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Securities and Exchange Commission v. E-Smart Technologies, Inc.

United States District Court, D. Columbia

October 13, 2015

SECURITIES AND EXCHANGE COMMISSION, Plaintiff,
v.
E-SMART TECHNOLOGIES, INC., et al., Defendants

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          For U.S. SECURITIES AND EXCHANGE COMMISSION, Plaintiff: Kenneth John Guido, Jr., LEAD ATTORNEY, U.S. SECURITIES & EXCHANGE COMMISSION, Enforcement, Washington, DC.

         MARY A. GRACE, Defendant, Pro se, Boulder, CO.

         TAMIO SAITO, Defendant, Pro se, Miyagi-Ken, Japan.

         ROBERT J. ROWEN, Defendant, Pro se, Sebastapol, CA.

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         MEMORANDUM OPINION

         JAMES E. BOASBERG, United States District Judge.

         This civil-enforcement case brought by the Securities and Exchange Commission has at long last rounded the corner from the liability phase to the remedy phase. In 2011, the SEC accused Mary A. Grace, Tamio Saito, e-Smart Technologies, Inc., Intermarket Ventures Inc., and IVI Smart Technologies, Inc., along with several individual brokers, of violating multiple provisions of the Securities Exchange Act of 1934 and the Securities Act of 1933 in connection with the unlawful sale of e-Smart securities. In three decisions spanning 2014 and 2015, the Court granted in substantial part the SEC's Motions for Summary Judgment on the liability of Grace and Saito. Separately, the Clerk entered a default against the three corporate Defendants -- e-Smart, Intermarket,

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and IVI -- on account of their failure to obtain counsel and defend against the SEC's accusations, and the brokers have all settled.

         The Commission now moves for specific remedies, seeking permanent injunctive relief -- i.e., bars on violating the securities laws, serving as officers or directors of publicly traded companies, and participating in penny-stock offerings -- disgorgement of all ill-gotten gains (along with pre-judgment interest), and civil penalties. It also asks for an opportunity to move for the establishment of a " Fair Fund" if the SEC manages to recoup sufficient assets to warrant distribution back to investors. The Court will grant the Commission's Motion in part and deny it in part, with instructions to the SEC and Grace to provide supplemental submissions on several issues pertaining to disgorgement and civil remedies.

         I. Background

         The Court has already set forth detailed background facts in the four decisions leading up to this point. See SEC v. e-Smart Technologies, Inc. (E-Smart I), 31 F.Supp.3d 69 (D.D.C. 2014) (denying Defendants' motion to dismiss); SEC v. e-Smart Technologies, Inc. (E-Smart II), 74 F.Supp.3d 306 (D.D.C. 2014) (granting partial summary judgment against Grace on counts I and II); SEC v. e-Smart Technologies, Inc. (E-Smart III), 82 F.Supp.3d 97 (D.D.C. 2015) (granting summary judgment against Grace on counts V and VII and denying judgment as to count VI); SEC v. e-Smart Technologies, Inc. (E-Smart IV), 85 F.Supp.3d 300, 2015 WL 1423495 (D.D.C. 2015) (granting summary judgment against Saito on counts I and V). The facts recited here are limited to those necessary to resolve the SEC's remedial requests, with some additional details provided for context.

         Mary A. Grace and Tamio Saito are the central players in this case. Grace was President, CEO, Chief Financial Officer, and a director of e-Smart Technologies, Inc., a publicly traded company that directed its business activities towards creating and selling " biometric identification verification systems." E-Smart II, 74 F.Supp.3d at 311. The company claimed that its blockbuster product was a " smart card" that could verify its possessor's identity using fingerprint sensors. Id. Grace, along with e-Smart's Chief Technology Officer, Saito, sought the assistance of investors to bring this technology to market. But in doing so, Grace, Saito, and the corporate Defendants committed a number of violations of the securities statutes, and the SEC maintains that the whole enterprise was a sham.

         In their first misstep, from early 2005 to the end of 2007, Defendants Grace and e-Smart sought investor capital by selling free-trading e-Smart shares without first registering those securities with the SEC -- a violation of sections 5(a) and (c) of the Securities Act. Id. at 324; see Mot., Declaration of Jeffrey R. Anderson, ¶ 7a-b; id., Exh. A-1 (Stock Issuance Spreadsheet); id., Exh. A-2 (Bank Deposits, 2006-2007). The sale actually consisted of a convertible-loan scheme, in which investors would make short-term loans to two intermediary corporations controlled by Grace (Intermarket and IVI), which would then offer up their restricted e-Smart shares as collateral for the loans. When the loans inevitably went into default, the " lenders" -- i.e., investors -- would be given the option to convert their notes into e-Smart stock at $0.10 per share. E-Smart II, 74 F.Supp.3d at 325. As a result of this scheme, " millions of dollars in 'loans' were exchanged for millions of unregistered, free-trading [e-Smart] shares," thereby circumventing the Securities Act's requirement that shares be registered. Id.

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          Separately, in a bid to make the company attractive to investors, Grace and Saito in 2007 and 2008 caused e-Smart to publish several claims about its business that subsequently proved false, in violation of section 10(b) of the Securities Exchange Act and SEC Rule 10b-5. Specifically, in a public filing made to the SEC in October 2007 -- the 2006 10-KSB -- Saito and e-Smart made numerous " detailed technological claims about the capabilities" of e-Smart's smart-card product, many of which proved false. E-Smart IV, 85 F.Supp.3d at 313. Several months later, in February 2008, Grace and e-Smart issued a press release in which the company falsely claimed to have landed a supremely profitable contract to supply the multinational corporation Samsung with 20 million smart cards. E-Smart II, 74 F.Supp.3d at 318.

         Finally, while sitting at its helm, Grace played a key role in e-Smart's failure to keep its books in order, implement proper internal controls, and file certain mandatory reports with the SEC (violations of the Exchange Act sections 13(a), 13(b)(2)(A), and 13(b)(2)(B), as well as Rules 12b-20, 13a-1, 13a-11, and 13a-13).

         Even though e-Smart proved rather skillful at fishing for capital from investors, it had little to no revenue, notwithstanding its principals' representations that substantial income would be forthcoming. See E-Smart II, 74 F.Supp.3d at 312. And, despite the anemic state of e-Smart's balance sheet, Grace had no compunction about drawing down the company's cash deposits, spending millions of dollars on hotels, travel, jewelry, clothing, restaurants, and other personal services. Id. at 313.

         The SEC filed this suit against Defendants in 2011. After a lengthy period of discovery, the Commission moved serially for summary judgment against all Defendants, which the Court largely granted. It held Grace liable for selling unregistered securities, making false statements in a 2008 press release, and failing to manage her business in accordance with SEC regulations. See E-Smart II, 74 F.Supp.3d 306; E-Smart III, 82 F.Supp.3d 97. It also held Saito liable for making false statements in the 2006 10-KSB and failing to make certain filings required of large shareholders. See E-Smart IV, 85 F.Supp.3d 300. When the three corporate Defendants failed to obtain counsel, the Court directed the Clerk to enter a default against them pursuant to Federal Rule of Civil Procedure 55(a). See ECF No. 118 (May 7, 2013, Order granting in part SEC's Motion for Default Judgment). With all issues of liability resolved, the SEC now seeks final judgment against all five Defendants.

         II. Legal Standard

         The substantive standards governing the SEC's particular remedial requests as to the individual Defendants will be set forth in each subsection below. In resolving this Motion, the Court must also determine whether judgment against the three defaulting corporate Defendants is appropriate. It therefore now summarizes the legal standard governing entry of default judgment.

         Federal Rule of Civil Procedure 55 establishes a two-step process for entering a default judgment against a party that fails to plead or otherwise defend. First, the Clerk enters the party's default, see Fed.R.Civ.P. 55(a), and then, unless the claim is for a sum certain, the Court determines whether to enter a default judgment, conducting hearings as necessary in order " to enter or effectuate judgment." Fed.R.Civ.P. 55(b)(2). " The determination of whether default judgment is appropriate is committed to the discretion of the

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trial court." Int'l Painters & Allied Trades Indus. Pension Fund v. Auxier Drywall, LLC, 531 F.Supp.2d 56, 57 (D.D.C. 2008) (citing Jackson v. Beech, 636 F.2d 831, 836, 205 U.S.App.D.C. 84 (D.C. Cir. 1980)).

         Although default resolves the question of liability against the defaulting party, see, e.g., Boland v. Elite Terrazzo Flooring, Inc., 763 F.Supp.2d 64, 67 (D.D.C. 2011), it does not necessarily determine Plaintiff's entitlement to all remedies requested. See SEC v. Mgmt. Dynamics, Inc., 515 F.2d 801, 814 (2d Cir. 1975) (requiring district court to " make an independent determination" regarding SEC's entitlement to equitable remedies); SEC v. One or More Unknown Traders in the Common Stock of Certain Issuers, 825 F.Supp.2d 26, 31-32 (D.D.C. 2010) (making " independent determination" regarding amount of disgorgement to be awarded against defaulting defendants). Where the remedy requested involves a particular sum -- as in the case of disgorgement -- the plaintiff " 'must prove its entitlement'" to such amount, but the court may, in resolving the motion, " 'rely on detailed affidavits or documentary evidence to determine the appropriate sum for the default judgment.'" Teamsters Local 639-Employers Health Trust v. Davis, 736 F.Supp.2d 168, 171 (D.D.C. 2010) (quoting Flynn v. Mastro Masonry Contractors, 237 F.Supp.2d 66, 69 (D.D.C. 2002)). Similarly, a plaintiff must prove its entitlement to injunctive relief based on actual evidence. See Mgmt. Dynamics, Inc., 515 F.2d at 814.

         The Court, therefore, will consider the merits of the SEC's particular requests for judgment against both the individual and the defaulting corporate Defendants.

         III. Analysis

         The Commission here requests four remedies. First, a permanent injunction barring: all five Defendants from committing securities-fraud violations, Grace and Saito from serving as officers or directors of publicly traded companies, and Grace and Saito from participating in any offering of penny stock. Second, disgorgement of $19,639,344 in ill-gotten gains and $9,332,640 in prejudgment interest from e-Smart, with the remaining Defendants jointly and severally liable for lesser portions of that total. Third, civil penalties against e-Smart ($1,950,000), Grace ($17,250,233.60), Saito ($520,000), IVI ($650,000), and Intermarket ($650,000). Last, the SEC requests that the final judgment include a provision allowing the SEC to move for establishment of a Fair Fund if it locates a sizeable-enough sum of Defendants' assets to warrant distribution to investors. The Court examines each set of remedies in turn.

         A. Injunctive Relief

         1. Securities-Violations Bar

         The SEC first asks this Court to permanently enjoin the five Defendants from future violations of the securities laws commensurate with the scope of each Defendant's liability. Simply stated, Plaintiff seeks a broad injunction against future violations by e-Smart and Grace, and a narrower one for Saito, IVI, and Intermarket.

         Section 21(d) of the Exchange Act, 15 U.S.C. § 78u(d), permits the SEC to seek, and district courts to grant, injunctions " commanding compliance with [federal securities] laws and regulations promulgated thereunder." SEC v. Savoy Indus., Inc., 665 F.2d 1310, 1318 n.54, 215 U.S.App.D.C. 7 (D.C. Cir. 1981). The remedy gives teeth to the securities laws by " subject[ing] defendant[s] to contempt sanctions if [their] subsequent [activity] is deemed unlawful . . . ." SEC v. Unifund SAL, 910 F.2d 1028, 1040 (2d Cir. 1990).

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          The essential question in deciding whether to issue a permanent injunction in light of past violations is whether there is a reasonable likelihood that the wrong will be repeated. SEC v. Bilzerian, 29 F.3d 689, 695, 308 U.S.App.D.C. 43 (D.C. Cir. 1994). In this Circuit, a court must generally consider three factors in deciding whether a future violation is reasonably likely: " 'whether a defendant's violation was isolated or part of a pattern, whether the violation was flagrant and deliberate or merely technical in nature, and whether the defendant's business will present opportunities to violate the law in the future.'" Id. (quoting SEC v. First City Fin. Corp., 890 F.2d 1215, 1228, 281 U.S.App.D.C. 410 (D.C. Cir. 1989)). No factor is dispositive; rather, the reasonable-likelihood-of-violation inquiry is to be answered " based on the totality of circumstances." First City, 890 F.2d at 1228. But see SEC v. Wills, 472 F.Supp. 1250, 1273 (D.D.C. 1978) (highlighting as " the most important" factor " whether the defendants' prior illegal conduct was repeated and persistent or merely amounted to an isolated incident" ).

         As to all Defendants, the SEC has shown a reasonable likelihood that the specific wrongs will be repeated. The securities violations they committed reveal a dogged pattern of using different tactics to obtain investor funds, regardless of whether the means for doing so violated federal law. Beginning at least with the convertible-loan scheme, masterminded by Grace and implemented with the help of IVI and Intermarket, e-Smart and its collaborators worked closely to ensure consistent streams of investor moneys. When the two-year period of unregistered security issuances ceased, Grace and Saito found ways of keeping investor money streaming in by misrepresenting e-Smart's revenue prospects and income potential, keeping e-Smart tenuously afloat for another three years. In short, the violations between closely related actors were numerous and repeated, and cannot be said to comprise a single " isolated incident." See SEC v. Johnson, 595 F.Supp.2d 40, 43-44 (D.D.C. 2009) (distinguishing series of closely related steps taken to commit single fraudulent act -- i.e., one " incident" -- from " 'repeated and persistent misconduct'" ) (quoting SEC v. Nat'l Student Marketing Corp., 457 F.Supp. 682, 715 (D.D.C. 1978)).

         The violations, moreover, were flagrant and deliberate. Defendants' actions were carried out with scienter and resulted in the loss of millions of dollars in investor capital. Nor were the violations " merely technical." SEC v. Savoy Indus. Inc., 587 F.2d 1149, 1165, 190 U.S.App.D.C. 252 (D.C. Cir. 1978) (defining technical violations as those that are " inconsequential" or that do not cause type of harm that statutory scheme was designed to prevent). On the contrary, they caused precisely the kind of harm to investors and the marketplace that the securities laws are designed to prevent. Defendants' violations here thus stand near the opposite end of the spectrum from violations of the technical or malum prohibitum variety. Cf. Black's Law Dictionary 1045 (9th ed. 2009) (defining malum prohibitum as an act that is wrongful " merely because it is prohibited by statute, although the act itself is not necessarily immoral" ).

         Finally, the SEC has submitted undisputed evidence that Defendants' business endeavors will, absent an injunction, present ample opportunity for them to violate the securities laws again. See Wills, 472 F.Supp. at 1273 (framing the inquiry as determining whether defendants are " now in positions where future violations can be anticipated" ). Central to the SEC's argument are indicia that e-Smart's brain trust, Grace and Saito, plan to continue developing and commercializing smart-card products of the type that landed them in hot water in the first place.

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          Most glaring is Grace's insistence that, despite the SEC's ongoing enforcement action and its success on summary judgment, she will continue selling, marketing, and seeking investors to support some version of a smart-card product through a non-party company, IVI Holdings, Ltd. See Grace Opp. at 40 (" If Plaintiff will leave Defendant's business alone now, the shareholders of Defendant's companies and their investors, lenders and shareholders can finally benefit." ); id. (" Defendant's [ sic] have never stopped [seeking future opportunities to market their product] -- it is Defendant's businesses. The survival and future of Defendant's companies, investors and shareholders depend on this. And- the product is not an 'alleged product.'" ).

         Although there is nothing wrong with seeking investor funds to sell a product per se -- assuming no securities laws are violated in the process -- Grace and Saito seem determined to repeat the same missteps that brought them before this Court. As an example, in Saito's motion seeking reconsideration of this Court's summary-judgment decision, he stated that the U.S. Patent and Trademark Office had issued five patents, filed between 2002 and 2007, covering some of the technologies e-Smart previously sought to develop. See ECF Nos. 663 (Saito Mot. for Reconsideration), 664 (same). Although his purpose in bringing up the patents is to show the legitimacy of his invention -- which, presumably, would illustrate the illegitimacy of this Court's conclusion that the claims in the 2006 10-KSB were fraudulent, see E-Smart IV, 85 F.Supp.3d 300, 2015 WL 1423495, at *18-19 -- his filings reveal his unyielding belief that the statements he made contained no false information whatsoever. In so doing, Saito sheds light on how he might treat such technology in the future, equating, as he does, the development of an idea (as embodied in a patent) with its reduction to practice in a commercially viable product (as was promised in the 2006 10-KSB).

         Grace, moreover, appears an inextricable partner in that technology's future marketing and commercialization. The patents are held by IVI Holdings, a company that she admits she formed " to own and hold the patents which were developed and patented and originally owned by IVI Smart Technologies, Inc." Grace Opp. at 26. Indeed, Grace insists that, but for the existence of non-party IVI Holdings and its willingness to " revive and reactivate th[ose] patents," they would have been lost, " saving defendant companies from utter ruin." Id. at 27 (emphasis added). The SEC provides additional evidence that, at least as of 2012, Grace was publicly repeating the same misrepresentations regarding the smart-card technology at the center of this suit in a website for a Hong Kong-registered company named I Am Holdings. See Mot., Att. D (Nov. 8, 2012, Screen Grab of www.iam-holdings.com); id., Att. E (Hong Kong Registration of I AM HOLDINGS). And Grace appears not to dispute that she intends to market and sell similar products in the future. See Grace Opp. at 27 (" The alleged wrongdoing . . . has nothing to do with the patents revived by IVI Holdings or the I AM card . . . . Plaintiff is trying to . . . prevent Defendants from continuing to do business, with products and companies that were never named or accused of any wrongdoing." ).

         The SEC has thus established a " reasonable likelihood" that Grace and Saito would commit securities violations in the future. And the Court sees no reason to part ways with that conclusion as applied to the corporate Defendants. See Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F.2d 341, 388 (2d Cir. 1973) (Timbers, J., dissenting in part) (" [W]here violations of the securities laws have been committed

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in the past by a corporation through its officers, the nature of the corporation and its officers is an important consideration in determining the likelihood of further violations." ). The Court will, therefore, impose on Grace and Saito a lifetime injunction against violating the securities laws as specified in the Conclusion infra.

         2. Officer-and-Director Bar

         The SEC also asks the Court to permanently bar Grace and Saito from serving as an officer or director of a publicly traded company on account of their violations of section 10(b) of the Exchange Act. That Act provides that, in a civil-enforcement action brought by the SEC:

[T]he court may prohibit, conditionally or unconditionally, and permanently or for such period of time as it shall determine, any person who violated [Section 10(b)] or the rules or regulations thereunder from acting as an officer or director of any issuer . . . if the person's conduct demonstrates unfitness to serve as an officer or director of any such issuer.

15 U.S.C. § 78u(d)(2) (emphasis added).

         Although neither Congress nor this Circuit has elaborated on the meaning of " unfitness" in this context, most courts have zeroed in on a series of non-exhaustive factors -- derived almost wholly from the scholarship of one law professor -- that purport to identify predictors of future unlawful behavior from known facts about a defendant's past conduct.

         The Second Circuit's six-factor framework in SEC v. Patel, 61 F.3d 137 (2d Cir. 1995), is the most prevalent. In assessing " unfitness" to serve, it required an evaluation of: " (1) the 'egregiousness' of the underlying securities law violation; (2) the defendant's 'repeat offender' status; (3) the defendant's 'role' or position when he engaged in the fraud; (4) the defendant's degree of scienter; (5) the defendant's economic stake in the violation; and (6) the likelihood that misconduct will recur." Id. at 141 (drawing from Jayne W. Barnard, When is a Corporate Executive " Substantially Unfit to Serve" ?, 70 N.C. L.Rev. 1489, 1492-93 (1992)).[1] Importantly, the Patel court was careful to emphasize the importance of the " likelihood of future misconduct" factor, requiring courts to find the facts sufficient to " justify the prediction that future misconduct will occur" before granting an injunctive remedy. Id. at 141.

         Two decades later -- and after Congress in 2002 modified § 78u(d)(2) to require only a showing of mere " unfitness" rather than " substantial unfitness" -- a court in this district articulated a revised, nine-factor version of the Patel test, also derived from an article written by Professor Barnard. See SEC v. Levine, 517 F.Supp.2d 121, 144 (D.D.C. 2007). Those factors include: " (1) the nature and complexity of the scheme; (2) the defendant's role in the scheme; (3) the use of corporate resources in executing the scheme; (4) the defendant's financial gain (or loss avoidance) from the scheme; (5) the loss to investors and others as a result of the scheme; (6) whether the scheme represents an isolated occurrence or a pattern of misconduct; (7) the defendant's use of stealth and concealment; (8) the defendant's history of business and related misconduct; and (9) the defendant's acknowledgment of wrongdoing and the credibility of his contrition." Id. at 145 (quoting Barnard,

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Rule 10b-5 and the " Unfitness" Question, 47 Ariz. L.Rev. 9, 46 (2005)). Recognizing that the central purpose of such injunctions was to " protect the public against future harm" by predicting individuals who were likely to commit future misdeeds, Barnard nevertheless omitted from the revised test the " likelihood of future misconduct" factor, in large part because of courts' inclination to lean on the " severity of the defendant's prior misconduct" as a predictive proxy instead of engaging in a " sincere effort to predict the future." Barnard, Rule 10b-5, 47 Ariz. L.Rev. at 30, 53. Instead, the test aimed for greater predictive accuracy by tailoring the Patel factors to identify " only those defendants who, by their conduct and attitude both in business and before the court, have demonstrated that they are 'opportunity seekers' . . . [who] look for ways to abuse or disrupt the capital markets." Id. at 55-56.

         The aim of both tests, therefore, is to separate likely recidivists from the reformed to ensure injunctions are entered only against the former. As a result, the Court need not pick and choose among the dueling frameworks because under both, Grace's and Saito's conduct and recent representations to the Court make clear that they are likely recidivists who are " unfit[]" to serve as a director or officer -- at least for the time being. Critical here is that, as discussed previously, both Defendants readily volunteered their intent to continue seeking investor capital in promoting and selling some version of a smart-card product. More importantly, the Defendants not only fail to accept the illegality of their previous behavior, but appear incredulous that any court could conclude that their prior statements to investors were anything but truthful. See Grace Opp. at 5 (" No Evidence of Fraud or Extreme Recklessness regarding the Samsung Press ...


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