In SEC v. Narvett, No. 13-C-927, 2014 BL 287642 (E.D. Wis. Oct. 14, 2014), the United States District Court for the Eastern District of Wisconsin held the proper amount the defendant must disgorge was the amount improperly obtained from investors less any documented amounts returned to investors.   Additionally, the court found that while Defendant's brother was willing to write off his contribution as a personal loan, the money was obtained fraudulently and must be included in the disgorgement calculation. The court also ordered civil penalties because Defendant's conduct was intentional and resulted in substantial losses. 

Defendant, the owner of Shield Management Group, Inc., agreed that he would not contest allegations brought by the Securities and Exchange Commission ("SEC") that he violated Section 17 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act in connection with a fraudulent scheme involving the offer and sale of promissory notes to family, friends, and others.  Therefore, the only issue left to the court was the amount of monetary relief owed.  The SEC sought relief in the form disgorgement of profits with interest, and a civil penalty.

The SEC sought disgorgement of $746,331.75, an amount they believed reflected the actual amount misappropriated. Defendant, however, contended the SEC failed to credit him the funds returned to investors and the personal loan of $50,000 from his brother.  The SEC, asserted that the repayments to investors were made in bad faith.  At least some of the funds came from $460,000 in personal loans obtained by the Defendant.  The loans, however, “were structured so as to avoid SEC jurisdiction and the lenders explicitly acknowledged that before making the loans they were aware" of Defendant's "'ongoing legal developments' with the SEC.”  The SEC also argued that the Defendant could only provide bank records to prove he returned $410,634 to investors. 

The court agreed that Defendant's loan from his brother was raised through the fraudulent scheme and as such, was subject to disgorgement; however, it also found that the penalty should be reduced by the amount returned to investors. The court based its calculation on two principles. First, because the burden of proof falls to the defendant regarding disgorgement, the court found the Defendant should be credited only for payments with proper supporting documentation. 

Second, the court required the SEC to distinguish between legally and illegally obtained profits because disgorgement may not be punitive. Because the proper disgorgement amount is the total contribution from investors less the distributions made, the court found that the Defendant reduced the amount of his gain by substituting personal debt for some of the profits and, thus, reduced the disgorgement amount. Based on this reduction, the court found the appropriate disgorgement was $335,697.42. Using a pre-judgment interest rate supplied by the Internal Revenue Service, the interest was determined to be $18,886.50.

The court next addressed the issue of civil penalties. Sections 20(d)(2) and 21(d)(3)(B) set forth three tiers of monetary penalties for violations, under which the maximum penalty is the greater of either “the gross amount of pecuniary gain” resulting from the violation or a statutory amount. The Defendant's fraud raised more than $746,000, exceeding the statutory cap under all three tiers and setting the maximum penalty at $746,000.

The court imposed a significant civil penalty of $300,000. In explaining the significance, the court reasoned:

• In this case, significant penalties are in order. [Defendant's] conduct was intentional. He has not admitted wrongdoing, and he has never explained his actions. Although the actual amount of losses incurred by the victims of [Defendant's] fraud remains to be seen, there is no question that his conduct created very substantial losses. Further, as noted by the SEC, the conduct at issue was not isolated, but involved recurrent Ponzi-like payments to investors while [Defendant] misappropriated investors' funds for personal use. Finally, with respect to [Defendant's] contention that he is broke, the fact that he may be destitute is not necessarily reason to reduce the penalty. The SEC interprets the fact that [Defendant] is destitute as proof that [Defendant's] paying back investors by soliciting loans was not in good faith, and that he is a continuing threat to the public. Given the ongoing dishonest and egregious breach of trust displayed by [Defendant] and the substantial amounts of money he obtained, I find that [Defendant's] financial difficulties are not a strong reason to reduce the civil penalty.

In sum, the United States District Court for the Eastern District of Wisconsin ordered the [Defendant] to disgorge profits of $335,697.42 with a prejudgment interest of $18,886.50 and pay a civil penalty of $300,000.

The primary materials for this post can be found on the DU Corporate Governance website.