Press Release: SEC Charges Shell Factory Operators with Fraud
A California stock promoter.
A New Jersey lawyer.
The Plaintiff: Securities and Exchange Commission (SEC)
What: The SEC charged defendant 1 and defendant 2 with violating or aiding and abetting violations of the antifraud, reporting, and securities registration provisions of the federal securities laws.
The SEC is seeking fines in the amount of the funds they fraudulently obtained plus interest and penalties, and permanent injunctions including an “officer-and-director bar” against defendant 1 (preventing him from becoming a board member of certain companies), and penny stock bars (stops individuals from purchasing penny stock or being involved with penny stock issuers, generally).
Securities laws prohibit fraudulent conduct both criminally and civilly, but the SEC is responsible only for civil enforcement and administrative actions. SEC penalties range from obtaining court orders stopping individuals from committing further violations (i.e., injunctions), requiring the turning over of funds that are obtained illegally, and other civil penalties.
Defendant 1 made about $2.25 million from selling these “shell” companies, and defendant 2’s firm received over $200,000 for their legal services.
Where: The complaint was filed in federal court in Los Angeles.
When: The alleged conduct happened from about 2006 to 2013. Both were charged on May 12, 2016.
Why: Defendant 1 and defendant 2 allegedly created phony companies, referred to as “shell” companies. “Shell” companies are publicly traded companies that have no real business or purpose.
Essentially, they formed several different startup companies and raised funds by misleading investors into believing that the companies would be operating and profitable, without ever intending to follow through on these representations.
How: Over a period of about seven years, both of them created nine shell companies, seven of which were sold.
Pending further investigation, the SEC issued “stop orders” for the last two created companies to prevent further fraud. “Stop orders” are a form of an injunction that suspends registration statements, preventing the sale of companies.
Both of them created the companies and recruited investors in generally the same way:
First, defendant 1 created a business plan and convinced a friend, friend of a friend, or relative to be a “puppet CEO,” meaning they would be the CEO only in name, but really defendant 1 had full control over the company, its operations, and sale. Defendant 1 offered these puppet CEOs $500 to $700 per month for this “position.”
Defendant 1, with the help of defendant 2 who was listed as counsel for the company, incorporated the company.
Defendant 1 set up about 35 “straw shareholders.” A “straw shareholder” is a person who purchases shares of stock in a company for someone else in order to commit fraud or get around legal restrictions. These shareholders were considered “straw shareholders” because many purchased their shares with cash defendant 1 gave them, and some were even deceased.
Some straw shareholders even paid for their shares with money orders, which defendant 2 eventually advised defendant 1 against to avoid scrutiny by authorities.
Both of them kept possession of the stock certificates for these straw shareholders. Stock certificates represent shareholder interest. A transfer of a stock certificate to someone else generally means a transfer of the shares represented in it, so generally, they should be kept with the respective shareholder until and if they are sold.
Defendant 2 and his law firm served as counsel to publicly register the company, using registration statements that laid out business plans that were never followed through with, the straw shareholders as the persons with controlling interest, and the puppet CEO as the officer, director, and employee.
To maintain their status as a publicly traded company, the companies were required to file periodic reports. In these reports, similarly misleading information was given.
Once the company was established as publicly traded, both of them recruited investors to purchase the company.
In these sales, defendant 1 appointed a representative for the straw shareholders. Defendant 2 prepared stock purchase agreements and escrow agreements, with defendant 2’s firm serving as the escrow agent. Once the escrow agent received the funds of the sale, they were wired to the representative after deducting legal fees.
Defendant 1 then directed the representative to wire portions of the funds to one or more of his own bank accounts.
After the sale, the puppet CEO resigned and new management entered.
Both of them, in the thick of their dealings, agreed to communicate via emails created in the various puppet CEOs’ names to avoid scrutiny by authorities.
Defendant 1 earned between $215,000 and $425,000 for each company sale, totaling seven sales. Defendant 2’s law firm earned over $200,000 in attorney’s fees from these sales.