As highlighted in yesterday’s post, the DOJ recently filed a brief in response to Ng Chong Hwa (Roger Ng’s) motion to dismiss a criminal indictment against him in connection with his alleged involvement in bribery schemes involving various Malaysian and Abu Dhabi officials in connection with 1Malaysia Development Berhad (1MDB).
In the brief, the DOJ sets forth its views on the FCPA’s internal controls provisions (believed to be the first instance in the FCPA’s 40+ years in which the DOJ has set forth its internal controls views in a contested matter).
The FCPA space has long know about SEC v. Worldwide Coin (a rare instance in which a court was tasked with substantively construing the books and records and internal controls provisions – see here for the prior post). In addition to citing this case in its brief, the DOJ also cited SEC v. E-Smart Technologies, 82 F.Supp.3d 97 (D.D.C. 2015).
Specifically, the DOJ stated:
“The government will prove at trial that the defendant did, in fact, conspire to circumvent U.S. Financial Institution #1’s internal accounting controls. See SEC v. e-Smart Technologies Inc., (citing examples of internal accounting controls that company at issue was lacking, including among others, proper documentation supporting company disbursements, policy on conflicts of interest, high-level supervision and review, training on company procedures, keeping current board minutes, poor communication among staff and consultants that led to inaccurate information, and inconsistencies in supporting documentation).”
As discussed below, the DOJ’s cite to e-Smart may have not been smart because the case does not exactly stand for the broad proposition that the DOJ asserts.
For starters, and similar to World-Wide Coin, the company at issue in e-Smart (e-Smart Technologies) was a complete mess and the pro se defense was a debacle as the court recognized. As stated by the court summary fashion:
“This case continues to provide a cautionary tale for investors. At the center of the story is pro se Defendant Mary Grace, the CEO of e-Smart Technologies, Inc., a public company that was in the business of developing and marketing purported biometric “smart” cards. Over the course of several years, the company touted significant technological advancements in SEC filings and press releases. At the same time, Grace persuaded investors to part with millions of dollars on assurances that the company was about to obtain or had obtained significant funding and contracts. But these great expectations rarely, if ever, were realized, and many investors later felt that Grace had misled them. The Securities and Exchange Commission shared that sentiment and brought this civil-enforcement action against e-Smart, Grace, and several others, alleging numerous violations of federal securities laws. At the heart of the Commission’s suit is the allegation that Grace lied about e-Smart’s technology and about impending contracts in order to obtain investor funds, which she then diverted to her personal use.
This Court has already granted the agency summary judgment on two of its five claims against Grace—namely, that she made material misrepresentations to the investing public and that she participated in a convertible-loan scheme to sell unregistered securities. Now the Court addresses the Commission’s Second Motion for Summary Judgment against Grace, which accuses her of violating certain reporting, recordkeeping, and internal-control provisions.
“[T]he SEC brought this civil-enforcement action on May 13, 2011, against Defendants e-Smart, Intermarket Ventures, Inc., IVI Smart Technologies, Inc., Grace, and e-Smart’s Chief Technology Officer, Tamio Saito, as well as brokers Robert Rowen, George Sobol, and Kenneth Wolkoff. The thrust of its Complaint is that e-Smart was a sham company with a bogus product. While the company claimed to have a commercially available and advanced smart card, it, in fact, had only a prototype that did not work as promised. The reported contracts and investments, according to the Commission, were complete fabrications intended to persuade investors to fork over their money. The agency believes that e-Smart’s “illegitimacy” is further underscored by the facts that the company frequently did not file required reports, that its books and records were in a constant state of disarray, and that it lacked virtually any system of internal controls. It lays the blame for these problems chiefly on Grace, asserting that she exhibited a total disregard for her fiduciary duties and legal obligations as the head of a public company, and that she violated numerous securities laws as a result.
In particular, the SEC’s Amended Complaint accused her of: (1) making material misrepresentations in public filings, press releases, and communications with investors, in violation of Section 10(b) of the Exchange Act and Rule 10b–5 (Count I); (2) selling unregistered securities, in violation of Sections 5(a) and (c) of the Securities Act (Count II); (3) failing to file required ownership statements, in violation of Section 16(a) of the Exchange Act and Rule 16a–3 (Count V); (4) certifying SEC filings that she knew were misleading or contained material omissions, in violation of Rule 13a–14 (Count VI); and (5) aiding and abetting the company’s failure to file required reports, maintain accurate books and records, and implement a system of internal controls over financial reporting, in violation of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B), as well as Rules 12b–20, 13a–1, 13a–11, and 13a–13 (Count VII). On the basis of these alleged violations, the Commission seeks a host of remedies including disgorgement, civil penalties, and an injunction prohibiting Grace from participating in penny-stock offerings, serving as an officer or director of issuers of securities, and engaging in further violations of federal securities laws.
After a lengthy and contentious discovery period, the SEC filed two separate Motions for Summary Judgment against Grace. The initial one addressed the first two counts against her—i.e., that she violated Section 10(b) and Sections 5(a) and (c), along with their attendant rules. This Court has already resolved that Motion in favor of the Commission. With respect to the Section 10(b) claim, the Court found that Grace had clearly violated the law by making material misrepresentations in a February 2008 press release about an e-Smart contract with Samsung. As to Sections 5(a) and (c), the Court concluded that Grace had participated in a convertible-loan scheme designed to sell millions of unregistered shares of e-Smart stock. It therefore entered judgment against her on Counts I and II.
The Court now turns to the SEC’s Second Motion, which covers the three remaining counts.
This Court has previously discussed, at considerable length, the various shortcomings of Grace’s pleadings in this case. Unfortunately, it once again finds itself trudging through her jumbled and confusing submissions. That is no small task. It does so largely unaided by briefing, as Grace here essentially re-filed her Opposition to the SEC’s First Motion for Summary Judgment, save for a few minor changes. Significant portions of it are, accordingly, irrelevant to the Second Motion, which deals with different counts from the First Motion. Indeed, in 46 pages, she devotes no more than a few sentences to several of the key claims involved in the SEC’s Second Motion. The brief, additionally, does not provide citations to her Statements of Fact.
Those Statements—there are multiple—also prove particularly opaque. Over the course of two weeks, she submitted 12 different documents labeled “Statement of Facts,” totaling 579 pages. There is no discernible organization to these Statements, and they contain almost no record citations to the over 6,000 pages of other material that she filed. Instead, her Statements consist largely of copied-and-pasted materials and unsupported assertions, the relevance of which is often unclear.
These sorts of pleadings have made addressing the Motions for Summary Judgment in this case extremely taxing. But as with the SEC’s First Motion, the Court is mindful of the impact of granting summary judgment when a pro se litigant is involved. It has, consequently, waded through her Statements to determine whether she has presented evidence to establish that there are genuine disputes of material fact. In the end, it finds that undisputed evidence shows that she violated the provisions in Count V and Count VII, but that summary judgment on Count VI would be premature on the present record. The Court will take up the counts in this order.”
As to the books and records and internal controls claims, the court stated in full as follows (certain internal citations omitted).
“Section 13(b)(2)(A) requires every issuer of registered securities to “make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer.” “Reasonable detail” is defined as the “level of detail … [that] would satisfy prudent officials in the conduct of their own affairs.” The provision “has three basic objectives: (1) books and records should reflect transactions in conformity with accepted methods of reporting economic events, (2) misrepresentations, concealment, falsification, circumvention, and other deliberate acts resulting in inaccurate financial books and records are unlawful, and (3) transactions should be properly reflected on books and records in such a manner as to permit the preparation of financial statements in conformity with [generally accepted accounting principles] and other criteria applicable to such statements.” SEC v. World–Wide Coin Investments, Ltd.,567 F.Supp. 724, 748 (N.D.Ga.1983) (citation omitted). Its purpose “is to strengthen the accuracy of records and the reliability of audits.”
The Court need not address all of the claimed deficiencies in e-Smart’s books and records because it finds that the company’s concealment of a convertible-loan scheme to sell unregistered securities resulted in inaccurate financial books and records. As explained in this Court’s Opinion on the SEC’s First Motion for Summary Judgment, Grace and others operated such a scheme from 2005 to 2007 to sell unregistered shares of e-Smart stock. Under the scheme, “lenders” provided short-term loans to Intermarket and IVI, which in turn offered restricted shares of e-Smart stock as collateral. When the loans went into default—the inevitable and intended outcome—the lenders could convert the notes to e-Smart stock at below-market rates. Grace would then authorize e-Smart’s transfer agent to issue unrestricted shares to the lenders on the basis of opinion letters from Maranda Fritz, e-Smart’s outside counsel. Later, e-Smart would issue IVI and Intermarket enough restricted shares to maintain the companies’ respective ownership percentages. As a result of this scheme, e-Smart distributed millions of unregistered, free-trading shares.
This scheme necessarily distorted e-Smart’s books. For instance, in its 2007 10–K, the company reported that it had issued 113,102,557 shares to IVI and Intermarket’s creditors for the loans, the proceeds of which were used as “working capital” for e-Smart and IVI. According to the 10–K, IVI and e-Smart had agreed to count the value of the shares it distributed on behalf of those companies ($6,740,157) as payments for license fees that e-Smart owed to IVI. But as discussed above and in this Court’s prior Opinion, these transactions were, in fact, disguised sales of e-Smart stock. Its books and records, therefore, in no way “accurately and fairly” reflected the nature of e-Smart’s transactions or the disposition of its assets.
Grace also knowingly provided substantial assistance to this falsification of e-Smart’s books. She was heavily involved in the loan scheme, and knew that this depiction of the transactions and their accounting on e-Smart’s books did not reflect reality. Indeed, in a June 2006 e-mail to e-Smart’s Board of Directors about fundraising, Grace had explained, in an apparent reference to the $0.10–share conversion rate under the loan scheme, that “there [wa]s not a shortage of shareholders who would buy stock at $.10,” because “[t]he market [wa]s at $0.12.” As CEO and CFO of e-Smart, she knowingly allowed this improper accounting to stand.
Her only response to the SEC’s allegations about the company’s books and records is to maintain that outside auditors prepared and confirmed the company’s financial statements. She does not, however, provide any evidence regarding the representations that were made to outside auditors about the loan transactions. She has therefore failed to show that the auditors certified the accounting of the loans with an accurate understanding of the transactions.
The Court thus finds that e-Smart violated Section 13(b)(2)(A) and that Grace aided and abetted these violations with scienter.”
As to the books and records and internal controls claims, the court stated in full as follows (certain internal citations omitted).
“Section 13(b)(2)(B) requires issuers to develop and maintain adequate internal controls over financial reporting. More specifically, issuers must have internal accounting controls that provide “reasonable assurances” that (1) “transactions are executed in accordance with management’s general or specific authorization; (2) transactions are recorded “as necessary … to permit the preparation of financial statements in conformity with generally accepted accounting principles” and “to maintain accountability for assets”; (3) “access to assets is permitted only in accordance with management’s general or specific authorization”; and (4) “the recorded accountability for assets is compared with existing assets at reasonable intervals and appropriate action is taken with respect to any differences.” A “reasonable” degree of assurance is one that “would satisfy prudent officials in the conduct of their own affairs.” “Examples of internal controls include manual or automated review of records to check for completeness, accuracy and authenticity; a method to record transactions completely and accurately; and reconciliation of accounting entries to detect errors.” Here, the Commission argues that the company lacked virtually any internal accounting controls to ensure that its financial records and reports were accurate and to ensure that corporate assets were not misappropriated. It has marshaled substantial evidence in support of these claims.
To begin, the company conceded that it had numerous internal-control failings when it filed its 2007 10–K in May 2009. See 2007 10–K at 35–38. Those admitted weaknesses included the following:
It is also clear that these were not new problems. Indeed, the lack of internal controls at e-Smart was evident at least as early as the beginning of 2007. At that time, e-Smart’s outside auditor, Horowitz & Ullmann, provided the company’s officers with a memo containing the firm’s observations regarding a lack of controls and providing recommendations about policies and procedures that the company could implement. This memo highlighted, among other things, that “[m]anagement is dominated by one person, the CEO, who unilaterally makes the decisions for the Company.” The CEO also “control[led] the bank accounts.” These circumstances created an ability, on the part of management, “to override controls,” which elevated the risk of fraud, including the risk that assets would be misappropriated and the risk of fraudulent financial reporting. On a related note, the memo noted “a significant lack of segregation of duties … with respect to the management of the Company’s funds,” as “[t]he CEO [wa]s the sole signatory on most, if not all, of the Company’s bank accounts” and “ha[d] the ability to disburse Company funds to any individual or business without receiving any authorization from other members of management.” Other observations included “a lack of controls with respect to the accumulation of proper documentation to support the Company’s disbursements,” “a lack of controls with respect to the segregation of personal and business expenses,” the lack of an independent audit committee, the “relatively inactive role” that the Board played in the company, and “a lack of controls … with respect to the recording and reconciling of the issuance of common stock.”
Other evidence that the SEC offers further demonstrates that the company lacked basic controls, particularly with respect to stock issuances. For instance, the outside auditors found that the company would issue more shares than were authorized. In November 2007, Stewart Hung, one of e-Smart’s outside auditors, wrote to Anthony Russo, e-Smart’s accountant, stating:
I see that you have a huge problem with the shares. By the end of March 2007, you have over 498M shares issued. But you are only authorized to issue 490M in common shares. To date you have 753M share [sic ] issued, but only authorized for 730M in common shares.
These are seriously [sic ] problem that you need to get [Grace] in the office to discuss face-to-face. I will have a lot of issues with the numbers as well as the dollar value. Even at the price of $.03, she has to account for over 7.6M in cash just in the first quarter alone.
Outside auditors were also frequently forced to seek additional information about stock issuances because they did not receive adequate supporting documentation and because the company would report stock issuances as canceled when they had not been. Those auditors even wrote to e-Smart’s Board in July 2008 to call its attention to 195,000,000 shares issued to employees, consultants, directors, and others—amounting to approximately $13,400,000 charged against the company’s income—that did not appear to have been approved by the Board.
Those inside the company similarly expressed concerns that e-Smart had significant problems documenting Grace’s share issuances and that many of those issuances involved possible conflicts of interest. For instance, Russo testified that Grace issued millions of e-Smart shares to family members and others, such as a woman who watched her apartment in Manhattan, without documentation. According to him, “She kept insisting they provided the company with services,” but no documentation was provided to that effect—it was “just her word.” E–Smart’s long-time outside counsel Maranda Fritz also wrote a letter to the company’s Board in August 2008, disclosing a host of concerns about e-Smart’s management and controls, including that:
Grace ha[d] continuously caused the issuance of substantial quantities of e-Smart stock to companies or entities controlled by her and to family members. Those hundreds of thousands of shares ha[d] been issued without any contemporaneous documentation or authorization and under circumstances which involve[d] substantial conflicts of interest, appear[ed] to lack substance or adequate consideration, and generally redound[ed] to the substantial detriment of the public company.
To be fair, the 2007 10–K, filed in May 2009, did claim that management was “in the process of implementing remediation efforts with respect to the material weaknesses.” It stated, for instance, that the company had hired “an assistant controller in the New York office as well as an outside accounting firm to supervise the [accounting] department and to work with them to improve the quarter-end and year-end accounting procedures.” The executive secretary in New York had also been assigned the task of maintaining proper Board minutes. Other planned efforts included making “a concentrated effort … to assure the board minutes are signed timely,” “implementing a policy of monthly board meetings with appropriate minutes signed in a timely matter [sic ],” developing a “formal policy regarding employee conflicts of interest drafted and implemented in 90 days,” and considering the development of a formal audit committee.
These remediation efforts, while commendable in theory, only highlight that e-Smart had significant and longstanding internal-control problems. The Court notes, additionally, that they did not address many of e-Smart’s shortcomings, including, for example, that Grace solely controlled e-Smart’s accounts or that transactions frequently lacked documentation. And aside from submitting evidence that an outside accounting firm was retained to help straighten out e-Smart’s books, Grace has not shown that the remainder of the proposed efforts were implemented or that they remedied the deficiencies.
Grace’s Opposition, in fact, does not mention the company’s internal controls. Even had she relied on the outside-auditor certifications here, as she did with respect to the books-and-records issue, the Court finds that those certifications do not create a material dispute as to whether the company satisfied its obligations under Section 13(b)(2)(B). For one thing, e-Smart conceded that it had extensive problems with respect to its internal controls. For another, the auditors’ certifications were of the company’s financial statements and did not appear to address the adequacy of e-Smart’s controls. The auditor certification in the 2007 10–K, for instance, specifically stated that the firm had not been “engaged to perform[ ] an audit of [e-Smart’s] internal controls over financial reporting,” and that it expressed no opinion on their effectiveness. Horowitz & Ullmann’s certifications of the 2005 10–KSB/A and the 2006 10–K, additionally, made no mention of the company’s controls, and Grace does not offer any evidence that the firm was retained to evaluate them.
In her Statements, Grace disputes that she had “exclusive control” over e-Smart’s business and financial matters, arguing that she obtained approval from the Board of Directors. In support, she offers a series of unsigned minutes from Board meetings, and a handful of e-mails and snippets of testimony indicating that the Board reviewed the 2006 10–K and ratified stock issuances. Whether the Board subsequently ratified some of her decisions, however, is immaterial. As noted previously, the company conceded in its 2007 10–K that it had numerous control problems (including the relative inactivity of its Board). The fact that the Board may have subsequently approved the issuance of stock does not speak to many of the control problems that were identified, such as the lack of documentation for loans and stock issuances, the lack of training and supervision for the “accounting department,” and the lack of systems to identify inconsistencies in the company’s financial records prior to the outside auditing process. It is highly ironic that Grace submits unsigned Board minutes as evidence of internal controls when e-Smart listed as one of its weaknesses the fact that Board minutes were often not current and that most lacked signatures. In sum, it is clear that e-Smart violated Section 13(b)(2)(B)’s mandate to develop, implement, and maintain a system of internal controls.
It is likewise clear that Grace substantially assisted these violations. She was e-Smart’s CEO and CFO and, consequently, bore special responsibilities with respect to the company’s internal controls. Yet she failed to adopt policies and procedures to ensure that transactions were appropriate and that improper or poorly documented transactions were quickly remedied. Many of the shortcomings in the company’s internal controls, furthermore, related specifically to Grace’s conduct. As an example, she was largely, if not solely, responsible for the stock issuances that lacked supporting documentation.
Grace also clearly knew that the company lacked essentially all forms of internal controls. She was, after all, the source of the problems: she regularly issued stock without adequate supporting documentation; she served on the Board, which rarely met and rarely signed off on the minutes; she was the Chief Financial Officer and could see that the accounting department was not adequately supervised; and she knew that outside auditors frequently had trouble reconciling e-Smart’s transactions.
She also signed certifications of the 10–K reports, which stated that she had evaluated the company’s internal controls over financial reporting, thus indicating that she was aware of the need to have and maintain internal controls. She repeatedly claims in her Opposition that others affixed her signatures to these documents and that she never reviewed them. The Court finds such assertions troubling coming from the person whom the securities laws expressly tasked with reviewing and certifying those documents. But, more importantly, she does not provide any evidence of this fact.
The Court is mindful that, in general, claims that issuers violated Section 13(b)(2)(B) or that others aided and abetted such violations are not well suited for summary judgment. Determinations about what is reasonable will often vary from company to company and require “a fact-intensive inquiry.” There can be no dispute, however, that e-Smart—led by Grace—failed to establish even basic controls to ensure that the company’s dealings were adequately documented and conducted in accordance with appropriate authorization. Summary judgment in favor of the SEC is therefore warranted.”