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Federal Trade Commission v. Network Services Depot

August 16, 2010

FEDERAL TRADE COMMISSION, PLAINTIFF-APPELLEE,
v.
NETWORK SERVICES DEPOT, INC.; NETWORK MARKETING LLC; NETWORK SERVICES DISTRIBUTION, INC.; CHARLES V. CASTRO; ELIZABETH L. CASTRO; GREGORY HIGH; SUNBELT MARKETING, INC., DEFENDANTS-APPELLANTS, AND PHYLLIS WATSON, RELIEF DEFENDANT.



Appeal from the United States District Court for the District of Nevada, Lloyd D. George, Senior District Judge, Presiding, D.C. No. 2:05-cv-00440-LDG-LRL.

The opinion of the court was delivered by: Pallmeyer, District Judge

FOR PUBLICATION

OPINION

Argued and Submitted June 15, 2010 -- San Francisco, California

Before: Pamela Ann Rymer and Raymond C. Fisher, Circuit Judges, and Rebecca R. Pallmeyer, District Judge.*fn1

OPINION

OVERVIEW

Appellants are a group of related companies and their principals, engaged in the business of marketing and selling internet kiosk investment opportunities. On summary judgment, the district court found Appellants civilly liable for making material misrepresentations and engaging in deceptive business practices in violation of Section 5(a) of the Federal Trade Commission Act ("FTC Act"), 15 U.S.C. § 45(a), and the FTC's Franchise Rule, 16 C.F.R. § 436 (2005). As a remedy, the district court imposed liability for equitable monetary relief upon the companies, their owner, and one of their senior officers. Because the court determined that fees for Appellants' attorney were paid from funds derived from the unlawful activities, the court also imposed a constructive trust over a portion of those fees. On appeal, Appellants contend that the district court erred in imposing a constructive trust upon their attorneys' fees and assert that unresolved issues of fact with regard to Appellants' mental states precluded summary judgment. For the reasons explained below, we affirm the district court's decision in its entirety.

BACKGROUND

I. The Sham "Business Opportunity"

From 2001 to 2004, Appellant Network Services Depot, Inc. ("NSD"), its owner Charles Castro, and its senior executive Gregory High were in the business of selling internet kiosk business opportunities. In theory, the internet kiosks were to be stand-alone computer terminals, placed in public spaces such as airports or hotel lobbies, at which a user could log onto the internet for a fee charged to the user's credit card. NSD sold the opportunities to investors for amounts ranging from $4,400 to $7,000 per kiosk. In return, the company promised that it would secure locations and arrange for installation and activation of fully functional kiosk terminals. NSD issued each customer who purchased a kiosk opportunity a bill of sale and a letter transferring NSD's rights, title, and interest in a specific kiosk to the customer. Ostensibly, the revenues thereafter generated by the kiosk would be paid to the customer under a quasi-franchise arrangement. In its sales pitch to prospective customers, NSD represented that the internet kiosks would generate substantial revenue. "Well placed devices will generate $1,000 per day," boasted one NSD PowerPoint presentation. NSD also provided customers with a disclosure agreement circular, which contained the following statements:

We will sell you one or more publicly-accessible Internet access terminal Businesses, fully installed at a specific location selected by you from among available Sites we have identified... or at a Site which you own or lease or have secured yourself....

Once you notify us of the Site you have chosen..., we will... install an Internet Access terminal at that Site, and sell to you that Business and assign the Site Agreement to you, if applicable... [and] Since you are purchasing one or more fully-operational Business(es), you will begin operation of your Business(es) immediately upon the Closing, which barring unforeseen circumstances will occur no later than 60 days after the Effective Date of your Sales Agreement, or 30 days after you have submitted a Site Acceptance Notice for each Business, whichever is later.

In late 2001, NSD and Castro entered into a working relationship with Ed Bevilacqua and his internet kiosk companies -Bikini Vending Corp., MyMart, Inc., and 360 Wireless Corp. (collectively referred to as "BVC")-whereby Bevilacqua and BVC agreed to supply and install the kiosks on NSD's behalf at locations that BVC identified and obtained. In exchange, NSD agreed to pay BVC a share of the proceeds generated from its ongoing efforts in promoting and selling the business opportunities to the public. Although it had delegated the task of securing locations and installing kiosks to BVC, NSD remained exclusively contractually obligated to its customers to place and install the kiosks.

In most instances, BVC also served as a third-party manager for NSD's customers, ostensibly operating and overseeing purchased kiosk sites on the customers' behalf. As part of its management agreement, BVC guaranteed that NSD's customers would receive a set minimum revenue payment each month. NSD promoted BVC's management abilities and the revenue guarantee in its sales and marketing materials, and BVC's representations ultimately became an integral NSD selling point. As Castro later explained: "I would like to be able to say that I was successful with [NSD] because of my charm and business savvy, et cetera. That's not why we were successful. We were successful because of Ed [Bevilacqua].... [T]he reality of it was the folks that bought from [NSD] were buying from Ed." Castro and Bevilacqua were in frequent communication, and the two men occasionally appeared together to promote the kiosk program in joint presentations. Appellant Gregory High also regularly communicated with Bevilacqua and other BVC agents and performed official acts, such as signing documents, on BVC's behalf in the regular course of his duties at NSD.

By most outward appearances, the partnership between NSD and BVC was a fruitful one. In 2003, BVC represented that it had already installed thousands of operational kiosk terminals, and NSD disseminated projections that claimed the average monthly revenue for such terminals exceeded $1,100 per machine per month. While there is no evidence that any NSD customer ever saw returns approaching those projections, BVC did send NSD's customers the guaranteed "minimum revenue payment" every month, as promised. NSD also continued to promise customers exponential growth in the internet kiosk market. Both NSD and BVC publicly stated that their goal was to install and sell 250,000 kiosk locations nationwide by 2006. Based largely on NSD's growth and revenue forecasts, more than 800 consumers purchased or traded other assets in exchange for thousands of NSD kiosk business opportunities by early 2004. According to a Federal Trade Commission ("FTC") analysis of Appellants' financial records, consumers paid NSD and its affiliates more than $18 million for participation in the kiosk program.

In reality, however, the vast majority of the kiosk opportunities that NSD sold to the public simply did not exist. Only 270 kiosks were ever actually manufactured and installed, and, of those, fewer than 160 ever had operational connections to the internet. As these numbers reveal, almost all of the thousands of business opportunities that NSD marketed and sold to the public were, in fact, a sham. According to BVC's former Chief Financial Officer Alejandro Tanabe, the minimum monthly payments that BVC sent to kiosk customers came primarily from money that the company received from NSD as new customers signed up for the program. "There was no other significant source of revenue," Tanabe testified, because all of the functioning kiosks combined generated less than $2,000 per month. Over the course of his tenure, Tanabe also discovered accounting irregularities at BVC that suggested Bevilacqua had diverted millions of dollars in revenue for his personal use.*fn2 The FTC now describes the operation as "a classic Ponzi scheme."

The scheme began to unravel in February 2004, when a California-based television news affiliate aired an investigative report exposing BVC's questionable business practices. In March 2004, Tanabe and other BVC employees came forward and confirmed that BVC had been perpetrating its fraudulent activities by funding payment obligations with money diverted from new investors. Appellants concede that the actions and representations made by BVC and Bevilacqua were fraudulent and misleading, and they do not dispute that the scheme resulted in millions of dollars in losses to NSD's customers. Appellants contend, however, that neither Castro nor High personally had any advance knowledge of the fraudulent scheme. Indeed, Appellants claim, NSD itself was the primary victim of Bevilacqua's fraud. According to Appellants, Bevilacqua deliberately concealed the full scope of the fraud in order to obtain payments totaling more than $10.5 million from NSD for the installation of kiosks that never existed.

In an affidavit produced in opposition to summary judgment, Castro stated that he first became aware of the fraudulent scheme in March 2004 when BVC's practices were unmasked by Tanabe. Castro then contacted the Federal Bureau of Investigation at the suggestion of an attorney. In cooperation with the FBI, Castro had five secretly recorded conversations with Bevilacqua between March 10 and March 12, 2004.*fn3 According to Castro, during these conversations, Bevilacqua "continued to perpetrate his fraudulent scheme."

The blanket denial in Castro's affidavit is at odds, however, with the deposition testimony that he gave earlier in the case. While Castro consistently disavowed all actual knowledge of fraud in that testimony, he acknowledged several incidents over the course of his relationship with Bevilacqua that were early indications of BVC's malfeasance. Castro and Bevilacqua had worked closely together to develop their mutual business interests after first meeting in 2001. "I thought he was a guy that understood the business," Castro testified. "[He] did not strike me as the kind of guy that would ever do what he did." As time went on, however, Castro began to suspect that Bevilacqua might prove incapable of delivering on some of the grand promises he was making to NSD's customers: "[W]hen Ed would articulate to a group of people, a room full of people, with myself being present... and he would say [he could install] 20,000 machines in two and a half years, it made me want to choke...." After one meeting in December 2003, when Bevilacqua made another grandiose projection to a group of NSD sales agents, Castro confronted Bevilacqua privately with his concerns: "I sat with Ed," Castro testified, "and [I] said, 'Ed, you, kind of, told the agents you had the capacity to do this [installation of 1,000 new machines per month]. Do you have the capacity to do this?' It was at that time he disclosed to me that he was about 300 [machines] behind [the number of existing orders] and that he had $2 million in the bank." At no point, however, did Castro ever publicly contradict or question the representations that Bevilacqua was making to NSD's customers or agents.

Also in late 2003, NSD began receiving reports from a number of customers who had visited the supposed sites of their kiosks only to find nothing there. Other customers reported that, while they knew their machines had not yet been installed, they had inexplicably begun to receive "minimum revenue payments" purportedly generated by the nonfunctional kiosks. Castro received many of these reports personally.*fn4 For example, Castro received an e-mail from one such customer, which made the following prescient observation:

I have been receiving my revenue payments as promised. I am deeply concerned, however, where my revenue payments are coming from. My machines are certainly not producing enough revenue to pay me the minimum amounts.... Where is the extra money coming from to allow BVC to make its required minimum monthly payments and more importantly, how long can this trend continue before BVC is in serious financial trouble?

Though Appellants now argue that such complaints were too isolated or insignificant to put Castro on notice that something was seriously amiss with BVC's practices, the undisputed evidence confirms that Castro was in fact increasingly concerned by the numerous complaints. In December 2003, Castro sent Bevilacqua an e-mail, saying: "As I'm sure you are aware, this is rapidly becoming a huge issue. Clients and agents are driving out to the sites to find no kiosks installed." In his reply message, Bevilacqua responded to this "huge issue" by asking Castro to direct that High compile a list of the complaining customers and the sites visited "so we can get them moved up in the list." High admitted that, around this same time, he began assigning new customers to kiosk sites that were, in his words, "not too close to where the client and agent live[d]" in order to make it more difficult for customers to physically inspect kiosk locations. In this way, NSD was complicit in disguising ...


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