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2: EX-99.1 Miscellaneous Exhibit 9± 36K
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5: EX-99.4 Miscellaneous Exhibit 4± 18K
6: EX-99.5 Miscellaneous Exhibit 16± 79K
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8: EX-99.7 Miscellaneous Exhibit 2± 12K
EX-99.5 — Miscellaneous Exhibit
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UNITED STATES DISTRICT COURT
FOR THE NORTHERN DISTRICT OF GEORGIA
ATLANTA DIVISION
SECURITIES AND EXCHANGE )
COMMISSION, )
)
Plaintiff, )
)
vs. ) CIVIL ACTION FILE NO.
) 1 98-CV-0803-RWS
)
INTERNATIONAL HERITAGE, INC., )
et al. )
)
Defendants. )
DEFENDANTS' MEMORANDUM IN OPPOSITION TO PLAINTIFF'S
MOTION FOR A PRELIMINARY INJUNCTION AND
OTHER EQUITABLE RELIEF
I. PRELIMINARY STATEMENT
The SEC, acting ex parte and in the guise of furthering the public
interest, has obtained a Temporary Restraining Order and other unwarranted,
draconian relief designed to destroy the Defendants' legitimate business and
the livelihood of tens of thousands of people. The SEC took this surprise
action even though the SEC has known the details of the Defendants' business
for more than eighteen months and has never advised them of the matters it
alleges here. Defendants International Heritage, Inc. ("IHI" or the
"Company"), Stanley H. Van Etten ("Mr. Van Etten"), Claude W. Savage ("Mr.
Savage"), Larry G. Smith ("Mr. Smith") and International Heritage Incorporated
("Heritage Incorporated") (collectively the "Defendants") respectfully submit
this Memorandum in Opposition to the SEC's request to continue these
oppressive measures pending trial. As outlined below and as will be
demonstrated at the evidentiary hearing scheduled to commence March 24, 1998,
the SEC's action is neither necessary nor appropriate, either factually or
legally, and is designed to pretermit any opportunity for the Company and
certain of its principals to defend themselves here and to prevent them from
otherwise engaging in legitimate business activity.
II. FACTS
A. History and Overview
1. The Company
International Heritage, Inc. ("IHI") is engaged principally in the direct
sale of nutritional and skin care products, telecommunications products, fine
gold and precious stone jewelry, collectibles and pro-line golf products and
accessories in the United States and Canada. IHI uses a network marketing
distribution system to market these products of recognized value through
catalog sales utilizing a network of independent retail sales representatives
("IRSRs") and catalog sales to end users. IRSRs are independent contractors
who sell products from IHI at retail to the public or purchase them for
personal consumption. IHI develops marketing materials used by IRSRs
including, but not limited to, sales brochures, audio and video tapes,
training manuals and business forms. Prospective IRSRs are only required to
purchase a career kit for $100 to become affiliated with the company. No
other material purchases are required for an individual to become an IRSR and
to build a retail sales organization. IRSRs may purchase, at their option,
additional marketing materials from the company to help develop their sales
skills to assist in marketing company products and sponsoring and training new
IRSRs.
IHI negotiates for and secures the rights, through contract, license or
other agreements, to market and sell the various products available to IRSRs.
IHI's product lines include jewelry from E.B. Harvey, Jewels by Evonne and
John Kragh Jewelers as well as fine collectible products manufactured by
Lalique, Mark Hopkins, Sorrento, Mont Blanc, Lladro, Chilmark, Swarovski, Reid
& Barton, Hummel, Bosca, Armani and other premium manufacturers. Additionally,
in March 1997, IHI introduced long-distance telephone service for both
residential and business customers from BTI (one of the nation's largest
long-distance suppliers, based in Raleigh, North Carolina) and a new pro-line
of golf products including golf equipment, clubs and accessories manufactured
by Callaway, TaylorMade, King Cobra, Topflight, Titleist and others. The
Company believes it is one of the first network marketing or direct sales
companies to sell golf clubs, equipment and accessories.
IHI has recently added a toll-free product order department which allows
retail customers and IRSRs to telephone IHI directly to place catalog orders.
Retail customers can purchase from IHI product catalogs which will have an
IRSR identification number, and upon order entry, the IRSR responsible for
distributing the catalog shall receive a commission from the sale.
2. Operations and Physical Plant
IHI uses state-of-the-art technology and a full staff to service its
IRSRs and retail customers. Customer service agents answer phones Monday
through Saturday. There are several bilingual service agents, proficient in
various languages, available to service IHI's IRSR and retail customers.
Business is processed and entered on a daily basis. IRSRs also have
technology support available 24 hours a day via the International Data
Communications Center ("IDCC"), Fax on Demand, and the Internet to assist and
provide support for all facets of the business. IHI conducts its operations
through its headquarters in Raleigh, North Carolina, and presently leases
approximately 60,000 square feet of office space for its executive offices and
operation center. The Company employs more than 200 individuals, a large
portion of which are minorities, handicapped individuals, and single parents.
Additionally, the Company services its Canadian IRSRs through approximately a
7,800 square foot facility located in Toronto. This facility serves as the
executive office, customer service and fulfillment facility for IHI's Canadian
operations.
3. Compensation Plan
IRSRs are compensated for sales of IHI products in accordance with the
Company's compensation plan (the "Plan"). The Plan is copyrighted under
federal law and, under IHI's written directions, IRSRs are not permitted to
modify or create any derivative form or version of the Plan when presenting
the business. IRSRs are required to purchase a retail business training kit
for $100, which is the Company's cost, but no other payment is required of a
person who wants to become an IRSR and benefit financially from their IHI
relationship.
IRSRs can benefit financially under the Plan in several ways. First,
IRSRs may sell IHI products at a normal retail price to consumers, generating
a profit for themselves directly, based on the difference between retail and
the representative's cost (the wholesale price paid by an IRSR).
Second, IRSRs may undertake to build a retail sales organization ("RSO")
and earn commissions on sales made by other IRSRs in the RSO ("override
commissions") as well as bonuses by helping or managing other IRSRs in their
RSOs. Before an IRSR may qualify to benefit from the sales of other IRSRs, he
or she must establish and qualify a retail business center. This, too, may be
accomplished by an IRSR without the payment of any monies to IHI for anything
other than wholesale products (nutritional and skin care products through
IHI's preferred customer program and the sale of BTI long distance telephone
services) which the IRSR receives and uses in his or her business or
personally. In addition, an IRSR can purchase other wholesale products, which
the IRSR can sell at retail price or use in his or her business or personally.
Until March 13, 1998, when, as described below, the Company announced at its
annual meeting for IRSRs the new plan authorized by the IHI Board of
Directors, an IRSR could also certify a retail business center by making a
down payment on the product being purchased and earning out the rest of the
purchase price from commissions on sales to or by those in his RSO. But here
too, no cash benefit was received by an IRSR until the product ordered by the
IRSR was paid for fully and shipped by the Company.
Finally, IRSRs can benefit by saving money on their discounted wholesale
purchases of Company products for personal use.
Under the Plan, the maximum earning potential for a single retail
business center is $1,000 per week in override commissions on retail sales of
company products and $1,500 per week in bonuses, for a maximum total
compensation of $2,500 per week. Each retail business center must requalify
every quarter in order to permit the IRSR to continue earning override
commissions and bonuses. In order to requalify, the retail business center
must accumulate certain minimum business volume. As noted above, the
Company's compensation Plan has been modified as a result of the IHI Board of
Directors' decision in November 1997 to eliminate any possibility of an IRSR
being able to establish a retail business center without someone, whether a
customer or the IRSR, paying for and receiving retail products.
IRSRs have quarterly retailing requirements of 12 company products, six
of which must be sold to non-IRSRs in order to earn override commissions and
bonuses. The Company's new compensation plan, which involves detailed
training, organization, and product materials which had been under preparation
for several months, is called the Flex-Level Compensation Plan (the "Flex
Plan"). It provides a unique type of compensation for IRSRs for the sale of
the Company's nutritional and skin care products. The Flex Plan is intended
to work in conjunction with the Company's base compensation plan and provide
various degrees of commissions on the sales of nutritional and skin care
products.
IHI's marketing programs, compensation plans and operations have been
structured to fit within the "Amway safeguards" in order to avoid either the
appearance or fact that IHI is operating an illegal pyramid scheme. These
safeguards were recognized as appropriate in the 1979 Federal Trade Commission
Amway decision In the Matter of Amway Corp., 93 F.T.C. 618 (1979).
4. Competition
IHI operates in a highly competitive business and competes with a number
of established network marketing companies, including Amway (disposable goods
distribution), Shaklee (health products distribution) and Mary Kay (beauty
products distribution). IHI competes not only for the sale of products, but
also for the services of successful IRSRs. Additionally, IHI competes with
traditional storefront retail sellers of fine jewelry, fine collectibles, and
pro-line golf products.
5. Compliance
Regulations regarding network marketing companies are complex and
overlapping and vary from jurisdiction to jurisdiction. Network sales
programs are affected by combinations of business opportunity, franchise,
securities, anti-pyramid, network distribution and state lottery statutes, as
well as U.S. Post Office lottery and Federal Trade Commission fraud
regulations. IHI has taken significant measures to comply with the various
laws that would apply to it in the jurisdictions in which it currently
operates and has created a training program and Compliance Department
("Compliance") to monitor IRSR adherence to IHI's policies and procedures
designed to ensure compliance with the various laws that govern its business.
IHI's corporate compliance department currently employs fourteen (14) persons
whose primary functions are to investigate and discipline violations of IHI's
policies and procedures. IHI devotes significant efforts and resources to
monitoring its operations and sales force.
6. The Individual Defendants
Mr. Van Etten is the President, Chief Executive Officer ("CEO") and
Chairman of the Board of IHI and Heritage Incorporated. Messrs. Savage and
Smith are Directors of IHI and Heritage Incorporated and are IRSRs, but they
are not involved in the day-to-day management of the business.
B. The SEC Action
On March 16, 1998, the SEC, after spending approximately eight months
conducting an informal private investigation into the activities of IHI
(during which IHI voluntarily produced voluminous materials and provided four
(4) persons for testimony as requested by the SEC, including the three
individual Defendants named in this action), filed a Complaint for Injunctive
and Other Relief in this Court. The Complaint alleges violations of
Sections 5(a), 5(c), and 17(a) of the Securities Act of 1933, Sections
10(b) and 15(d) of the Securities Exchange Act of 1934, and Rules 10b-5 and
15d-11 promulgated thereunder. The SEC seeks disgorgement and civil penalties
against the Defendants. At the same time, the SEC sought and obtained,
without any notice whatsoever to the Company or any of the individual
defendants, a Temporary Restraining Order and the draconian relief of a
Receiver and an asset freeze. On March 18, 1998, after a hearing where the
SEC strenuously opposed any relief for the Company from the Court's March 16,
1998, Orders, the Court entered a clarifying Order under which the Company is
allowed to keep its doors open and engage in sharply curtailed business
activity, which, if continued for any appreciable period, will result in a
total shut-down
of the Company.
III. ARGUMENT
A. The Legal Standards Applicable To This Action
The SEC cannot prevail on its motion for a preliminary injunction unless
it can make a "proper showing" that "any person is engaged or is about to
engage in acts or practices" in violation of the Securities Act or the
Exchange Act. Section 20(b) of the Securities Act, 15 U.S.C. Section
77t(b); Section 21(d)(1) of the Exchange Act 15 U.S.C. Section 78t(d)(1).
To make such a proper showing, the SEC must offer "positive proof" of the
likelihood of future violations, which requires the SEC to "go beyond the mere
fact of past violations and offer `positive proof' of the likelihood of
further violations in the future." SEC v. Warner, 674 F. Supp. 841, 844 (S.D.
Fla. 1987); SEC v. Blatt, 583 F.2d 1325, 1334 (5th Cir. 1978). Where the SEC
fails to make a showing of the "reasonable likelihood" that a defendant will
violate the securities laws prior to the date for trial, the SEC's motion for
preliminary injunction must be denied. SEC v. Warner, 674 F. Supp. 841, 844
(S.D. Fla. 1987); see also SEC v. Caterinicchia, 613 F.2d 102 (5th Cir.
1980).
In determining whether an injunction should issue in SEC cases, the
courts have looked to the totality of the circumstances, and fashioned a group
of factors to be considered:
(1) the egregiousness of the defendant's actions;
(2) the isolated or recurrent nature of the infraction;
(3) the degree of scienter involved;
(4) the sincerity of the defendant's assurances against future
violations;
(5) the defendant's recognition of the wrongful nature of his conduct;
and
(6) the likelihood that the defendant's occupation will present
opportunities for future violations.
SEC v. Blatt, 583 F.2d 1325, 1334 n.29; SEC v. Nadel, No. 90-6401, 1991 U.S.
Dist. LEXIS 17849 (S.D. Fla. Aug. 28, 1991); SEC v. Carriba Air, Inc., 681
F.2d 1318, 1322 (11th Cir. 1982).
As demonstrated below, the SEC cannot satisfy the requirement of
"positive proof" of the likelihood of future violations.
The legal standards applicable to the other continuing interlocutory
relief sought by the SEC show why the SEC is not entitled to that relief here.
First, in deciding whether or not to appoint a receiver, the Court must
determine that appointment of a receiver is "necessary to prevent the
dissipation of a defendant's assets pending further action by the court." SEC
v. the American Bd. of Trade, Inc., 830 F.2d 431, 436 (2d Cir. 1987). The
Fifth Circuit has stated that the appointment of a receiver is necessary "in
instances in which the corporate defendant, through its management, has
defrauded members of the investing public; in such cases, it is likely that,
in the absence of the appointment of a receiver to maintain the status quo,
the corporate assets will be subject to diversion and waste." SEC v. First
Fin. Group, 645 F.2d 429, 438 (5th Cir. 1981). Only upon a "prima facie
showing of fraud and mismanagement" may the Court appoint a receiver. SEC v.
Keller Corp., 323 F.2d 397, 403 (7th Cir. 1963). Obviously, this is not
relief to be granted lightly; it invariably rings the death knell for the
receivership entity.
Second, while the freezing of assets in an SEC enforcement action may be
used to assure that funds which become due can be collected, SEC v. Unifund
SAL, 910 F.2d 1028, 1041 (2d Cir. 1990), the decision to order a temporary
freeze of assets in an SEC enforcement action "requires particularly careful
consideration." SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082, 1105 (2d
Cir. 1972). An unwarranted freezing of assets will undoubtedly undermine the
Court's goal of compensating investors, should the SEC ultimately prevail,
because the freeze will disrupt the Company's business affairs so as to
financially destroy the business. Id. at 1106. Therefore, in determining
whether to order an asset freeze, "the court must weigh `the deleterious
effects' the freeze may have on the defendants' business against `the
considerations indicating the need for such relief.'" SEC v. Current Fin.
Servs., Inc., 783 F. Supp. 1441, 1443 (D.D.C. 1992) (citing Manor Nursing, 458
F.2d at 1106).
B. The SEC's Claims Are Without Merit
The Establishment of IHI's Business Centers Do Not Involve The Sale
of Securities
The sine qua non of an SEC action is the offer, purchase or sale of a
security; otherwise the SEC has no authority to be here and the Court has no
jurisdiction to act. Here, the SEC contends that the Company's method of
establishing retail business centers, at least in part, involves the sale of a
security. While the SEC may have had a colorable--but incorrect--argument on
this point in the past, there is no question that IHI's present operation
permits no serious argument that the sale of securities is involved. We
analyze both the past and present business arrangements below.
The SEC contends that the Defendants are offering and selling securities
in the form of "investment contracts" as defined at Section 2(1) of the
Securities Act (15 U.S.C. Section 77b(1)), and Section 3(a)(10) of the
Exchange Act (15 U.S.C. Section 78c(a)(10)). Although the term "investment
contract" is included in the definition of a security under both Acts, the
term was not given any substance until the Supreme Court's landmark opinion in
SEC v. W.J. Howey & Co., 328 U.S. 293 (1946).
In Howey, the Supreme Court stated that "an investment contract for
purposes of the Securities Act means a contract, transaction or scheme whereby
a person invests his money in a common enterprise and is led to expect profits
solely from the efforts of the promoter or a third party...." Howey, 328 U.S.
at 298-99, 66 S.Ct. at 1103.
The SEC correctly notes (Memorandum in Support, p. 15) that the Eleventh
Circuit has recognized the Howey test, as rearticulated in United Hous.
Found., Inc. v. Forman, 421 U.S. 837 (1975), thusly: "the presence of an
investment in a common venture premised on a reasonable expectation of profits
to be derived from the entrepreneurial or managerial efforts of others."
Villeneuve v. Advanced Bus. Concepts Corp., 730 F.2d 1403, 1404 (11th Cir.
1984) (en banc). Paying lip service to this controlling law, the SEC glosses
over the heart of the element it must prove to prevail: that any expectation
of profits is to be derived from the entrepreneurial or managerial efforts of
others. Thus, the SEC contends, without any support whatsoever, that "the IHI
program was plainly designed and marketed to give an investor the expectation
that the fabulous returns he would receive would come from the efforts of
other individuals in his `downline.'" (Memorandum in Support, p. 16).
This contention is erroneous and demonstrates the fallacy of the SEC's
position here. First, no one can seriously suggest that the IHI program has
ever provided an "expectation of fabulous returns." It cannot be disputed
that all of IHI's materials specify the maximum weekly commission compensation
to an IRSR for business center sales by his or her RSO as $2,500 per week with
detailed explanations showing the amount of retail product sales and hard work
necessary to achieve these results. Moreover, the IHI materials stressed the
necessity for IRSRs to work with those in their RSOs to make a success of the
business.
Second, unlike all of the cases cited by the SEC where the common
enterprise was with, and the expectation of profits derived from the efforts
of, the promoters or an existing third party, here the SEC makes the
incredible leap of logic that the "efforts of others" element is satisfied by
those in the IRSR's potential "downline." But a prospective IRSR could hardly
have a reasonable expectation of profits to be derived from the efforts of
people not even in the enterprise yet and who may not even have been known to
the potential IRSR. The SEC's theory here not only flies in the face of the
law; it flies in the face of logic.(1)
Thus, upon application of the key element here, the "efforts of others"
element of the Howey test, the Court will see that the argument is no more
than a plea that this Court disregard what the Supreme Court has said and
accept the SEC's view that, essentially "any efforts" from even unknown others
meets the Howey test. Acceptance of the SEC's contention would be contrary to
binding precedent and would stand the investment contract test on its head.
Even if the "efforts of others" the SEC pointed to were the efforts of
IHI, the SEC's case would still fail. For example, in Villeneuve, en banc,
the Eleventh Circuit held that the Defendant there was not selling securities
in the form of investment contracts because the "efforts of others" test was
not met. The purchaser of an area agreement for a self-watering, flower
planter business was required to periodically check and restock his displays
with planters he ordered from the defendant once the defendant identified and
established locations for the business. The Court held that it could discern
no basis for concluding that the profits which the purchaser of the area
agreement expected to
--------------------------
(1) While the SEC does provide a handful of anecdotal declarations from
people who never even became involved in the program to recite their
understanding of IHI's program, that hardly suffices as the kind of evidence
necessary to prove that the IHI program involved a security.
--------------------------
realize were to be derived from the defendants' entrepreneurial or managerial
efforts. Id. at 1404.
In the instant case, IRSRs earn substantial profit from retail product
sales. IHI representatives must participate in the training and management of
their down-line sales organizations to foster their productivity.
Additionally, they must have 12 retail sales of product including six to
non-IRSRs each quarter in order to earn override commissions and bonuses. No
retail sales business volume is generated by recruiters. IRSRs meet with
prospective purchasers, negotiate with local business for catalog placement,
organize sales and training meetings and frequently work long hours to
maximize the potential for their businesses. It is the efforts of the IRSRs,
not of others, which are significant to their profit.
The success of distributors' IRSRs depends on their efforts in selling
the products and services offered by IHI. To that end, representatives are
required to become familiar with and market the Company's products. They must
attend regular training programs and engage in significant efforts involved in
the ordering and delivery of products. While representatives may be
successful in building sales organizations, the success of those sales
organizations and the ability of any representative to receive a profit is
dependent upon their ability to market the Company's products and services.
In order for any business center to receive any override commission or bonus,
retail sales business volume ("RSBV") of 1000 must be generated by each of the
two subordinate legs of the retail business center. That can only be done by
the sale of product by the subordinate representative or sales to him or her
for either resale or personal consumption. That subordinate representative's
recruitment of other individuals as distributors for the Company is
insufficient to generate the business volume necessary to create any override
commission or development bonus. Accordingly, IRSR's expectations of profit
are not inextricably tied to the efficacy of the Company's efforts. The SEC's
oft stated contention that commissions and bonuses can be earned without any
product being "shipped"-even though not really relevant-is simply wrong.
The SEC cannot sustain its burden that International Heritage business
centers constitute securities because the expectation for profits derived
solely from the efforts of others is not present.
C. The Defendants Have Not Committed Fraud
The SEC has alleged that the Defendants have engaged in conduct violative
of the securities anti-fraud provisions. To prevail, the SEC must prove that
the Defendants, acting with scienter,(2) made material representations or
omitted material facts in the offer or sale of securities. The SEC alleges
such fraud in the establishment of retail business centers (contending they
are securities), in connection with the sales of IHI notes offered in a
non-public offering in 1997, and in an SEC filing on Form 8-K made in March
1998. None of these allegations has merit: some are
-----------------------------
(2) Except as to Sections 17(a)(2) and (3) of the Securities Act.
-----------------------------
unsupported and unsupportable in fact and the remainder are immaterial as a
matter of law.
First, the facts. The SEC contends that the Defendants failed to
disclose increased losses to investors in IHI's 1997 note offering. But, the
increased losses were disclosed. Second, the Commission alleges that IHI
failed to disclose that it was operating a pyramid scheme, that it was a model
of corporate compliance and regulatory [sic] right, as well as certain
background information relating to Mr. Van Etten.
1. The Materiality Test
The Commission's allegations are immaterial. In Basic Inc. v. Levinson,
485 U.S. 224 (1988), the Court expressly adopted, in the context of
Section10(b) and Rule 10b-5 claims, the materiality standard set forth in
TSC Indus. v. Northway, Inc., 426 U.S. 438 (1976). The Levinson Court
endorsed a fact-specific inquiry which "depends on the significance the
reasonable investor would place on the withheld or misrepresented
information." 485 U.S. at 240.
-----------------------------
(3) See the Declarations of Sarah Johnson; Arnold N. Troeh, Ph.D.; Alan J.
Moore; Steve A. Lee; Steven K. Hagen; James P. Mayo; Lynn Simonson and Eunice
Simonson; Jean Wedin; BCD Farms, Inc.; Mark S. Griffin, M.D.; Donald C. Olson
and TamiJo Olson; Dorcas Liu; Lois Coonc; Pamela A. Johnson; Gale Simonson and
Leroy Simonson; Claude H. Lewis; William D. Griffin (Leisure Time Rentals);
Eric J. Geoffroy; Lloyd Geoffroy, Jr.; Harry B. Mains; John A. Neal; Richard
Masi; Randall J. Johnson; John D. LeBlanc; Charles T. Hilton, Jr.; Josette A.
Broussard; Carlan J. Hanks; Randy Tolf; Jeffery Langness; Norbert Louis Ming;
Egbert Louis Ming; Howard J. Hammond; Daniel R. Madung; and David Martin and
Tricia Martin, filed contemporaneously with this Memorandum.
-----------------------------
In TSC Industries, the Court held that the general standard of
materiality is: "[a]n omitted fact is material if there is a substantial
likelihood that a reasonable shareholder would consider it important in
deciding how to vote."(4) 426 U.S. at 449. The Court further explained this
standard as, "there must be a substantial likelihood that the disclosure of
the omitted fact would have been viewed by the reasonable investor as having
significantly altered the total mix' of information made available." Id.
2. Defendants Are Not Engaged in An Illegal Pyramid Scheme
The Commission has alleged that IHI's business activities constitute an
illegal pyramid scheme and therefore necessarily runs afoul of the securities
antifraud provisions. Nothing can be further from the truth. IHI is a
legitimate network marketing company engaged in the sale of quality products
and services to its distributors and on a retail basis.
The focus of pyramid schemes is to exact a substantial fee from
participants for the right to recruit other participants into the program.
The marketing plans generally require a person seeking to become a distributor
to pay a large sum of money as an entry fee (called a "headhunting fee") or to
purchase a large amount of nonreturnable inventory ("inventory loading"). In
------------------------------
(4) The Court adopted this standard for Section 10(b) and 10b-5 in
Levinson, but in TSC Industries the standard was in the context of Rule 14a-9.
------------------------------
exchange, the new distributor would secure the right to recruit others who
would, in turn, pay large sums of money as headhunting fees or purchase large
amounts of inventory with some of this money going to the recruiter.
In the program described in SEC v. Koscot Interplanetary, Inc., 497 F.2d
473 (5th Cir. 1974) a favorite reference in the SEC's Memorandum, different
levels of participation in the marketing plan were available, offering
different levels of compensation, for varying amounts of investment. For an
investment of $1,000, a supervisor could receive a 55% discount from retail
price on goods. In addition, if that supervisor introduced a prospect to
Koscot, he/she would receive $600 of the $1,000 investment. Thus, by securing
two new investors, a distributor could begin to turn a profit. A person could
also invest $5,000 with Koscot to purchase cosmetics at an even greater
discount and sponsorship of a $5,000 investor would result in a $3,000
commission. Thus commissions were directly tied to recruitment. Id. at 475.
Another tactic used in pyramid schemes is the avoidance of an explanation
of the program to potential recruits prior to their attendance at a meeting.
Promoters hold out the prospect of substantial earnings but say nothing about
the nature and workings of the program with the objective of tantalizing
prospective members through the elements of "curiosity, enthusiasm and money."
In Koscot, for example, sales trainees and independent sales agents were
encouraged to present a false facade of success to encourage recruits to
invest. Finally, in a pyramid scheme, the product is vastly overpriced and
merely incidental to the real business of the scheme which is the endless
recruitment of additional salespersons.
IHI's business is markedly different than that traditionally associated
with a pyramid scheme. The distributors are not required to pay large sums of
money as "headhunting fees," nor are they required to purchase a large amount
of nonreturnable inventory. All that is required to become an IRSR for IHI
is, as noted above, the payment of the $100 to purchase the not-for-profit
career kit. Moreover, unlike Koscot, IRSRs begin on an equal footing in terms
of potential compensation. The International Heritage program is fully and
completely explained through the use of a scripted presentation and a slide
show (although a flow chart may be used in some cases). The Company has
strict policies against diverging from the script. Finally, while the
potential maximum earnings for a retail business center are spelled out in the
presentation, with associated warnings that these numbers are not "meant as
income projections, nor are they indicative of any [IRSR's] existing or future
income." In fact, IRSRs are prohibited from making specific income
projections and the use of hypotheticals in explaining the compensation
program is clearly indicated as such.
The IHI program is designed to promote the generation of profits through
the retail sales of products to the consuming public, ensure a conservative,
realistic presentation of both the program and business opportunity to
prospective representatives, and provide a fairly priced and demonstrably
beneficial service to its members. It is not a case in which the only effort
required of a representative is to secure other representatives to participate
in the program. Company materials, presentations and communications
repeatedly emphasize that a company representative or director must expect to
work hard at retail selling in order to turn a profit in his or her business.
Moreover, as the SEC's own exhibits show, IHI strives to ensure that its
program is marketed without unnecessary hype, "get rich quick" stories, or
misrepresentations about the business. Finally, all representatives agree
they must exercise supervisory responsibilities upon all other representatives
within their sales group. There is no question that IHI is marketing a fairly
priced, intrinsically valuable product. The intrinsic worth of its product
and effectiveness of IHI's basic marketing objective of selling merchandise to
the retail consumer distinguish the IHI opportunity from the pyramid schemes
of the past.
IRSRs do not receive commissions or profit from their recruitment of
other individuals, but through the building of a retail sales organization
engaged in the sale of IHI's products and services. Theoretically, in a
pyramid scheme, a market may become saturated and the supply of new potential
recruits dry out leaving most of those involved without a means of recouping
the money they paid to join. The mathematical saturation approach, while
attractive for the SEC's purposes of alleging fraud, is posited without regard
to the actual facts, or even reality. Its use as a government tool to make
such fraud charges was explicitly rejected more than twenty years ago in
Ger-Ro-Mar, Inc. v. Federal Trade Comm'n, 518 F.2d 33 (2d Cir. 1975). In
Ger-Ro-Mar, the court noted
The sole evidence to support the Commission's holding that the plan
is inherently unfair and deceptive, is a mathematical formula, which
shows that if each participant in the plan recruited included only
five new recruits each month and each of those recruited five
additional recruits in the following month, and this process were
allowed to continue, at the end of only 12 months the number of
participants would exceed 244 million, including presumably the
entire staff of the FTC. The Commission concludes that this, in
effect, is the impossible dream and that the siren song of
Symbra'Ette must be stilled. . . . However, we live in a real world
and not fantasyland.
. . . [T]he fact is that Symbra'Ette, which commenced business in
1963, did not reach its peak in distributorships until 1972 when it
had attracted some 3,635 distributors. The record does not indicate
the geographical distribution of these vendors, and we have no study
or analysis in the record which would realistically establish that
some recruiting saturation exists which would make the entry of
additional distributors and the recruitment of others potentially
impossible in any practical sense. While the Commission need not
establish actual deception by the testimony of disappointed
entrepreneurs, it has failed entirely to establish a potential
threat. Not all Americans aspire to the calling in issue and not
all who are attracted will continue indefinitely. Id. at 37.
(footnote omitted).
In any event, concerns of saturation are not present in IHI's business.
First, it must be pointed out, there is a natural, significant attrition rate
of approximately 20% among people involved in the network marketing business.
Additionally, since business owners are encouraged to sell products to
friends, relatives, business associates, etc., there is little overlap in the
distribution network for product.
3. IHI Did Not Misstate its Attitude Regarding Compliance
The SEC also alleges that the Defendants have misrepresented IHI's
approach to the myriad regulatory bodies it faces. IHI's representations
regarding its approach to corporate compliance and regulatory relations is not
a misrepresentation. The Staff has alleged that IHI's belief and
representation that it is "regulatory [sic] right" constitutes
misrepresentation in light of the firm's agreements with the North Carolina
Attorney General's office, the Georgia Department of Consumer Affairs, and the
State of Florida to assure that IHI's programs comply with the laws of those
respective States. To the contrary, these matters reflect not a history of
non-compliance, but rather corporate intent and philosophy of dealing with its
business and the regulations governing its business in a forthright and
responsible manner. Rather than burying its corporate head in the sand, IHI
strives to work with its regulators to remain in good standing and to address
in a timely and forthright manner any concerns which those regulatory bodies
may possess. Moreover, in no case has any state or federal agency precluded
IHI from conducting business in their jurisdiction.
4. Mr. Van Etten's Personal Bankruptcy Was Not Required to be Disclosed
The extent to which the SEC is willing to go to allege fraud here is
shown by the smear that it was fraudulent for the Defendants not to disclose
Mr. Van Etten's prior personal bankruptcy and related IRS tax lien. The IRS
tax lien occurred in June of 1990 and Mr. Van Etten filed personal bankruptcy
in March of 1991, as a result of a significant tax liability and the
commencement of foreclosure proceedings on his home. On the advice of
counsel, in the interest of protecting himself and allowing time in which to
deal with these problems, Mr. Van Etten filed his personal bankruptcy as a
defensive maneuver. With the exception of a small portion of his obligations
which were discharged, Mr. Van Etten ultimately satisfied all of his financial
obligations, including the tax lien. But these items are not material facts
requiring disclosure under the federal securities laws.
The Staff's suggestion that such information might have been required to
be closed, assuming arguendo that IHI is engaged in the sale of securities, is
without merit. Item 401 of Regulation S-K requires the disclosure of personal
bankruptcies of company management that are material and have occurred within
the five years prior to the date of entry (emphasis added). Mr. Van Etten's
personal bankruptcy is not material as a matter of law with respect to the
Form 8-K filed by International Heritage, Inc. on or about March 6, 1998, as
well as the "term sheet" for the convertible notes offering dated July 1997,
as outside of the five-year limitation contemplated by Regulation S-K.
Item 401(f) of Regulation S-K states that the required disclosure for
involvement in certain legal proceedings regarding directors, persons
nominated to become a director or executive officers is disclosure of those
proceedings which occurred during the past five years and which are material
to an evaluation of the ability or integrity of such persons; some courts,
however, have required disclosure of legal proceedings outside this five year
limitation. See SEC v. Scott, 565 F.Supp. 1513, 1527 (S.D.N.Y. 1983), aff'g,
734 F.2d 118 (2d Cir. 1984); Bertoglio v. Texas Int'l Co., 488 F.Supp. 630,
661 (D. Del. 1980) (finding that five years was only a minimum disclosure
standard); but see United States v. Yeaman, No. 96-51-03, 1997 U.S. Dist.
LEXIS 2678, *31-2 (E.D. Pa. Mar. 10, 1997) (finding that SEC release numbers
5949 and 5758 are inconsistent with plain language of Regulation S-K, and
therefore SEC's interpretation of duty to disclose outside five years is
incorrect).
In Bertoglio, the court noted that "[p]laintiff's proxy materials
disclosed some, though not all, of Ling's financial history . . . [which
presented] TI shareholders . . . with an unflattering, though arguably
incomplete, picture of Ling's financial background." 488 F.Supp. at 659-60.
This left the shareholders "unaware of arguably relevant indicators of Ling's
fitness to serve as a director." Id. at 660. Plaintiff's defense was that
the episode was outside the five-year required reporting period. Id. at 661.
The court stated that the five-year disclosure period was only a guideline and
other material legal proceedings(5) must be disclosed. Id. The court
explained that the policy considerations around the adoption of the five-year
rule "likely revolve[d] around the diminishing relevance of `ancient
history'." Id. The court stated that it was likely ancient history to report
a "ten or fifteen year old incident [which] mars an otherwise unblemished
record." Id. The omission in this case, however, was material because it
"was the first in a series of securities law and business difficulties for Mr.
Ling that continue until the present time." Id.
In Scott, the court found the omission of an almost twenty year old
insurance fraud conviction to be material. 565 F.Supp at 1527. The court
found this omission material under the TSC Industries materiality standard;
however, the court also noted that "Scott actually filed an affidavit to the
contrary in support of Cayman Re's application for a reinsurance license."
Id. The court found that the filing of this affidavit was "a conscious and
deliberate intent to withhold . . . obviously relevant information." Id. at
1528.
The Yeaman decision explained the distinction between incomplete
disclosures about legal proceedings and the failure to
------------------------------
(5) The Court used the TSC Industries test for materiality.
------------------------------
disclose proceedings where there is no duty to disclose. The court explained
that Rule 12b-20 "provides that once disclosure has been made, the issuer must
be sure to add all other and further material information needed to insure
that the disclosures, which have been made, are not materially misleading."
1997 U.S. Dist LEXIS 2678 at *18. Proceedings outside the five year period,
however, which were not part of a misleading disclosure, need not be
disclosed. Id. at *29. The court held the SEC's interpretation that the
five-year period was only a guide was inconsistent with the plain language of
Regulation S-K itself. Id. at *31. The court noted that the SEC was fully
capable of amending the regulation to achieve a desired result, which was
evidenced by the fact that in 1978 the SEC reduced the required disclosure
period from 10 to 5 years. Id. at *33 n.14.
Both the Bertoglio and Scott decisions appear to be consistent with the
Yeaman opinion because they involved misleading disclosure rather than lack of
disclosure with no duty to disclose.
5. IHI Did Not Make Material Misrepresentations in Connection with the
Sale of Convertible Notes
The Commission has also alleged that the Company committed fraud in
connection with its sale of convertible notes between August 5, 1997, and
October 31, 1997. The Staff alleges that IHI failed to disclose adverse
financial information which came to its attention during the course of that
offering.
The Staff alleges that the term sheet for the notes offering set forth
financial information disclosing an operating loss of approximately $1.9
million during the first four months of 1997, and further that the term sheet
did not disclose that by the time of the offering IHI's losses had increased
to $7.6 million and that IHI was facing a severe shortage of operating funds.
For the reasons set forth below, it is clear that the Staff's allegations are
without merit.
IHI relied upon competent, experienced counsel to advise it in connection
with the offering of these securities. A determination was made that that
specific disclosure concerning the extent of losses and the updating of the
term sheet was not required given the oral disclosures to prospective
investors.
In connection with any subscription to the note offering, investors were
required to represent that:
(a) that they have carefully read the term sheet and understand
and have evaluated the risks of an investment in the notes;
(b) have been provided with the opportunity to obtain additional
information concerning the offering of the notes or the Company;
(c) have been given the opportunity to ask questions of and
receive answers from the Company or its representatives concerning
the notes or an investment in the notes and have been given a
further opportunity to verify the accuracy of that information;
(d) that an investment in the note was speculative and involved a
high degree of risk of loss of the entire investment
The term sheet for the offering included audited financial statements
from the Company as of December 31, 1997. Those financial statements
indicated an operating profit of approximately $1.3 million. Additionally,
the term sheet included unaudited financial information which reflected an
operating loss for the first four months of 1997 of approximately $1.9
million, or a substantial "swing" in profitability of approximately $3.2
million. The Risk Factors section of the term sheet discloses adverse
information with respect to the prospects for the Company's profitability and
the probability of management success in enhancing probability.
Specifically the term sheet states that the proceeds of the note offering
will be used for working capital, general corporate purposes and expansion of
Company office space. At page 10 of the term sheet, the Company notes that
it:
. . . anticipates that the net proceeds of the Offering, together
with existing resources and cash generated from operations, if any,
should be sufficient to satisfy the Company's working capital
requirements through the end of 1997; however, there can be no
assurance that the Company's working capital requirements during
this period will not exceed its available resources or that these
funds will be sufficient to meet the Company's long-term cash
requirements for operations, including repayment of the Notes upon
maturity. In the event the Company's plans or assumptions change or
prove to be inaccurate, or the net proceeds of the Offering together
with cash generated from future revenues, if any, prove to be
insufficient to fund operations (due to unanticipated expenses,
problems or otherwise), the Company may find it necessary and/or
advisable to reallocate some of the net proceeds within the
above-described categories or to use portions thereof for other purposes
and therefore management will have significant discretion regarding
how and when such proceeds will be applied. (emphasis added).
Additionally, at page 13, the term sheet indicates:
History of Operating Losses; Uncertainty of Future Profitability.
The Company was incorporated on April 28, 1995, and from that date
until June 21, 1995, the Company's operations consisted primarily of
raising capital, developing a business plan, implementing business
policies, recruiting professional advisors and administrative
activities. During this development stage, the Company incurred
losses of approximately $225,000. From the date of inception
through December 31, 1996, the Company had accumulated losses of
$617,572. As of December 31, 1996, the Company had stockholders'
equity of $305,827 and its current liabilities exceed its current
assets by $1,664,390. . . . The Company had net income of
$1,312,251 for the year ended December 31, 1996. However, the
Company lost $1,808,813 during the first four months of 1997
primarily due to the decline in margins from the Company's
commission pay out structure. There can be no assurance that the
Company's strategy to increase profitability will be successful or
that the Company will be profitable in the future.
6. The Form 8-K Filed by the Company on March 6, 1992 Was Not
Materially Misleading
The Staff has alleged that the Form 8-K filed by the Company on March 6,
1998, and signed by Mr. Van Etten contains "misrepresentations and omissions
designed to conceal the fact that IHI, the only significant asset of Heritage
Incorporated (formerly KARA) is operating a pyramid scheme.
In United States v. Matthews, 787 F.2d 38 (2d Cir. 1986), the court
considered an appeal from a criminal conviction for violations of Section 14A
and SEC Rule 14A-9 promulgated thereunder. The charge on which Matthews was
convicted alleged that Matthews was elected to the Board of Directors of
Southland Corporation in 1981 by means of a proxy statement which failed to
disclose, among other things, that he was a member of a conspiracy "to bribe
members of the New York State Tax Commission in order to obtain favorable
rulings on tax matters of interest to Southland." Id. at 39. In reversing
Matthews' conviction on these counts, the court held "that Matthews was not
legally required to confess that he is guilty of an uncharged crime in order
that Southland's shareholders could determine the morality of his conduct."
Id. at 49. In the instant case, International Heritage is operating a
legitimate business enterprise and not a pyramid scheme as alleged by the
Commission. Under the Matthews doctrine, the Company was not required to
disclose that it was operating as a pyramid scheme when in fact it was not and
did not believe it to be so.
The Staff also challenges language in the Company's Form 8-K with respect
to the Commission's informal investigation and the Company's responses to the
Staff's requests for information. The Staff does not dispute that the Company
has been cooperating with the Staff for approximately eight months and that
the Commission instituted this action without any prior notice or opportunity
to be heard on behalf of the Company. The Company had been engaged in
discussions and continuing production of documents and information to the
Staff through and including the commencement of this action, all without the
Staff's having to resort to subpoena or the Commission's subpoena enforcement
process. In fact, as recently as March 11, 1998, the Company provided
additional information to the Staff pursuant to its verbal requests. However,
given the Company's ongoing and complete cooperation with the Staff prior to
the commencement of this action, the Staff's suggestion that the Company's
disclosures relating to the Commission's investigation in the Form 8-K are
materially false is without merit.
To date, none of the Defendants have been found to have violated state or
federal securities laws or to have engaged in any fraudulent conduct. The
Commission's allegations in this action are just that -- mere allegations.
The Staff's argument is premised entirely upon the Court's acceptance of their
argument that the distributorships or business centers established by
representatives of the Company constitute investment contracts. Moreover, as
more fully set forth above, the Commission's allegations of fraud in
connection with the offering of certain convertible note interests are totally
without merit. It is unlikely that the Commission will be able to establish
by the positive proof required a "reasonable likelihood" Defendants will
violate federal securities laws.
As the Staff points out in its Complaint, the Company has been the
subject of inquiry or investigation by several state agencies charged with
enforcing the anti-pyramid laws in that state. The Company has addressed each
state's concern and reached an appropriate resolution of those concerns which
does not require the Company to cease any aspect of its operations or
business. Far from being indicative of prior violations, these actions
confirm the legitimacy and appropriateness of the Company's business plan.
The Company has throughout its history, tried to conduct itself in
accordance with applicable state and federal laws, employing legal, accounting
and industry professionals to guide it through the myriad of regulations
governing its business. There is no evidence which suggests that Defendants
operated or attempted to operate with any fraud or deceit in the conduct of
its business activities. Nor can it be said that the Company acted with
reckless disregard to such issues.
When the SEC sought its ex parte relief, the Court did not have the
opportunity to weigh "the deleterious effects" of its freeze order on IHI's
business, and those effects are ruinous. If IHI is unable to compensate its
sales representatives, all of whom are independent contractors, and its
employees or to purchase, pay for and receive or ship its products, it is
effectively out of business. To the extent that the goal of the freeze order
was to protect the assets in the event the SEC ultimately prevails, the freeze
order will have exactly the opposite effect. So long as the freeze order
remains in place, the Company will disintegrate leaving nothing to satisfy any
claims against the Company.
The Staff has offered no evidence that the Company or Company management
has or is about to engage in "the dissipation of . . . [D]efendants' assets .
. . ." SEC v. American Bd. of Trade, Inc., supra at 436. Moreover, the
Commission has not sustained its burden to prove that the corporate assets
will be subject to diversion and waste. International Heritage is an ongoing
viable business engaged in the manufacture and purchase for resale of quality
products. There is no evidence to suggest that corporate officers or
management have been "looting" the corporation. To the contrary, in an effort
to enhance the Company's profitability, management has undertaken numerous
steps, including the acceptance of cuts and deferrals in compensation in order
to better manage the Company's assets.
[Remainder of page intentionally left blank]
IV. CONCLUSION
Based on the foregoing, the SEC Motion for a Preliminary Injunction and
Other Equitable Relief should be denied and the ex parte Orders, as modified
by this Court's Order of March 18, 1998, should be dissolved.
Respectfully submitted,
/s/Michael K. Wolensky
Michael K. Wolensky, Esq.
Georgia Bar No. 773125
Robert G. Brunton, Esq.
Georgia Bar No. 090784
David J. Gellen, Esq.
Georgia Bar No. 289172
Kutak Rock
Suite 2100
225 Peachtree Street, N.E.
Atlanta, GA 30303-1731
(404) 222-4600
Brent E. Wood, Esq.
Wood & Francis, PLLC
P.O. Box 164
Raleigh, NC 27602
919/282-0801
Counsel for Defendants
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CERTIFICATE OF SERVICE
This is to certify that I have this day caused to be served a copy of the
DEFENDANTS' MEMORANDUM IN OPPOSITION TO PLAINTIFF'S MOTION FOR A PRELIMINARY
INJUNCTION AND OTHER EQUITABLE RELIEF, by hand delivery, properly addressed as
follows:
William P. Hicks, Esq.
District Trial Counsel
United States Securities and
Exchange Commission
3475 Lenox Road, NE, Suite 1000
Atlanta, GA 30326-1232
Joel Piassick, Esq.
Kilpatrick Stockton LLP
Suite 2800
1100 Peachtree Street, N.E.
Atlanta, GA 30309-4530
This 24th day of March, 1998.
/s/Michael K. Wolensky
Dates Referenced Herein and Documents Incorporated by Reference
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