On March 2, 2017, Judge Amos Mazzant III of the United States District Court for the Eastern District of Texas dismissed an amended complaint filed by the United States Securities and Exchange Commission (“SEC”) against the Attorney General of Texas, Warren Paxton, Jr., for alleged securities fraud. The SEC alleged that Paxton defrauded investors in Servergy, Inc., by touting the company in the absence of any disclosure that Paxton would earn commissions from the investments he solicited. But the SEC’s amended complaint was dismissed with prejudice on the grounds that, among other things, the SEC did not plead facts sufficient to establish that Paxton had any duty to disclose his commissions to the investors in Servergy. SEC v. William E. Mapp, III, et al., No. 4:16-cv-00246 (E.D. Tex. Mar. 2, 2017), ECF No. 96. The SEC’s original complaint had been dismissed on October 7, 2016 for substantially the same reasons, and the Court found that the SEC’s attempted cures were insufficient.
Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 prohibit misstating or omitting a material fact in connection with the purchase or sale of a security with the intent to deceive, manipulate, or defraud. The requirements of Section 17(a) of the Securities Act of 1933 are substantially the same, except that Section 17(a) does not require any particular intent. But critically, in cases alleging securities fraud by omission, a defendant cannot be found liable unless the defendant had a specific duty to disclose. Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, 511 U.S. 164, 174 (1994).
According to the SEC, in 2011, Paxton engaged in securities fraud by omission in violation of the securities laws when he solicited investments in Servergy, Inc., a Texas-based technology company. Specifically, the SEC claimed that Paxton solicited investments from various acquaintances, former clients to whom he had once provided legal services, and members of investment groups of which he was also a member, all without disclosing that Paxton would receive commissions from Servergy for any successful solicitations. In its amended complaint, the SEC included multiple pages of allegations which sought to establish that Paxton had a duty to disclose his commissions, and thus that he violated the securities laws by omitting that information when soliciting investors. Specifically, the SEC alleged that Paxton had a duty to disclose his commissions based on his “formal and informal fiduciary relationships and [his] obligation to tell the entire truth when he undertook to solicit investments,” which the SEC claimed was established by the facts of his personal relationships with the investors. For example, the SEC pointed to things such as Paxton’s status as a registered investment adviser before December 2004, the fact that some of the individuals he solicited were former legal clients, the fact that the people he solicited trusted him and that some would not have invested in Servergy but for Paxton’s solicitations, and Paxton’s participation in various small investment groups, one of which had an “express policy” that no members should make money from the investments of other members. The SEC contended that these things, taken together, would have created a reasonable expectation among investors that Paxton had a duty to tell the entire truth when soliciting investments. First Amended Complaint, SEC v. William E. Mapp, III, et al., No. 4:16-cv-00246 (E.D. Tex. Oct. 21, 2016), ECF No. 40.
In response to Paxton’s motion to dismiss the amended complaint, Judge Mazzant held that the SEC had not alleged sufficient facts to establish that Paxton had a specific fiduciary duty to the investors. The Court also held that it did not matter that certain investors only invested in Servergy because of Paxton’s solicitations, because that fact could establish only the materiality of Paxton’s solicitations, rather than any duty to disclose. Indeed, according to Judge Mazzant, even if the members of Paxton’s investment groups trusted Paxton not to recommend investments in which Paxton had an interest, “fiduciary relationships do not arise from mere subjective trust alone.” Moreover, although Paxton would have had a duty to disclose his commissions had he disclosed only a portion of the truth on that specific subject, the court pointed out that Paxton had never made any representations about the benefits he received from soliciting investors, so he was under no duty to disclose his commissions in order to tell the entire truth.
The court’s opinion dismissing the SEC’s complaint was careful and technical, turning chiefly on the fact that Paxton had no legal duty to disclose his Servergy compensation arrangement to solicited investors. Indeed, though Judge Mazzant noted that there may have been good moral or policy reasons for Paxton to have disclosed his commissions, he pointed out that “it is not the province of the Court to stretch federal securities laws beyond their scope,” and the federal securities laws require a specific duty to create liability for fraud by omission.
Click here to view Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver
Click here to view SEC v. William E. Mapp, III, et al. (ECF No. 96)
Click here to view SEC v. William E. Mapp, III, et al. (ECF No. 40)