United States District Court, S.D. California
ORDER DENYING PLAINTIFF'S MOTION FOR SUMMARY JUDGMENT; GRANTING DEFENDANTS' MOTION FOR PARTIAL SUMMARY JUDGMENT; AND GRANTING DEFENDANTS' MOTION TO SET ASIDE DEFAULT
[DKT. NOS. 61, 64, 66, 72.]
GONZALO P. CURIEL, District Judge.
Before the Court are Plaintiff Securities and Exchange Commission's motion for summary judgment; and Defendants ABS Manager, LLC and George Charles Cody Price's motion for summary judgment and motion to set aside default. (Dkt. Nos. 61, 64, 66.) Oppositions and replies were filed. (Dkt. Nos. 70, 71, 73, 74, 75, 77.) After a review of the briefs, supporting documents, and the applicable law, the Court DENIES Plaintiff's motion for summary judgment; GRANTS Defendants' motion for partial summary judgment; and GRANTS Defendants' motion to set aside default.
On February 8, 2013, Plaintiff Securities and Exchange Commission ("SEC") filed a complaint along with an ex parte application, without notice, for a temporary restraining order ("TRO") and order freezing assets; appointing a receiver over defendant ABS Manager, LLC and the entities it controls and manages; prohibiting the destruction of documents; granting expedited discovery; and requiring an accounting. (Dkt. Nos. 1, 2.) The SEC also filed an ex parte application, without notice, for an order temporarily sealing the entire file until the asset freeze is served. (Dkt. No. 2.) On February 11, 2013, the Court denied Plaintiff's ex parte application for TRO and denied Plaintiffs' ex parte application to temporarily file entire case under seal. (Dkt. No. 3.) On February 19, 2013, Plaintiff filed a motion for preliminary injunction along with an ex parte motion to shorten time for hearing on the motion for preliminary injunction. (Dkt. No. 5.) After briefing by both parties, on February 27, 2013, the Court granted Plaintiffs' ex parte motion and set the matter for hearing on March 15, 2013, which was continued to March 19, 2013 after granting the parties' joint motion to continue the hearing date. (Dkt. Nos. 22. 24, 30.) On March 20, 2013, the Court granted Plaintiff's motion for preliminary injunction and for an order partially freezing assets of ABS Manager and the Funds, preserving documents, and requiring an accounting and denying Plaintiff's motion for an order freezing all funds' asset and personal assets and order appointing a receiver. (Dkt. No. 31.) A preliminary injunction order was filed on April 4, 2013. (Dkt. No. 35.)
The complaint alleges violations of sections 206(1) and 206(2) of the Investment Advisers Act of 1940; violations of section 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8; violations of section 17(a) of the Securities Act of 1933 ("Securities Act"); violations of section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5; and violations of section 20(a) of the Securities Exchange Act of 1934. (Dkt. No. 1.)
Plaintiff moves for summary judgment as to all causes of action in the complaint. Defendants move for summary judgment as to the first two causes of action based on violations of the Investment Advisers Act of 1940 as they contend they fall under an exception to the definition of investment adviser. Defendants also move to set aside default entered against Relief Defendants Cavan Private Equity Holdings, LLC and Lucky Star Events, LLC. (Dkt. No. 59.)
ABS Manager, LLC was formed by George Charles Cody Price ("Price") in March 2009. Price is ABS Manager's sole member, and serves as its President and Chief Executive Officer. From 2009 to the present, 35 individuals invested about $20 million to three Funds, ABS Fund, LLC (Arizona) ("ABS Fund Arizona"), ABS Fund, LLC (California) ("ABS Fund California") and Capital Access, LLC Fund (collectively known as the "Funds") managed by Defendants. Investors received membership units or interests in the Funds in which they invested and a brokerage held the securities.
The ABS Fund Arizona was first offered in March 2009 and sold units to about 13 or 14 investors for around $2.4 million. (Dkt. No. 64-3, Dean Decl., Ex. 1 at 1.) ABS Fund Arizona's Private Placement Memorandum ("PPM") stated that investors were entitled to a rate of 18% on their unreturned capital contribution. ( Id. at 6.)
The ABS Fund California, also known as the Nationwide Platinum Fund, was first offered in June 2010 and sold units to 35 investors for about $14.1 million. (Dkt. No. 64-3, Dean Decl., Ex. 2 at 1-2.) The ABS Fund California's PPM stated that investors were entitled to a 12.5% variable return with a minimum of 7.48% on their unreturned capital contribution. (Id.)
The Capital Access Fund was first offered in August 2012 and sold units to 35 investors for about $18.8 million. (Dkt. No. 64-3, Dean Decl., Ex. 3 at 1.) This Fund provided that investors were entitled to a 12.5% variable return with a minimum of 7.48% on their unreturned capital contribution. ( Id. at 8-9.)
The Funds used investor funds to obtain U.S. government issued agency interest only ("IO") collaterized mortgage obligations ("CMO") and reverse IO CMOs which were purchased through brokerage accounts maintained by the Funds with licensed broker dealers, such as Morgan Stanley Smith Barney ("Morgan Stanley"). The investors receive monthly interest payments that accumulate in the accounts. These calculations are conducted by a third-party accounting professionals. The Fund, through ABS Manager, distributed the accumulated monthly interest to the investors according to the accountant's spreadsheets. The accounting firms send monthly account statements to each investors, which reflect distributions and the investor's monthly membership interest account statements. The third party accounting firms also calculate the compensation that ABS manager is to receive after distributions are made to the Fund's investors. SEC disputes theses facts to the extent that the accounting firms did not base calculations or did not take into consideration the net asset value of the Funds.
Mortgage-backed securities (MBS") are bonds whose payments are secured by the principal and interest payments made by borrowers in a collection, or pool, of mortgages. (Dkt. No. 64-28, Weiner Expert Report at 6.) Mortgage backed securities can be either "Agency" or "Non-Agency." ( Id. at 9.) A government-backed instrument is known as Agency.
An Agency carries the names of one of the mortgage Government Sponsored Entities ("GSE"): Fannie Mae, Freddie Mac or Ginnie Mae. In return for a fee taken as a slice of interest from the mortgage payments in the pool, the GSEs guarantee the timely payment of principal and interest of each of the mortgages in the pool. (Id.) This Agency' guarantee effectively removes default risk from the investment because if a mortgagor defaults, the Agency purchases the loan from the pool at full face value, along with any interest accrued and owed, and that repurchase is passed along to investors in the pool.
Ginnie Mae is not a government agency, but is a wholly-owned government corporation located within the U.S. Department of Housing and Urban Development (HUD)'" ( Id. at 10.) Fannie Mae and Freddie Mac are "government-chartered, but publicly-owned, corporations, with common and preferred stock that trade on public stock exchanges." (Id.) This Agency "guarantee" applies to timely payment of interest and principal but not on a decline in the market value of any security or a guarantee that an investor will necessarily earn a positive return on the holding of a security. (Id.)
An Agency Collateralized Mortgage Obligation ("Agency CMO") was created from MBS and "redirects the principal and interest cash flows from a pool of similar mortgage pass-throughs into a different and newly-created set of bond classes or tranches.'" ( Id. at 12.) CMO tranches can be tailored to meet a particular investment need or investor class. (Id.) While there is an Agency guarantee as to the required payments to investors, it does not guarantee a liquid market or a positive return on an investment, especially one that is sold prior to its maturity date. ( Id. at 13.) A type of Agency CMO is an interest only ("IO") where investors receive only the interest payments. (Id.) Because it receives no principal, it has no underlying principal balance but instead has a "notional" balance which tracks the balance of the underlying bond from which it was structured. ( Id. at 14.) Since there is no principal payment, the investor does not receive a final return of principal as a single payment on the final maturity date or as a stream distributed throughout the life of the investment. (Id.) The investor is only entitled to interest flows during the time the security is outstanding. (Id.) Should mortgage refinancings increase, then the flow is reduced and ultimately extinguished. (Id.) Owning an IO security "constitutes a sort of race to recoup the initial investment plus enough additional interest to produce a desired level of return before the security disappears." (Id.)
An Inverse IO is a CMO tranche that pays only interest and with a coupon that resets monthly according to an inverse-type formula. ( Id. at 18.) These are the "among the most complex, difficult to understand, value and manage mortgage derivative securities... and are considered to be among the riskiest forms of CMO securities." (Id.)
According to Plaintiff, the Inverse IOs contain two risks. First, the risk of a rise in LIBOR reducing the coupon as a result of the coupon formula, and second, the risk of an increase in mortgage prepayments, which will cause the notional balance of the security to pay down and eventually evaporate. The Agency guarantee provides no protection as to these risks. According to Price, the "government backing" of Agency IOs and Inverse IOs eliminates IO credit risk and several other risks. (Dkt. No. 73-2, Price Decl. ¶ 34.)
All three of the Funds' PPMs state the Fund would invest in various types of collateralized mortgage obligations ("CMO") but do not mention the specific type. (Dkt. No. 64-3, Dean Decl., Ex. 1 at 1; Ex. 2 at 11; Ex. 3 at 7.) Ultimately, the ABS Funds were invested in two particular types of Agency CMOs: IO and Inverse IO tranches. (Dkt. No. 68-4, Suppl. Dean Decl., Ex. 37, Price Depo. at 118:20-23; 119:19-120:7; 121:10-18; 122:3-8; 123:34-124:1; 249:5-12.)
Agency IO and Inverse IO tranches of CMOs are high risk, volatile securities. (Dkt. No. 64-3, Dean Decl., Ex. 7 at 16-17; see also Dkt. No. 64-28 Weiner Report. at 15.) While the parties dispute the degree of risk, it is clear that these investments were not for the ordinary investor but required a sophisticated investor. (See Dkt. No. 64-3, Dean Decl., Ex. 1 at 5 (only certain sophisticated accredited investors who are able to bear a substantial loss of their capital contribution may invest); Ex. 2 at 7 (investor required to represent that they are sophisticated in busines and financial matters or have been advised by someone who is); Ex. 3 at 5 ("this offering involved substantial risks... investors in the company must have such knowledge and experience in business and financial matters as will enable them to evaluate the merits of the proposed investment... and be able to bear the economic risks of this investment.") In their opposition, Defendants concede and state that the investors understood the high risk of investing in these types of securities and that they could lose their total investment and they also understood that the preferred return was not guaranteed nor were there any guarantees regarding the backing for the securities purchased by the fund. (Dkt. No. 73-3, Price Decl., Ex. F, Flagg Decl.¶ 9; Dkt. No. 73-3, Price Decl., Ex. G, Murch Decl. ¶ 16.)
According to Price, Agency CMOs are "fairly sophisticated and not easily understood by the average financial advisor. This is primarily due to the simple fact these securities are traded in a specialized market and are considered odd lot' purchases. Where as most banks look to lend against what are called "round lot' CMOs which are larger in average size than odd lot' smaller in size CMOs. While there is always a market in which these securities can be sold, it requires doing a lot of homework and making sure that the bid and ask prices are commensurate with the value of the income generated by the interest-only CMOs in order to obtain a fair price. Not every firm has a person who is an expert in this area, and there are only a few qualified individuals at the films that do have the ability and desire to evaluate and trade these securities." (Dkt. No. 73-2, Price Decl., Ex. A, Price Decl. in Opp. to Pl's Ex Parte Appl. ¶ 11.)
From 2010 to 2012, the Funds made interest payments to investors of 12% to 18%. However, the value of certain portfolios held by ABS Arizona and Capital Access had decreased significantly in value.
A. Legal Standard for Federal Rule of Civil Procedure 56
Federal Rule of Civil Procedure 56 empowers the Court to enter summary judgment on factually unsupported claims or defenses, and thereby "secure the just, speedy and inexpensive determination of every action." Celotex Corp. v. Catrett, 477 U.S. 317, 325, 327 (1986). Summary judgment is appropriate if the "pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law." Fed.R.Civ.P. 56(c). A fact is material when it affects the outcome of the case. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986).
The moving party bears the initial burden of demonstrating the absence of any genuine issues of material fact. Celotex Corp., 477 U.S. at 323. The moving party can satisfy this burden by demonstrating that the nonmoving party failed to make a showing sufficient to establish an element of his or her claim on which that party will bear the burden of proof at trial. Id. at 322-23. If the moving party fails to bear the initial burden, summary judgment must be denied and the court need not consider the nonmoving party's evidence. Adickes v. S.H. Kress & Co., 398 U.S. 144, 159-60 (1970).
Once the moving party has satisfied this burden, the nonmoving party cannot rest on the mere allegations or denials of his pleading, but must "go beyond the pleadings and by her own affidavits, or by the depositions, answers to interrogatories, and admissions on file' designate specific facts showing that there is a genuine issue for trial.'" Celotex, 477 U.S. at 324. If the non-moving party fails to make a sufficient showing of an element of its case, the moving party is entitled to judgment as a matter of law. Id. at 325. "Where the record taken as a whole could not lead a rational trier of fact to find for the nonmoving party, there is no genuine issue for trial.'" Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 587 (1986). In making this determination, the court must "view the evidence in the light most favorable to the nonmoving party." Fontana v. Haskin, 262 F.3d 871, 876 (9th Cir. 2001). The Court does not engage in credibility determinations, weighing of evidence, or drawing of legitimate inferences from the facts; these functions are for the trier of fact. Anderson, 477 U.S. at 255.
B. Anti-Fraud Provisions: Sections 17(a)(1)-(3) of the Securities Act; Section 10(b) of the Exchange Act and Rule 10b-5
Plaintiff moves for summary judgment on the anti-fraud provisions of the Securities Act and the Exchange Act. The third cause of action alleges violations of sections 17(a)(1), 17(a)(2), and 17(a)(3) of the Securities Act, 15 U.S.C. §§ 77q(a)(1), 77q(a)(2), & 77q(a)(3). Section 17(a) prohibits fraud in the offer or sale of securities and provides:
It shall be unlawful for any person in the offer or sale of any securities...by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly
(1) to employ any device, scheme, or artifice to defraud, or
(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
15 U.S.C. §§ 77q(a)(1)-(3).
The fourth cause of action is for violations of section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b); and Rules 10b-5(a-c), 17 C.F.R. § 240.10b-5. Section 10(b) prohibits fraud in connection with the purchase or sale of any security:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange-...
(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as ...