Opinion
No. 1:02-cv-01118-DFH-VSS
March 23, 2004
ENTRY ON SEC's MOTION FOR SUMMARY JUDGMENT
Defendant Church Extension of the Church of God, Inc. ("CEG") is a not-for-profit corporation that funds the construction and renovation of churches and other facilities associated with the Church of God, a religious denomination based in Anderson, Indiana. Defendant United Management Services, Inc. ("UMS") is a subsidiary of CEG and manages many of CEG's investments and projects. The United States Securities and Exchange Commission ("SEC") filed this securities fraud action against defendants CEG and UMS and their former presidents, James Perry Grubbs and Shearon Louis Jackson.
The claims here arise from CEG's sales of approximately $85 million in investment notes to church members over several years. CEG has not been able to make timely interest payments to investors as required by the notes. CEG and UMS reached a settlement with the SEC at the time the case was filed, in July 2002. Pursuant to that settlement, and under supervision by this court and a court-appointed conservator, CEG has undertaken an extensive restructuring project to try to come as close as possible to meeting its obligations to the note holders. Those efforts are ongoing.
In the meantime, the SEC's case has proceeded against Grubbs and Jackson. The SEC seeks relief against Grubbs and Jackson under Section 20(b) of the Securities Act of 1933, 15 U.S.C. § 77t(b), and Section 21(d) and (e) of the Securities Exchange Act of 1934, 15 U.S.C. § 78u(d) (e). The SEC alleges that Grubbs and Jackson violated Section 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q(a), Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, by misleading the buyers of the notes about how the proceeds would be used and about CEG's financial condition.
The case is now before the court on the SEC's motion for summary judgment on its claims against Grubbs and Jackson as individuals. To win summary judgment, of course, the SEC must show that any reasonable trier of fact would have to find in its favor, even when giving Grubbs and Jackson the benefit of conflicts in the evidence and the benefit of any reasonable inferences that might be drawn in their favor from the evidence. See Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 255 (1986).
According to the SEC, CEG encountered serious financial problems in the late 1980s as a result of defaults on loans it had made and a negative "spread" between the interest rates CEG had promised to pay investors and the loan payments it received from local church congregations and other borrowers. The SEC contends that Grubbs and Jackson then orchestrated a fraudulent scheme over a period of years, in which they misled church members into buying the notes.
The scheme, as alleged by the SEC, included a number of so-called "bargain sales," in which CEG bought assets that were the subject of high appraisals for prices much less than the appraised values. For reporting purposes, CEG would treat the differences between the high appraised values of the acquired property and the low purchase prices as non-cash contributions that could be treated as a form of income.
It appears that such bargain sale transactions can be lawful as long as, through such a transaction, the seller actually intends to give the buyer a donation of the difference between a fairly appraised value and the sale price. See 34 Am.Jur.2d Federal Taxation ¶ 19150 (2004) ("A taxpayer may sell property to a charity and receive less than the property's fair market value. The seller-donor generally realizes taxable gain on the sale or exchange, but gets a charitable deduction for the bargain element."). The SEC contends, however, that CEG, at the behest of Grubbs and Jackson, used deliberately inflated appraisals for many such transactions. According to the SEC, Grubbs and Jackson then used those transactions to overstate CEG's income by more than $25 million and to avoid recording losses of more than $25 million. The SEC also contends that CEG misled note buyers about the quantity and quality of monetary reserves it had set aside to meet financial obligations. The SEC's motion presents Grubbs and Jackson as the masterminds of the entire scheme. Grubbs was president and CEO of CEG. Jackson was president of UMS.
The SEC must prove its claims by a preponderance of the evidence. Herman Made an v. Huddleston, 459 U.S. 375, 390-91 (1983). To prove its fraud claims under Section 17(a)(1) of the 1933 Act and Section 10(b) of the 1934 Act, which is all that the SEC addressed in its opening brief, the SEC must prove that a defendant acted with fraudulent scienter. For these purposes, fraudulent scienter means the defendant acted with the intent to deceive, manipulate, or defraud, or with reckless disregard for the truth of the statements made. Emst Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976); Ambrosino v. Rodman Renshaw, Inc., 972 F.2d 776, 789 (7th Cir. 1992); Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1044 (7th Cir. 1977).
There is a small set of extreme cases in which fraudulent scienter can be decided against a defendant as a matter of law; a defendant's explanation or evidence may be so insubstantial, incredible or implausible that no reasonable finder of fact could credit it. See In re Chavin, 150 F.3d 726, 728-29 (7th Cir. 1998) (affirming denial of bankruptcy discharge based on summary judgment finding of fraud, but recognizing case was "exceptional"); S.E.C. v. Jakubowski, 150 F.3d 675, 681-82 (7th Cir. 1998) (affirming finding of fraudulent scienter under § 10(b) of Securities Exchange Act); S.E.C. v. Kahn, 2002 WL 1163723, at *4 (N.D. III. May 31, 2002) (finding scienter as a matter of law under securities laws). These few cases recognize, however, that they are exceptional. In general, where the evidence permits an inference of fraudulent scienter, questions of intent are questions for the trier of fact.
In this case, the SEC's motion for summary judgment must be denied because the evidence shows genuine issues of material fact concerning fraudulent scienter. The record presents these issues with respect to individual transactions and with respect to the overall course of the CEG transactions and issuance of notes. The SEC's evidence would permit an inference of fraudulent scienter by Grubbs and Jackson, but that is not the standard that must be met here. The issue on the SEC's motion for summary judgment is whether any reasonable jury would be required to find fraudulent scienter on this record.
In testimony before the court, defendants Grubbs and Jackson have denied acting with fraudulent intent. They have also come forward with evidence tending to show a relative lack of sophistication and experience with securities law and property appraisals. Viewing the evidence in the light reasonably most favorable to defendants, as the court must at this stage, the court must note the absence of evidence of any personal enrichment of these defendants. Especially in light of the entities here — the Church of God and its associated business arms — it is not clear that the defendants had any substantial motive to pursue the fraudulent scheme attributed to them. There is no evidence, for example, that they received kickbacks or other personal enrichment from the property sellers in the bargain sale transactions in question. Their direct compensation does not appear to have been exorbitant. Nor is there evidence that their direct compensation derived from ill-gotten proceeds. The evidence would allow a trier of fact to find that Grubbs and Jackson were devoted to the success of the Church of God and CEG, and that they would not have deliberately harmed these institutions or church members. The SEC is not required to prove motive as an element of its case, but evidence of motive (or its absence) is relevant in evaluating the defendants' intentions. See In re Northern Telecom Ltd. Securities Litigation, 116 F. Supp.2d 446, 462 (S.D.N.Y. Sept. 28, 2002) (granting summary judgment for defendants on issue of scienter).
The SEC makes the unsupported and untenable assertion that evidence of motive or its absence "is irrelevant to the scienter analysis." See SEC Reply Br. at 18, citing S.E.C. v. Piper Capital Mgmt, Inc., No. 3-9657, 73 S.E.C. Docket 2525, 2000 WL 1759455, at*44 (S.E.C. Release No. ID-175, Nov. 30, 2000), citing in turn S.E.C. v. U.S. Environmental, Inc., 155 F.3d 107, 111-12 (2d Cir. 1998). The cited Second Circuit case denied a motion to dismiss, holding that the SEC's allegations of scienter were sufficient. The court stated that "as long as [defendant], with scienter, effected the manipulative buy and sell orders," his motivation would be irrelevant. 155 F.3d at 112 (emphasis added). In other words, the court said, if one assumes a defendant has violated the law, the presence or absence of personal motivation is not a defense. That is a far cry from holding that evidence of motive or its absence is irrelevant in deciding the underlying question of fraudulent intent in the first place. Similarly, the ALJ in the cited SEC proceeding correctly held that the SEC is not required to prove a motive, not that such evidence is irrelevant. 2000 WL 1759455, at *44.
In addition, the evidence allows the inference that professional advisers — lawyers, accountants, and appraisers — as well as CEG board members and staff members, played extensive roles in reviewing and approving the transactions in question. The SEC asserts, for example, that all of the Offering Circulars promoting the notes included an unqualified report from an independent auditor. There is also evidence that would allow a trier of fact to find that Grubbs and Jackson were not terribly sophisticated when it came to securities laws, accounting, and the valuation of commercial ventures and real estate. The evidence, viewed in the light most favorable to defendants, would allow the inference that they relied on those professional advisers and their approval of the transactions and disclosures in question. There is a vital difference here between deliberate fraud on the one hand, and on the other hand bad business judgment and even sloppy business practices regarding the "bargain sale" transactions.
This evidence does not by any means prove that Grubbs and Jackson acted properly, and all of the evidence favorable to the defendants is certainly subject to rebuttal with opposing evidence and argument. But it is all evidence that tends to weigh against their liability. This evidence must all be considered in their favor on summary judgment, giving them the benefit of favorable inferences from it.
The SEC's approach to the evidence is shown by its objection to all 70 paragraphs of the statements of additional fact submitted by Grubbs and Jackson on the theory that the statements are not submitted by any admissible evidence "other than the Defendant's own affidavit" See Pl. Reply to Def. St. of Add 1 Material Facts (emphasis added). The courts have long since abandoned the rule that a party cannot be a witness, and the Seventh Circuit has decisively laid to rest "the misconception that evidence presented in a `self-serving' affidavit is never sufficient to thwart a summary judgment motion." Payne v. Pauley, 337 F.3d 767, 773 (7th Cir. 2003). The defendants' affidavits address matters within their personal knowledge and are otherwise admissible.
Also, the SEC seeks summary judgment as to the whole case. Even if the court could find fraudulent scienter as a matter of law with respect to any specific transaction, the SEC's motion for summary judgment did not develop the case with respect to more than a handful of specific transactions. Furthermore, Grubbs and Jackson did challenge the overall conclusions of the SEC's investigator, whose summary affidavit set forth the overall case but also includes argument that falls short of evidence to establish facts as being beyond reasonable dispute.
The SEC did not develop any argument in its opening brief concerning theories of liability on Count II under Sections 17(a)(2) and (a)(3) of the Securities Act of 1933, 15 U.S.C. § 77q(a)(2) (3), which do not require proof of fraudulent scienter. In its reply brief, as defendants predicted, the SEC asserted in one conclusory paragraph that its evidence tending to support a finding of fraudulent scienter also shows negligence as a matter of law. The Seventh Circuit has explained that when a party moves for summary judgment on Ground A, the opposing party is not required to respond with his evidence on Grounds B and C, which might have been raised in the motion for summary judgment but were not. Malhotra v. Cotter Co., 885 F.2d 1305, 1310 (7th Cir. 1989), superseded by statute on other grounds as stated in Rush v. McDonald's Corp., 966 F.2d 1104, 1119-20 (7th Cir. 1992); Nassar v. Life Ins. Co. of North America, 2003 WL 23101799, at *2 (S.D. Ind. Sept. 5, 2003) (refusing to address ground for summary judgment first raised in reply brief). That rule is one of basic fairness, to avoid "bait-and-switch" motions. The SEC devoted only eight pages of its opening brief to its legal arguments, and saved most of its detailed analysis for its reply brief. The issue of negligence under Sections 17(a)(2) and (a)(3) of the Securities Act of 1933 was not fairly presented by the SEC's motion and will not be decided on its motion for summary judgment.
For the foregoing reasons, the SEC's motion for summary judgment against defendants Grubbs and Jackson is hereby denied. The SEC's motion to strike portions of the defendants' submissions is denied. The case remains scheduled for trial on July 6, 2004.
So ordered.