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From Securities Regulation Daily, February 18, 2015

SEC's approximation of fraud proceeds falls short, court says

By Rodney F. Tonkovic, J.D.

A district court has found that the disgorgement was appropriate against the orchestrators of a Ponzi scheme, but asked the Commission to return with more support for its request. The Commission brought this civil enforcement action against New York-based McGinn Smith & Co. and its owners Timothy M. McGinn and David L. Smith alleging violations of the securities laws arising out of an elaborate, long-term Ponzi scheme. The court found that summary judgment was appropriate based on both collateral estoppel and the undisputed evidence showing no genuine issues of material fact. While the court granted the Commission's request for an injunction and officer-director bar, it declined to order disgorgement, requiring instead  that the agency come back with more explanation and documentary evidence to support its approximation of the proceeds of the fraud (SEC v. McGinn, Smith & Co., Inc., February 17, 2015, Sharpe, G.).

Background. The Commission alleged that McGinn and Smith orchestrated a Ponzi scheme that raised over $136 million in more than twenty unregistered debt offerings. McGinn and Smith told investors that their money would be used to acquire various public and private investments but it was, instead, funneled into various entities owned or controlled by the defendants. The money was then used to fund unauthorized investments and unsecured loans, make interest payments to investors, for McGinn and Smith's "lifestyle" expenses, and to cover the payroll at McGinn, Smith & Co.

In 2010, the Commission filed a complaint and was granted a temporary asset freeze, still in effect, on the defendants' assets. In a parallel criminal action, McGinn and Smith were found guilty in February 2013 of conspiracy to commit mail and wire fraud, mail fraud, wire fraud, securities fraud, and filing false tax returns. They were sentenced to 15 and 10 years imprisonment, respectively, fined, and ordered to pay restitution. In September 2013, the SEC charged 10 former McGinn, Smith brokers with violations of the securities registration and antifraud provisions for their involvement in the scheme; one of the brokers settled in 2014.

Collateral estoppel. In this case, the Commission alleged that the defendants violated the antifraud provisions of the securities laws and the Investment Advisers Act. The Commission alleged further that McGinn and Smith aided and abetted violations of Exchange Act Sec.15(c)(1) and Rule 10b-3. The court found that the Commission was entitled to summary judgment because all of the elements of collateral estoppel were met. The issues in this case and the criminal case were identical, the court said, involving the same defendants and the same conduct. The court then concluded that there were no outstanding questions of material fact with respect to the defendants' violations and granted summary judgment on these causes of action.

Unregistered securities. The Commission also sought summary judgment on a cause of action alleging the sale of unregistered securities. The court found that there was no dispute that the notes at issue were "securities" or that they were not registered. The defendants were unable to invoke any exemptions to registration.

Sanctions. The court then found that disgorgement was appropriate, but neither granted the Commission's request for disgorgement of $124 million nor fashioned appropriate relief on its own. While McGinn and Smith clearly committed "pervasive and egregious" violations, the court said that it was unable to make an informed decision as to the appropriate disgorgement amount. In support of its assertion that $124 million was a reasonable approximate of the proceeds of the fraud, the Commission cited one paragraph of the receiver's declaration. The court rejected this calculation, calling for more explanation and evidence, and gave the Commission one more chance to propose a reasonable approximation of the profits. The court denied the Commission's request for civil penalties in the amount of the defendants' pecuniary gain for similar reasons.

Next, the court granted permanent injunctions against further violations of the Securities Act, Exchange Act, and Investment Advisers Act. According to the court, McGinn and Smith acted with a high degree of scienter in perpetrating a scheme that involved multiple debt offerings, spanned several years, and defrauded hundreds of investors. Finally, the court granted an officer-director bar against McGinn, who had served as CEO of a publicly traded company.

The case is No. 1:10-cv-457.

Attorneys: David P. Stoelting for the SEC. William J. Brown (Phillips Lytle LLP) for McGinn, Smith & Co, Inc., McGinn, Smith Advisors, LLC, McGinn, Smith Capital Holdings Corp., First Advisory Income Notes, LLC, First Excelsior Income Notes, LLC and First Independent Income Notes, LLC.

Companies: McGinn, Smith & Co, Inc.; McGinn, Smith Advisors, LLC; McGinn, Smith Capital Holdings Corp.; First Advisory Income Notes, LLC; First Excelsior Income Notes, LLC; First Independent Income Notes, LLC.

MainStory: TopStory FraudManipulation NewYorkNews

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