Only in Texas: Civil Securities Fraud Claims Dismissed but Criminal Charges Head to Trial

Chief executive officer

Warren “Ken” Paxton, Jr. is the attorney general of Texas. He’s had some ups and downs this week, to be sure.

On Friday, October 7, 2016, the Eastern District of Texas dismissed all of the securities charges filed by the SEC against him.

On Wednesday, October 12, the Texas Court of Criminal Appeals refused to hear a last-ditch appeal by him to dismiss criminal charges for the same conduct.

It doesn’t take a legal genius to spot this anomaly. Criminal charges are tougher to prove; civil claims are easier. So why were the civil claims dismissed but the criminal charges still standing?

The Supposed Securities Fraud

(These facts are taken from the decision of the Eastern District of Texas, which in turn relies on the allegations in the SEC’s complaint. Given that they are entirely unproven, take them with a grain of salt.)

In the summer of 2011, Mr. Paxton (then a Texas state representative) began helping a cloud-services company called Servergy find investors. Servergy’s CEO offered him a 10% commission. Mr. Paxton didn’t do all that much—he invited 7 investors to a pitch at Servergy’s office and introduced the CEO to 5 other investors.

Some of the 12 people Mr. Paxton recruited were in an investment group to which he belonged. According to the Eastern District of Texas:

Based on prior dealings in the investment group, members trusted one another to consider the interest of the group as a whole and not exploit one another for a member’s personal benefit. Typically, the member who recommended the investment would monitor the investment going forward and represent the group’s interest. Paxton did not inform the investment group of his compensation arrangement with Servergy.

Five of the twelve prospects invested a total of $840,000 in Servergy, and Mr. Paxton received 100,000 shares of Servergy.

The Claims and Charges Against Mr. Paxton

The SEC filed its complaint in April 2015, alleging that Mr. Paxton had violated Sections 17(a) and 17(b) of the Securities Act and Sections 10(b) and 15(a) of the Exchange Act.

In the summer of 2015, Mr. Paxton was indicted by a Collin Count (Tex.) grand jury of securities fraud and failure to register with the state securities board.

The Dismissal of the SEC’s Charges

The explanation of the dismissal of the SEC’s charges is remarkably straightforward. If you want to read a good example of a court marching through its reasoning step-by-step, this is a good one.

To survive a motion to dismiss, the SEC must allege facts showing (1) there was a misstatement or omission; (2) of material fact; (3) in connection with the purchase of a security; (4) made with scienter.

I’ll summarize the opinion in 10 brief points:

First, the court held that Mr. Paxton’s statements that Servergy was a “great company” and an “interesting investment opportunity” were “mere puffery,” not misstatements of fact.

Second, his other alleged “misstatements” – that he had met with Servergy management and that the investment would double in price – were not alleged to be false.

Third, even though a fiduciary relationship gives rise to a duty to speak (and therefore an omission could lead to liability), Mr. Paxton’s membership in the investment club did not create a fiduciary relationship. He had no “de facto control and dominance” over the other members. And there were no allegations of “fiduciary-like duties regarding investment recommendations” as opposed to monitoring investments for the group.

Fourth, there is no duty to disclose compensation for a non-broker. “[N]o court since [SEC v. Torr, 22 F. Supp. 602, 606 (S.D.N.Y 1938)] has held a stock promoter liable as volunteer fiduciary.”

Fifth, there is no liability here for a supposed “half-truth.” Under this theory, if a person makes a partial disclosure, then he has an obligation to make a complete disclosure where the partial disclosure would be misleading standing alone. But this theory requires a disclosure on a specific subject—and the SEC did not allege that Mr. Paxton made any disclosures about compensation at all.

Sixth, the claim under Section 17(a) had to be dismissed. Under Section 17(a), a person who circulates a communication about a security must “disclos[e] the receipt, whether past or prospective, of such consideration and the amount thereof.” The problem for the SEC is that even though Mr. Paxton indeed circulated an email promoting the stock, he wasn’t compensated for circulating the email. He was alleged to have been compensated only when someone invested in Servergy.

Seventh, Mr. Paxton’s supposed failure to conduct due diligence on the security does not give rise to any liability. “Even if the Commission had alleged such a duty [to conduct due diligence], courts have held that failure to conduct due diligence on a promoted stock does not give rise to liability.”

Eighth, an unrecorded oral communication  (a telephone call to a potential investor) does not give rise to Section 17(b) violation. The case law requires some type of “tangible media” be circulated—not just a conversation.

Ninth, there was no violation of Section 17(b) – for either the phone calls or emails – because there must be a “publicity element” to the communication under the statute. These communications were not public or broadly disseminated.

Tenth, Mr. Paxton did not need to register as a broker under Section 15(a)(1) because he was not alleged to have any control over the account of others. “[C]ontrol over the account of others is an element [of an offense] rather than a factor.”

What Will Happen Next?

The court did give the SEC 15 days to replead its complaint. It remains to be seen whether the Commission can allege sufficient facts in good faith to file the complaint again. I’d guess that he Commission will be fairly cautious about repleading. When you lose once in front of a judge, you better come strong the second time around.

For now, though, it seems as though Mr. Paxton’s criminal charges will head to trial in Texas. I think the arguments over the jury instructions in that case will be the pivotal issue. It doesn’t sound like there’s a lot of dispute over the facts here (maybe there is—I have no inside baseball here), so the law will be the real driver of outcome.

Congrats to Mr. Paxton’s legal team in the civil case and best of luck in the criminal one, too.

This entry was posted in Securities fraud. Bookmark the permalink.

One Response to Only in Texas: Civil Securities Fraud Claims Dismissed but Criminal Charges Head to Trial

  1. Pingback: Like DOJ, the SEC Has Trouble with Misleading Press Releases | Grand Jury Target

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