==========================================START OF PAGE 1====== UNITED STATES SECURITIES AND EXCHANGE COMMISSION SEC v. LEONARD S. Sands, et al. Civil Action No. 93-7510 JGD (JRx) Litigation Release No. 15046 / September 16, 1996 Accounting and Auditing Enforcement Release No. 814 / September 16, 1996 On August 30, 1996, the Honorable Judge John G. Davies, Central District of California, issued his findings of fact, conclusion of law, and judgment, in which he found that defendants Leonard S. Sands ("Sands"), First Pacific Bancorp ("Bancorp"), and PacVen, Inc., violated the anti-fraud and disclosure provisions of the federal securities laws in connection with three financing schemes: (1) the fraudulent funding of the Bancorp offering, (2) the improper recording of residual interest wrap notes ("RIWNs") as assets and as income on the consolidated financial statements of the Bancorp, and (3) the improper recording of unfunded certificates of deposit issued by the National Bank of Liberia, the central bank of that country, and then offering them to the public for sale. 1. THE 1987 BANCORP OFFERING In 1987, the Bancorp offered for sale, pursuant to a registration statement filed with the Commission, $2.55 million units in a "mini-max" offering. The prospectus called for a minimum funding level of $1.5 million. The prospectus also required the refund of subscriptions if the minimum funding did not occur. In November 1987, one month after the minimum was to have been raised and one month prior to closing, a check in the amount of $1 million, drawn on the Bank of Montreal through its branch in the Bahamas, was returned through international banking channels. Instead of refunding subscriptions proceeds, as promised by the prospectus, defendant Sands, Chairman of both the Bancorp and the Bank, bought the $1 million position to save the offering from failing. Because Sands, a control person, bought in the offering to save it, the Court found that defendant Sands' purchase was not a bona fide investment and accordingly held that Sands and Bancorp had violated Section 17(a) of the Securities Act of 1933 ("Securities Act"), and Section 10(b) and Rules 10b-5 and 10b-9 of the Securities Exchange Act of 1934 ("Exchange Act."). The Court also found that defendant Sands had failed to file the requisite Form 4, as required by Section 16(a) of the Exchange Act and Rule 16a-3 thereunder, and an amendment to Schedule 13D, ==========================================START OF PAGE 2====== as required by Section 13(d) of the Exchange Act and Rule 13d-2 thereunder, for having increased his ownership in Bancorp by over 1%. Moreover, the Court found that defendant Sands had schemed, along with defendant Charles W. Knapp ("Knapp"), to divert $500,000 of offering proceeds of PacVen into the Bancorp offering. Defendants Sands and Knapp diverted the PacVen offering proceeds, purportedly in exchange for "commercial paper" issued by Trafalgar Holdings, Ltd., a Knapp company, through several other affiliated companies of Trafalgar and into the Bancorp offering to help reach the minimum. By diverting the funds through Knapp's companies and into the failed Bancorp offering, the Court held that defendants Sands and Bancorp violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rules 10b-5 and 10b-9 thereunder. (Defendant Knapp settled the first day of trial.) The Court also held that Sands violated Section 17(a) of the Securities Act and Section 10(b) and Rule 10b-5 thereunder because he caused the diversion of PacVen's offering proceeds into an affiliated company. The registration statement prohibited affiliated party transactions. Sands was Chairman of both the Bancorp and Pacven, and he was CEO of both companies. Further, the Court found that PacVen's annual report for 1987 and its first two quarterly reports for 1988 contained the materially false and misleading statement that PacVen had "loaned $500,000 of the proceeds to an unrelated party, at nine percent interest, in exchange for a secured promissory note." These periodic reports were materially false and misleading because the monies had been diverted (not loaned), the promissory note was not "secured," and the note was continuously extended without ever being required to be repaid to PacVen. Moreover, these reports failed to disclose the material fact that the $500,000 offering proceeds had been diverted and failed to disclose the affiliate transaction between Bancorp and PacVen. Accordingly, defendants Sands and PacVen were held to have violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. PacVen and Sands were also held to have violated, without a showing of scienter, Section 15(d) of the Exchange Act and Rules 12b-20, 15d-1 and 15d-3 thereunder, Sands for having failed to correct the accuracy of those reports. Further, Sands was held to have violated Section 20(a) of the Exchange Act. Finally, the Court held that PacVen violated Section 13(b)(2)(A) of the Exchange Act for failing to maintain accurate books and records of the disposition of the funds. Sands was held to have violated Section 13(b)(2)(A) and Rule 13b2-1 and Section 20(a) of the Exchange Act because he knew or was reckless in not knowing that PacVen had inaccurately recorded the diversion as a "loan" and failed to have the records corrected. ==========================================START OF PAGE 3====== See also Exchange act Release No. 33295 (December 7, 1993). 2. THE RESIDUAL INTEREST WRAP NOTES In September and October 1989, in another effort to make it appear the Bank was healthy, Bancorp and the Bank acquired eight RIWNs in exchange for $766,000 cash from the Bank and eight series of perpetual preferred stock, 100 shares per series, of the Bancorp. RIWNs are all-inclusive purchase money notes which wrap around and are subordinate to a HUD mortgage note, the principal financing instrument for low-income housing projects. In valuing these RIWNs, however, the Court found that the methodology and assumptions employed to calculate the present value of the RIWNs were flawed, among other reasons, because the defendants relied on inflated appraisals reports on the underlying HUD projects written at an earlier point in time, for a different company, and for a different purpose; and because defendants built into a set of "agreed-upon" procedures to be applied by Touche Ross, an outside accounting firm, assumptions designed to overstate the present value of the RIWNs. Nevertheless, it was these values which formed the basis for the Bancorp's reporting of the eight RIWNs as assets. In December 1989, the Bank acquired three additional RIWNs in exchange for unearned fees from a real estate development project, which consisted of $1,060,000 in "up-front" consulting fees and $968,000 in "back-end" success fees (i.e., 50% of the projected net profit on sale of the completed housing project). However, Deloitte, Haskins & Sells ("DH&S"), the Bancorp's independent auditors, advised defendants Sands and Bancorp that these fees could not be recognized as income because the earnings process was not complete (i.e., there was little documentary evidence to show that the services had been performed by year-end as represented, and there was a question as to their collectability.) To circumvent these problems, the Bank "combined" and "re-packaged" the consulting and success fees under a new label, called "development fees," which the Bancorp defined in its filings with the Commission as "residual profit interests in real estate developments." The Bank then swapped these fees for the three additional RIWNs. By this maneuver, the Bank recorded revenue in the amount of $1,968,709 -- the exact amount of consulting and success fees -- on the 1989 Bancorp financial statements. The Court found that the Bancorp filed periodic reports with the Commission which contained materially false and misleading statements regarding the transaction by which it and the Bank acquired RIWNs, the description and value of the RIWNs, and the financial condition of those entities. In addition, the Court found that the improper inclusion of the RIWNs in the financial statements in the 1989 10-K and March 1990 10-Q allowed Bancorp to convey the false impression that Bancorp's financial condition was improving when, in fact, it had deteriorated materially. ==========================================START OF PAGE 4====== The Court found that defendants Sands and Bancorp pumped up shareholders' equity and assets simply by issuing the perpetual preferred stock of the Bancorp. In the consolidated financial statements incorporated in its annual report for the fiscal year ending December 31, 1989 ("1989 10-K") and in a quarterly report for the period ended March 31, 1990 ("March 1990 10-Q"), Bancorp recorded and reported as assets $5,618,000 purportedly representing the value of eleven (11) RIWNs. In fact, the eleven RIWNs had a value of no more than approximately $766,000, the cash consideration paid by Bank for the first eight (8) of the RIWNs. The inclusion of the RIWNs in the consolidated financial statements, however, increased shareholders' equity by over 150%, from approximately $3.3 million in 1988 to $8.35 million for 1989 and at March 31, 1990. In fact, Bancorp's shareholders' equity had decreased materially in 1989 and at March 31, 1990. The Court further found that the periodic reports were materially false and misleading by improperly recognizing the $1.968 in "development fees" as income upon the exchange of consulting and success fees for three of the RIWNs. There were no actual consulting fees paid to the Bank. Instead, the consulting fees were simply added to the outstanding amount of the loans made to the developer and "straw borrowers" by the Bank. Moreover, the loans were structured so that all loan fees and interest would be funded by lines of credit, requiring no debt service by the borrowers. Prior to resigning as auditors in May 1989, DH&S had determined that the upfront consulting fees could not be recognized as income because the fees were "inextricably linked" to the loans. DH&S had also determined that the loan arrangements constituted a joint venture, and as such, the consulting fees were "equity kickers" (i.e., an advance payments against overall expected residual profits). As such, income recognition was impermissible. Therefore, the Court concluded that the Bank's recording of these development fees, merely by swapping unearned consulting and success fees for three RIWNS, resulted in a material overstatement of pretax income of $18,146 (instead of a loss of approximately $2 million). Thus, the Court held that defendants Sands and Bancorp violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Moreover, the Court held that defendant Bancorp violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a- 1 and 13a-13 thereunder. Further, the Court held that defendant Sands was liable with and to the same extent, under Section 20(a) of the Exchange Act, as the Bancorp for these violations. See also Exchange Act Release No. 33296, Accounting and Auditing Enforcement Release No. 511; and Litigation Release No. ==========================================START OF PAGE 5====== 14051, Accounting and Auditing Enforcement Release No. 549 (April 13, 1994). 3. THE CERTIFICATES OF DEPOSIT ISSUED BY THE NATIONAL Bank OF LIBERIA a. False and Misleading Periodic Reports In a further attempt to cure the Bank's and Bancorp's deteriorating capital base and to relieve pressure from bank regulators, defendants Sands, Geiger and Bancorp obtained six unfunded certificates of deposit issued by the National Bank of Liberia ("NBL") with face value of $3 million, for which these defendants agreed to swap an additional 100 shares of Bancorp's perpetual preferred stock. The Court found that, in 1990, Bancorp filed periodic reports with the Commission which contained materially false and misleading statements about the value of the six CD's and the transaction in which Bancorp acquired them. In the consolidated financial statements contained in its 1989 10-K and March 1990 10-Q, Bancorp reported as an asset the $3 million face value of six CD's. In fact, the CD's had a value of zero; they were never funded by NBL or by any other entity. By recording and reporting the six CD's as assets of $3 million, the defendants not only overstated working capital from operations for year-end 1989, but in addition, inflated shareholders' equity by 57% -- up from $5.3 million to $8.3 million. The Court held that defendant Sands and Bancorp had violated Section 10(b) and Rule 10b-5 of the Exchange Act because, prior to filing the 1989 10-K and March 1990 10-Q, Sands and Bancorp knew or were reckless in not knowing that the six CD's had no value, but permitted the filing of false periodic reports anyway. The Court also held that defendants Sands and Bancorp violated Section 13(a) of the Exchange Act and Rule s 12b-20, 13a-1 and 13a-13 thereunder for the material omissions and misstatements. Defendant Sands was further held liable, under Section 20(a) of the exchange Act, with and to the same extent as defendant Bancorp. [See Exchange Release No. 33296; Accounting and Auditing Enforcement Release No. 511. See also Exchange Act Release No. 33294; Accounting and Auditing Enforcement Release No. 509.] b. The Offer to Sell Liberian CDs The Court found that, from January through May 1990, ==========================================START OF PAGE 6====== defendants Bancorp, Sands and Geiger, together with defendant Dass, acting through defendant Apex, attempted to sell all forty (40) of the unfunded CD's both within the United States and abroad. This included the six CD's acquired by Bancorp. The Court first concluded that a Liberian CD was an evidence of indebtedness and thus a "security" because, among other things, investors were not accorded the same level of protection provided to CDs issued in the United States; Liberia was virtually bankrupt and had been blacklisted from the IMF; and Liberia was experiencing a civil war. The Court then found that defendants Bancorp, Sands and Geiger, when offering the CD's for sale, knew that the CD's had no value. Nevertheless, they made materially false and misleading statements, and omitted material facts, regarding the CD's to the investing public. Accordingly, the Court held that defendant Bancorp violated Section 17(a) of the Securities Act. Defendant Geiger had yet to be tried on these same allegations. 4. RELIEF Even though the conduct occurred in 1987 through 1990, the Court held that injunctions were appropriate against defendants Sands, Bancorp and PacVen. The Court found evidence of a high level of scienter in this case, numerous violations of the federal securities laws, including a pattern of untimely filing of periodic reports and reports which contained numerous materials misstatements or omissions, and the lack of recognition of any wrongdoing. The Court also found defendant Sands substantially unfit to serve as an officer or director of a public company. The Court found that Sands engaged in conflicts of interest, breached his fiduciary duties to the shareholders of both Bancorp and PacVen, made false representations to auditors, denied auditors access to crucial information, extracted large fees (both legal and consulting) from the Bank under a management service contract between the Bank and the Bancorp, received interest payment on the debentures he unlawfully purchased, and engaged in a pattern of late and misleading filings. Accordingly, Court held that defendant Sands, though a lawyer, should be permanently and unconditionally barred from ever acting as an officer or director of a public company. Further, defendant Sands and Bancorp were jointly and severally ordered to make restitution of $688,000 in connection with their fraudulent funding of the 1987 Bancorp offering. That amount represented the $500,000 diverted from PacVen, and the $188,000 raised from the public. The Court also ordered ==========================================START OF PAGE 7====== prejudgment interest from the date of December 1987, the closing of the Bancorp offering, to date of entry of judgment. See also Litigation Release No. 13904 (December 14, 1993); and Release No. 1401 (April 13, 1994).