E-Alert Case Updates
In Federal Securities Regulation Case, Default Judgment Is Entered Against Defendants and Injunctive and Civil Remedies Are Imposed
United States Securities and Exchange Commission v. China Infrastructure Investment Corp.
In SEC v. China Infrastructure Investment Corp., et al. (“CIIC”), Civ. No. 15-cv-00307 (BAH) (May 26, 2016), a securities regulation case, the Court granted Plaintiff’s motion for default judgment under Fed. R. Civ. P. 37(b)(2) and permanently restrained and enjoined Defendants from violating several 1934 Exchange Act provisions, barred the two individual Defendants (“Xipeng”) and (“Feng”) from acting as officers or directors for any future publicly-traded company, and imposed civil penalties against all three Defendants.
CIIC, a Nevada corporation headquartered in Zhengzhou, Henan Province, The People’s Republic of China, owns and operates a portion of the Pinglin Expressway in China, and was listed on the NASDAQ stock exchange from 2008 to early 2012. Prior to its delisting, Lei (not a party in this action) held the position of CFO of CIIC. After three months of his hiring, Lei resigned from his post, citing personal reasons. This resignation was communicated to Feng, Corporate Secretary, an Independent Director of CIIC’s audit committee, an outside auditor, and its legal counsel. In response, the Independent Director advised Feng to appoint an interim CFO, needing a representative to file forms with the SEC. Feng replied and stated falsely that Lei would stay on as CFO until the correct forms were filed, and additionally stated that the CFO was on sick leave. On September 30, 2011, CIIC responded to a NASDAQ request for information concerning its under-maintained stock price (minimum bids on NASDAQ must be $1.00), and, without Lei’s authorization, attached Lei’s electronic signature to the document. During October and November of 2011, CIIC sent its principal auditor management representation letters in connection with its quarterly review. These letters contained Lei’s forged signature, and further materially misrepresented that no signatories had knowledge of fraud affecting CIIC and that there had been no violations whose effect should be considered for disclosure in CIIC’s consolidated financial statements. The empty CFO position was, of course, not revealed. As such, Forms 10-K, 10-Q, and 10-K/A filed with the SEC contained Lei’s forged signature and failed to disclose the resignation. The first contact between Lei and any person associated with CIIC came in late November, 2011, when Lei explained to CIIC’s Independent Director that he had found his name falsely listed in the corporation’s Yahoo! Finance profile.
On March 3, 2015, the SEC filed suit against the Defendants, alleging eight counts of securities fraud. After a proper service, answer, and Joint Meet and Confer report, the Court entered a Scheduling Order requiring Rule 26 disclosures to be exchanged by June 16, 2015, any additional parties joined and pleadings amended by the same date, and all discovery to be closed by June 1, 2016. From that point forward, the Defendants became unresponsive. The Defendants subsequently failed to respond to fifty-three SEC requests for admission, fewer than ten interrogatories, and seventeen requests for production of documents to each Defendant. On August 27, 2015, as a result of the failure to respond, the SEC moved to compel response to the interrogatories and requests for production of documents, and to deem admitted each of the pending requests for admission. On the same day, Defendants’ counsel moved to withdraw due to failure to honor its retainer agreement.
When the motion to withdraw was granted, the Court cautioned Defendants that corporations are not allowed to appear pro se, and absent counsel, default judgment could be entered against CIIC. The Defendants failed again to respond to this order to respond. On October 27, 2015, the Court granted the SEC’s motion to compel and deemed admitted the requests for admissions. On the same day, the Court in a Minute Order, expressly warned the Defendants that noncompliance would result in default judgment against the Defendants pursuant to Fed. R. Civ. P. 16(f)(1) and 37(b)(2)(A)(vi). Failing again to comply, the SEC moved for default judgment as to all Defendants. As of May 19, 2016, the SEC was still unable to contact Defendants to file a required joint status report with the Court.
At issue for the Court was whether standards were met to successfully enter a default judgment against the three Defendants and what remedies the Court could enforce. Fed. R. Civ. P. 37(b)(2) provides that the Court may order sanctions, including default judgment, for failure to obey a discovery order. Following the standards set forth in Webb v. District of Columbia, 146 F.3d 964 (D.C. Cir. 1998), the Court looked to whether the errant party’s behavior severely hampered the other party’s ability to present its case, whether there was prejudice caused to the judicial system when the party’s misconduct put an intolerable burden on the District Court by requiring the Court to modify its operations to accommodate the delay, and whether sanctions would deter similar misconduct in the future. As default judgment is a sanction of last resort, the Court must find clear and convincing evidence of misconduct and provide specific, reasoned explanation why lesser sanctions would not be appropriate. Additionally, an order of default judgment does not establish liability in the amount of damages claimed, but rather requires an independent determination.
The Court first reviewed whether the Defendants failed to obey the Court’s discovery order. The Defendants in this case violated every Court order since September 17, 2015 and continued to remain absent up to the point of Chief Judge Howell’s opinion. Further, there was no evidence presented that the Defendants had any intention of rectifying their continued violations.
In response to the inquiries dictated by Webb, the Court answered all three questions in the affirmative. First, the Defendants’ failure to respond to interrogatory and production of document requests severely hampered the SEC’s ability to present its case on the merits. Second, the Defendants’ conduct unreasonably delayed this case; Defendants had missed three Court-ordered deadlines and had been approaching the discovery deadline without production, completely stalling litigation. Third, the Defendants’ behavior demonstrated disrespect for the Court and exhibited a need to deter future misconduct. Failure to participate in any manner with the Court’s Orders demonstrated a complete lack of respect for the Court’s authority.
Finally, the Court determined that lesser sanctions would not be appropriate in this case. The Defendants engaged in a pattern of disobedience and noncompliance with court orders, which had prejudiced the opposing party. The Court’s numerous “warning shots” had no visible effect on the Defendants, demonstrating that lesser sanctions would not serve to deter future misconduct. Accordingly, the Court found ample clear and convincing evidence of misconduct and appropriately entered default judgment against the Defendants on all counts.
The SEC sought two forms of injunctive relief and second-tier civil penalties against the Defendants. The first form of injunctive relief aimed to enjoin the Defendants from future violations of securities laws. SEC v. Bilzerian, 29 F.3d 689 (D.C. Cir. 1994) laid out a three-factor test when determining the reasonable likelihood of future violations: whether the violation was isolated or part of a pattern, whether the violation was flagrant and deliberant as opposed to technical, and whether the defendant’s business would provide opportunities for violation in the future. Applying these factors, the Court, again, answered all three in the affirmative. First, the Defendants consistently falsified Lei’s signature on SEC filings and letters to NASDAQ; these actions were part of a pattern, rather than an isolated incident. Second, the Defendants deliberately submitted false documents to the SEC, while aware of Lei’s resignation, in order to avoid negative publicity from the CFO’s resignation. This flagrant attempt to pull the wool over investors’ eyes was neither technical nor inconsequential. Third, as a registered company, CIIC had the future opportunity to continue to violate securities regulations. As such, Xipeng and Feng would have played a central role in all future SEC filings. Accordingly, the Court ordered permanent enjoinment from future violations of securities laws.
The second form of sought after injunctive relief aimed to enjoin Xipeng and Feng from acting as officers or directors of any future publicly-traded company. 15 U.S.C. § 78u(d)(2) dictates that the court may prohibit, conditionally or unconditionally, and permanently any person who has violated Section 10(b) of the Exchange Act, or corresponding rules, from acting as an officer or director of an entity that has securities registered under § 78 or required to file reports under § 78o(d). The qualifier for this prohibition is if the person’s conduct demonstrates “unfitness” to serve. To determine whether each Defendant was “unfit” to serve, the Court looked to both a six factor scheme from the Second Circuit exhibited in SEC v. Patel, 61 F.3d 137 (2nd Cir. 1995) and a nine factor scheme from another district court in the D.C. circuit exhibited in SEC v. Levin, 517 F. Supp. 2d 121 (D.D.C. 2007). The general goal of each of these tests is to ensure that only “likely recidivists” are enjoined from serving as officers and directors. Based on the record as a whole, the Court concluded that barring the Defendants from serving a publicly-traded company was justified. Further, the Court found that a permanent bar was appropriate, given the Defendants’ blatant disregard of the regulatory process and lawful orders of the Court.
The final remedy sought by the SEC was civil penalties against all three Defendants. The SEC sought second-tier civil penalties, amounting to the greater of $75,000 for a natural person or $375,000 for any other person, or the gross amount of pecuniary gain as a result of the violation. The SEC provided evidence that the violations involved “fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement” as mandated by 15 U.S.C. § 78u(d)(3)(B)(ii). Each Defendant was proven to have committed at least four fraudulent acts, evidenced by the falsifications of Lei’s signature and material misrepresentations in SEC filings. Accordingly, the Court found that second-tier civil penalties were appropriate in this case and imposed a total penalty of $300,000 against both Feng and Xipeng, and $1,500,000 against CIIC.
In sum, the Court granted the SEC’s motion for default judgment and imposed two levels of injunctive relief and civil penalties against the three Defendants.
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