SEC Settlement Gives Respondent 168 Years To Pay

February 17, 2016

We are regularly bombarded with press releases heralding some purportedly profound and historic settlement or verdict.  Inevitably, as we read through the breathless prose announcing the legal outcome, we are told that some company or individual will pay a significant disgorgement and/or a crippling fine; but the cynics among us (of which I am one) arch an eyebrow at the announced dollars because we know that such sums are not always paid in full, if at all. Consequently, what looks like a financial burden upon a purported crook may well be nothing more than a non-collectible debt or, at worse, an obligation that is laughed at by the defendant/respondent.

Case In Point

On April 17, 2015, the Securities and Exchange Commission's ("SEC's") Division of Enforcement ("Enforcement") filed an Order Instituting Administrative AND Cease-And-Desist Proceedings, Making Findings, AND Imposing Remedial Sanctions AND A Cease-and-Desist Order AND Notice Of Hearing (the "OIP") against Respondent Russell C. Schalk, Jr., who represented himself pro se. In the Matter of Russell C. Schalk, Jr.  (OIP, Securities and Exchange Commission, '33 Act Rel. No. 9751; '34 Act Rel. No. 74753; Invest.Co. Act Rel. No. 31555; Admin Proc. File No. 3-16498 /April 17, 2015). In the "Summary" portion of the OIP, we find the following allegations:

From January 2007 to March 2012, Schalk violated Section 5(a) and 5(c) of the Securities Act in connection with unregistered offers and sales of at least $1,973,000 of the securities of Raintree Racing, LLC ("Raintree Racing"), and at least $362,000 of the securities of Raintree Thoroughbred Farm, Inc. ("Raintree Farm") to at least sixteen investors in at least six states. In connection with these sales, Schalk made material misrepresentations and failed to disclose material facts to investors concerning (i) the merits and risks associated with the investment, (ii) the speculative nature of the promised 20% return on investment, (iii) the safety of invested principal, and (iv) the financial condition of Raintree Racing. In addition, Schalk prepared Raintree Farm Private Placement Memoranda (PPMs), and prepared and enabled the distribution of account statements to investors that made material misrepresentations and omissions concerning the financial condition of Raintree Farm. Schalk also diverted at least $220,000 of Raintree Racing and Raintree Farm assets to his personal bank account. As a result of the conduct described above, investors lost $1,472,959.

As to Respondent Schalk's role in the above, Enforcement asserted that he was the sole control person of both Raintree Racing, LLC, ("Racing") and Raintree Thoroughbred Farm, Inc. ("Farm") and, further, was a 1/3 owner of Racing and President, Chief Executive Officer, and Secretary-Treasurer of Farm. Neither Raintree entity was ever registered with the SEC. No offerings of Racing were registered under the Securities Act. Farm had submitted Regulation D filings in 2007 and 2010 for private offerings.


In anticipation of the OIP, without admitting or denying the findings, Respondent Schalk submitted an Offer of Settlement, which the SEC accepted. In settling the OIP, Schalk agreed to, among other things, the following:

Pursuant to this Order, Respondent agrees to disgorgement of $1,472,959, prejudgment interest of $280,271.55, and a third tier civil penalty of $1,600,000.00 based on the number of investors, and further agrees to additional proceedings to determine his ability to pay. In connection with such additional proceedings: (a) Respondent agrees that he will be precluded from arguing that he did not violate the federal securities laws described in this Order; (b) Respondent agrees that he may not challenge the validity of this Order, including amounts lost by investors and misappropriated by Respondent as stated in this Order; (c) solely for the purposes of such additional proceedings, the allegations of the Order shall be accepted as and deemed true by the hearing officer; and (d) the hearing officer may determine Respondent's ability to pay on the basis of affidavits, declarations, excerpts of sworn deposition or investigative testimony, and documentary evidence. Respondent reserves the right to contest his ability to pay the disgorgement, civil penalties, and prejudgment interest ordered.

Ability to Pay

At first blush, it all comes off as impressive: Schalk agreed to pay a $1.6 million penalty and a $1,472,959 disgorgement plus prejudgment interest of $280,271.55. As I noted earlier, however, there are cynics among us and we immediately wonder how much of that nearly $3.356 million will actually get paid by Schalk. After all, what are we to make of the language in the proposed settlement where Schalk "reserves the right to contest his ability to pay the disgorgement, civil penalties, and prejudgment interest"? Moreover, SEC Administrative Law Judge James E. Grimes (the "ALJ")  is called upon to conduct a hearing on the following issue:

IT IS ORDERED that Respondent's ability to pay the amounts set forth in Section V hereof shall be determined by an Administrative Law Judge to be designated by further order as provided by Rule 110 of the Commission's Rules of Practice, 17 C.F.R. § 201.110, and that the Administrative Law Judge may determine Respondent's ability to pay in additional proceedings on motion of the Commission on the basis of affidavits, declarations, excerpts of sworn deposition or investigative testimony, and documentary evidence.

Following a June 9, 2015, conference and without objection from the Enforcement or Schalk, the ALJ eschewed conducting an in-person hearing and deliberated over the "ability to pay" issue solely based upon written submissions. In the Matter of Russell C. Schalk, Jr.  (Initial Decision, Securities and Exchange Commission (Initial Decision, Securities and Exchange Commission, Admin Proc. File No. 3-16498 /February 10, 2016).

Enforcement contended that Schalk had not demonstrated a bona fide inability to pay the disgorgement because he had not accounted for money that he had diverted from the Raintree entities and he allegedly continued to operate Farm. Additionally, Enforcement argued that the ALJ was vested with the discretion to establish a payment schedule, and could order Schalk to pay:
  • nothing;
  • a reduced amount; or
  • the full amount.
Having the burden of demonstrating his alleged inability to pay, Schalk submitted a sworn financial disclosure statement with an explanation and his 2007 through 2014 tax returns. Given the sensitivity of some of the financial disclosures, the ALJ issued a protective order.

In framing the parties' contentions, the ALJ noted that:

Relying on the public interest factors enunciated in Steadman v. SEC, the Division argues that the sanctions ordered by the Commission "are entirely appropriate." Opp. at 4-6; see Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981). The Division also argues that Schalk has not convincingly shown his inability to pay disgorgement because he has not accounted for the money he diverted from the Raintree entities and continues to operate Raintree Farm. Opp. at 8. Finally, the Division argues that in light of Schalk's conduct and the public interest, he should be required to pay the penalties imposed. Id. at 9-10.

Page 4 of the Initial Decision

Schalk denied that he is still operating Raintree Farm, asserting that he does not know why its website is still active. Id. at 3. With regard to the $220,000 he diverted from the Raintree entities, Schalk states that he contributed $350,000 to one or perhaps both of the entities. Id. at 4. He asserts that his attorney told him that he "could recoup those monies." Id. According to Schalk, the $220,000 represents a portion of the funds he "recoup[ed]" with his counsel's blessing. Id. Schalk did not submit a declaration from his counsel in support of this assertion.

Page 5 of the Iinitial Decision

As to Schalk's evidence in support of his professed inability to pay, the ALJ treats much of the presentation dismissively:

I disregard Schalk's assertion that the $220,000 he took from the Raintree entities represents a portion of the funds he "recoup[ed]" with his counsel's blessing. The OIP recites that he diverted these funds without authorization. OIP at 9. Schalk agreed not to contest the amount that he took and further agreed to accept the OIP's allegations as true. Id. at 13. Schalk has therefore failed to account for the $220,000 he took from the Raintree entities.

[REDACTION in the original] I do doubt, however, that he needs what most people would view as a luxury vehicle. This is especially so in light of the fact that he is liable for disgorgement of $1,472,959 and prejudgment interest of $280,271.55.

It may be that Schalk signed this lease before the Commission issued the OIP. But, as he has agreed, by the time he signed the lease, he had already fraudulently induced investors to invest over $2 million. Crediting the cost of a luxury vehicle against Schalk's obligations would effectively encourage people in Schalk's situation to spend extravagantly. I therefore disregard half the amount of Schalk's lease.

Page 7 of the Initial Decision

ALJ's Initial Decision

Following his consideration of the parties' positions, the ALJ decided that Schalk had, in fact, not demonstrated an absolute inability to pay the disgorgement and/or civil monetary penalties; however, the ALJ found that Schalk's ability to pay was impaired to the extent that he would be required to pay no more than $20,000 a year towards the disgorgement and monetary penalties. In reaching his decision, the ALJ offers this rationale, in part:

During a prehearing conference held in December 2015, I noted that the Commission normally considers a respondent's alleged inability to pay in the course of assessing whether the public interest supports imposing a monetary penalty. Tr. 42. Indeed, in this proceeding, the Commission conducted its public interest analysis before assessing disgorgement and civil penalties. OIP at 13 ("[T]he Commission deems it appropriate in the public interest to impose the [following] sanctions."). The Commission then "institute[d] [these] proceedings to determine Respondent's ability to pay." Id.

The Division nevertheless argues that, regardless of Schalk's purported inability to pay, I could, and should, still order him to pay the full amount of disgorgement and penalties assessed by the Commission. Opp. at 4-6. This is because the Respondent's inability to pay is only one factor in the public interest analysis, and the other factors outweigh any purported inability to pay. Id. at 4-6, 8. In other words, the Division contends that I am permitted to reweigh the public interest factors and conduct my own public interest analysis.5 Tr. 43-44.

I disagree with the Division's argument. The language of the OIP is clear. The Commission "deem[ed] it appropriate in the public interest to impose the sanctions agreed to in the [settlement] [o]ffer, and to institute proceedings to determine Respondent's ability to pay," and therefore directed me to "determine Respondent's ability to pay in additional proceedings." OIP at 13-14 (emphasis added). In other words, the Commission already found it was in the public interest to accept the agreed-upon sanctions and to take Schalk's ability to pay into account. Nowhere in the OIP did the Commission direct me to perform a public interest analysis or to reevaluate whether it was in the public interest to consider ability to pay. Instead, as is made clear in the OIP, the Commission has already assessed the public interest. Id. at 13. If the Commission wanted me to conduct a public interest analysis, it would have specified so, as it has done on many occasions.6 Accordingly, as directed by the Commission, my sole task is to determine whether Schalk has demonstrated an inability to pay the disgorgement and civil monetary penalties assessed.

Pages 6 - 7 of the Initial Decision

Bill Singer's Comment

The ALJ's rationale is nuanced and, frankly, Enforcement seems to have been hoisted on its own petard. For starters, the ALJ is essentially telling Enforcement that it should have thought about the core "ability to pay" issue before proposing the settlement at issue. Pointedly, the ALJ is declining to conduct a public-interest analysis of Schalk's "ability to pay" because he asserts that Enforcement presumably took that issue into consideration when it negotiated and ultimately signed-off on the Offer of Settlement. As such, the ALJ found that what arrived on his desk, so to speak, was an open issue NOT as to whether the public interest required a ruling that Schalk should be compelled to pay the agreed-to disgorgement, interest and fine but, in a more narrow sense, the issue presented to the ALJ was solely whether Schalk "demonstrated an inability to pay the disgorgement and civil monetary penalties assessed." The ALJ found that Schalk demonstrated, at most, he could pay $20,000 towards his financial obligations under the settlement. At that rate, Schalk will pay down the $3.356 million subject to his settlement in about 168 years.

Alas, all is not done because the full SEC (the Chair and Commissioners) must now review the ALJ's "Initial Decision" and decide whether to accept it, reject it, or modify it. My guess is that the end of this road will not be the simple thump of a rubber stamp on the ALJ's recommendation.