Securities and Exchange Commission v. Johnson et al

Filing 140

OPINION AND ORDER: re: 83 MOTION To Exclude Expert Report filed by American Growth Funding II, LLC, Ralph C Johnson. In conclusion, (1) the opinions contained in paragraphs 13 to 32 of the Devor Report are admissible under Rule 402 because they are relevant to proving the materiality of Defendants' misrepresentations, (2) the opinions contained in paragraphs 33 to 57 of the Devor Report are admissible under Rule 402 because they are relevant (i) to proving that Defendants acted with s cienter and (ii) to rebutting the AGF Defendants' defense of good faith, and (3) the opinions contained in the Devor Report are admissible under Rule 403, because "unfair surprise" is not aproper ground for excluding the opinions conta ined that report and because those opinions are unlikely to confuse the issues or mislead the finder of fact. For these reasons, the Court DENIES Defendants' Motion to Exclude the Expert Report of Harris L. Devor. The Clerk of Court is directed to terminate the motion at ECF No. 83. If Defendants wish to submit their own expert report rebutting Mr. Devor's report, they shall serve such a report on or before March 31, 2018, Depositions of Harris L, Devor and Defendants' rebuttal experts, if any, shall be completed on or before April 27, 2018. SO ORDERED., ( Deposition due by 4/27/2018.) (Signed by Judge Kimba M. Wood on 3/01/2018) (ama)

UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK

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SECURITIES AND EXCHANGE
COMMISSION,

USDSSDNY
DOCUMENT
ELECTRONICALLY FILED
DOC #: ------,------.--DATE FILED: 3
/t<"t'

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Plaintiff,
V.

16-CV -828 (KMW) (DCF)
AMERICAN GROWTH FUNDING II, LLC,
PORTFOLIO ADVISORS ALLIANCE, INC.,
RALPH C. JOHNSON, HOWARD J. ALLEN
Ill, and KERRI L. WASSERMAN,

OPINION & ORDER

Defendants.

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KIMBA M. WOOD, United States District Judge:
In this action, the Securities and Exchange Commission ("SEC") asserts claims under
Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") and Rule 10b-5
thereunder, and Sections 17(a)(l ), (2), and (3) of the Securities Act of 1933 (the "Securities Act")
against Defendants Ralph C. Johnson, American Growth Funding II, LLC ("AGF II"), Howard J.
Allen III, Kerri L. Wasserman, and Portfolio Advisors Alliance, Inc.

The SEC alleges that

Defendants violated these securities laws by making materially false statements to investors and
potential investors.

Defendants deny these allegations.

Defendants AGF II and Johnson (the

"AGF Defendants") have now moved to exclude the Expert Report of Harris L. Devor, CPA (the
"Devor Report").
For the reasons stated below, the AGF Defendants' Motion is DENIED because (1) the
opinions contained in paragraphs 13 to 32 of the Devor Report are admissible under Rule 402
because they are relevant to proving the materiality of Defendants' misrepresentations, (2) the
opinions contained in paragraphs 33 to 57 of the Devor Report are admissible under Rule 402
because they are relevant (i) to proving that Defendants acted with scienter and (ii) to rebutting

the AGF Defendants' defense of good faith, 1 and (3) the opinions contained in the Devor Report
are admissible under Rule 403, because "unfair surprise" is not a proper ground for excluding the
opinions contained in the that report and because those opinions are unlikely to confuse the
issues or mislead the finder of fact.

BACKGROUND

I.

A.

The SEC's Allegations

The SEC alleges that, in 2008, Defendant Johnson began operating a company called
American Growth Funding LLC ("AGF").

,r 20.)

(Compl.,

To raise money for AGF, Johnson

used a number of investment vehicles, including Defendant AGF II.

(Id.)

Defendants sold

"units" in AGF II to investors, promising a 1% return each month in exchange for investor funds.
(Id.,

~

21.)

After receiving these investor funds, AGF II loaned these funds to AGF, which, in

tum, loaned them to various third-party businesses.

(Id.,~ 23.)

According to the SEC, Defendants made multiple material misrepresentations in
connection with raising money for AGF II.

(Compl.,

,r,r 1-7.)

As relevant here, the SEC

alleges that Defendants distributed Private Placement Memoranda ("PPMs") in 2011 and 2012
stating that, "[a]s has been policy in the past, [AGF II's] annual financial statements will
continue to be audited."

(Compl., ,r,r 24, 28.)

In fact, however, AGF II's 2011 and 2012

financial statements were not audited until 2014, at which time they were audited by non-party
Seymour Weinberg.

1

(Devor Report, ECF No. 85-1, ~ 32.)

The other paragraphs of the Devor Report-paragraphs I through 13-provide information about Mr. Devor's
qualifications, compensation, the materials he considered, the scope of his assignment, and a summary of his
opinions. Because the opinions contained in the other portions of the Devor Report are admissible, testimony
by Mr. Devor on the topics in these parawaphs is admissible as well.

2

B.

The Devor Report

On February 3,2017, the SEC served Defendants with an expert report prepared by a
certified public accountant, Harris L. Devor (the "Devor Report").
essence, the Devor Report consists of two parts.

(ECF No. 84, at 3.)

In

First, Mr. Devor describes the characteristics

of an external audit and explains why external audits, including those of AGF II's financials,
matter to investors.

(ECF No. 85-1, fi'il 13-32.)

Second, Mr. Devor describes AGF II's

financials, explains that certain types of analyses were needed to properly audit those financials,
and explains why Mr. Weinberg's 2014 audits did not properly analyze those financials.
33-57.)

(Id.,

'il'il

In particular, Mr. Devor asserts that, because AGF II's investments consisted almost

completely of a loan receivable from AGF, and because that receivable was of questionable
value, any legitimate audit of AGF II's financial statements needed to analyze the underlying
financials of AGF.

(Id.)

Mr. Weinberg's audits of AGF II's financials did not do so.

(Id.)

Thus, Mr. Devor concludes that Mr. Weinberg essentially "failed to perform an audit at all."
(Id., 'if'if 41-49, 57.)

C.

Relevant Procedural History

The SEC commenced this action on February 3, 2016.
Defendants filed their respective Answers on April 22, 2016.
February 3, 2017, the SEC served the Devor Report.

(Comp!., ECF No. 1.)
(ECF Nos. 30, 32.)

(See ECF No. 84, at 3.)

2017, Defendants Johnson and AGF II moved to exclude the Devor Report.

On or about

On March 9,
(ECF No. 83.)

On June 9, 2017, after discovery had closed, the SEC moved for summary judgment. 2
No. 119.)

2

The SEC's motion for summary judgment will be decided at a later date.

3

(ECF

II.

DISCUSSION

The AGF Defendants have moved to exclude the Devor Report on the grounds that the
opinions contained therein are irrelevant under Rule 402 and are unfairly surprising and
misleading under Rule 403.
A.

(Defs.' Mem., ECF No. 84, at 4-11.)

Rule 402

I.

Legal Standard

Under Federal Rule of Evidence 402, all relevant evidence should be admitted unless
another rule, a statute, or the United States Constitution provides otherwise.

Evidence is

relevant if it has "any tendency to make a fact" that is "of consequence in determining the action"
any "more or less probable than it would be without the evidence."

Fed. R. Evict. 401.

Determinations of relevance are entrusted to the sound discretion of the district court.

See, e.g.,

United States v. Amuso, 21 F .3d 1251, 1263 (2d Cir. 1994).
2.

Application

The opinions contained in the Devor Report are relevant and thus admissible under Rule
402.

As discussed below, Mr. Devor's anticipated testimony about the importance of audits is

relevant to the materiality of Defendants' alleged misrepresentations.

Mr. Devor's anticipated

testimony concerning the inadequacy of Mr. Weinberg's 2014 audits is relevant both to proving
scienter and to rebutting Defendants' defense of "good faith."
a)

Testimony about the Importance of Audits

The opinions contained in paragraphs 13 to 32 of Mr. Devor's expert report-which
concern the nature and importance of audits generally and of AGF II's audits in particular-are
relevant to showing that Defendants' misrepresentations were material.
13-32.)

(See Devor Report,

~~

To prove a violation of the relevant securities laws in this case, the SEC will need to

show that Defendants "made a material misrepresentation or a material omission as to which

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[they] had a duty to speak, or used a fraudulent device."

SEC v. Frohling, 851 F.3d 132, 136

(2d Cir. 2016) (citation and internal quotation marks omitted).

A "material" misrepresentation

"is one that 'assume[s] actual significance' for a reasonable investor deciding whether to
purchase the security at issue."

Fed. Haus. Fin. Agency for Fed. Nat'! Mortg. Ass 'n v. Nomura

Holding Am., Inc., 873 F.3d 85, 146 (2d Cir. 2017) (citation omitted and brackets in original).
Mr. Devor's anticipated testimony about the nature and importance of audits will help the
jury understand why an investor would want to know that a company has had its financials
audited.

For example, Mr. Devor will explain that audits are often the only way for investors to

know that financial statements are free of misstatements or misrepresentations.
~

17.)

(Devor Report,

This testimony would show why Defendants' alleged misrepresentations about AGF II

being audited would have had "actual significance" to a reasonable investor and, thus, would
have been "material."

See Fed. Haus. Fin. Agency for Fed. Nat'! Mortg. Ass 'n, 873 F.3d at 146.

For this reason, and because accountants are well-equipped to provide testimony about audits,
Mr. Devor's anticipated testimony is relevant.

See SEC v. Johnson, 525 F. Supp. 2d 70, 74

(D.D.C. 2007) (holding that "accounting principles underlying recognition ofrevenue,
materiality, the conduct of audits, etc., are not the type of knowledge within the 'ken' of the
average juror, and such testimony is unquestionably relevant to the various accounting issues at
play in this case."); Nappier v. PricewaterhouseCoopers LLP, 227 F. Supp. 2d 263, 276 (D.N.J.
2002) ("[T]he determination of what accounting practices comprise [generally accepted
accounting principles] is a question of fact best addressed through expert testimony .... ").
Accordingly, the opinions contained in paragraphs 13 to 32 of the Devor Report are
admissible under Rule 402.
b)

Testimony about the Inadequacy of Mr. Weinberg's 2014 Audits

The opinions in paragr~ph~ ~:, tQ ~7 Qf Mr,

5

D~vor's r~port-concwning th~ lliitur, of

AGF Il's financials, the types of analyses necessary to properly audit AGF II's financials, and the
inadequacy of Mr. Weinberg's 2014 audits of AGF II's financials-are relevant both to proving
scienter and to rebutting the AGF Defendants' defense of good faith.

To show scienter under Section l0(b) of the Exchange Act and Rule l0b-5 thereunder, as
well as under Section 17(a)(l) of the Securities Act, the SEC must show that Defendants acted
with the "intent to deceive, manipulate, or defraud, ... or at least [with] knowing misconduct."
SECv. FirstJerseySec., Inc., 101 F.3d 1450, 1467(2dCir.1996).

Inthecontextofthiscase,

the fact that a proper audit of AGF II's financials required an audit of AGF's financials provides
an explanation for why Defendants might lie about AGF II's financials being audited.

In

particular, Mr. Devor will testify that in 2011 and 2012, the majority of AGF II's assets consisted
ofloans receivable from AGF, and that AGF's assets consisted of loans receivable from various
businesses.

(Devor Report, ri,-r 33-35.)

Many of AGF's loans receivable, however, were past

due by over 90 or 180 days, indicating that AGF may have been unable to repay its loan to AGF
II.

(Id., ,-r,-r 54-55.)

Because the shaky nature of AGF II's and AGF's investments could have

alarmed investors, Defendants may have been motivated to keep those investments secret.

But

as Mr. Devor notes, a proper audit of AGF II's financial records would require an auditor to
review and possibly comment on AGF's financials.

(See id., ,-r,-r 51-57.)

Knowing this,

Defendants had reason to lie about AGF II's 2011 and 2012 financial records being audited,
rather than hiring an auditor who might expose the nature of AGF II's and AGF's investments.
Defendants' motive to lie, in tum, makes it more likely that Defendants acted with scienter.
Mr. Devor's opinion that Mr. Weinberg's audit was inadequate provides further evidence
of Defendants' motive to lie:

After delaying hiring an auditor for over a year, it is noteworthy

that the auditor Defendants did hire failed to properly analyze AG F's financials.

This fact

BupportB the inforcm,c that DcfcndfilltB Bought out an auditor who would ignore AGF's
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financials-an inference further supported by the fact that Defendants met with, but did not hire,
multiple auditors who told Defendants that any audit of AGF II would require an audit of AGF.
(See Devor Report,~ 48.)

The inference that Defendants sought out an auditor who would

ignore AGF's financials, in turn, suggests that Defendants were concerned about disclosing those
financials.

And the inference that Defendants were concerned about disclosing AGF's

financials makes it more likely that Defendants would lie about having conducted an audit of
those financials.
Mr. Devor's opinion that Mr. Weinberg's audits were inadequate is also relevant to
rebutting the AGF Defendants' defense of "good faith."

The fact that the auditor Defendants

ultimately hired did not review AGF's financials supports the theory that Defendants attempted
to avoid a proper audit by hiring an unscrupulous auditor.

Mr. Devor's opinion that Mr.

Weinberg's report was inadequate from an accounting standpoint further supports this theory.
(See Devor Report,~~ 51-57.)

Because Mr. Devor's opinion rebuts the AGF Defendants'

defense that they sought to hire an auditor in "good faith," it is relevant and admissible.
Accordingly, the opinions contained in paragraphs 33 to 57 of the Devor Report are
admissible under Rule 402 because they are relevant to proving that Defendants acted with
scienter and to rebutting the AGF Defendants' defense of ·"good faith."
B.

Rule 403

1.

Legal Standard

Under Federal Rule of Evidence 403, relevant evidence may be excluded "if its probative
value is substantially outweighed by a danger of one or more of the following:

unfair prejudice,

confusing the issues, misleading the jury, undue delay, wasting time, or needlessly presenting
cumulative evidence."
evidence.

Rule 403 does not identify "unfair surprise" as a ground for excluding

Althou~h the adviso~ committee notes to Rule 403 state that "claims of unfair

7

surprise may still be justified," those notes also state that when a party claims unfair surprise,
"the granting of a continuance is a more appropriate remedy than exclusion of the evidence."
Fed. R. Evid. 403, advisory committee's notes on 1972 proposed rules.
2.

Application

The AGF Defendants claim that, even if Mr. Devor's opinions are relevant, they should
still be excluded because the SEC did not give proper notice that it would attack the sufficiency
of Mr. Weinberg's audits.

(See Defs.' Mem., at 9-10.)

The AGF Defendants argue that this

portion of Mr. Devor's opinion should be excluded because, in its Complaint, the SEC did not
(Id)

mention the adequacy of Mr. Weinberg's audits.

The SEC, however, was not required to

fully outline its trial strategy in the Complaint, much less its strategy for responding to the AGF
Defendants' affirmative defense of "good faith."
The AGF Defendants also argue that admitting Mr. Devor's testimony would be unfair
because Mr. Weinberg, the auditor who conducted the 2014 audits, was not deposed.

It is not

an unfair surprise, however, for an expert report to be based on the documentary record rather
than on deposition testimony.

The SEC served its expert report well in advance of trial and

there is no evidence that it failed to comply with any discovery obligations.

There is therefore

no reason for this Court to exclude Mr. Devor's report on the basis of unfair surprise.

That Rule

403 does not identify "unfair surprise" as a ground for excluding evidence, and that the advisory
notes counsel against excluding evidence on that basis, further weighs against doing so here.
See Fed. R. Evid. 403, advisory committee's notes on 1972 proposed rules.

If Defendants

believe that they must depose Mr. Weinberg to adequately address the Devor Report at trial, they
are free to request that discovery be reopened for that limited purpose.
As a second ground for excluding Mr. Devor's testimony under Rule 403, the AGF
Defendants claim that Mr. Devor' s tystim9ny,

if actmitt~ct, coulct C~Ui:lC the finder of foct to
8

mistakenly believe that the Defendants are liable merely because the audits of AGF II's
financials were inadequate.

(See Defs.' Memo, at 11.)

The Court finds it unlikely that the

finder of fact would be confused or misled in this manner.

And regardless, any risk of the

finder of fact being misled is outweighed by the probative value of this evidence; as discussed
above, Mr. Devor's testimony is highly relevant to support the SEC's theory of scienter and to
rebut Defendants' defense of good faith.

If during trial Defendants still believe that the finder

of fact may be misled by this testimony, they are free to propose an appropriate limiting
instruction.
Accordingly, the opinions contained in Mr. Devor's expert report are admissible under
Federal Rule of Evidence 403.

III.

CONCLUSION
In conclusion, (I) the opinions contained in paragraphs 13 to 32 of the Devor Report are

admissible under Rule 402 because they are relevant to proving the materiality of Defendants'
misrepresentations, (2) the opinions contained in paragraphs 33 to 57 of the Devor Report are
admissible under Rule 402 because they are relevant (i) to proving that Defendants acted with
scienter and (ii) to rebutting the AGF Defendants' defense of good faith, and (3) the opinions
contained in the Devor Report are admissible under Rule 403, because "unfair surprise" is not a
proper ground for excluding the opinions contained that report and because those opinions are
unlikely to confuse the issues or mislead the finder of fact.
For these reasons, the Court DENIES Defendants' Motion to Exclude the Expert Report
of Harris L. Devor.
The Clerk of Court is directed to terminate the motion at ECF No. 83.
If Defendants wish to submit their own expert report rebutting Mr. Devor's report, they

shall serve such a report on or before March 31,

2018, Depositions of Harris L, D~vor and
9

Defendants' rebuttal experts, if any, shall be completed on or before April 27, 2018.
SO ORDERED.
Dated: New York, New York
March 1, 2018

(~W'l-~
KIMBA M. WOOD
United States District Judge

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