Securities and Exchange Commission v. Kovzan
Filing
34
MEMORANDUM AND ORDER granting in part and denying in part 23 Defendant's Motion to Dismiss the Amended Complaint. The motion is granted with respect to Counts One, Two, Three, Four, and Nine to the extent they are based on the conduct alleged in Paragraph 50 of the amended complaint, and with respect to Count Six to the extent it is based on the conduct alleged in Paragraphs 55(b), 56(c), and 57 of the amended complaint; and those claims are hereby dismissed. The motion is denied in all other respects. Signed by District Judge John W. Lungstrum on 8/4/2011. (ses)
IN THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF KANSAS
SECURITIES AND EXCHANGE
COMMISSION,
)
)
)
Plaintiff,
)
)
v.
)
)
STEPHEN M. KOVZAN,
)
)
Defendant.
)
)
_______________________________________)
Case No. 11-2017-JWL
MEMORANDUM AND ORDER
In this case, the Securities Exchange Commission (“SEC”) has brought various
claims against defendant Stephen M. Kovzan under the federal Securities Act of 1933
(“Securities Act”), 15 U.S.C. § 77a et seq., and the federal Securities Exchange Act of
1934 (“Exchange Act”), 15 U.S.C. § 78a et seq. The matter is presently before the Court
on defendant’s motion to dismiss the amended complaint (Doc. # 23). For the reasons
set forth below, the motion is granted in part and denied in part. The motion is
granted with respect to Counts One, Two, Three, Four, and Nine to the extent they are
based on the conduct alleged in Paragraph 50 of the amended complaint, and with
respect to Count Six to the extent it is based on the conduct alleged in Paragraphs 55(b),
56(c), and 57 of the amended complaint; and those claims are hereby dismissed. The
motion is denied in all other respects.
I.
Background
Beginning in 2000, defendant served as Vice President of Financial Operations
and as Chief Accounting Officer (“CAO”) at NIC Inc. (“NIC”), a company located in
Olathe, Kansas. In August 2007, defendant became NIC’s Chief Financial Officer
(“CFO”). Jeffery Fraser, one of NIC’s founders, served as NIC’s Chief Executive
Officer (“CEO”) and Chairman of the Board of Directors from May 2002 until 2008.
In this civil enforcement action, the SEC brings claims against defendant under
the Securities Act and the Exchange Act, seeking civil money penalties, an injunction
against further violations, a prohibition against defendant’s acting as an officer or
director of a publicly-traded company, and disgorgement of any ill-gotten gains. The
SEC’s claims are centered on its allegations that from 2002 to 2005 Mr. Fraser received
over $1.18 million in perquisites that were not reported by NIC as his income, including
(a) the costs for Mr. Fraser to commute by private aircraft from his home in Wyoming
to NIC’s headquarters in Kansas, and (b) reimbursements for other personal expenses,
including for homes, vacations, cars, electronics, and other items. The SEC alleges that
defendant was involved with the preparation and signing of public filings with the SEC
from 2002 to 2006 that were materially false and misleading because they failed to
disclose Mr. Fraser’s perquisites as income.
2
II.
Standards Governing a Motion to Dismiss
The Court will dismiss a cause of action for failure to state a claim only when the
factual allegations fail to “state a claim to relief that is plausible on its face,” Bell
Atlantic Corp. v. Twombly, 550 U.S. 544, 570 (2007), or when an issue of law is
dispositive, see Neitzke v. Williams, 490 U.S. 319, 326 (1989). The complaint need not
contain detailed factual allegations, but a plaintiff’s obligation to provide the grounds of
entitlement to relief requires more than labels and conclusions; a formulaic recitation of
the elements of a cause of action will not do. See Bell Atlantic, 550 U.S. at 555. The
Court must accept the facts alleged in the complaint as true, even if doubtful in fact, see
id., and view all reasonable inferences from those facts in favor of the plaintiff, see Tal
v. Hogan, 453 F.3d 1244, 1252 (10th Cir. 2006). Viewed as such, the “[f]actual
allegations must be enough to raise a right to relief above the speculative level.” Bell
Atlantic, 550 U.S. at 555. The issue in resolving a motion such as this is “not whether
[the] plaintiff will ultimately prevail, but whether the claimant is entitled to offer
evidence to support the claims.” Swierkiewicz v. Sorema N.A., 534 U.S. 506, 511 (2002)
(quoting Scheuer v. Rhodes, 416 U.S. 232, 236 (1974)).
3
III.
Statute of Limitations
A.
Discovery Rule
The SEC filed this action on January 12, 2011. Defendant argues that all claims
relating to conduct before January 12, 2006, should be dismissed as barred by the fiveyear statute of limitations found at 28 U.S.C. § 2462. That statute provides:
Except as otherwise provided by Act of Congress, an action, suit, or
proceeding for the enforcement of any civil fine, penalty, or forfeiture,
pecuniary or otherwise, shall not be entertained unless commenced within
five years from the date when the claim first accrued . . . .
Id. The SEC agrees that Section 2462 applies here, but it argues that the statute of
limitations is subject to a “discovery rule” for fraud claims. The SEC argues that if such
a rule is applied, the action is timely, based on its allegations that it first received inquiry
notice of the fraud at issue here in June 2007, that it subsequently exercised due
diligence in investigating, and that it could not have discovered the facts underlying the
fraud until several years after receiving inquiry notice. Thus, the Court must determine
whether Section 2462 should be subject to a discovery rule in this context.
The Supreme Court recently described the discovery rule as follows:
[I]n the statute of limitations context, the word “discovery” is often used
as a term of art in connection with the “discovery rule,” a doctrine that
delays accrual of a cause of action until the plaintiff has “discovered” it.
The rule arose in fraud cases as an exception to the general limitations rule
that a cause of action accrues once a plaintiff has a complete and present
cause of action. This Court long ago recognized that something different
was needed in the case of fraud, where a defendant’s deceptive conduct
may prevent a plaintiff from even knowing that he or she has been
defrauded. Otherwise, “the law which was designed to prevent fraud”
could become “the means by which it is made successful and secure.”
4
Bailey v. Glover, 21 Wall. [88 U.S.] 342 (1874). Accordingly, “where a
plaintiff has been injured by fraud and remains in ignorance of it without
any fault or want of diligence or care on his part, the bar of the statute
does not begin to run until the fraud is discovered.” Holmberg v.
Armbrecht, 327 U.S. 392, 397 (1946) (internal quotation marks omitted;
emphasis added). And for more than a century, courts have understood
that fraud is deemed to be discovered when, in the exercise of reasonable
diligence, it could have been discovered.
Merck & Co. v. Reynolds, 130 S. Ct. 1784, 1793-94 (2010) (other citations and internal
quotations omitted, emphasis in original). Most often cited is this statement of the rule
from Holmberg:
[T]his Court long ago adopted as its own the old chancery rule that where
a plaintiff has been injured by fraud and “remains in ignorance of it
without any fault or want of diligence or care on his part, the bar of the
statute does not begin to run until the fraud is discovered, though there be
no special circumstances or efforts on the part of the party committing the
fraud to conceal it from the knowledge of the other party.” Bailey v.
Glover, 21 Wall. [88 U.S.] 342, 348; and see Exploration Co. v. United
States, 247 U.S. 435 [(1918)]; Sherwood v. Sutton, Fed. Cas. No. 12,782,
5 Mason 143 [21 F. Cas. 1303 (C.C.D.N.H. 1828)].
This equitable doctrine is read into every federal statute of
limitation.
Holmberg, 327 U.S. at 397.1 The Tenth Circuit, in reliance on Holmberg and Bailey, has
consistently applied this discovery doctrine (sometimes called equitable tolling) in cases
1
In TRW Inc. v. Andrews, 534 U.S. 19 (2001), the Court rejected the argument that
a statute of limitation must include the discovery rule unless that statute explicitly states
that it does not, and it concluded that Congress’s intent not to include a general discovery
rule could be inferred from a statute. See id. at 27-28 (statute of limitations that provided
an explicit discovery rule for willful misrepresentations did not also include a discovery
rule for other conduct).
5
involving private securities fraud claims. See, e.g., Anixter v. Home-Stake Prod. Co.,
977 F.2d 1549, 1551 (10th Cir. 1992); State of Ohio v. Peterson, Lowry, Rall, Barber &
Ross, 651 F.2d 687, 692 (10th Cir. 1981); Esplin v. Hirschi, 402 F.2d 94, 103 (10th Cir.
1968).
Although the Tenth Circuit has not addressed the application of the discovery rule
in the context of Section 2462, a few other circuits have done so. Defendant relies most
heavily on 3M Company v. Browner, 17 F.3d 1453 (D.C. Cir. 1994), in which the D.C.
Circuit Court refused to apply the discovery rule and applied Section 2462 to bar a
review of penalties imposed by the Environmental Protection Agency for violations of
an environmental statute. The court noted that the case did not involve any issue of
discovering latent injuries, for which the discovery rule was developed. See id. at 1460.
The court also noted that in the 19th Century, when the predecessor to Section 2462 was
enacted, a claim generally “accrued” at the time of the violation. See id. at 1462. The
court further stated that application of the statute of limitations should not be influenced
by the agency’s particular difficulties in enforcing the environmental statute, as such
consideration might require hearings to determine whether the agency adequately lived
up to its responsibilities. See id. at 1461.
Trawinski v. United Technologies, 313 F.3d 1295 (11th Cir. 2002), involved a
private enforcement action for violations of the Energy Policy and Conservation Act,
which claims were governed by the statute of limitations in Section 2462. The Eleventh
Circuit cited 3M in stating (without further analysis) that “[t]his discovery rule, which
6
might be applicable to statutes of limitations in state tort actions, has no place in a
proceeding to enforce a civil penalty under a federal statute.” See id. at 1298 (citing 3M
Co., 17 F.3d at 1462-63). Similarly, in Federal Election Commission v. Williams, 104
F.3d 237 (9th Cir. 1996), the Ninth Circuit agreed (without analysis) with 3M’s rejection
of the application of the discovery rule to Section 2462. See id. at 240 (citing 3M Co.,
17 F.3d at 1462-63).
The problem with defendant’s reliance on these three cases is that they were not
fraud cases. Thus, these courts had no occasion to consider the application of the fraud
discovery rule, as that doctrine has been recognized by the Supreme Court. Defendant
has cited a number of district court cases involving enforcement actions by the SEC in
which the court cited 3M in rejecting the discovery rule as applied to Section 2462; only
in one of those cases, however, did the court address the fact that 3M did not involve
fraud claims. See SEC v. Jones, 2006 WL 1084276, at *5-6 (S.D.N.Y. Apr. 25, 2006).2
In Jones, the court found 3M “instructive” even though it did not involve fraud claims.
See id. at *6. Specifically, the court noted the D.C. Circuit’s statement that “[a]n
2
In most of the cases cited by defendant, the court felt bound to follow precedent
from its circuit court of appeals. See SEC v. Huff, 758 F. Supp. 2d 1288, 1338 (S.D. Fla.
2010) (following Trawinski); SEC v. Leslie, 2008 WL 3876169, at *9 & n.13 (N.D. Cal.
Aug. 19, 2008) (following Williams); SEC v. Berry, 580 F. Supp. 2d 911, 919 (N.D. Cal.
2008) (following Williams); SEC v. Richie, 2008 WL 2938678, at *11 (C.D. Cal. May
9, 2008) (following Williams); SEC v. Scrushy, 2005 WL 3279894, at *2-3 (N.D. Ala.
Nov. 29, 2005) (following Trawinski). Defendant also cites SEC v. Microtune, Inc., __
F. Supp. 2d __, 2011 WL 540280 (N.D. Tex. Feb. 15, 2011); in that case, however, the
court merely noted that it previously rejected the discovery rule, without any analysis or
citation. See id. at *4 n.7.
7
agency’s failure to detect violations, for whatever reasons, does not avoid the problems
of faded memories, lost witnesses and discarded documents [and] nothing in the
language of § 2462 even arguably makes the running of the limitations period turn on
the degree of difficulty an agency experiences in detecting violations.” See id. (quoting
3M Co., 17 F.3d at 1461).
Only three days ago, however, the Second Circuit effectively repudiated Jones
(which had been issued by a district court in its circuit) by its opinion in SEC v. Gabelli,
__ F.3d __, 2011 WL 3250556 (2d Cir. Aug. 1, 2011). In Gabelli, an enforcement action
by the SEC, the Second Circuit held that the discovery rule defines when a securities
fraud claim accrues for purposes of applying Section 2462, thereby relieving the SEC
of the need to plead fraudulent concealment by the defendant. See id. at *8. The Second
Circuit stated:
Although the defendants make much of the fact that Section 2462 does not
expressly state a discovery rule, this Court has previously held that for
claims that sound in fraud a discovery rule is read into the relevant statute
of limitations. Indeed, the Supreme Court has recently affirmed that a
fraud claim “accrues” only when the plaintiff discovers the fraud. Merck,
130 S. Ct. at 1793-94. Thus, while Congress might have to affirmatively
include language about a discovery rule in the event that it wanted a
discovery rule to govern the accrual of non-fraud claims or wanted to
impose a limit on using a discovery rule for certain fraud claims, it would
be unnecessary for Congress to expressly mention the discovery rule in the
context of fraud claims, given the presumption that the discovery rule
applies to these claims unless Congress directs otherwise. See Holmberg
v. Armbrecht, 327 U.S. 392, 397 (1946) (the discovery rule for claims of
fraud “is read into every federal statute of limitation”) (emphasis added).
Id. (citation and footnote omitted). The Second Circuit noted that the defendants’
8
reliance on 3M was misplaced because that case did not involve fraud claims. See id. at
*8 n.4 (citing 3M Co., 17 F.3d at 1460-63).
The Second Circuit cited SEC v. Koenig, 557 F.3d 736 (7th Cir. 2009), a
securities fraud enforcement action in which the Seventh Circuit rejected 3M and applied
the discovery doctrine to Section 2462. See id. at 739. The Seventh Circuit reasoned as
follows:
We need not decide when a “claim accrues” for the purpose of §
2462 generally, because the nineteenth century recognized a special rule
for fraud, a concealed wrong. See, e.g., Bailey v. Glover, 88 U.S. (21
Wall.) 342 (1874); Holmberg v. Armbrecht, 327 U.S. 392 (1946). These
days the doctrine is apt to be called equitable tolling. Whether a court
says that a claim for fraud accrues only on its discovery (more precisely,
when it could have been discovered by a person exercising reasonable
diligence) or instead says that the claim accrues with the wrong, but that
the statute of limitations is tolled until the fraud’s discovery, is
unimportant in practice. Either way, a victim of fraud has the full time
from the date that the wrong came to light, or would have done had
diligence been employed. And the United States is entitled to the benefit
of this rule even when it sues to enforce laws that protect the citizenry
from fraud, but is not itself a victim. Exploration Co. v. United States, 247
U.S. 435 (1918).
Id. at 739 (one citation omitted, emphasis in original). Thus, each circuit court that has
addressed the application of the discovery rule to Section 2462 in a fraud case has
concluded that the rule should be applied.
Moreover, in SEC v. Tambone, 550 F.3d 106 (1st Cir. 2008), withdrawn, 573 F.3d
54 (2009), restated in part, 597 F.3d 436 (2010), a fraud case involving Section 2462,
the First Circuit held that the SEC could rely on the doctrine of equitable tolling, if the
SEC could establish “(1) that there were insufficient facts available to put it on inquiry
9
notice of the possibility of fraud, and (2) that it exercised due diligence in attempting to
uncover the factual basis underlying this alleged fraudulent conduct at the point when
those facts were available.” See id. at 148. Thus, although the First Circuit did not
mention the “discovery rule,” it essentially applied the same standard under Section
2462.
As noted above, in Williams, the Ninth Circuit agreed with 3M’s rejection of the
discovery rule. See Williams, 104 F.3d at 240. The Ninth Circuit proceeded, however,
to quote the same pertinent language from Holmberg in concluding that the doctrine of
equitable tolling would apply. See id. Such tolling would require proof of the following:
“fraudulent conduct by the defendant resulting in concealment of the operative facts,
failure of the plaintiff to discovery the operative facts that are the basis of its cause of
action within the limitations period, and due diligence by the plaintiff until discovery of
those facts.” See id. at 240-41. Thus, although the Ninth Circuit rejected a general
discovery rule for all actions under Section 2462, it appears that that court would apply
such a standard, under the doctrine of equitable tolling, in the event of a fraud case. See
also SEC v. Huff, 758 F. Supp. 2d at 1339 (cited by defendant, supra note 2) (rejecting
discovery rule under Trawinski, but following Koenig and Williams in allowing equitable
tolling in the event of fraud if the plaintiff exercised due diligence).
In SEC v. Alexander, 248 F.R.D. 108 (E.D.N.Y. 2007), the court chose not to
resolve the question at that time, but after a thorough analysis, it found that “[o]verall,
there are significant reasons for finding that a discovery rule governs the accrual of the
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limitation period contained in Section 2462” in a fraud enforcement action by the SEC.
See id. at 120. The court noted that “[t]here is a serious question as to whether the 3M
court’s reasoning applies in the fraud context.” See id. at 118. The court first addressed
the D.C. Circuit’s argument that when Section 2462’s predecessor was enacted, claims
were considered to accrue at the time of the conduct at issue; the Alexander court
reviewed Supreme Court cases beginning in the 19th Century, including Bailey and
Holmberg, and concluded that in light of the discovery rule recognized by the Supreme
Court, “the case law concerning the meaning of ‘accrue’ in the context of fraud cases is
far more ambiguous in the period prior and subsequent to the adoption of Section 2462’s
predecessor than in the non-fraud context addressed by the 3M court.” See id. at 120.
The Alexander court further noted that many of the administrative concerns cited in 3M
do not apply in the context of fraud claims because the court must address the agency’s
due diligence regardless, whether under a theory of equitable tolling or the under the
discovery rule. See id.; see also SEC v. Kearns, 691 F. Supp. 2d 601, 611-13 (D.N.J.
2010) (allowing the use of the discovery rule with Section 2462, distinguishing 3M as
a case that did not involve fraud); SEC v. Buntrock, 2004 WL 1179423, at *12 (N.D. Ill.
May 25, 2004) (same).
In response to the Supreme Court’s pronouncement in Holmberg, defendant does
not appear to dispute that ordinarily a discovery rule should apply in fraud cases.
Defendant argues nonetheless that the rule should apply only in remedial actions, and
should not apply in penal actions by the government. The Court rejects that argument.
11
Defendant cites again to 3M, in which the D.C. Circuit reasoned that the
discovery rule was intended to address the problem of latent injuries, while a civil
penalty action does not include injuries or damage from the violation as a required
element. See 3M Co., 17 F.3d at 1460. This reasoning is inapposite here, however,
because the fraud discovery rule (not addressed in 3M) is based on the problem in
learning of the fraud, not a problem of discovering the injuries (as in the latent injury
context discussed in 3M).
Defendant also points to SEC v. Fisher, 2008 WL 2062699 (N.D. Ill. May 13,
2008), in which the court noted (without deciding the question of the applicability of the
discovery rule) that an SEC enforcement action might be distinguished from private
securities cases:
The SEC has a veritable army of trained attorneys, all of whose salaries
are paid for with public dollars. In addition, unlike a private securities
plaintiff, the SEC possesses subpoena power even before it files a lawsuit.
This provides the Commission with a distinct investigatory advantage over
a typical private securities plaintiff. This advantage at least partially
undermines the policy justification for delaying the start of the limitations
clock.
Id. at *4. Despite such advantages for the SEC, the Court is not persuaded that the
discovery rule (and the Supreme Court’s recognition of it for fraud cases) should not also
apply to enforcement actions.
First, the Supreme Court “long ago pronounced the standard: ‘Statutes of
limitation sought to be applied to bar rights of the Government must receive a strict
construction in favor of the Government.’” Badaracco v. C.I.R., 464 U.S. 386, 391
12
(1984) (quoting E.I. Dupont de Nemours & Co. v. Davis, 264 U.S. 456, 462 (1924)).
Defendant argues that Badaracco and Davis were actually remedial cases, in which the
Government was the injured party. The Tenth Circuit, however, has held that, under this
same standard, Section 2462 specifically—which relates only to penal actions—must be
narrowly construed in favor of the Government. See United States v. Telluride Co., 146
F.3d 1241, 1244-45 (10th Cir. 1998) (quoting Davis, 264 U.S. at 462).
Moreover, in Exploration Co. v. United States, 247 U.S. 435 (1918), in which the
Supreme Court applied its rule from Bailey, the Court stated:
We are aware of no good reason why the rule, now almost universal, that
statutes of limitations to set aside fraudulent transactions shall not begin
to run until the discovery of the fraud, should not apply in favor of the
government as well as a private individual.
Id. at 449. It is true that in Exploration Co., the Government was the injured party as the
seller of the land in question, see id.; but, as noted above, courts have applied the
discovery rule in enforcement actions under Section 2462 (which must necessarily be
penal). See Gabelli, __ F.3d __, 2011 WL 3250556; Koenig, 557 F.3d 736; Kearns, 691
F. Supp. 2d 601; Buntrock, 2004 WL 1179423. In Koenig, the Seventh Circuit
specifically rejected this argument by defendant in holding that “the United States is
entitled to the benefit of this rule even when it sues to enforce laws that protect the
citizenry from fraud, but is not itself of victim.” See Koenig, 557 F.3d at 739 (citing
Exploration Co., 247 U.S. 435); see also Alexander, 248 F.R.D. at 119 (quoting
Exploration Co., 247 U.S. at 449). The Court in Kearns also specifically rejected this
13
argument “that the government is entitled to less equitable protection from the statute of
limitations than a private plaintiff.” See Kearns, 691 F. Supp. 2d at 612-13 (citing
Badaracco, 464 U.S. at 391-92). As the Kearns court reasoned: “The government’s
resources, even assuming they are massive as compared to a private person, cannot be
unleashed against a fraudulent party until the government is able, with due diligence, to
detect the fraud.” Id. at 613.
In summary, the Court is persuaded by the reasoning of Gabelli, Koenig, Kearns,
and Alexander, and it therefore rejects the 3M court’s rationale in refusing to apply the
discovery rule to Section 2462. Based on the reasoning of those courts, as well as the
Tenth Circuit’s consistent adherence to the Holmberg discovery rule in securities cases,
the Court believes that the Tenth Circuit would apply the discovery rule in a securities
fraud case by the SEC subject to Section 2462.
In this case, the SEC brought suit within five years of the date on which it alleges
that it first received inquiry notice of the alleged fraud. The Court rejects defendant’s
argument that the SEC cannot meet the due diligence requirement as a matter of law.
The SEC alleged that it “proceeded with due diligence during the limitations period,”
and the Court does not believe that any further allegations are necessary to refute a
negative inference that the SEC should have learned something sooner. See Gabelli, __
F.3d __, 2011 WL 3250556, at *8 & n.5 (citing Marks v. CDW Computer Ctrs., Inc., 122
F.3d 363, 368 n.2 (7th Cir. 1997)) (rejecting argument that the SEC was required to
plead reasonable diligence for application of the discovery rule, as the lapse of the
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limitations period was an affirmative defense; requiring the SEC to plead why it did not
discover a fraud sooner would nonsensically require proof of a negative in the
complaint). Whether the SEC acted diligently in this case presents a question of fact for
later resolution.
Finally, defendant has not disputed the SEC’s characterization that all of the
claims except for Count 5 sound in fraud and should therefore be subject to the discovery
rule. Accordingly, for all claims other than Count 5, the Court denies defendant’s
motion to dismiss based on the statute of limitations.
B.
Fraudulent Concealment
Because Count 5 is not subject to the discovery rule, the Court must address the
SEC’s alternative argument that the doctrine of fraudulent concealment tolls the statute
of limitations for Count 5 violations occurring before January 12, 2006. To toll the
statute of limitations based on fraudulent concealment, the SEC must show the use of
fraudulent means by defendant, successful concealment from the SEC, and that the SEC
did not know or by the exercise of due diligence could not have known that it might have
a cause of action. See Ballen v. Prudential Bache Sec., Inc., 23 F.3d 335, 337 (10th Cir.
1994).
The parties dispute whether the SEC may rely on the self-concealing nature of the
alleged fraud or whether it must allege separate affirmative acts of concealment. The
Court need not resolve that issue at this time, however. In its opinion in In re Urethane
Antitrust Litigation, 235 F.R.D. 507 (D. Kan. 2006) (Lungstrum, J.), this Court noted the
15
three different standards that courts have applied for fraudulent concealment. See id. at
518. The Court rejected the strictest “separate and apart” standard, which would require
evidence, separate and apart from the acts of concealment involved in the underlying
violation, that the defendant affirmatively acted to conceal the claim; the Court
concluded that Tenth Circuit precedent did not support such a standard, and that the
Tenth Circuit caselaw indicates that any affirmative act of concealment, including those
involved in the underlying violation, is sufficient (the intermediate standard). See id. at
518-19.
In this case, the Court concludes that the SEC’s amended complaint at least
satisfies the intermediate standard. The complaint alleges various acts of concealment
by defendant, including his failure to disclose the relevant issues to auditors.
Accordingly, even if the SEC is not entitled to rely on a self-concealing standard (which
the Court declines to decide presently), its pleading sufficiently alleges fraudulent
concealment. The Court further concludes that the complaint sufficiently alleges facts
relating to the SEC’s diligence in its investigation following its receipt of inquiry notice.
Accordingly, the Court denies in its entirety defendant’s motion to dismiss based on the
statute of limitations.
C.
Continuing Violation
Denial of defendant’s limitations argument is also appropriate in light of the
SEC’s reliance on the continuing violation doctrine. Under that doctrine, if the alleged
unlawful practice continues into the limitations period, the complaint is timely if filed
16
within the required limitations period (in this case, five years) measured from the end of
that practice. See Havens Realty Corp. v. Coleman, 455 U.S. 363, 380-81 (1982).
In response to this theory, defendant first notes that some courts have questioned
whether the continuing violation doctrine should apply in enforcement actions.
Defendant has not cited any cases actually rejecting the doctrine, however, and several
courts have in fact recognized the continuing violations doctrine in SEC enforcement
cases. For instance, in SEC v. Huff, 758 F. Supp. 2d 1288, 1340-41 (S.D. Fla. 2010), the
court reviewed the purposes of the securities statutes and concluded as follows:
In view of Haven Realty’s example in applying the “continuing
violations” doctrine to effectuate congressional intent, this Court
concludes that not applying the doctrine in the SEC enforcement context
could frustrate congressional purpose in enacting the Securities Act and
the Exchange Act in that the nature of certain types of securities violations
is such that they necessarily take time to detect. While time passes,
however, such violations can inflict significant harm on the investing
public. If wrongdoers may continue to reap the benefit of their continuing
violations with no threat of punitive enforcement actions, then, for some,
the possibility that they may eventually merely have to return what may
be left of their ill-gotten gains may become simply a cost of doing
business. Such an outcome conflicts with congressional intent to prevent
securities fraud. Consequently, this Court finds that the “continuing
violations” doctrine may apply where the appropriate facts exist.
Id. at 1340-41 (following SEC v. Ogle, 2000 WL 45260 (N.D. Ill. Jan. 11, 2000)); see
also SEC v. Kelly, 663 F. Supp. 2d 276, 287-88 (S.D.N.Y. 2009) (applying the doctrine);
SEC v. Pentagon Capital Mgmt. PLC, 612 F. Supp. 2d 241, 267 (S.D.N.Y. 2009) (same).
Defendant has not offered any argument why the doctrine should not be applied in
enforcement actions or why the Court should not following the reasoning of the court in
17
Huff. In addition, in United States v. Jensen, 608 F.2d 1349 (10th Cir. 1979), the Tenth
Circuit noted that the applicable statute of limitation would not be a bar in that case if
there was an ongoing scheme continuing into the limitations period. See id. at 1355.
Accordingly, the Court will recognize the continuing violation doctrine for purposes of
this case.
The Court also rejects defendant’s argument that the SEC’s use of this doctrine
in this case fails as a matter of law. The SEC has alleged a continuous scheme by
defendant, and Count 5 alleges a failure to maintain records and controls continuing into
2006. Whether the alleged violation is a continuing violation is better suited for
resolution after consideration of the facts, and defendant has not cited any authority
suggesting that this issue should be decided as a matter of law at this stage. Therefore,
the Court denies defendant’s limitations argument based on this theory as well.3
IV.
Counts One, Two, and Three
In Count One, the SEC alleges that defendant violated Section 10(b) of the
Exchange Act, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5. In Counts
Two and Three, the SEC alleges violations of Section 17(a) of the Securities Act, 15
3
In light of these rulings, the Court need not address defendant’s argument that
Section 2462 should apply not only to the SEC’s civil penalty claims, but also to its
claims for injunctive relief and for an officer-director bar. The Court also rejects as
premature defendant’s argument, asserted only in a footnote, that the SEC’s
disgorgement claim is not viable.
18
U.S.C. § 77g(a). All three counts are based on the SEC’s allegations that defendant
committed fraud by failing to disclose perquisites received by Mr. Fraser, NIC’s CEO,
and thus by under-reporting Mr. Fraser’s income in filings with the SEC. See 17 C.F.R.
§ 229.402 (“Item 402”) (requiring disclosure of CEO compensation, including
“perquisites and other personal benefits”). Defendant challenges these claims on a
number of grounds.
A.
Duty
1.
COMMUTING EXPENSES
In part, the SEC bases its fraud allegations on defendant’s failure to disclose as
compensation NIC’s payments for Mr. Fraser’s “commuting expenses to travel between
his Wyoming home and Kansas office.” See SEC Release No. 5904, 1978 WL 170874,
at *5 (Feb. 6, 1978) (use of a company plane for “commuting purposes” is a form of
remuneration requiring disclosure). Defendant argues that any claim based on such
allegations regarding commuting expenses should be dismissed on the basis that the SEC
has not alleged facts giving rise to a duty to disclose any payments for Mr. Fraser’s
travel between Wyoming and Kansas. Defendant argues that in the absence of any
definition by the SEC, “commuting” should mean regular and frequent travel between
the person’s home and workplace, and defendant notes that the SEC has not alleged any
facts bearing on that standard, including the frequency of Mr. Fraser’s trips or how much
time he worked in Wyoming or in Kansas. Finally, defendant cites an e-mail from NIC’s
Assistant Controller to defendant stating the belief that, for tax purposes, NIC would be
19
able to show that Mr. Fraser’s regular place of work was in Wyoming, that he spent only
a few days a month in Kansas, and that the expenses therefore were not for commuting.4
The SEC responds that it need not necessarily show “commuting” expenses, as
long as it proves a personal benefit, such as reimbursement for travel for personal
reasons. With respect to this air travel between Wyoming and Kansas, however, the
SEC has alleged only that the expenses should have been disclosed as commuting
expenses. Thus, the Court will address that specific claim.
The Court concludes that the SEC has alleged sufficient facts to support this claim
based on commuting expenses. The amended complaint alleges that Mr. Fraser’s home
was in Wyoming and that “his” NIC office was in Kansas. In the e-mail cited by
defendant, the Assistant Controller actually stated that he did not have enough
information to determine Mr. Fraser’s regular place of business, and that although he
believed the company could show that Mr. Fraser spent only a few days a month in
Kansas, such a conclusion “would be based on an analysis of [Mr. Fraser’s] business
activity for a year.” The SEC alleges in its complaint that NIC undertook no such
analysis. Moreover, as the SEC points out, in a follow-up e-mail to defendant, his
superior stated that his “knowledge of ‘home office’ would lead [him] to believe KC is
the home office.”
4
Defendant argues that the Court should consider this e-mail because it was
referenced in the complaint and the SEC has not disputed its authenticity. See Gee v.
Pacheco, 627 F.3d 1178, 1186 (10th Cir. 2010).
20
At this stage, the Court accepts as true the allegations that Mr. Fraser lived in
Wyoming, that his office was in Kansas, and that he commuted between those two
places. The SEC’s claim based on those allegations is not implausible, and the SEC need
not support that claim with all possible evidence at this time. Accordingly, the Court
denies this argument for dismissal of Counts One, Two, and Three as they relate to
commuting expenses.
2.
OTHER PERSONAL EXPENSES
With respect to the alleged reimbursements to Mr. Fraser for other personal
expenses, defendant argues that such payments do not constitute “compensation” to Mr.
Fraser for purposes of the disclosure requirement, see 17 C.F.R. § 229.402, because that
money was essentially stolen or looted by Mr. Fraser. Thus, defendant argues that NIC
did not make an affirmative decision to pay Mr. Fraser those amounts to “compensate”
him for his work for the company, and that in fact NIC eventually required repayment
by Mr. Fraser for those expenses.
Defendant relies solely on Andropolis v. Red Robin Gourmet Burgers, Inc., 505
F. Supp. 2d 662 (D. Colo. 2007). In that case, the court reasoned as follows:
I find the plain language of 17 C.F.R. § 229.402 does not contemplate the
disclosure of “compensation” taken from a company, but is limited to
compensation “awarded to, earned by, or paid to” certain officials.
Clearly, in this case, the aircraft usage was not “awarded to, earned by, or
paid to” Snyder as—once such usage was discovered—Snyder was
required to reimburse the Company for his undocumented expenses. . . .
Thus, I find 17 C.F.R. § 229.402 imposes no duty to disclose improperly
taken executive “compensation.”
21
Id. at 685. In Andropolis, the court distinguished another case, In re Tyco Int’l, Ltd.,
2004 WL 2348315 (D.N.H. Oct. 14, 2004), as one in which senior executives authorized
and participated in the looting, while in Andropolis, a senior executive took advantage
of weak internal controls for his own personal gain. See Andropolis, 505 F. Supp. 2d at
684-85 (citing Tyco, 2004 WL 2348315, at *2).
The Court rejects this argument. Even in Andropolis, on which defendant relies,
the court recognized a distinction for this purpose between mere looting and payments
authorized by the company. In SEC v. Das, 2010 WL 4615336 (D. Neb. Nov. 4, 2010),
the court reviewed Andropolis and noted that the issue presents a fact-specific inquiry.
See id. at *7. The court rejected the argument based on Andropolis as follows:
The court in Andropolis recognized that almost all cases interpreting Item
402 involve money or benefits knowingly given to executives by the
company. While the money in Andropolis clearly had been wrongfully
taken, in this case, the SEC has stated a claim that Defendants knowingly
caused Info to pay for Gupta’s private expenses. In other words, the
Complaint sufficiently alleges that through the Defendants’ actions, Info
awarded the funds to Gupta. Accordingly, the Court will not dismiss the
SEC’s claim on the basis that the perquisites cannot be considered
compensation.
Id. (citation omitted). Similarly, in the present case, the SEC has alleged facts
suggesting that defendant had notice of problems with Mr. Fraser’s expenses, that Mr.
Fraser received reimbursements for personal expenses nonetheless, and that Mr. Fraser
was not required to repay all such reimbursements. Those allegations are sufficient to
state a claim at this point, and therefore the Court denies defendant’s motion to dismiss
22
on this basis.5
B.
Scienter
Defendant next argues that, with respect to Counts One and Two, the SEC has not
sufficiently alleged facts supporting the element of scienter. See SEC v. Wolfson, 539
F.3d 1249, 1256-57 (10th Cir. 2008) (citing Aaron v. SEC, 446 U.S. 680, 697 (1980))
(scienter required for claims under Section 10(b) and Section 17(a)(1), not for claims
under Sections 17(a)(2) or (3)). Scienter requires a showing of an intent to defraud or
recklessness. See City of Phila. v. Fleming Cos., 264 F.3d 1245, 1257-58 (10th Cir.
2001).
1.
COMMUTING EXPENSES
With respect to Mr. Fraser’s commuting expenses, defendant argues that the
complaint does not allege facts plausibly supporting scienter. Defendant notes the lack
of guidance concerning “commuting” from the SEC, and he argues that the decision to
reimburse Mr. Fraser for those expenses was made by the Board of Directors. He argues
that he had no real motive to commit the fraud here. Finally, defendant argues, based on
the same e-mails cited above, see supra Part IV.A.1, that he and the company did address
the commuting issue and concluded that Mr. Fraser was not commuting and that the risk
5
In addition, defendant has not responded to the SEC’s argument that, even if Item
402 did not require disclosure here, such a duty arose from defendant’s fiduciary status
and from the need to correct misleading statements. See New Jersey Div. of Inv. v. Sprint
Corp., 314 F. Supp. 2d 1119, 1128 (D. Kan. 2004) (Lungstrum, J.) (citing cases and
listing circumstances giving rise to a duty to disclose).
23
of a contrary finding was low. Defendant justifies the lack of any analysis by noting that
he and NIC would already have known how often Mr. Fraser traveled to Kansas from
Wyoming.
The Court rejects this argument and concludes that the SEC has adequately
pleaded facts supporting a plausible claim of scienter. The SEC has alleged that
defendant knew that Mr. Fraser lived in Wyoming but had his office in Kansas, and thus
that defendant knew that Mr. Fraser was being reimbursed for commuting expenses. The
SEC further alleges that defendant was warned about the issue in 2004, when he was told
that an analysis would be required, but that defendant refused to conduct such an
analysis. Defendant disputes that Mr. Fraser’s office was in Kansas, but at this stage, the
Court must accept the SEC’s allegation that his office was in Kansas and that defendant
knew that fact. As the SEC notes, defendant conceded to his superiors that the issue was
a “gray area,” and the SEC has alleged that the Board deferred to defendant’s judgment
on the issue, but that defendant nevertheless did not conduct the necessary analysis.
Finally, the SEC has alleged that defendant personally benefitted from the alleged
misconduct through sales of the company stock and by receiving a promotion, which
allegations support an inference of motive.6
6
The cases cited by defendant to support his argument that an allegation of insider
trading does not sufficiently support scienter were cases under the PSLRA, which
involve a higher pleading standard for scienter. See, e.g., In re Sun Healthcare Group,
Inc. Sec. Litig., 181 F. Supp. 2d 1283, 1296 (D.N.M. 2002). In this case, the SEC is
required to plead scienter only generally. See Fed. R. Civ. P. 9(b). Moreover, the SEC’s
(continued...)
24
2.
OTHER PERSONAL EXPENSES
Defendant also seeks dismissal based on a lack of scienter relating to other
perquisites received by Mr. Fraser. Defendant argues that the alleged facts show only
that defendant knew that Mr. Fraser was not submitting sufficient documentation to
support his claimed expenses, and do not show that defendant knew that the claims were
for personal expenses. He argues that e-mails discussing the issue, cited by the SEC, did
not raise red flags and that analyses of the issue did not show which items were not
actually repaid by Mr. Fraser.
The Court again concludes that the SEC’s allegations are sufficient. The SEC has
generally alleged that defendant acted recklessly or with intent in authorizing
reimbursements to Mr. Fraser for personal expenses beginning in 2002, as permitted by
Rule 9(b). Moreover, those allegations are not merely conclusory, as the SEC has
alleged a number of facts supporting a plausible case of scienter. The SEC has not only
relied on e-mails, but has alleged that defendant was informed about problems with Mr.
Fraser’s expenses and that the issue was raised with him repeatedly. It is true that much
of the discussion concerned a lack of documentation, but, of course, one reason for any
such requirement is to ensure that the claimed expenses are proper and are not personal.
The allegations also support the inference that defendant knew that Mr. Fraser was
6
(...continued)
motive allegations were not limited to insider trading, but also referenced defendant’s
promotion.
25
claiming personal items, as the SEC has alleged the following: that Mr. Fraser received
reimbursements for seemingly personal items such as homes, cars, clothing, and spa
treatments; that defendant reviewed analyses and heard concerns about Mr. Fraser’s
claims for personal expenses; that Mr. Fraser would claim expenses in round (and
therefore, probably inaccurate) figures; that defendant had been told that personal items
were among those for which Mr. Fraser sought reimbursement; and that defendant on
one occasion admitted that the decision had been made not to “bust Mr. Fraser’s chops”
concerning reimbursement for personal items. Defendant also argues that he did attempt
to address the issue with superiors, who assumed responsibility for the payments; the
SEC has alleged, however, that defendant authorized the payments while knowing they
were for personal expenses, and that he nonetheless failed to disclose such perquisites
in the public filings.
The Court therefore rejects defendant’s arguments based on scienter.
C.
Fraud Post-2006
The Court also rejects defendant’s argument that any conduct occurring after NIC
adopted new procedures in 2006 cannot support a claim for fraud. The SEC has
adequately alleged that defendant failed to disclose perquisites in proxy statements and
annual reports for the years from 2002 through 2006, and it has further alleged that steps
taken by NIC in 2006 did not sufficiently address the problem of Mr. Fraser’s expense
reimbursements. Accordingly, there is no basis to remove claims based on conduct
26
beginning in 2006 from the case at this time.7
D.
Materiality
Defendant next argues that the alleged misstatements regarding Mr. Fraser’s
income were not material as a matter of law. To satisfy the materiality requirement,
“there must be a substantial likelihood that the disclosure of the omitted fact would have
been viewed by the reasonable investor as having significantly altered the ‘total mix’ of
information made available.” Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988)
(quoting TSC Indus. v. Northway, Inc., 426 U.S. 438, 449 (1976)).
Defendant argues that disclosure of the perquisites to Mr. Fraser would not have
been viewed as having altered the total mix of information about NIC as a matter of law.
Defendant argues that the disclosure would not really have affected NIC’s financial
statements because the payments to Mr. Fraser were already accounted for (as business
expenses), and that the amounts in question represented a very small percentage of NIC’s
annual revenue. Defendant argues that investors’ views would not have been affected
by the disclosure of the mere facts that Mr. Fraser’s commuting expenses were paid and
that he had failed to supply sufficient receipts for expenses, especially in light of the fact
that Mr. Fraser had helped to turn around the company’s performance after his return as
CEO. Defendant also notes that NIC’s stock price rose in 2007 after NIC disclosed that
Mr. Fraser had received significant compensation in 2006.
7
Contrary to the argument in defendant’s reply brief, the SEC did address this
issue in its response brief. See Memorandum in Opposition at 31-32.
27
As this Court has previously noted, however, the question of materiality “is a
mixed question of law and fact and ordinarily should be reserved for the trier of fact,”
and that a request for dismissal at this stage should only be granted if the information is
obviously immaterial. See In re Sprint Corp. Sec. Litig., 232 F. Supp. 2d 1193, 1215-16
(D. Kan. 2002) (Lungstrum, J.). In this case, the SEC has pleaded sufficient facts to
support a plausible claim that satisfies the materiality requirement. For example, the
SEC has alleged that disclosure of the perquisites was required by the applicable law;
that investors were told in NIC’s filings that Mr. Fraser was working for no
compensation, while in fact Mr. Fraser received over $1.18 million in undisclosed
perquisites; and that NIC’s stock price dropped 16 percent in 2008 in the days after NIC
disclosed that Mr. Fraser had repaid $283,000 for improperly-reimbursed expenses. See
SEC Staff Accounting Bulletin No. 99, 1999 WL 1123073 (Aug. 12, 1999) (cited by
defendant) (qualitative factors may make misstatements involving small amounts
material), cited in United States v. Nacchio, 519 F.3d 1140, 1162-63 (10th Cir. 2008)
(noting that the amount at issue does not end the inquiry and that “[s]pecial factors might
make a smaller [misstatement] material”), vacated in part, 555 F.3d 1234 (10th Cir.
2009); see also United States v. Bilzerian, 926 F.2d 1285, 1298 (2d Cir. 1991) (finding
a stock price drop and the fact that disclosure was required to be relevant to the
materiality inquiry).
In this case, the Court cannot say that the alleged perquisites to Mr. Fraser would
not have altered the total mix of information concerning NIC as a matter of law, at least
28
not until all of the facts entering into that total mix have been identified. The SEC is not
required to have identified every single such fact in its complaint, and its allegations do
raise a plausible inference of materiality here. Accordingly, the Court denies this basis
for dismissal.8
E.
Reference to Code of Ethics
Finally, defendant seeks dismissal of these counts to the extent that they are based
on Paragraph 50 of the amended complaint, which alleges that NIC’s proxy statements
were misleading because they referred to NIC’s code of ethics without also disclosing
violations of that code. Defendant argues that merely referring to a code of ethics does
not imply an absence of violations, and that otherwise every breach of a fiduciary duty
would be transformed into fraud. See Andropolis, 505 F. Supp. 2d at 685-86 (company’s
mandatory adoption of a code of ethics does not imply that all directors and officers are
adhering to the code, and omission of violations does not render the statement of
adoption misleading).
In response, the SEC insists that the proxy statements do not merely refer to the
code of ethics. The actual language in the proxy statements (attached to the complaint)
8
Defendant argues that Rule 9(b)’s particularity requirement applies to this
element of materiality and that the SEC was therefore required to break down the alleged
$1.18 million in perquisites among the years and particular type of expense alleged. The
Court rejects this argument as a basis for dismissal. The Tenth Circuit has never applied
Rule 9(b) in a way that would require a plaintiff to break down amounts like this. The
facts alleged by the SEC here create a plausible inference that the omissions and
misstatements concerning Mr. Fraser’s compensation were material.
29
is as follows:
The Board has adopted a Code of Business Conduct and Ethics to
promote its commitment to the legal and ethical conduct of the Company’s
business, which can be found on the Company’s Web site. All employees,
including the Chief Executive Officer, Chief Financial Officer and other
senior officers, are required to abide by the Code of Business Conduct and
Ethics, which provides the foundation for compliance with corporate
policies and procedures, and best business practices. The policies and
procedures address a wide array of professional conduct, including
methods for avoiding and resolving conflicts of interest, protecting
confidential information and a strict adherence to all law and regulations
applicable to the conduct of the Company’s business. The Company
intends to satisfy its obligations, imposed under Sarbanes-Oxley, to
disclose promptly amendments to, or waivers from, the Code of Business
Conduct and Ethics, if any, on the Company’s Web site.
(Emphasis added.)
The Court agrees with defendant on this issue. In these documents, NIC stated
only that it had adopted a code, that all employees were required to follow it, and that
any waivers would be disclosed on the company’s website. NIC did not suggest thereby
that there had been no violations or waivers. The SEC has not cited any authority
supporting its theory. Cf. City of Roseville Employees’ Retirement Sys. v. Horizon Lines,
Inc., 686 F. Supp. 2d 404, 415 (D. Del. 2009) (noting that this theory by the SEC “has
been soundly rejected by those courts that have considered it”). Accordingly, the Court
grants defendant’s motion as it relates this issue, and the Court dismisses Counts One,
Two, and Three to the extent they are based on the reference in proxy statements to
NIC’s code of ethics.
30
V.
Counts Four and Nine
In Count Four of the amended complaint, the SEC asserts a claim for aiding and
abetting violations of Section 13(a) of the Exchange Act, 15 U.S.C. § 78m(a), and Rules
12b-20 and 13a-1, 17 C.F.R. §§ 240.12b-20, 240.13a-1. In Count Nine, the SEC asserts
a claim for aiding and abetting violations of Section 14(a) of the Exchange Act, 15
U.S.C. § 78n(a), and Rules 14a-3 and 14a-9, 17 C.F.R. §§ 240.14a-3, 240.14a-9. By
these counts, the SEC alleges that defendant aided and abetted NIC in violating these
laws by filing false and misleading annual reports and proxy statements.
First, defendant seeks dismissal of these claims on the basis that the SEC has not
stated claims for the underlying violations by NIC, for the same reasons asserted with
respect to Counts One, Two, and Three. For the same reasons set forth above, see supra
Part IV, the Court denies the motion to dismiss on this basis, with the exception that
Counts Four and Nine are dismissed to the extent that they based on the reference in
proxy statements to NIC’s code of ethics, see supra Part IV.E.
Defendant also argues that these aiding and abetting claims require a showing of
actual knowledge and not mere recklessness, based on the aiding-and-abetting statute’s
reference to “any person that knowingly provides substantial assistance to another person
in violation of a provision of this chapter.” See Exchange Act, Section 20(e), 15 U.S.C.
§ 78t(e); see also SEC v. Rivelli, 2010 WL 2775623, at *4 (D. Colo. July 14, 2010)
(following majority of courts that have held that aiding-and-abetting statute requires
actual knowledge). The SEC argues in response that it may show mere recklessness
31
under this statute. The Court need not resolve this issue at this time, however, as it
concludes that the SEC’s allegations satisfy either standard. As set forth above, the
complaint alleges facts supporting a plausible inference that defendant was warned and
thus had knowledge that Mr. Fraser was commuting and was receiving reimbursements
for personal expenses. Accordingly, the Court denies defendant’s motion for dismissal
of Counts Four and Nine on this basis.
VI.
Count Six
In Count Six, the SEC alleges that defendant made false or misleading statements
to NIC’s auditors in violation of Rule 13b2-2 of the Exchange Act, 17 C.F.R. §
240.13b2-2. Specifically, the SEC alleges that defendant made false representations in
letters sent to the auditors in March of every year from 2003 to 2007, in connection with
annual audits of NIC’s preceding-year financial statements. The SEC generally cites two
separate alleged misrepresentations: (1) that defendant had no knowledge of any fraud
or suspected fraud affecting NIC, see Amended Complaint ¶¶ 55(b), 56(c), 57; and (2)
that NIC maintained effective internal controls over financial reporting and that all
deficiencies in those controls had been disclosed, see Amended Complaint ¶¶ 55(a),
56(a) & (b), 58.
Defendant first notes that the letters stated that the information therein was to the
best of NIC’s knowledge and belief, and he argues that the SEC has not alleged
sufficient facts to show that he had knowledge of any intentional fraud by Mr. Fraser.
32
Again, however, the Court concludes that the complaint includes sufficient factual
allegations to raise a plausible inference that defendant knew of the underlying fraud
(either by Mr. Fraser or by NIC with respect to its annual reports and proxy statements).9
Defendant also argues that the statements regarding knowledge of any “fraud”
were not false or misleading based on the definition of “fraud” as used in the letters to
the auditors (which were attached to the complaint). Each letter cited in the amended
complaint stated that the term “fraud” was understood to mean “those matters described
in Statement on Auditing Standards No. 99 [SAS 99].” For that reference to SAS 99,
both parties have cited the document Consideration of Fraud in a Financial Statement
Audit, AU Section 316. In that document, “fraud” is defined as “an intentional act that
results in a material misstatement in financial statements that are the subject of an audit.”
Id. § 316.05. Defendant argues that because the SEC has not pointed to any fraud in
NIC’s financial statements (for the reason that, because the alleged perquisites were
already accounted for as business expenses instead of compensation to Mr. Fraser, the
financial statements were essentially correct), the letters’ statements that NIC did not
have any knowledge of any “fraud” were not false.
The SEC does not dispute that there has been no such misstatement alleged
9
Although defendant argues that scienter must be alleged in connection with this
claim, the case he cites actually holds to the contrary. See SEC v. Espuelas, 579 F. Supp.
2d 461, 487 (S.D.N.Y. 2008) (“Like Rule 13b2-1, 13b2-2 does not require the SEC to
plead scienter.”). The Court need not resolve the issue, however, as the SEC’s
allegations would satisfy a requirement of pleading scienter.
33
relating to the financial statements. Instead, it argues that AU Section 316.06 indicates
that “fraud” covers not only “misstatements arising from fraudulent financial reporting,”
but also “misstatements arising from misappropriation of assets.” See id. § 316.06. In
elaborating on the latter type of misstatement, however, the document states: “The scope
of this section includes only those misappropriations of assets for which the effect of the
misappropriation causes the financial statements not to be fairly presented, in all material
respects, in conformity with GAAP.” The SEC has not offered any reason why the fraud
alleged in this case caused NIC’s financial statements to be inaccurate.
Accordingly, the Court agrees with defendant that the letters to the auditors
limited the meaning of the word “fraud” as used in the letters, and that the SEC has not
alleged facts to support a claim that the statements disclaiming a knowledge of “fraud”
(as defined) were false. Accordingly, the Court grants defendant’s motion to that extent,
and it dismisses Count Six to the extent based on the misstatements alleged in
Paragraphs 55(b), 56(c), and 57 of the amended complaint.
Defendant argues that the lack of any misstatements in the financial statements
also dooms the SEC’s claims based on the letters’ references to NIC’s “internal control
over financial reporting.” Defendant notes that the 2005, 2006, and 2007 letters state
that they are provided in connection with the auditors’ opinions as to “whether the
Company maintained, in all material respects, effective internal control over financial
reporting . . . based on the criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
34
Commission (COSO).” The COSO document relates in pertinent part to “financial
reporting,” that is, “the preparation of reliable published financial statements.” It is
possible, however, that NIC did not have effective internal control relating to the
preparation of financial statements (based on the failure to require proper expense
documentation from Mr. Fraser, for instance) even if no financial statements were
misstated. Accordingly, defendant has not shown that theses statements in the letters to
the auditors could not have been false, and the Court therefore denies defendant’s motion
as it relates to the other bases for Count Six.10
VII.
Count Seven
In Count Seven, the SEC alleges that defendant “knowingly circumvented or
knowingly failed to implement a system of internal accounting controls or knowingly
falsified books, records, or accounts,” in violation of Section 13(b)(5) of the Exchange
Act, 15 U.S.C. § 78m(b)(5). Defendant argues that scienter must be shown and that the
SEC has failed to allege facts supporting an inference that defendant had the requisite
knowledge. The court rejects this argument for the same reasons set forth above with
respect to the allegations bearing on defendant’s knowledge. See supra Parts IV.B, V,
VI. Accordingly, the Court denies defendant’s motion for dismissal of Count Seven.
10
The 2003 and 2004 letters deny any deficiencies in internal controls affecting
“financial data,” and do not contain any reference in that context to “financing reporting”
or to the COSO document. Accordingly, defendant’s argument fails with respect to
those years and the allegation in Paragraph 55(a) of the amended complaint.
35
VIII. Counts Five and Eight
In Count Five of the amended complaint, the SEC alleges that defendant aided
and abetted NIC’s violations of Sections 13(b)(2)(A) and (B) of the Exchange Act, 15
U.S.C. § 78m(b)(2)(A) and (B), which require accurate books and records “in reasonable
detail” and a system of internal accounting controls sufficient to provide “reasonable
assurances” that transactions are recorded as necessary to permit the proper preparation
of financial statements and to maintain accountability for assets. In Count Eight, the
SEC alleges a violation of Exchange Act Rule 13b2-1, 17 C.F.R. § 240.13b2-1, based
on defendant’s causing the falsification of books and records.
Defendant argues that the facts in the amended complaint do not establish a
violation of the applicable “reasonableness” standard as a matter of law. Defendant
points in particular to certain factors set out in the SEC’s Staff Accounting Bulletin No.
99 (SAB 99), 64 Fed. Reg. 4515001, 45154, 1999 WL 625156 (Aug. 19, 1999). This
standard of reasonableness presents a fact question, however, and defendant has not
provided any authority supporting his argument that this issue should be decided as a
matter of law. Moreover, SAB 99 makes clear that the factors cited by defendant are not
exhaustive, as it indicates that any factors relating to a misstatement’s materiality should
also be considered. For the same reasons set forth above with respect to materiality, see
supra Part IV.D, the Court concludes that the SEC has stated plausible claims as alleged
in Counts Five and Eight, and the Court therefore denies defendant’s motion to dismiss
those counts.
36
IT IS THEREFORE ORDERED BY THE COURT THAT defendant’s motion
to dismiss the amended complaint (Doc. # 23) is granted in part and denied in part.
The motion is granted with respect to Counts One, Two, Three, Four, and Nine to the
extent they are based on the conduct alleged in Paragraph 50 of the amended complaint,
and with respect to Count Six to the extent it is based on the conduct alleged in
Paragraphs 55(b), 56(c), and 57 of the amended complaint; and those claims are hereby
dismissed. The motion is denied in all other respects.
IT IS SO ORDERED.
Dated this 4th day of August, 2011, in Kansas City, Kansas.
s/ John W. Lungstrum
John W. Lungstrum
United States District Judge
37
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