A U.S. district judge for the Southern District of New York has approved a consent order between the U.S. Securities and Exchange Commission and the liquidators of Caledonian, paving the way for a settlement in the case against the bank and its brokerage for their alleged role in facilitating a number of penny stock pump-and-dump schemes.

On Sept. 28, Judge William Pauley approved the consent order between the parties and denied a motion by Sentinel Trust Services, the “putative owner of equity interests in Caledonian,” opposing the deal.

However, Judge Pauley criticized the $25 million disgorgement that he approved as part of the agreement, as “somewhat of a legal fiction” because the SEC is prepared to waive payment of that sum and Caledonian is not in a position to pay it.

While the “phantom judgment against a defunct entity” allows Caledonian’s assets to be distributed to creditors and permits the SEC to point to a $25 million disgorgement as a precedent in future litigations, he said, it raises the question of how U.S. investor victims and U.S. securities markets benefited from this enforcement action and the proposed settlement.

“How does a $25 million disgorgement judgment that is waived – and not disclosed in SEC public reports – serve as a deterrent? What message does a pro forma disgorgement send to scam artists and the offshore financial institutions that enable their frauds?” he asked in his ruling.

In addition, he questioned whether the SEC had ascertained whether any creditors in the Cayman Islands liquidation were themselves participants in the pump-and-dump schemes and who was “really behind the multitude of corporate veils that remain intact in this case?”

Nevertheless, the judge concluded that the public’s interest in “knowing the truth” behind a litigation should not be a factor when evaluating the settlement agreement and that public interest considerations rest largely with the SEC.

Disgorgement questioned

The $25 million disgorgement amount represents a compromise between the $1.4 million that Caledonian received in commissions in the alleged fraudulent pump-and-dump schemes and the $38 million its clients, who perpetrated the fraud, obtained in net proceeds.

In his ruling, the judge doubted whether a disgorgement exceeding Caledonian’s profit would hold up in a trial, given that the purpose of disgorgement is to offset a defendant’s unjust enrichment and not a punishment to deter violations, which is the objective of a civil penalty.

The SEC said it did not seek a civil penalty in the case because it would be difficult to enforce in the Cayman Islands. In a previous hearing, the SEC added that if disgorgement covered only the amount earned in commissions, “a bank could do this type of transaction for myriad customers, and when it’s caught, just disgorge what it gained from that single customer and then keep the commissions for all the other customers.”

Court documents allege Caledonian received commissions in more than just the four pump-and-dump schemes detailed in the lawsuit.

The U.S. securities regulator submitted a declaration by one of the perpetrators of the fraud who had worked for Gregg Mulholland, the man behind two of the defendant companies that were Caledonian’s clients.

The witness, whose name was kept anonymous due to his involvement in other trials, said, as a member of the Mulholland Group, he had deposited shares with Caledonian Securities. He also stated he was told by Caledonian Securities that the Mulholland Group was “far and away” the brokerage’s biggest client.

“During my time with the Mulholland Group, they conducted approximately 42 pump-and-dump schemes. I believe that Caledonian acted as a broker on behalf of Legacy, Clear Water, or other entities affiliated with the Mulholland Group in approximately 40 of these promotions. I personally prepared the paperwork transferring the stock certificates into the names of [International Business Corporations] controlled by the Mulholland Group in connection with approximately 28 of these pump-and-dump schemes,” he said.

“In connection with the stock I deposited on behalf of the Mulholland Group, Caledonian’s due diligence was either ridiculous or non-existent,” he stated.

In May, Mulholland pleaded guilty in the Eastern District of New York to fraudulently manipulating the stocks of more than 40 U.S. publicly traded companies and laundering more than $250 million in profits through at least five offshore law firms. His sentencing date is set for Oct. 27.

In the present case, Judge Pauley said simply because Caledonian brokered the transactions for its clients, the disgorgement could not automatically encompass the proceeds of these clients. Moreover, the evidence that Caledonian exercised “control” over the alleged pump- and-dump schemes is relatively “thin” and relies mainly “on inferences to be drawn from Caledonian’s business relationship with Clear Water and Legacy Global,” the judge said.

“But while this Court is not fully persuaded that the SEC’s evidence could support the scope of its disgorgement remedy at a trial, this is not a trial – it is a jointly proposed motion for a consent judgment.”

Judge rejects Sentinel’s objection to the deal

Sentinel had objected to the settlement proposal and the $25 million disgorgement, which represented the consolidated equity of Caledonian Bank when it was liquidated.

The bank’s equity owner also wanted Caledonian’s liquidators to sue the SEC. Sentinel argued its legal counsel could defend the enforcement action and lodge a $100 million counter-claim against the U.S. regulator on the ground that the initial freezing order against the bank was excessive and caused substantial and unwarranted harm to Caledonian by causing a run on the bank.

In addition, Sentinel demanded that Caledonian cover the legal and litigation costs, Sentinel’s legal counsel would receive a 47.5 percent contingency fee of the proceeds in a successful litigation, that $35.7 million of Sentinel’s equity would be prioritized over claims by Caledonian’s creditors and that any additional amounts recovered in the action would be split equally between Sentinel and Caledonian Bank.

As a result, Caledonian’s creditors would not have been paid in full and Sentinel would have been compensated for more than its $30 million in equity.

“Unsurprisingly, Sentinel’s proposal failed to gain traction with Caledonian’s creditors, the Cayman liquidators, or the Cayman Islands court,” Judge Pauley wrote in his ruling.

The judge also questioned whether Sentinel was the “ultimate equity owner” of Caledonian, calling the assertion “debatable.”

He noted a multitude of levels above and below Sentinel in the ownership structure. The sole shareholder of record for the two defendants in the case is Caledonian Global Financial Services Inc., whose sole shareholder is Sentinel.

However, Sentinel’s “beneficial interest” in the shares it purports to “own” is dubious, the judge noted. Sentinel is holding those shares for the beneficiaries of the New World STAR Trust, but the beneficiaries of the trust are not identified.

At the same time, the ownership of Sentinel is also “elusive,” Judge Pauley stated.

Sentinel is fully owned by Blackbriar Holdings Inc., which is fully owned by Tiger Management Holdings Ltd., which is 100 percent owned by Spartan Holdings, which is owned 100 percent by Iconic Holdings Investment, Ltd., “whose principals are undisclosed.”

“Navigating the labyrinth of Caledonian’s ownership is an ordeal rivaling Theseus’s, but without Ariadne’s guiding string,” Judge Pauley wrote. “It is an understatement to say that Sentinel and its controlling affiliates’ interest in this action is opaque.”

Sentinel had failed to explain why an agreement between the SEC and Caledonian would affect Sentinel’s ability to file an action against the SEC, the judge said.

“At bottom, the flaw with Sentinel’s argument is that whoever is behind Caledonian, apparently it is not Sentinel.”

Even if Sentinel were Caledonian’s representative, rather than just an agent for the trust beneficiaries, it could not bring a counterclaim in this enforcement action but would have to file a separate lawsuit, the judge ruled. “Because Sentinel cannot intervene to assert a damages claim against the SEC in this enforcement action, Sentinel’s only apparent purpose in intervening is to object – as a non-party observer – that entering the proposed consent decree would disserve the public interest,” he concluded, adding, “Intervention at this stage serves only to delay the prolonged settlement negotiations between the SEC and Caledonian.”