai failed to disclose his beneficial ownership of securities in violation of Sections 13(d) and 16(a) of the Exchange Act, which require owners of securities to report their ownership of stock when their holdings exceed certain thresholds. Following summary judgment by the district court for the SEC, only Tsai remained on appeal.

Registration violations. Tsai argued that the district court erred by permitting the SEC to move for summary judgment on the basis of an alleged "non-fraud-based" violation of Section 5's registration requirements when, he alleged, the SEC's complaint and interrogatory answers indicated only a "fraud-based" theory of violation. Tsai argued that the SEC belatedly shifted from characterizing the 33 shareholders as nominees to characterizing them as real owners of MAS XI stock, and that this shift prejudiced his defense.

The appellate court found that the SEC's initial complaint specifically identified the legal and factual bases for its claims, and sufficiently alerted Tsai to the bases for his liability. Although the SEC's complaint labeled MAS XI's shareholders as nominees and not real owners, it adequately identified the underlying factual issue of Tsai's relationship to the 33 shareholders.

Tsai also argued that the sale of securities was exempt from registration requirements and that the district court erred by holding that SEC Rule 144(k) did not apply to the sale of the unregistered securities. The appellate court found that given the shareholders' grant of stock powers to Tsai and the significant differential between the amounts received by Tsai and the shareholders in the transfer, the district court had properly concluded that there was no genuine dispute of material fact that the 33 shareholders were MAS XI affiliates under the control of Tsai. Because Tsai had control over the shareholders and MAS XI, the Rule 144(k) safe harbor was unavailable and the registration requirements of Section 5 applied to the transactions.

Reporting violations. Tsai said he did not report ownership of the 250,000 shares held by the 33 shareholders because he did not own the stock and did not have "investment power" over the stock which would trigger disclosure obligations under SEC Rule 13d-3(a). The appellate court disagreed, finding that because Tsai held stock powers signed in advance by the shareholders, he could and did use their shares as he saw fit, and should have disclosed his beneficial ownership of the shares.

The court also found that Tsai satisfied the "pecuniary interest" requirement of Rule 16a-3, and so was a beneficial owner and should have reported under that rule.

Judgment upheld. The district court permanently enjoined Tsai from violating registration requirements of the Securities Act and reporting requirements of the Exchange Act. The appellate court upheld the injunction, finding that the district court had not abused its discretion and the SEC had met the standard of showing a reasonable and substantial likelihood that Tsai, if not enjoined, would violate the securities laws in the future.

The case is 10-3546.

Attorneys: Hope Hall Augustini for the SEC. Ronald Edward DePetris (DePetris & Bachrach, LLP) and Matthew Thomas Anderson (Luper, Neidenthal & Logan) for Sierra Brokerage Services, Inc. and Aaron Tsai.

Companies: Sierra Brokerage Services, Inc.; MAS Acquisition XI Company

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