1 F.Supp.2d 337

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Larry P. Ellsworth, Mark J. Kreitman, Daniel J. Hurson, Securities and Exchange Commission, Washington, DC, for S.E.C.

Harold Ruvoldt, Fishbein Badillo Wagner Harding, New York, NY, for Cavanagh and U.S. Milestone.

Sanford Remz, Hutchins, Wheeler & Dittmar, Boston, MA, for Electro-Optical Systems Corp.

David Spears, Linda Imes, Richards Spears Kibbe & Orbe, New York, NY, for Chachas.

Irving Einhorn, Los Angeles, CA, for Chachas.

Edward Medvene, Talcott, Lightfoot, Vandevelde, Sadowsky, Medvine & Levine, Los Angeles, CA, for Brooksbank.

Charles J. Hecht, Hecht & Steckman, P.C., New York, NY, for Levy.

Martin Kaplan, Gusrae Kaplan & Bruno, New York, NY, for Tacopino.

Diana D. Parker, Morvillo, Abramowitz, Grand, Iason & Silberberg, P.C., New York, NY, for Tamar Lehman.

Paul May, Steere & May, New York, NY, for Tim Timlin.

COTE, District Judge.

This case concerns a scheme through which the defendants reaped millions of dollars in profits at the expense of the American investor by creating active trading in the United States securities market without making the disclosures that were required for the benefit of the investing public by the Securities Act of 1933.

Specifically, in this action, which was filed on March 13, 1998, the Securities and Exchange Commission ("SEC") alleges that the defendants offered and sold securities of Electro-Optical Systems Corporation ("EOSC") in violation of the registration and antifraud provisions of the United States securities laws, codified at 15 U.S.C. 77e ("Section 5") and 77q(a) ("Section 17(a)"), and 15 U.S.C. 78j(b) ("Section 10(b)"). According to the SEC, the defendants defrauded the public primarily small, on-line investors of at least $5 million over the course of the scheme, the profits of which allegedly have been distributed among the defendants and relief defendants. In the underlying action, the SEC seeks, with respect to each of the defendants, a permanent injunction against future violations of the securities laws, and civil penalties, as provided for under 15 U.S.C. 78u(d)(3).¹ The SEC also seeks disgorgement of all proceeds related to the scheme, plus pre-judgment interest, from all of the defendants and relief defendants.

Pending a resolution on the merits, the SEC seeks a preliminary injunction against the defendants and a continued freeze on their assets sufficient to satisfy whatever proceeds plus pre-judgment interest and civil penalties, if any, for which the defendants ultimately are found liable. The SEC also seeks a continued freeze on the assets and stock of the relief defendants that are traceable to the allegedly unlawful activities at the heart of this action.

On March 13, 1998, this Court issued a temporary restraining order (the "March 13 Order" or "TRO") which, inter alia, suspended trading by the defendants in EOSC stock; froze the assets of the defendants and the accounts of the relief defendants that contained EOSC stock or the proceeds from sales of the stock; ordered an accounting of the defendants' assets; and required the repatriation into the United States of all proceeds from the sales of EOSC stock by the defendants, to be deposited into the registry of the United States District Court for the Southern District of New York.

The March 13 Order also set forth an expedited discovery and briefing schedule for a preliminary injunction hearing, which was modified in subsequent conferences with the parties. By its own terms, the TRO provided that it would remain in effect "pending determination of the Commission's Motion for a Preliminary Injunction." The hearing, which was originally scheduled to begin on March 25, was put over to March 31 at the request of the defendants and the relief defendants who had appeared in the action, each of whom felt that they needed more time to prepare.²

In the course of the hearing on the SEC's motion for preliminary relief, the SEC entered into stipulations with several of the defendants and relief defendants that modify the terms of the freeze order.³ Three defendants also have reached agreements with the SEC disposing entirely of the SEC's motion for preliminary relief insofar as it concerns them. Namely, Cosimo Tacopino ("Tacopino"), the trader at Donald & Co. who placed many of the trades in EOSC shares at issue here, has consented to the Court's entry of a preliminary injunction against future violations of Sections 5, 17(a) and 10(b) against him, and has deposited a total of $352,279.14 in the Court's registry pending a resolution of this case. EOSC, the company whose stock is at issue in this case, has entered into an agreement with the SEC whereby the SEC has withdrawn its motion for preliminary relief against the company. Defendant Donald & Co. has entered into an agreement with the SEC providing for a sum of $233,811.07 to be deposited in the Court's registry pending a resolution of this matter and withdrawing the SEC's motion for a preliminary injunction as to this defendant.

Although all of the defendants have been served, many of them including all of the foreign defendants have failed to appear in this action. Defendant Thomas A. Hantges ("Hantges"); the Spanish entities, Customer Safety, S.L., Cambiarios, S.L., and Construcciones, S.L. (collectively "the Spanish entities"); and the Caribbean entities, Optimum Fund ("Optimum") and Agira Trading ("Agira"), were served but have not appeared. All of the relief defendants have been served, with the exception of the following individuals and entities: Kenneth Kehoe, Erin Martin, SHBL Associates Europe Ltd., Bernd Stieghorst ("Stieghorst"), Metropolitan Trade Finance Ltd., Jean-Pierre Neuhaus, and Carmillo Monastra. The Court does not consider the claims brought by the SEC against those relief defendants who have not been served.

The hearing on the SEC's motion for a preliminary injunction began on March 31, 1998 and continued through April 8, 1998. The Court took direct testimony in the form of affidavits from each of the following witnesses, who were also cross-examined at the hearing: Cameron Funkhauser, who works in the Department of Market regulation of the National Association of Securities Dealers ("NASD"); Galen O'Kane, an investor who bought EOSC shares through the internet; John Chachas, George Chachas' brother and a banker at First Boston; Richard Day ("Day"), the transfer agent for Curbstone Acquisition Corp. ("Curbstone") and EOSC; Ara Proudian ("Proudian"), the trader who bought shares pursuant to an order by Cavanagh on December 19; Jeffrey Bruss ("Bruss"), who prepared a stock report about EOSC in January 1998 for his internet publication, The Future SuperStock; and Richard Tucker, an expert on securities law offered by defendant Cavanagh. The Court also received the affidavits and cross-examination of defendants Thomas Cavanagh ("Cavanagh"), George Chachas ("Chachas"), Thomas Brooksbank ("Brooksbank"), and William Levy ("Levy"), and relief defendant Anthony Luttenberger. Chris Chaleki, an engineer at EOSC, also performed a demonstration of EOSC's product in Court and was subject to cross-examination, although he did not provide an affidavit in advance.

The Court has also received voluminous documentary evidence and deposition testimony in support of, and in opposition to, the SEC's motion. The Court has reviewed all of this evidence carefully, in addition to the legal briefing provided by counsel.

For the reasons set forth below, the Court finds that the SEC has made a proper showing that defendants Chachas, Brooksbank, Hantges, Levy, Cavanagh, U.S. Milestone ("Milestone"), Customer Safety, Cambiarios, Construcciones, Optimum, and Agira violated Section 5 of the Securities Act of 1933 ("the Securities Act"), and that these defendants may be found liable at trial for disgorgement of proceeds plus penalties for their violations. The Court finds that a preliminary injunction against future violations of Section 5 of the Securities Act is properly entered, however, only with respect to defendants Cavanagh, Milestone, Levy, Chachas, Customer Safety, Construcciones, and Cambiarios, as to each of whom the SEC has established a likelihood of repetition.

The SEC also has made a proper showing that defendants Cavanagh, Milestone, Customer Safety, Cambiarios, Construcciones, and Chachas violated Section 17(a) of the Securities Act and Section 10(b) of the Securities Exchange Act of 1934 ("the Exchange Act"), and that these defendants may be held liable at trial for disgorgement of proceeds and penalties associated with their violations. Because the SEC has demonstrated a likelihood of repetition as to Cavanagh, Milestone, Customer Safety, Construcciones, and Cambiarios, a preliminary injunction against future violations of Sections 17(a) and 10(b) is properly entered against these defendants.

To preserve the status quo pending a final determination of this matter, the Court extends the freeze order contained in the TRO, except with respect to those defendants and relief defendants, set forth above, with whom the SEC has reached agreements in lieu of, or modifying, the terms of the freeze order embodied in the TRO. As to those defendants and relief defendants, the terms of their agreements with the SEC shall remain in effect pending the final resolution of this case.

The scheme alleged by the SEC involves a broad cast of characters and a complicated series of events. In brief, the SEC alleges that a malevolent investment banker, Cavanagh, and his lawyer, Levy, approached a development stage company, WTS Transnational, Inc. ("WTS"), that had a dire need for capital. These two then set in motion a plan that had little to do with raising funds for WTS, but instead was designed to line their pockets. The scheme called for Cavanagh and his nominees to obtain for pennies a large block of shares of the company just as it merged with a public shell company.⁴ Cavanagh and his nominees would then sell the shares into the public market at prices that they would help to inflate. The success of the scheme depended on the participation of the shareholders of the shell company, who would transfer to Cavanagh and his nominees their "affiliate" shares of the shell company.

The recitation of facts that follows sets forth more specific findings about the individuals and entities involved in this scheme and the sequence of events.

A. The "Cast of Characters"

1. The Operating Company

WTS is a Massachusetts corporation with its principal place of business in Massachusetts. WTS was founded in 1990 by Charles Weaver ("Weaver"), a former employee of Texas Instruments and Honeywell, who is now 56 years old. According to the December 23, 1997 Form 8-K filed with the SEC ("December 23 8-K"), WTS developed and [was] in the process of producing state-of-the-art fingerprint biometric systems for the information security and access control market segments ... [that would] eliminate obnoxious and manifold passwords or personal identification numbers and replace them with biometric verification of the individual.

Weaver has invoked his Fifth Amendment privilege against self-incrimination and refused to testify in this lawsuit.

As of September 30, 1997, WTS had $10,000 in assets and $655,000 in current liabilities, including $359,000 in accounts payable and $172,000 in deferred compensation. The payroll and related expenses for the nine months ended September 30, 1997 was $31,000.

2. The Investment Banker

Milestone, a New York corporation, is an investment banking company specializing in Regulation S offerings.⁵ Its principals are Cavanagh and Frank Nicolois ("Nicolois"), each of whom owns 50% of the company. In 1993, Cavanagh was fined $20,000 by the NASD and barred from association with any NASD member in any capacity for failure to provide testimony or to respond to NASD requests for information concerning transactions and activities in which he was involved while employed at a NASD member firm.

3. The Lawyer

Since 1991, Levy has been Milestone's attorney and has structured and negotiated the terms of the Regulation S transactions in which Milestone has acted as a distributor. Levy is a securities attorney and the sole lawyer at the law firm of Levy & Levy, in Voorhees, New Jersey. He has on occasion brought corporate merger partners together, marrying a blank check company⁶ with one that has an operating business.

In 1975, the Second Circuit affirmed the entry of a preliminary injunction against Levy for his participation in a securities fraud that bears remarkable similarities to the instant endeavor. See SEC v. Management Dynamics, Inc., 515 F.2d 801 (2d Cir. 1975). In that prior action, Levy brought together a shell and an operating company, participated in the review and issuance of two misleading communications to the public regarding the merged entity, and facilitated the offering of unregistered shares for sale that did not bear any restrictive legend when they should have. Levy's codefendants created a false appearance of greater interest in the stock of the company than was justified, resulting in an increase of the company's share trading price from 38 cents to as high as $6 within a six month period. See id. at 806. Levy was thereafter permanently enjoined from violating the antifraud and registration provisions of the same securities laws upon which the SEC is suing here. Id. at 809-10.

4. The Broker

During the critical time at issue here, Cavanagh directed significant trading through Tacopino, a registered representative at Donald & Co., which is a registered broker-dealer in New Jersey. Tacopino has invoked his rights under the Fifth Amendment and refused to testify in this action.

5. The Shell Company

Curbstone was a blank check or shell corporation that existed for the purpose of merging with a private company with business operations. Its officers and directors during the critical times at issue here were Chachas and Brooksbank.

Chachas is a corporate and securities lawyer with the two partner law firm of Wenthur & Chachas in La Jolla, California. The firm's clients are primarily small, privately-held corporations, for whom Chachas prepares private placement memoranda and files periodic reports. Chachas and Brooksbank were law school classmates and have been friends for the past 10 years.

Brooksbank is an attorney with Brooksbank & Associates in Las Vegas, Nevada. In 1990, Hantges, who is in the securities business and had at that time just attained control of Curbstone, brought Brooksbank into the company with him. Shortly thereafter, Brooksbank asked Chachas to prepare quarterly and annual reports for Curbstone, whose SEC filings were no longer current. Over the succeeding years, Chachas prepared corporate resolutions, drafted amended articles and by-laws, worked with auditors and prepared annual reports for Curbstone.

In early 1996, Brooksbank, Chachas, and Hantges decided to restructure Curbstone and to get it listed on an exchange. Chachas asked Jim Franklin ("Franklin"), a business acquaintance of Chachas from San Diego, for assistance in getting Curbstone listed.

On November 6, 1996, Curbstone filed an S-8 registration statement with the SEC that registered 3,500,000 shares. Day of ARTCO, Curbstone's transfer agent, issued certificates for the registered shares without any restrictive legend. Thereafter the shares were quoted on the NASD electronic quotation medium referred to as the OTC Bulletin Board. Four individuals, Chachas, Brooksbank, Hantges, and Franklin ("the Curbstone Management" or "Management Shareholders"), each held just under 25%, and together held 97.33% or 3,427,506 shares ("the Management Shares") of the Curbstone common stock as of late 1997. Each of the four Curbstone principals had invested approximately $6,000 in setting up and managing the company. It was their hope that from any merger they would collectively receive $125,000 for this collective investment of $24,000 as well as some stock in the new entity for long-term investment purposes.

By late 1997, Chachas and Brooksbank were the sole officers and directors of Curbstone.

Throughout the course of the transactions at issue here, the Management Shares were treated as one block and all negotiations about the block were managed by Chachas. Thus, although only Brooksbank and Chachas held control positions at Curbstone, in the sense that they were officers and directors, the Court refers to the block of shares held by the four shareholders as the "Management Shares" because for all practical purposes they were one block under the control of Chachas.

B. The Events

1. Milestone agrees to raise equity for WTS.

WTS had an idea and needed cash in order to rent space in which it could produce what it called a "pre-production unit" that could be shown to potential customers.⁷ Maier Lehman ("Lehman") introduced Cavanagh to WTS representatives at a meeting in New York City on July 15, 1997, that was attended by Lehman and two other persons involved in the search for financing for WTS, Michelle Weiss ("Weiss") and Ari Friedman ("Friedman"). After the merger, Cavanagh gave Lehman, Weiss, and Friedman unlegended⁸ Curbstone stock as a "finder's fee" to compensate them for their roles in introducing Milestone to WTS. Not long after the July meeting, Milestone agreed to act as investment banker for WTS.

The initial understanding between WTS and Milestone is set out in a letter of intent "effective" September 22, 1997. Milestone represented that it is in the business of assisting corporations in raising equity capital through private placement of a company's stock. The letter described, inter alia, an intent to enter into an agreement whereby Milestone would have the exclusive right to raise $1 million in equity capital for WTS in a private placement offering in exchange for an aggregate of 30% of the WTS common stock, and after raising such funds would have a one year option to raise an additional $3 million for another 10% of the stock. It was expected that half of the $3 million, or $1.5 million, would be provided to WTS within five months of its receiving the initial investment of $1 million. Through this financing arrangement WTS indicated a willingness to give up 40% of its stock ownership in exchange for $4 million.

At this same time Milestone was looking for a shell into which WTS could be merged. Cavanagh asked Levy to locate such a candidate and Levy began to deal directly with WTS. Although Levy was retained by WTS as its counsel on December 12, and represented WTS at the time it was acquired by Curbstone, the initial dealings between Levy and WTS were far from smooth. By November 5, 1997, WTS's Weaver was complaining to Milestone about the status of negotiations with Levy. Specifically, the private placement memorandum that Levy had developed for WTS reflected WTS giving up 40% of its stock for a $1 million investment. While WTS believed that a finder's fee of 10% of the money raised was reasonable to compensate an investment banker for its work, it opposed giving up 10% of the company's equity as a finder's fee, particularly since there was an additional $2.5 to $3 million to raise after the first $1 million had been found. As described in the letter, Levy was pushing for a merger with a shell to coincide with the $1 million investment, although WTS's Weaver didn't understand that those events had to coincide.⁹

The complaints about Levy continued. In a memorandum labelled "status of letter of intent," which responded to a proposed letter of intent sent by Levy to WTS on November 7, WTS complained vociferously to Milestone about Levy's proposal. WTS believed that its original understanding with Milestone was fair to all concerned. It contemplated that WTS would give up 40% of its equity in return for an investment of $4 million dollars, $3 million of which would be invested four to six months after the initial investment. WTS planned to use the first $1 million invested in the company to produce "preproduction units that demonstrate performance and actual production costs." With the "hardware" that would result from such work, WTS expected that Milestone would be able to find an investor to place the next $3 million into the company. Although the document is somewhat confusing on this point, it appears that WTS contemplated that Milestone would be compensated for its work by retaining that portion of the 40% in equity that Milestone did not require in order to entice the $4 million investment, or if Milestone did not use any of its own money, it would be entitled to a finder's fee of 10% and legal fees of 5%. Consequently, WTS expected to receive $850,000 of the first $1 million investment.

In contrast, Levy's proposal treated the investors, whom WTS considered a "key" ingredient to its success as a business, "almost [as] an after thought [sic]."¹⁰ Levy wanted WTS to exchange 40% of its equity for $1 million and to give Milestone thereafter the right to raise an additional $3 million for an additional 600,000 shares, which Levy suggested should be priced at $5 per share. Under Levy's plan, 10% of WTS's equity would be used as a finder's fee for Milestone and the investment of $3 million would result in a market capitalization of $53 million. The author pointed out that a finder's fee of 10% was customary and that a market capitalization of $53 million was "astronomical at this stage." (Emphasis added.) WTS predicted that the next investor would "rachet" down the $5 per share price. In contrast, WTS estimated that the appropriate market capitalization at the point at which $1 million was invested was approximately $3.4 million, and after an investment of all $4 million, approximately $10 million.¹¹

Finally, a Letter of Intent effective November 13, 1997, was executed by Weaver and Nicolois on behalf of WTS and Milestone, respectively. Milestone agreed to use its best efforts to have Milestone or its clients advance to WTS $1 million as a note convertible into 30% of WTS's issued and outstanding common stock. It was also the intention of the parties that WTS would become a wholly-owned subsidiary of a publicly traded company before December 15, 1997, with WTS shareholders receiving 95% of the issued and outstanding capital of the new company and the shell's shareholders retaining 5%. Milestone would then convert its note and receive shares in the new entity "in proportion to its then ownership of WTS." The letter also required WTS to issue 6,054 shares (amounting to 10% of the entity's outstanding stock) to be registered in the name of Milestone, subject to repurchase by WTS or the new entity if Milestone failed to make an investment of $3 million in the stock of WTS or the new entity. It was contemplated that investors would purchase up to 5,000 shares of WTS for $3 million, with a $1.5 million investment being made by May 31, 1998, and the remaining $1.5 million invested by September 30, 1998.

On November 20, 1997, one week after the Letter of Intent was executed, Weiss and Friedman executed a consulting agreement in which Milestone "acknowledged[d]" the consulting services they had rendered in connection with WTS and agreed to issue 150,000 shares of common stock to them in the event that WTS became a publicly traded company as a result of Milestone's efforts in full satisfaction for their consulting services.

2. Milestone secures a bridge loan.

As is apparent from the negotiations among Milestone, Levy, and WTS, WTS was in urgent need of $1 million. In November 1997, Cavanagh arranged with Stieghorst, a director of Optimum Fund, a Grand Cayman entity, for the Fund to make a $500,000 bridge loan to WTS, convertible into equity.

In December 1997, and contemporaneous with the acquisition described below, Milestone oversaw a $1 million offering of EOSC shares. Specifically, the Optimum Fund bridge loan was converted into 1,054,241 EOSC shares at a price of $.47 per share, and Agira Trading, of the British Virgin Islands, also invested $500,000 for an identical number of shares at the same price per share. There is no evidence that these Regulation S shares have been sold since they were issued. Milestone was paid $100,000 by EOSC and $30,000 by the investors for these Regulation S offerings.

The December 23 8-K describes the bridge loan as follows:

[P]rior to Closing, WTS shall have caused the bridge loan in the amount of $500,000 to be converted to common stock of WTS or an additional 500,000 to be invested as equity, and further shall cause immediately following Closing to have an additional $500,000 to be invested and infused into Curbstone.

The "Material Liabilities of WTS" listed in the 8-K include "a bridge loan in the amount of $500,000 from Optimum Fund." There was no other description of the Regulation S transactions or the bridge loan in the December 23 8-K.

3. Levy finds Curbstone and structures the acquisition.

In November 1997, Levy selected Curbstone as the WTS merger partner. Levy had met Curbstone's Chachas earlier in 1997, when they were on opposite sides of another transaction in which an operating company represented by Levy merged into a shell owned by Chachas and Brooksbank. By late November, the Curbstone Management, that is its four principal shareholders, had agreed to pursue the transaction. Levy negotiated the terms of the transaction with Chachas, who kept the other three principal shareholders advised of the progress of the talks.

Chachas prepared a draft exchange agreement by marking up the agreement that Levy had used in the prior transaction in which Levy and Chachas had both been involved. According to the terms of the agreement, upon closing the Curbstone shareholders would hold no more than 5% of the fully diluted stock of the new company, i.e., 925,217 shares. The balance of the 3,521,876 shares of Curbstone would be cancelled. All of the WTS shares would be exchanged for 17,547,475 newly issued shares of Curbstone. This would allow WTS management to control the company, and give the Curbstone shareholders an investment opportunity in a company with an operating business. It was also agreed that the officers and directors of Curbstone would all resign and be replaced by WTS personnel. A November 25 draft Acquisition Agreement reflects these terms. This structure resembles the understanding between Weaver and Milestone reflected in the November 13 Letter of Intent, that is, that WTS would give up no more that 5% of its stock for a merger into a shell.

From the beginning of the negotiations, Chachas envisioned two separate payments to the Management Shareholders for their agreement to participate in the merger. As reflected in a document that he drafted in late November, he expected that the four Management Shareholders would receive $125,000 in cash and would be paid $1.2 million by "market makers" for 300,000 of their shares in the new company, priced in three equal units at between $3 per share to $5 per share.¹²

By December 1, Chachas was requesting $125,000 in cash at the closing and $2,352 million within six weeks thereafter in return for the sale by the Curbstone Management of a majority of their shares in the new company.¹³ On December 2, 1997, Chachas sent Levy what he characterized as "the only two acceptable alternatives" for closing and "our best and final effort." Under the first alternative, the Curbstone Management would be paid (1) $125,000 in cash at a closing on December 5, and (2) an additional $2,352 million in four installments between December 16, 1997, and March 13, 1998. The latter payment purchased 542,000 shares belonging to Curbstone Management. To insure performance by the purchasers, the Curbstone transfer agent would not release newly issued common stock to WTS or cancel the 2,596,659 shares of Curbstone common stock due to be cancelled until the first installment payment of $450,000 had been received, which was due no later than December 16. The second alternative contemplated an immediate payment of a "$10,000 no [sic] refundable deposit," as well as a December 16 closing, with the $125,000 in cash and first installment payment of $450,000 due at that time. The remainder of the 542,000 shares would be available for purchase in three installments spanning the time between December 16 and March 13, 1998. Under both proposals there would be no change in the Curbstone transfer agent until March 15, 1998, or until all the 542,000 shares had been acquired, whichever occurred first.

Following discussions with Levy on December 3, 1997, Chachas sent Levy a written outline of "the terms for the closing of the Curbstone/WTS acquisition." The acquisition agreement would be signed on December 4 and Curbstone Management would be paid $25,000 as a non-refundable deposit. The closing would occur no later than January 16, or when the balance of the $125,000 is payable and the first round of 150,000 shares of Common Stock of Curbstone have [sic] been purchased from the Curbstone shareholders at a net of $3.00 per share and full payment has been received.

The remainder of the 542,000 shares would be made available for purchase in blocks of shares at monthly intervals running to April 17, on which date the final 92,000 shares would be available for purchase at $6 per share.¹⁴ Under this agreement, the transfer agent could be changed after 30 days.¹⁵ The latter sales of 392,000 shares are in the nature of a call option agreement, with the Curbstone Management having no direct control over the exercise of the options.

Over December 2 and 3, Chachas and Levy finally agreed on the following payments to Curbstone Management in exchange for their agreement to acquire WTS:

1) a $25,000 non-refundable payment, which Levy sent to Chachas on December 8;

2) a $100,000 payment for the sale of 2,563,000 Curbstone Management Shares described below, which payment Levy sent to Chachas on December 12;

3) the purchase of 150,000 Curbstone Management Shares for $450,000, or $3 per share, for which payment was made on December 12;

4) An oral agreement that Milestone had an option to purchase in the following three rounds the following Curbstone Management Shares: 150,000 shares at $4 per share by February 13, 1998; 150,000 shares at $5 per share by March 13, 1998; and 92,000 shares at $6 per share by April 17, 1998.

As this list indicates, Chachas, Cavanagh, and Levy decided that the vast majority of the Curbstone Management Shares would not be cancelled. Instead, they arranged a sale for $100,000 of 2,563,000 of the shares that had been slated for cancellation. Although Chachas at first understood that the shares were to be transferred to Milestone, he was later informed that the certificates for the shares were to be issued in the names of three Spanish clients of Milestone ("the Spanish Shares"). Although Chachas presents this arrangement simply as a means by which Curbstone Management could get $100,000 for shares that otherwise would have been cancelled, this critical decision substantially changed the entire transaction, and was essential to the fraud. It afforded Milestone, and those associated with it, the means to profit enormously from the fraud while giving absolutely nothing of value to WTS. Indeed, the arrangement radically transformed the terms of the merger, in that it would no longer be true that all but 5% of the shares of the new entity would be traded for WTS stock.¹⁶ As a result of the decision not to cancel over 2.5 million of the Management Shares, not 5%, but approximately 16% of the EOSC stock was held by Curbstone shareholders or those to whom they sold. In any event, both Milestone and Curbstone Management now had a strong motive to create a market price for the new entity that would allow them to sell the shares covered by the call option agreement and the Spanish Shares for a significant profit. As Brooksbank frankly recognized at the hearing with respect to the option agreements, "if we were going to make any money [out of the merger] this was where it was going to happen." On December 5, Levy sent Chachas by telefax a revision of the exchange agreement that reflected the decision that there would be no cancellation of the Curbstone Management Shares.

4. Chachas and others execute the "December 5, 1997" stock exchange agreement ("Exchange Agreement") between WTS and Curbstone.

The Exchange Agreement, which bears the date December 5 on its cover, but was executed by Chachas and Brooksbank on December 8, contains the following terms.¹⁷ Curbstone would deliver to the WTS shareholders 15,488,120¹⁸ shares of authorized, but previously unissued unregistered shares of Curbstone in exchange for all of the issued and outstanding shares of WTS owned by the WTS shareholders. The Exchange Agreement included the representation that those shares given in exchange for the WTS stock had not been registered and would be issued with a restrictive legend. The Agreement further represented that the authorized capital stock of Curbstone consisted of 3,521,876 shares of stock issued and outstanding prior to the Closing. The Closing was to be held on or prior to January 16, 1998.

On December 5, Chachas and Brooksbank executed a corporate resolution authorizing Day to issue 17,596,601 restricted shares, which included the 15,488,120 shares described in the final Exchange Agreement as well as 2,108,481 shares divided between Agira and Optimum.¹⁹ Of the 15,488,120 restricted shares to be issued, 500,000 shares were to be issued to Levy, and 2,108,481 were to be issued to Milestone. The certificates for all of these shares were to be delivered to Levy. In addition, the transfer agent was instructed to cancel 33,659 shares of Curbstone held by Curbstone shareholders. As a consequence of the December 5 resolution, there were 21,084,818 issued and outstanding shares of Curbstone. As described below, however, these instructions were not sent to Day until after the Curbstone Management had received $575,000 in cash.

5. The Spanish Shares move from Curbstone into the market.

Cavanagh contends that the 2,563,000 Curbstone Management Shares purchased for $100,000 were sold to three clients of Vicente Tur Ortola, an attorney whom Cavanagh had met in Spain in June 1996.²⁰ According to Cavanagh, Tur Ortola represents groups of investors who want to invest in U.S. publicly traded corporations. While Cavanagh contends that he told Levy in late November that some Milestone clients wanted to purchase Curbstone stock, both Levy and Cavanagh deny negotiating the terms of the transaction between Chachas and Tur Ortola. On the other hand, it is undisputed that Chachas never spoke to Tur Ortola and dealt for all practical purposes solely with Levy. In any event, I find that Cavanagh, through Levy, negotiated these sales with Chachas.

Chachas structured the sale of the Spanish Shares so that it appeared to occur on December 18, immediately after the closing of the acquisition. He fully recognized that, if sold before the closing, these shares were indisputably "control shares." Relying on the fact that the shares had been registered initially in 1996 under an S-8, the Purchase Agreements for the sale of the Spanish Shares drafted by Chachas (there were three identical agreements except for the name of the purchaser) represented that the shares "have been registered securities and will be free of restrictive legend upon delivery." The Agreements further provided that Chachas would hold the shares until "all conditions for the Closing of the Agreement for Exchange of Stock between Curbstone and WTS ... have been satisfied ...." The Purchase Agreements also included a provision that the Curbstone Management Shareholders had the right to repurchase the shares at the same price for which they had sold them, in the event that the Closing of the acquisition of WTS by Curbstone was completed on or before January 16, 1998. The Purchase Agreements also contained "representation and warranties" by the purchasers, discussed at greater length below, which provided that the purchasers were accredited investors and had no present agreements to resell the shares.

Chachas provided the Purchase Agreement to Levy with blanks for the number of shares and total purchase price, the name of the purchaser and the date of purchase.²¹ It appears that Levy faxed the Purchase Agreements to Milestone on December 5; that Milestone's Nicolois faxed the Agreements to "Vincent Tur" on December 10; and that three such agreements were executed on December 11 on behalf of purchasers, and returned. Chachas contends that he signed the Agreements on December 19.

Although there are three separate agreements, each for the purchase of one-third of the Spanish Shares, it is apparent that the purchase of the entire block was controlled by a single entity.²² Moreover, as is evident from the date on the account opening statement at Donald & Co., Cavanagh laid the groundwork for reselling these shares into the American securities market on December 11, that is, even before the shares had been paid for.²³ On December 12, Milestone sent the cash $100,000 for purchasing the 2.563 million Spanish Shares to Chachas' escrow account from its escrow account at Levy's law firm. Thus, the Spanish Shares were purchased at a price of less than four cents per share, specifically, $.39.

In a twice-underlined instruction to Day on December 17, Chachas ordered Day to issue 2,353,217 shares to the three Spanish entities "without legend." On December 18, 1997, the stock certificates were issued and sent to Levy. Chachas understood that it was important to both Levy and Cavanagh that any shares sent to Milestone or its clients be unlegended shares. In documents prepared by Chachas as early as November, Chachas indicated to Levy that 3,510,027 of the 3,521,876 issued Curbstone shares were "free trading" shares. Chachas was acutely aware that there were severe restrictions on the sale of Curbstone Management Shares if sold by affiliates or persons in control of Curbstone. According to Chachas, so long as the Curbstone Management Shares were sold after the acquisition, and thus after the four Curbstone Management Shareholders were no longer affiliates or in control of the corporation's operations, the stock could be sold without any restrictions on its being traded in United States securities markets. Among the steps Chachas took to make it appear that the sale of Spanish Shares did occur after the acquisition, were (1) inserting language in the Purchase Agreement making the delivery of the shares contingent on the acquisition; (2) holding the $100,000 paid for the shares in an escrow account until after the acquisition; (3) executing virtually all of the documents associated with the acquisition prior to sending instructions to Day to transfer the Spanish Shares; and (4) issuing instructions to Day directing him to issue the unregistered Curbstone shares to WTS (which were exchanged for the WTS shares and thus effected the merger) prior to transferring the 2,353,217 Curbstone Management Shares to the three Spanish entities.²⁴

Levy was fully familiar with Chachas' rationalization that taking the above-described steps would justify the sale of the Curbstone Management Shares without any legend restricting their resale. He testified at the hearing that he conveyed to Cavanagh Chachas' own legal conclusion that the Spanish Shares were "free trading" shares, as well as his concurrence in that judgment. Cavanagh in turn contends that he was entitled to and did rely upon Levy's legal opinion that the Spanish Shares were free trading shares. In any event, all three men knew that the purchase of unlegended Spanish Shares was an essential part of the acquisition of WTS by Curbstone, and that at the time those shares were committed to be sold, and were paid for, they were owned by men who controlled the decision as to whether Curbstone would acquire WTS.²⁵

Between December 24 and 26, the Spanish Shares as well as other EOSC shares were deposited into trading accounts at Donald & Co. The 2,713,000 shares so deposited constituted at least 77% of the "market float," that is, 77% of the 3,521,876 shares that were available for trading in the public market. Beginning in late December 1997, Tacopino began systematically liquidating these shares.²⁶ When these shares are combined with the remaining 392,000 shares tied up by the Option Agreement and the 200,000 shares held by Curbstone Management under a lock-up agreement, Cavanagh controlled approximately 95% of the market float prior to liquidation.

6. The acquisition is completed.

On December 12, Levy wire transferred to Chachas $550,000, representing the $100,000 payment for the purchase of the 2,563,000 Spanish Shares and $450,000 for Milestone's exercise of the first round of options to purchase 150,000 shares. In connection with that first amount of money, Levy wrote that the $100,00 was wired "to complete the sale of 2,563,000 shares as of December 1, 1997," (emphasis added) the date Chachas had inserted into the agreement to purchase the Spanish shares. Chachas distributed the $550,000 among the four Management Shareholders on December 19. Chachas tendered his resignation as an officer and director of Curbstone on December 12 and wrote to Levy:

It is my understanding that the agreement between Curbstone and WTS has been fully executed and thus this transaction is closed .... As I indicated previously I will be glad to edgarize²⁷ and file the 8-K if you need my assistance.

On December 16, 1997, Milestone signed the agreement dated November 20, 1997, that Weiss and Friedman who had introduced Milestone to WTS had sent to Milestone on November 21, 1997. Pursuant to this document, Milestone agreed to convey 150,000 shares of EOSC to the two individuals as full payment for their consulting services.

During this period of time, Chachas obtained a CUSIP number for the new company and was notified that the company would bear the OTC trading symbol of EOSC. On December 16, he confirmed with Levy the appropriate division among the three Spanish entities of the "2,563,000 Free trading [shares] purchased for $100,000." On December 17, 1997, Chachas sent by overnight mail instructions to Day to issue new stock and to cancel and transfer existing stock.

On December 18, Chachas and Brooksbank, acting as the "entire Board of Directors," executed a corporate resolution appointing four WTS employees as directors, accepting their own resignations as officers, and appointing in their stead five WTS employees as officers. On that same day, Day acted on the instructions that Chachas had sent him, completing both the acquisition and the sale of the Spanish Shares.

7. December 19, 1997 trading moves the EOSC stock price to over $5 per share.

On December 19, at about 10:22 a.m., before there had been any public announcement of the acquisition, Cavanagh called Proudian, a trader at Alexander, Wescott & Co., and told him to buy 500 shares of EOSC at $7 per share for his client, Optimum Fund.²⁸ Proudian called Donald & Co, placed the order, and made the trade. A trade at $7 per share reflected a market capitalization for EOSC of $140,000,000. As recently as November, the President of WTS labelled a market capitalization of $53 million after the investment of $4 million (which WTS had yet to receive) "astronomical."

The last trade before this $7 purchase of stock had, of course, occurred before the acquisition that had fundamentally changed the nature of the company. It occurred on November 12, 1997, when the stock had traded around 20 cents per share. Prior to Cavanagh's purchase, the December 19 market maker quotes for the stock were $.50 bid for 5,000 shares and no offer, that is, the market maker would pay $.50 for the stock and was not quoting a price at which it would sell the stock.²⁹ After Cavanagh's purchase, Donald & Co. immediately changed its market maker quotes to $5 bid for 500 shares and $7 ask. Within minutes a second market maker followed suit.

The second trade in EOSC occurred at 10:53 a.m., when 3,000 shares were purchased at $5.50 per share through a Canadian broker-dealer for the account of Banca del Gottard, Zurich, Switzerland. Jean-Pierre Neuhaus, a Milestone client, who has signatory power over the account that placed the order, soon received 50,000 EOSC shares from Cavanagh out of the Customer Safety account.

Cavanagh orchestrated another purchase of EOSC stock on behalf of Optimum Fund at 11:13 a.m. This time Cavanagh placed a market order for 2,500 shares, which was filled at $5,375. Cavanagh contends that Stieghorst of Optimum Fund was enthusiastic about the stock and wished to own some.³⁰

Chachas then placed the fourth and final retail trade of the day: a market order for 100 EOSC shares at 2:10 p.m. The order was filled at $5 7/8.³¹

The effect of Cavanagh's first trade was to shift the market maker quotes for the EOSC stock. The cumulative effect of these four trades was to set a price for EOSC stock at over $5 per share prior to the public announcement of the acquisition, which occurred at 6:17 p.m. that day. Cavanagh and Chachas each had a substantial motive to move the price of the EOSC stock as high as possible in order to maximize their profits from the sales of Management Shares that they would be making in succeeding weeks. I find that both Cavanagh and Chachas placed their orders with the intent to help establish a market price for EOSC at or above $5 per share.³²

After the close of business on December 19, Curbstone announced the acquisition, which was reported on the business wire. The terms of the acquisition were reported as follows:

Curbstone Acquisition Corp., a public company, Friday announced that it had completed the acquisition of 100 percent of the stock of WTS Transnational Corp., a privately held company, in exchange for the original issuance of 15,488,120 shares of Curbstone common stock.³³ Curbstone has changed its name to Electro-Optical Systems Corp. The Bulletin Board symbol has been changed to "EOSC." The directors and officers of Curbstone have resigned and have elected the directors and officers of WTS to succeed them.

8. Chachas prepares the December 23, 1997 Form 8-K.

At the request of Levy, Chachas prepared the Curbstone Form 8-K,³⁴ filed on December 23, 1997. According to Chachas, he prepared the 8-K as an accommodation to EOSC, because he knew how to do electronic filing with the SEC (through the Edgar system), and, since the Christmas holidays were approaching, it would have been difficult for the company to find someone else to prepare the filing on short notice.

The 8-K provided the public with its most extensive information to date about WTS and the terms of the Curbstone/WTS merger. It included a copy of the Exchange Agreement, but did not disclose the sale of the Spanish Shares, the option agreement, the transfer of restricted stock to Milestone,³⁵ or the transfer of restricted stock to Levy. The 8-K indicated, as discussed above, that WTS had received a bridge loan in the amount of $500,000 that was to be converted into equity, and that an additional $500,000 was to be invested in Curbstone immediately after the closing. It did not disclose, however, that Regulation S stock had already been issued in connection with this $1 million investment.

The 8-K indicated that a total of 19,009,996 shares of Curbstone/EOSC stock would be outstanding after the closing. That figure includes the 3,521,876 shares that were represented as issued and outstanding prior to the closing, and the 15,488,120 shares that were represented as being newly issued to WTS. It did not indicate what the architects of the transaction already knew namely, that the total number of outstanding shares was actually closer to 21 million shares. The additional 2.1 million shares had been issued to Agira and Optimum under Regulation S concurrently with the closing.

The 8-K was amended by a filing that EOSC made on February 18, 1998.³⁶ This filing disclosed the Regulation S sales to Agira and Optimum. It also indicated that the total number of shares outstanding was 21,084,818.³⁷ The amended 8-K did not, however, cure all of the deficiencies in the December 23 filing. Because the amended 8-K was not the focus of the preliminary injunction hearing, the Court will note only a few brief observations about its failings.

Most importantly, it continued to portray the WTS-Curbstone merger as a stock-for-stock transaction, without disclosing the considerable additional terms of the deal that have been set forth in this Opinion. It also continued to represent, as had the December 23 8-K, that the 15,488,120 shares of Curbstone stock that were issued at the time of the acquisition went directly to WTS shareholders. In fact, according to the transfer agent's records, only 12,022,558 of those shares went to WTS shareholders. 500,000 shares went directly to Levy, and 2,108,481 shares went directly to Milestone. An additional 857,081 shares went to Inversora Dactilar, S.L., the Spanish entity that Cavanagh indicated he had lined up to provide additional financing for EOSC. Finally, the amended 8-K indicated that, to the knowledge of EOSC management, no agreements as to any matters existed amongst the former shareholders and any other shareholders of EOSC. Although it may have been true that EOSC management did not know about the side agreements arranged by Cavanagh, Levy, and Chachas, these agreements certainly did exist and EOSC's attorney, Levy, was their primary architect.³⁸

9. The Future Superstock picks EOSC.

On January 12, 1998, an internet publication called The Future Superstock released to its subscribers its choice as the "Stock Pick of the Year for 1998" EOSC. It observed, after a lengthy discussion of the company's product plans, that The Future Superstock had set "a price target" of $15 to $18 per share for the EOSC stock over the next three months to a year. Among the data the publication relied upon in making its assessment of the company was its trading history, which was described as having begun on December 19, 1997, and having included a high of $7 per share and a low of $5 per share. On January 24, 1998, this article was publicly released. During the mid-January period, Cavanagh stepped up the pace of his liquidation of EOSC shares and the volume of trading in EOSC stock soared. Lehman,³⁹ the man responsible for introducing Cavanagh to WTS, was responsible for introducing Bruss, Future Superstock's owner, to EOSC. Bruss, who testified at the hearing, explained that his investigation of EOSC included studying the EOSC trading history, interviewing its management, and looking at its business plan.

Bruss' prediction that EOSC stock would be trading at $18 per share by the end of the year was extraordinary. That prediction assumed a market capitalization of $378,000,000 for a company that had not yet received even a full $1 million from outside investors and that, as explained below, had not even successfully produced a prototype to show to potential customers. Indeed, on the very day that Bruss first released his article, January 12, EOSC's Weaver was writing an internal memo about "hype," acknowledging that he would rather not say anything until EOSC had a product on the street. According to Weaver, "We do not have a product that we can show today. We will in about four months."

10. The January 30 EOSC press release falsely describes EOSC's state of production.

By January 30, however, EOSC abandoned any reticence it had about issuing press releases. It issued a release conveying that EOSC was already selling its new product to a company called ADL Data Systems, Inc. ("ADL"). The release of this statement to the press was orchestrated by Levy and Friedman, one of those responsible for introducing WTS to Cavanagh in the summer of 1997. In late January 1998, Friedman,⁴⁰ who also was a client of ADL, suggested to ADL's President David Pollack that Pollack might want to look at, and get distribution rights to, EOSC's fingerprint identification unit. Pollack contacted Weaver and began discussions about the fingerprint technology. Shortly thereafter, on January 30, Levy sent a draft letter to Pollack describing an agreement between the two companies. Pollack revised the draft letter to EOSC and sent it to Weaver. Pollack specifically told Levy that the letter was not a purchase order, and that he couldn't purchase what he hadn't evaluated.

Both Pollack and Weaver signed the letter, which concerns a "Proposed Joint Venture." It reads in pertinent part as follows:

"[A]s per my negotiations with your agent, enclosed please find our Purchase Order for 1,000 units of your Fingerprint Identification System. These units are to be delivered to our office soon after we've had the opportunity to test your evaluation units and the price will be finalized prior to shipment .... [Assuming the success of a field test,] we both agree to enter into a Joint Venture to market on an exclusive basis these units in the nursing home, long term care facilities, and adult homes and on a non exclusive basis home care agencies ...."⁴¹

No Purchase Order was attached to the letter.

At the same time that Levy was drafting the letter exchanged between the two CEOs, he was busy drafting a press release for simultaneous distribution. In doing so, he telefaxed copies of his drafts of the press release to Lehman, his colleague Michelle Weiss,⁴² and Future Superstock's Bruss.⁴³ The January 30, 1998 press release issued by EOSC reads in pertinent part as follows:

ELECTRO-OPTICAL SYSTEMS CORP. (OTC-Bulletin Board: EOSC) a public company, announced today that it received a Purchase Order from ADL Data Systems, Inc., a leading system integrator and software provider to the nursing home and health care industry, for an initial order of 1,000 Finger Print Verification Units for an undisclosed price. The Purchase Order and accompanying Letter of Agreement state that upon the successful evaluation and testing of these units initially with selected ADL nursing home clients, ADL agrees to market additional units in a joint venture with EOSC to national health care sources. ADL estimates that the first year of the joint venture following the test placement could result in the sale of a minimum of 15,000 units.

The false statements in this press release included the representation that EOSC had received an initial order for 1,000 units from ADL. Levy and other defendants have tried to justify this false statement by testifying that there is an industry practice of "conditional" orders that are subject to the customer's approval of the product and confirmation. The press release does not describe such an arrangement, however, and the evidence is strong that both Levy and Weaver knowingly participated in the dissemination of this false information to the public.

This is perhaps an appropriate point at which to describe in greater detail the technology that EOSC was in the process of developing in January. During the April hearing, the EOSC fingerprint identification technology was demonstrated in court using a computer "mouse" and computer terminal. In the demonstrations, a person was "enrolled" in the list of those granted access to the computer's files by having the person place her thumb on a pad on the mouse three times to permit three different impressions of the person's thumbprint to be taken. Once enrolled, an enrollee is supposed to have her thumbprint read and recognized by placing her thumb on the mouse's pad again. This entire process was demonstrated with three different new enrollees. The demonstrations underscored how sensitive the placement of the individual's thumb on the mouse's pad is. Thus, there was some difficulty getting a good quality print to enroll a person and some difficulty have the computer identify an enrolled person. The technology appears to hold great promise, but clearly remains in the development stage.

The devices on which the process was demonstrated to the Court were not those intended for ADL. EOSC was creating a miniaturized version of the technology for ADL, among other potential customers, and had hoped to have a prototype manufactured by June or July 1998 to hand to prospective customers so that orders could be solicited. The point at which that prototype could be handed to customers would mark the end of the development stage for the product. As of January 30, ADL did not even have mechanical drawings for the prototype. If EOSC had successfully created a prototype to give to ADL and prospective customers by June or July, and had the customers wanted to order the product, EOSC could have been manufacturing it in significant quantities by the end of 1998. While EOSC may yet create a viable product, it has not yet done so and its development of the product was nowhere near the level of completion that was represented in the January 30 press release.

A. Jurisdiction

The Court has subject matter jurisdiction over this matter pursuant to Sections 20(d)(1) and 22(a) of the Securities Act, 15 U.S.C. 77t(d)(1) and 77v(a), and Section 21(d)(3)(A), 21(e) and 27 of the Exchange Act, 15 U.S.C. 78u(d)(3)(A), 78u(e) and 78aa. The Court has personal jurisdiction over all of the defendants and relief defendants under Section 27 of the Exchange Act, 15 U.S.C. 78aa. See SEC v. Unifund SAL, 910 F.2d 1028, 1033 (2d Cir.1990); Bersch v. Drexel Firestone Inc., 519 F.2d 974, 998 (2d Cir.1975); Leasco Data Processing Equipment Corp. v. Maxwell, 468 F.2d 1326, 1339-40 (2d Cir.1972). Venue is proper in the Southern District of New York pursuant to Section 22(a) of the Securities Act, 15 U.S.C. 77v(a), and Section 27 of the Exchange Act, 15 U.S.C. 78aa.

B. Standards for Granting a Preliminary Injunction with SEC as Plaintiff

Section 21(d) of the Exchange Act provides, in pertinent part:

Whenever it shall appear to the Commission that any person is engaged or is about to engage in acts or practices constituting a violation of any provisions of this chapter [or] the rule or regulations thereunder ... it may in its discretion bring an action in the proper district court ... to enjoin such acts or practices, and upon a proper showing a permanent or temporary injunction or restraining order shall be granted without bond.

15 U.S.C. 78u(d) (emphasis supplied). Thus, to grant a preliminary injunction upon the SEC's request, the Court must find that the SEC has made a "proper showing" of actions by the defendants that violate their statutory obligations. See Unifund SAL, 910 F.2d at 1035. In this Circuit, the SEC, unlike a private litigant, need not show risk of irreparable injury to obtain an injunction, nor the unavailability of remedies at law. Id. at 1036.⁴⁴

In Unifund SAL, the Second Circuit held that the "proper showing" required of the SEC is analogous to the traditional "likelihood of success" standard regularly applied to private litigants. See id. at 1037. The SEC's burden of proof varies, however, depending upon the nature of the preliminary relief the Commission seeks. Thus, a more substantial showing of likelihood of success, both as to violation and risk of recurrence [is required] whenever the relief sought is more than preservation of the status quo. Like any litigant, the Commission [is] obliged to make a more persuasive showing of its entitlement to a preliminary injunction the more onerous are the burdens of the injunction it seeks.

Id. at 1039.

The SEC seeks various forms of preliminary relief predicated on an extension of the individual measures embodied in the March 13 Order, namely: (1) a preliminary injunction enjoining the defendants from future violations of the securities laws; (2) an asset freeze; (3) an accounting of the defendants' assets; (4) the repatriation of all monies associated with trades by the defendants in EOSC stock; and (5) a freeze on any further trading by the defendants and relief defendants in EOSC stock. An injunction against future securities violations is among the sanctions noted by the Second Circuit in Unifund SAL as having "grave consequences." 910 F.2d at 1040. The consequences of such an injunction are grave for individuals who are regularly involved in the securities industry, like many of the defendants in this action, because the injunction places them in danger of contempt charges in all future securities transactions. Id. The reputational and economic harm of suffering a preliminary injunction, especially on charges of fraud, is also severe for individuals who make their living in the securities industry, such as Chachas, Levy, and Cavanagh. These individuals stand to lose considerable business and respect in their communities if even a preliminary injunction is entered.

Accordingly, to obtain this relief, the SEC must make a substantial showing of likelihood of success as to both a current violation and the risk of repetition. Id. In this litigation, the SEC alleges that the defendants engaged in a scheme that violated three distinct portions of the securities laws: Section 5 of the Securities Act, which prohibits the sale of unregistered securities; Section 17(a) of the Securities Act, which generally prohibits fraud in the offer or sale of securities; and Section 10(b) of the Exchange Act, which prohibits manipulative and deceptive devices in connection with the purchase or sale of securities. This Opinion will discuss these theories of relief in turn.

C. Claims Under Section 5

1. The Sale of the Management Shares

Section 5 provides, in pertinent part:

Unless a registration statement is in effect as to a security, it shall be unlawful for any person, directly or indirectly

(1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise; or

(2) to carry or cause to be carried through the mails or in interstate commerce, by any means or instruments of transportation, any such security for the purpose of sale or for delivery after sale.

15 U.S.C. 77e(a) (emphasis added). It is undisputed that the purpose of Section 5, consistent with the overall purpose of the Securities Act, is to "protect investors by promoting full disclosure of information thought necessary to informed investment decisions." SEC v. Harwyn Indus., 326 F.Supp. 943, 953 (S.D.N.Y.1971) (quoting SEC v. Ralston Purina Co., 346 U.S. 119, 124, 73 S.Ct. 981, 97 L.Ed. 1494 (1953)).

The Securities Act sets forth the types of information that must be included in a registration statement. For example, information about the issuer's financial condition, the identity and background of management, and the price and amount of securities to be offered must be included in the registration statement. See 15 U.S.C. 77g and 77aa. SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082, 1098 (2d Cir.1972) (discussing information to be included in a registration statement and prospectus delivered to prospective purchasers); Harwyn Indus., 326 F.Supp. at 953 (discussing the significance of registration to prospective purchasers).

To establish a prima facie case for a Section 5 violation, a plaintiff must prove three elements: first, that no registration statement was in effect as to the securities; second, that the defendant sold or offered to sell these securities; third, that there was a use of interstate transportation, or communication, or of the mails in connection with the sale or offer of sale. See Neuwirth Investment Fund, Ltd. v. Swanton, 422 F.Supp. 1187, 1193 n. 8 (S.D.N.Y.1975) (quoting Hill York Corp. v. American Int'l Franchises, Inc., 448 F.2d 680, 686 (5th Cir.1971)). To prove a violation of Section 5, a plaintiff need not establish scienter. See SEC v. Universal Major Indus., 546 F.2d 1044, 1047 (2d Cir. 1976); SEC v. Softpoint, Inc., 958 F.Supp. 846, 859-60 (S.D.N.Y.1997) (Sotomayor, J.).

Here, it is not seriously disputed that the SEC has made out a prima facie case for a violation of Section 5.⁴⁵ The main transaction at issue with respect to the Section 5 claim consists of the sale of 2,563,000 shares of Curbstone stock the Spanish Shares by defendants Chachas, Brooksbank, Hantges, and nonparty Franklin on December 12, 1997, to defendants Customer Safety, Cambiarios, and Construcciones.⁴⁶ Under the terms of this sale, which was negotiated in the weeks prior to the actual transfer, the Management Shareholders received approximately 3.9 cents a share, resulting in a total payment of $100,000. The Management Shareholders did not register these sales. Many of these shares ultimately were resold to the public, again without registration.⁴⁷

Nevertheless, all of the defendants, but most importantly Chachas, who negotiated the sales on behalf of the Management Shareholders, argue that the sales to the Spanish entities were exempt from Section 5's requirements. Chachas argues that the sales did not violate Section 5 because those sales fit clearly within the exemption afforded by Section 4(1) of the Securities Act for transactions by any person other than an issuer, underwriter or dealer. The stock that he sold in post-acquisition transactions had been obtained by him while a registration statement was in effect and thus was not restricted. Further, at the time of his first sales and thereafter, he was no longer an affiliate of the company, because he had resigned as an officer and director, and because he had carefully structured the transactions of December 18 so that the 15,000,000 new shares of stock were issued to the WTS before his own sale.

(Emphasis added). The SEC claims that the exemption relied upon by the defendants ("the 4(1) exemption") does not apply, because the Management Shareholders were "affiliates," as that term will be defined below, and therefore stood in the shoes of the issuer, at the time of the sale.

The Court finds that the 4(1) exemption does not apply. Section 4(1) of the Securities Act, codified at 15 U.S.C. 77d, provides, in pertinent part, that "[t]he provisions of section 77e of this title shall not apply to ... transactions by any person other than an issuer, underwriter, or dealer." 15 U.S.C. 77d(1). The purpose of this exemption is to allow the free trading among individual investors of securities that have already been registered. Thus, a transaction is exempt from Section 5's requirements if it is a trade by an ordinary investor rather than an issuer, underwriter, or dealer. A party seeking to invoke this exemption has the burden of proving that the exemption applies.⁴⁸ See Ralston Purina, 346 U.S. at 126 (1953).

Section 2 of the Securities Act sets forth the definitions of "issuer" and "underwriter." Section 2(4) defines an "issuer" as "any person who issues or proposes to issue any security." 15 U.S.C. 77b(a)(4). The issuer is generally the company that issues a security. Section 2(11) defines the term "underwriter" as any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participating in the direct or indirect underwriting of any such undertaking.

15 U.S.C. 77b(a)(11) (emphasis added). For the purposes of the definition of an "underwriter," the term "issuer" is defined as including, "any person directly or indirectly controlling or controlled by the issuer, or any person under direct or indirect common control with the issuer." Id. To establish that a person is "under direct or indirect common control with the issuer," the SEC has generally asked whether the particular person is "in a position to obtain the required signatures of the issuer and its officers and directors on a registration statement." Loss and Seligman, supra note 5 at 247.⁴⁹

The SEC claims that Chachas and the Curbstone Management Shareholders were "issuers" under the foregoing definition, or affiliates, when they sold the Spanish shares in that they were under direct or indirect common control with the issuer, Curbstone. The SEC bases this argument on the facts that two of the Management Shareholders, Chachas and Brooksbank, were officers and directors of Curbstone, and that the group collectively controlled 97% of its stock prior to the merger with WTS. Because the SEC maintains that the sale of the Spanish shares occurred prior to the completion of the merger with WTS on December 18, it argues that, at the time of the sale, the Management Shareholders were still in control of Curbstone. In the alternative, the SEC argues that, should the Court find that the actual sale occurred after the merger, the Management Shareholders acting through Chachas offered to sell their shares prior to the merger, and that such an offer alone constitutes a violation of Section 5.⁵⁰

Chachas concedes that if the sale of the Spanish Shares occurred while he was an affiliate, then the sale would have been unlawful under Section 5.⁵¹ Chachas' testimony and written submissions make clear that he understood the implications of selling the Management Shares before the merger was completed while the Management Shareholders were still affiliates and that he studiously crafted the transactions so as to make it appear, at least formally, that the sales occurred after the merger.

The liability of the Management Shareholders, the Spanish entities, and the other defendants who played a substantial role in the sale of the Management Shares thus turns on whether the Management Shareholders were in fact "issuers" within the meaning of Section 2(11) or affiliates or control persons at the time of the sale of the Spanish Shares. Alternatively, these defendants may be found liable if the SEC is correct that an offer to sell occurred prior to the completion of the merger and that such an offer is sufficient to constitute a violation of Section 5.

The defendants (led by Chachas) would focus the Court's attention with respect to the first issue whether the Management Shareholders were affiliates at the time of the actual sale on the exact timing of the events in question. According to Chachas, the Management Shareholders ceased to be in control of Curbstone soon to be renamed EOSC on December 18th, at the moment that Day, the transfer agent for Curbstone, issued the 15.5 million new shares of Curbstone to WTS. At that moment, they contend, the ownership of the Management Shareholders was diluted from 97% to 16.6% of the company. Relying also on the facts that Chachas and Brooksbank had resigned as officers and directors of Curbstone before December 18, and that their resignations were accepted on December 18, Chachas claims that the December 18 transfer of the majority of the shares to WTS constituted the final act necessary to remove all vestiges of control from the Management Shareholders.⁵²

If the Court were to separate the sale of the Spanish Shares from the acquisition transaction, I would find that the sale occurred first. Chachas' agreement to acquire WTS was contingent on his prior receipt of $100,000paid on December 12. As Levy wrote to Chachas on December 12, that payment completed the sale of the Spanish shares as of December 1 the date on the Purchase Agreement for those shares. Only with the receipt of that money did Chachas and Brooksbank resign and issue instructions to the transfer agent. Moreover, according to the December 23 8-K prepared by Chachas, the acquisition did not close until December 18.

When the substance of these events is elevated above this form, however, it is clear that they should be viewed through an "integrated" analysis. Although the Court is unaware of any SEC or court opinion applying the concept of "integration" to the precise question of whether a seller of securities is a control person, the concept has been applied in numerous other contexts covered by the securities laws. As Professors Loss and Seligman have described the rationale for integration:

[b]ecause securities subject to a transaction exemption are exempted on a transaction-by-transaction basis, the possibility exists that an apparently exempt transaction is actually part of a larger offering for which no exemption is available. The concept of "integrating" offerings is intended to prevent an issuer from avoiding registration by structuring a transaction in two or more apparently exempt offerings (or one exempt and one nonexempt offering) when they actually should be considered a single nonexempt transaction.

Loss and Seligman, supra note 5 at 278 (emphasis added). SEC v. North American Research and Dev. Corp., 424 F.2d 63, 70-71 (2d Cir.1970) (rejecting defendants' attempt to use an exemption under the Securities Act to insulate their distribution of stock by analyzing the "substance of the transactions" and finding the purposes of the Securities Act best served by treating separate acts as "jointly conceived and jointly consummated"); Non-Public Offering Exemption, Securities Act Release No. 4552, 1962 WL 3573, at *3-4 (S.E.C. Nov. 6, 1962) (discussing how the concept of integration could be applied to find public offering where an issuer claimed there were only several private offerings); The Crowell-Collier Publishing Company, Securities Act Release No. 3825, 1957 WL 7724 (S.E.C. Aug. 12, 1957) (same); Securities Act Release No. 4434, 1961 WL 3670, at *1-2 (S.E.C. Dec. 6, 1961) (discussing how the concept of integration could be applied to find a public offering without exemption where an exemption for a local offering was claimed). Cf. Universal Major Indus. Corp., 546 F.2d at 1047 (approving use of the integrated offering concept although not requiring the SEC to establish its existence in connection with that Section 5 violation). Bearing in mind that the policy objective of the Securities Act is "to protect investors by promoting full disclosure of information thought necessary to informed investment decisions," Ralston Purina, 346 U.S. at 123, and that exemptions should be interpreted "in light of the statutory purpose," id., the Court finds that Chachas' formalistic view of the events in question must be rejected in favor of an integrated analysis.

Applying this analysis, the Court finds that the two allegedly separate transactions i.e., the merger of Curbstone with WTS and the sales of the Spanish Shares should be treated as one, since the documentary and testimonial evidence strongly supports an inference that they were one in the minds of the individuals who structured them. More importantly, however, the Court finds that they should be viewed as one because of their significance when viewed together to the investing public.

As the SEC has explained in the context of analyzing whether an offering of securities is public or private,

[t]he following factors are relevant to [the] question of integration: whether (1) the different offerings are part of a single plan of financing, (2) the offerings involve issuance of the same class of security, (3) the offerings are made at or about the same time, (4) the same type of consideration is to be received, (5) the offerings are made for the same general purpose.

Securities Act Release No. 33-4552, 1962 WL 3573, at *3. See also Loss and Seligman, supra note 5 at 278-282. Not all of these factors need be established to justify a finding that transactions claimed to be separate were in fact one integrated transaction. Indeed,

[n]either the Commission nor the courts have provided express guidance on how to weigh these factors when analyzing an integration problem. A review of the cases and no-action letters strongly suggests that the "single plan of financing" and "same general purpose" factors normally are given greater weight than the other factors.

Id. at 280.

Here, the merger between WTS and Curbstone and the sales of the Spanish Shares were so interconnected that one would not have happened without the other. Indeed, the Purchase Agreements entered into between the Spanish entities and the Management Shareholders explicitly provided that the sales would not occur unless and until the merger with WTS was completed. Similarly, Chachas made clear in his correspondence with Levy that the merger with WTS would not go forward until he actually had the cash in his account representing the $100,000 payment for the Spanish Shares and the $450,000 payment for the first round of the options. Although Chachas backed away from this theory of the events during his testimony, the documents that he drafted speak for themselves. In addition, the theory that the transactions were integrated is consistent with the position expressed by Chachas and Brooksbank throughout this proceeding, including their in-court testimony, that the Management Shareholders originally hoped to get $125,000, plus stock, out of any merger that Curbstone entered into with an operating company. The Management Shareholders received the $125,000 they sought in two installments: the $25,000 non-refundable cash deposit and the $100,000 payment for the sale of the Spanish Shares. Viewed objectively, and subjectively from the perspective of the Management Shareholders, the merger and the sales of the Spanish Shares therefore were clearly part of a single plan of financing, and shared the same general purpose i.e., to provide the group with its desired investment return.

From the perspective of Levy, Cavanagh, and Milestone, the two events also were part of a single plan of financing and shared a general purpose. These three defendants were interested in bringing about the acquisition of WTS, ever since they had been retained by that company to provide financing. Viewing the facts in the light most favorable to them, Levy, Cavanagh, and Milestone at the very least had an incentive to arrange the Spanish sales in order to ensure that the Curbstone shareholders went through with the acquisition. Accordingly, Cavanagh and Levy arranged for the Management Shareholders to sell their shares to the Spanish entities. Thus, despite Cavanagh's protestations to the contrary in court, he knew that the merger would not go through unless the sales of the Management Shares were assured and that the two events therefore were part of one larger scheme.

Weighing the evidence according to its probative force, instead of in the light more favorable to Cavanagh, the conclusion is compelling that the sale of the Spanish Shares furthered Cavanagh's consistent effort to gain control of as many shares as possible from the acquisition. Charts Chachas had prepared and sent to Levy during the negotiations of the acquisition reflect vividly how essential it was to Levy and Milestone that the latter obtain a significant number of shares from the acquisition. According to those charts, Milestone intended to use 10% of EOSC's equity (the 2,108,481 shares intended for Optimum and Agira) to raise $1 million, and 2.88% (the 607,081 shares intended for Inversora) to raise $3 million. Thus, although WTS had expected that it would be necessary to use 40% of its equity to raise $4 million, Milestone intended to use just 12.88%. The remainder of the 40% would be split between Milestone and Levy, the former getting 22.16%, the latter 3.56%. Thus, the final chart Chachas prepared, which was sent to Levy on December 5, reflected Milestone getting 2,563,000 or 12.16% of the equity by purchasing the Spanish Shares for $125,000, as well as getting another 2,108,481 shares or 10% of the equity. The final distributions of equity are not very different from these plans. In rounded figures, Curbstone kept 3% of the shares (after the sale of 300,000 shares pursuant to the option agreement); WTS received 57% of the shares; 10% of the equity went to Agira and Optimum for their $1 million investment; 3% of the equity was given to Inversora in return for a promised $3 million investment; 2% of the equity went to Levy; and the balance, roughly 24% of the shares, went to Milestone.

Even more to the point, however, what was essential to Milestone was its control of the "float," that is, the number of shares that could be traded. All of the shares issued by Curbstone for the acquisition were unregistered, were accompanied by a legend on the stock certificate explaining that fact, and therefore were unavailable for resale into the public market. Before Chachas and Levy negotiated the sale of the Spanish Shares to Milestone, those shares were slated for cancellation. At that point in time, therefore, it was expected that the Management Shareholders would have 925,217 shares, 80% of which would be under Milestone's control: 542,000 through the option agreement and 200,000 through a lock-up agreement running until March 15, 1997. Once Milestone negotiated the additional purchase of the Spanish Shares, it increased its control of the float to 95%.⁵³

The Court therefore finds that the two events were integrated in the minds of their architects, that they were part of a single plan, and that the events occurred at or about the same time and were made for the same general purpose. Equally as important for determining whether a violation of Section 5 has occurred, however, are the implications of these events for investors who ultimately bought or sold the shares that were made available to the public as a result of these transactions. Thus, it is also relevant to ask whether investors received all the information to which they were entitled under the Securities Act before the shares released through this transaction were bought and sold in the public market. See Ralston Purina, 346 U.S. at 125 ("the applicability of Section 4(1) should turn on whether the particular class of persons affected need the protection of the Act"); Universal Major Indus., 546 F.2d at 1047 (the inquiry under Section 5 depends "not so much upon the nature of the offering as upon the need for protection of the class of offerees; i.e., whether they have the information which a registration would disclose, or have access to it").

The Court finds that investors did not have all the information to which they were entitled concerning the acquisition, and that material information that was uniquely in the possession of the Management Shareholders including, most importantly, information relating to the sales of the Spanish Shares, the option agreement, and the Regulation S transactions was not disclosed. This is precisely the kind of information that control persons are presumed to have, and which the Management Shareholders did not cease to have upon the issuance of 15.5 million new shares to WTS. It would be an odd construction of Section 5 indeed if affiliates of a company, who are limited in their ability to sell their stock to the public precisely because of their presumed superior access to information about the company, suddenly faced no limitations five minutes (or however long it took Day to issue the 15.5 million shares to WTS) after they ceased to be affiliates. To accept Chachas' argument that the literal transfer of majority ownership constitutes the moment at which a former affiliate may sell freely into the market is to ignore the guiding purpose of the Securities Act the protection of "those who do not know market conditions from the overreachings of those who do," Charles Hughes & Co. v. SEC, 139 F.2d 434, 437 (2d Cir.1943) and the rationale for restrictions on affiliate shares in the first place. Cf. North American Research and Dev. Corp., 424 F.2d at 71 (discouraging a trial court from attributing "undue significance to the date ... when control passed"). Compare Rule 144(k) (establishing that certain restrictions under Rule 144 do not apply to the sale of restricted securities when the sale is for the account of a person who has not been an affiliate for three months). 17 C.F.R. 144(k) (emphasis added). See also A.A. Sommer, Jr., "Who's `In Control' S.E.C.," 21 Bus. Law. 559, 579 (1966) (suggesting a rule that restrictions concerning control persons should no longer be applicable where "a bona fide severance of participation in or influence over or control of the issuer occurs with no reasonable expectation of its rehabilitation"). To put it another way, if the December 23 8-K prepared by Chachas and filed on behalf of Curbstone and EOSC to report the acquisition had been filed at the time of the acquisition and fully and accurately disclosed all material information relating to the terms of the acquisition, then the Curbstone shareholders would have held no unfair advantage over the American investor, and their loss of control would have immediately allowed them to sell their stock holdings without further registration.

The question of whether a person is in a position of "control" is a question of fact and depends on the totality of the circumstances, including an appraisal of the influence the individual has on the management and policies of a company. See United States v. Corr, 543 F.2d 1042, 1050 (2d Cir. 1976). A person can be in a position of control over a corporation even without owning a majority of the voting stock. Id. Here, the Court finds that the SEC has amply met its burden of establishing that, for purposes of determining whether a Section 5 violation occurred, the Management Shareholders, acting through Chachas, were in a position of control over the company at the time that their shares were sold to the Spanish entities, even if the certificates comprising the majority ownership of the merged entity were transferred simultaneously or a few moments before the certificates effecting the sale of Spanish Shares were transferred.⁵⁴ Throughout the days at issue here, the Management Shareholders controlled the decision of whether to acquire WTS and whether to file a registration statement to cover their sale of the Management Shares. They chose to proceed with the former and to omit the latter.⁵⁵ Accordingly, the Court finds that the sale of the Spanish Shares was not exempt from registration under Section 4(1), because, for all practical purposes, it was a sale by affiliates.

2. The "Offer" of the Management Shares

The Court turns next to the SEC's alternative argument that an offer to sell unregistered securities constitutes a violation of Section 5. The pertinent section provides:

it shall be unlawful for any person, directly or indirectly ... to offer to sell or offer to buy ... any security, unless a registration statement has been filed as to such security ....

15 U.S.C. 77e(c) (emphasis added). The SEC contends that, at a minimum, Chachas offered to sell the Management Shares to the Spanish entities in the two weeks prior to the completion of the merger, while he and the Management Shareholders unequivocally were still affiliates.

Chachas responds that, as an affiliate, he was only engaged in "preliminary negotiations" to sell the shares, apparently in reliance upon the definition of "offer to sell," in which Congress specifically excluded, for purposes of 15 U.S.C. 77e(c), preliminary negotiations or agreements between an issuer (or any person directly or indirectly controlling or controlled by an issuer, or under direct or indirect common control with an issuer) and any underwriter ....

15 U.S.C. 77b(a)(3) (emphasis supplied). Accordingly, Chachas characterizes the discussions with Levy and the signing of the Purchase Agreements as "preliminary negotiations" for the sale of the securities. Alternatively, Chachas contends that there was no offer made for the sale of the Management Shares prior to the merger, because the sale of the shares was always conditioned upon the completion of the merger and, in addition, could be rescinded if the Management Shareholders decided for any reason that they did not want to go through with the deal.

The Court finds both of Chachas' arguments meritless. First, the "preliminary negotiations" exemption contained in Section 77b(a)(3) does not insulate all preliminary negotiations prior to a public sale by an issuer or affiliate. Instead, it insulates only those negotiations whereby an issuer or affiliate establishes an arrangement with underwriters, prior to the filing or approval of a registration statement, for the distribution of securities to the public. See Loss and Seligman, supra note 5 at 80-81. Where no registration statement is contemplated, as was the case here, the exemption for preliminary negotiations is inapplicable.

Second, the Court finds unpersuasive Chachas's reasoning as to why an offer was not made in this case. Citing numerous provisions of Corbin on Contracts and the Restatement of Contracts, Chachas claims that no offer existed on these facts because the Spanish entities were incapable of creating a binding contract through their simple "acceptance" of the terms that had been conveyed to them by Chachas. In essence, Chachas argues that there was no offer because (1) any "contract" that would have been created was subject to the condition precedent that the acquisition occur; and (2) the "contract" would have been illusory because it gave the Management Shareholders the unilateral right to cancel the transaction without penalty.

Even if the Spanish entities had no legal recourse in the face of cancellation of the transaction, the existence of an "offer" is not undermined whether analyzed under the common law or under the Securities Act. The enforceability of a contract is simply not the touchstone for the existence of an offer.

The Securities Act defines "offers" broadly to include "every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value." 15 U.S.C. 77b(a)(3). This definition has been interpreted as going well beyond the common law concept of an offer. See Diskin v. Lomasney & Co., 452 F.2d 871, 875 (2d Cir. 1971). If Section 5 were concerned only with the creation of legally enforceable contracts for the sale of unregistered securities, Section 77e(c)'s prohibition on offers to sell or offers to buy would not have been included in the statute. Thus, even if the "offer" in this case, once accepted, did not give rise to an enforceable contract, that fact is immaterial for purposes of determining whether the harm with which Section 5 is concerned occurred.

Although the Second Circuit in Diskin did not decide "whether or not a dealer can lawfully make a conditional and revocable offer to sell ... if it is made clear that the offer cannot be accepted until the effective date," 452 F.2d at 875, the Court finds that, on the facts of this case, the conditional nature of the Management Shareholders' offer does not preclude a finding that an offer within the meaning of the Act was made. Unlike in Diskin, which was concerned with a dealer rather than an issuer, no registration statement was ever contemplated for the sale of these shares. In addition, not only had an offer been made, but money had been received in "acceptance" of the offer. Finally, it was entirely within the power of the offerors in this case to ensure that the conditions that they had attached to their offer were met. By December 8, the merger agreement between WTS and Curbstone had been signed by Chachas, and according to the testimony of Chachas and Brooksbank, only ministerial acts remained to be done after December 12 to ensure the transaction's completion. Thus, the condition precedent contained in the Purchase Agreements, that the merger be completed before the shares would be transferred, hardly injected into the transaction the element of uncertainty that Chachas would have the Court believe. Taking into account the realities of the situation, the Court finds that an offer to sell affiliate shares in fact was made in violation of Section 5, culminating in a sale, as outlined above, of affiliate securities.

3. The Claimed 4(1) Exemption

Chachas claims that, even if the Court should find that he made an offer of securities or sold securities while he was an affiliate, an injunction would not be warranted since he did not act with scienter. According to Chachas, he was entitled to and did rely on an exemption known as 4(1) , which is not contained in the Securities Act but nevertheless has been recognized implicitly by the SEC and explicitly by commentators. See, e.g., Loss and Seligman, supra note 5 at 338; Hicks, Exempted Transactions Under The Securities Act of 1933 9.05 (1992); The Section "4(1) " Phenomenon: Private Resales of "Restricted" Securities, 34 Bus. Law. 1961 (1979).

The 4(1) exemption, which allows affiliates to sell substantial amounts of their shares to private investors, has been so named because it falls between the cracks of the 4(1) and 4(2) exemptions, which allow, respectively, for private sales among persons who are not issuers, underwriters, or dealers, and for private sales by an issuer. As is the case for an issuer claiming an exemption for a private sale under 4(2), an affiliate claiming a 4(1) exemption has the burden of establishing that such sales do not constitute a disguised public distribution.

Here, Chachas claims that, although he did not rely on 4(1) for the ultimate sale of the Management Shares, he believed that his negotiations with the Spanish entities, through Levy and Cavanagh, were exempted from Section 5 because of this provision.⁵⁶ During his testimony, Chachas referred to the "reps and warranties" contained in the Purchase Agreements. The portion of the agreements to which Chachas referred provided that [t]he Purchaser is investing solely for its own account and has no present agreements to transfer rights to this Subscription Agreement or to the Shares to any other person.

Acknowledging that he did no research on the Spanish entities who signed these agreements, Chachas contends that the aforementioned "reps and warranties" provided sufficient assurance that the shares would not be sold into the public market. According to Chachas, his insertion of these "reps and warranties" into the Purchase Agreements satisfied any due diligence required of him under law.

The Court finds this not to be the case. Although the SEC has never articulated exactly what steps an issuer or affiliate must take to fall within the private placement exemption, the elicitation of bare representations that the buyer does not have any present agreement to resell is plainly insufficient. As the Commission advised in The Crowell-Collier Publishing Co.,

An issuer may not establish a claim to an exemption under Section 4(1) [now 4(2)] merely by collecting so-called "investment representations" from a limited group of purchasers if in fact a distribution by such persons occurs. Counsel and their issuer and underwriter clients cannot base a claim to exemption from registration under the Securities Act upon the mere acceptance at face value of representations by purchasers that they take for investment and disclaim responsibility for investigation and consideration of all relevant facts and circumstances pertinent to a determination that the transactions do not involve a public offering.

Securities Act Release No. 3825, 1957 WL, at *5 (emphasis added).

That a buyer who purported to buy for investment purposes sells to the public within a short period of time is not conclusive of the buyer's intent at the time of purchase from the issuer or affiliate. See Loss and Seligman, supra note 5 at 329. Nevertheless, such a rapid resale raises a strong inference that the buyer intended to resell, and puts the burden on the affiliate or issuer to demonstrate that it took adequate precautions to ensure that such a resale would not occur. Accordingly, the SEC has noted approvingly of precautions such as placing a legend on the securities alerting the buyer to the restricted character of the securities. See 17 C.F.R. 230.502(d), Regulation D Rules Governing the Limited Offer and Sale of Securities Without Registration Under the Securities Act of 1933 ("Regulation D") (approving the use of a legend as an indication that the seller has taken reasonable care to ensure that shares sold pursuant to a private placement are not resold into the public). As the Second Circuit observed in affirming a preliminary injunction in 1975 against Levy,

[g]ranting that it was not an unconditional requirement of a valid private placement at that time, it is clear, and an expert such as Levy must have known, that such a legend is the single most effective device for preventing resale of restricted shares.

SEC v. Management Dynamics, 515 F.2d at 810 (emphasis supplied).

Another effective device is the issuance of a "stop-transfer order" to the transfer agent for the securities, which would prevent the buyer from reselling without obtaining an opinion by counsel for the issuer as to the legality of the resale.⁵⁷ See Use of Legends and Stop-Transfer Instructions as Evidence of Non-Public Offering, Securities Act Release No. 5121, 1970 WL 10604 (S.E.C. Dec. 30, 1970). In addition, the prudent issuer or affiliate may wish to make inquiries into the financial condition of the buyer to determine, for example, whether the amount of securities purchased is unduly large in relation to his or her financial means, or whether he or she borrowed to finance the purchase so that he or she might intend or be forced to resell in the near future in order to repay his loan. Prudence would seem also to dictate some inquiry, before making a sale, into the prospective buyer's record with respect to holding securities for long-term investment in the past.

Loss & Seligman, supra note 5 at 334. At the very least, an affiliate who sells under the private placement exemption should know the identity of the buyers who purport to take for investment purposes. See The Cro-well-Collier Publishing Co., 1957 WL 7724, at * 5.

Chachas, Levy, and Cavanagh admit that they took none of these precautions.⁵⁸ Although it is clear from the investment letter obtained from WTS as part of the Exchange Agreement that at least Chachas and Levy knew how to extract a detailed representation that restricted shares would not be resold, see note 57, supra, no similar commitment was sought regarding the Spanish Shares. Chachas admitted that he did not know the identity of the buyers until the Purchase Agreements were signed, but conveyed blank Purchase Agreements to Levy and Cavanagh for signature by whomever the purchasers turned out to be. Cavanagh testified that he did no independent research on the Spanish entities, but relied on the representation made by Vicente Tur Ortola, the Spanish lawyer, that these clients were interested in a long-term investment. Thus, none of the defendants who were involved in the sale of the Spanish Shares had any knowledge of the financial condition of the purchasers, their corporate structure, the identity of their principals, or their history of investment. Accordingly, Chachas' argument that the offer was covered by the 4(1) exemption because the Spanish entities did not intend to resell must fail.⁵⁹

This argument also appears quite disingenuous in light of the testimony by all of the defendants associated with the transaction, and the early documents drafted by Chachas, that Chachas was informed that the purchaser of the shares whom he initially was told would be Milestone was interested in "free-trading" shares. The argument likewise is implausible in light of the record demonstrating the efforts made by Chachas to ensure, at least formally, that the Management Shareholders were no longer affiliates at the time of sale. Although Chachas' counsel correctly notes that there is no authority preventing an individual from claiming two different exemptions for a transaction, the Court finds that Chachas' alternative arguments in reality are not different legal arguments so much as they are different factual arguments. Either the evidence demonstrates that Chachas thought that the Spanish Shares were purchased solely for investment purposessuch that he could have offered and sold them even as affiliate sharesor it does not. Chachas has not argued that his understanding of the intent of the purchasers evolved over time. To the contrary, his testimony was clear that he did not know whose name would be on the Purchase Agreements until he received them back after their execution.

More importantly, however, all of the evidence including the testimony by Levy, Cavanagh, and Brooksbank, as well as Chachas' own actions supports a finding that Chachas knew the entire time that the shares had to appear to be freely tradeable at the time of sale, because that was what the purchasers wanted. In short, Chachas knew, or had reason to k