How the Texas AG beat SEC’s fraud case

October 10, 2016

(Reuters) – In 2011, before he was elected to serve as the Attorney General of Texas, Ken Paxton was a practicing lawyer and an influential member of the Texas House of Representatives. That July, he struck a deal with the founder of Servergy, a computer company developing cloud data storage servers. After a meeting with the company’s then CEO, Paxton said he’d recruit investors to buy shares in the company’s private offerings. Servergy, in turn, agreed to pay him a 10 percent commission.

Paxton reached out to a dozen friends, clients, business associates and fellow members of investment club he belonged to, telling them he’d met with Servergy management and considered the company a great investment opportunity. In the space of just a few weeks, Paxton convinced five of his contacts to invest a total of $840,000 in Servergy. In August 2011, the company issued Paxton his commission, a stock certificate for 100,000 shares then valued at $100,000.

Paxton neglected to tell his friends he was being paid to promote the company. He also neglected to tell them that his due diligence on Servergy consisted only of his meeting with the CEO.

The Securities and Exchange Commission accused Paxton of fraud last April, in a complaint that also alleged Servergy deceived prospective investors about pre-orders by Amazon and other big companies that rely on cloud computing. According to the SEC, Paxton violated antifraud provisions of both the Exchange Act and the Securities Act by promoting Servergy without disclosing that he’d benefit if his friends invested.

On Friday, Paxton and his lawyers at Wilmer Cutler Pickering Hale & Dorr got the case dismissed (although the SEC has two weeks to try to revive it). U.S. District Judge Amos Mazzant of Sherman, Texas ruled that Paxton was under no obligation to tell his friends, clients and investment club pals that he would be making money off of their investments. Nor did he mislead them, the judge said, by telling them only part of the truth about his relationship with Servergy.

The message of Judge Mazzant’s thoughtful ruling is caveat investor: If you’re buying stock based on a friend’s recommendation, it’s up to you to ask questions.

The crux of the decision addressed Paxton’s relationship with members of his investment club, who shared stock tips with one another. The 5th U.S. Circuit Court of Appeals, according to Judge Mazzant, has not previously had to decide whether a “relationship of trust” creates a disclosure duty. The judge looked to the 2nd Circuit’s decision in U.S. v. Chestman for the principle that fiduciary duties arise when one side is considered an authority and the other side relies on that authority. The SEC did not allege that Paxton “had any sort of control or dominance over his investment club members,” Judge Mazzant wrote, so he had no fiduciary duty to them.

The judge was also skeptical of the SEC’s argument that Paxton’s failure to disclose his prospective commission was a fraudulent omission under the Exchange Act. SEC lawyers had cited the 5th Circuit’s ruling in First Virginia Bankshares v. Benson, which held that half-truths can be fraudulent. But according to the judge, First Virginia triggers an obligation only to tell the full truth on a particular subject “when a defendant undertakes to say anything on that particular subject.” In other words, “the Commission would have to identify a statement made by Paxton regarding his compensation that was materially misleading” because it omitted key information, the judge said. But the SEC hadn’t alleged Paxton said anything at all to investors about the commission he was due to receive.

The SEC’s alternate theory, accusing Paxton of fraud under the Securities Act for communicating a stock tip without disclosing his commission, is a more unusual tactic for the agency – especially because its allegations were not based on a widely distributed tip but on an email and a phone call to individual potential investors. The investor who received the email didn’t end up buying Servergy shares, so, according to Judge Mazzant, the communication cannot be the basis of a fraud claim.

And the phone call, he said in a matter of first impression, falls outside the range of the Securities Act provision. “The term ‘communication’ should not be interpreted so broadly as to include all unrecorded forms of communication,” he wrote. “To hold otherwise would be contrary to longstanding Supreme Court and 5th Circuit precedent regarding (an) established canon of statutory interpretation.”

Paxton counsel Matthew Martens of Wilmer told me his side was gratified the judge took the time to dive into explanations of why the SEC hadn’t shown fraud. “This is a significant victory,” he said. An SEC spokesman declined to comment on the decision or whether the agency planned to amend its complaint against the Texas AG.

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