On October 26, 2011, the Southern District Court of New York denied Defendant Steven Gould’s motion to dismiss a fraud claim by the Securities and Exchange Commission (“SEC”), finding that the Commission had sufficiently pled a claim against a CFO despite the barrier imposed by the Supreme Court’s decision in Janus. See Janus Capital Group, Inc. v. First Derivative Traders, 131 S.Ct. 2296, 2302 (2011).

The SEC filed a claim for injunctive relief against West End, an unregistered investment adviser that created and managed private funds, and its CFO, Steven Gould. The defendants allegedly committed fraud by misrepresenting the performance of financial investment funds and misusing investor assets. The CFO moved to dismiss; however, the court held the SEC met the pleading standards, adequately alleged the CFO acted with scienter, and showed a reasonable likelihood the CFO would commit future violations of securities laws. SEC v. Landberg, No. 11 Civ. 0404, 2011 WL 5116512, at *1-8 (S.N.D.Y. Oct. 26, 2011).

According to the amended complaint, the defendants had two primary funds, the Franchise Fund and the Hard Money Fund, and an interest reserve account (“IRA”) that defendants held in trust. Because the two primary funds did not generate enough returns, the defendants used assets unrelated to the funds to satisfy their obligations. The complaint contended the defendants fraudulently obtained $8.5 million in loans, withdrew millions of dollars from the IRA for unauthorized use, and misappropriated $1.5 million for personal use. The CFO allegedly not only knew, or was reckless in not knowing, but also participated in and concealed the fraud.  

The SEC asserted violations of Section 17(a) of the Securities Act of 1933 (“’33 Act”), Section 10(b) and Rule10b-5 of the Securities Exchange Act of 1934 (“’34 Act”), and certain sections of the Investment Company Act of 1940 (“’40 Act”).  The SEC claimed the CFO committed primary violations of the ‘33 and ‘34 Acts and aided and abetted violations of the ‘40 Act.      

In order to state a claim under Section 10(b) and Rule 10b-5 of the 1934 Act, a plaintiff must show the defendants “(1) made a material misrepresentation or a material omission as to which he had a duty to speak or used a fraudulent device; (2) with scienter; (3) in connection with the purchase or sale of securities.” The same requirements are necessary to state a claim under section 17(a) of the 1933 Act, except scienter is not necessary.

The CFO sough dismissal on a number of grounds, including under the standard set by Janus v. First Derivative Traders. In that case, the Supreme Court held that liability only attached to persons or entities who have “ultimate authority over the [untrue] statement, including its content and whether and how to communicate it.” The court assumed the reasoning in Janus applied, but decline to dismiss on that basis for two reasons. First, the court explained that statements could be attributed to a speaker from surrounding circumstances and this was “strong evidence” the statement was made by the person to whom it is attributed.

Second, the court found that Rule 10b-5 provides an additional basis for the SEC claim by prohibiting “any device, scheme, or artifice to defraud” or participation in any “act, practice, or course of business” which constitutes fraud or deceit. The court held the SEC adequately alleged facts, that if found to be true, would establish the CFO violated Rule 10b-5 by participating in a fraudulent scheme or act.

The CFO also sought dismissal for failure to plead scienter. In order to plead scienter, a plaintiff must establish a “strong inference” of fraudulent intent by alleging facts to show that the defendant had both motive and opportunity to commit fraud, or by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. The SEC must show the CFO caused the statements to be made and knew the statements would be distributed to investors or was reckless in not knowing. Recklessness can occur when the CFO shuns a duty to monitor and check information or when he ignores the obvious signs of fraud.

The court found that the SEC had sufficiently alleged facts supporting an inference of fraud.  The CFO, according to the opinion, had implicitly taken the position that he had been “fooled” by the fraud.  The court, however, found that the SEC had identified

facts that would place a reasonable person on notice as to the falsity of the representations being made and that suggest [the CFO] was ignoring obvious signs of fraud. [The CFO’s] factual claim that his role as CFO of a public company was merely that of a "scrivener," can only be resolved at trial or on a full factual record. Moreover, a party cannot ‘escape liability for fraud by closing his eyes to what he saw and could readily understand.’

With respect to claims for aiding and abetting, the CFO argued that the SEC was attempting to apply a provision of Dodd-rank retroactively. Section 929M of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) allowed the Commission to bring actions for aiding and abetting based upon recklessness, and the CFO argued that recklessness should not be applied here because its application would be retroactive. The court rejected the argument, concluding that recklessness was already an existing standard in the jurisdiction. Further, the court found the SEC complaint meet both, the recklessness and actual knowledge standards.

Section 20(b) of the 1933 Act, Section 21(d)(1) of the 1934 Act, and Section 209(d) of the 1940 Act allow federal courts to enjoin a person “who is engaged, or is about to engage, in acts or practices” which establish or will establish a violation. The court must determine if there is a reasonable likelihood of future violations by considering the egregiousness of the past actions,  the degree of scienter, the isolated or repeated nature of the violations, whether the defendant accepted blame for his conduct, and whether the nature of the defendant’s occupation makes it likely he will have the opportunity to commit future violations.

The court held that the alleged circumstances in this case were sufficient for a reasonable fact finder to attribute the false financial statements to the CFO. The complaint alleged that he repeatedly and knowingly engaged in and tried to conceal, conduct that violated the ’33, ’34, and ’40 acts. The court deemed the allegations to be sufficient to plead a reasonable likelihood of recurrence.

The court denied the defendants motion to dismiss because the SEC satisfied the heightened pleading standards, adequately pled scienter, and demonstrated a reasonable likelihood the violations would continue to occur.

The primary materials for this case may be found on the DU Corporate Governance website.