TRANSCRIPT OF PROCEEDINGS BEFORE THE HONORABLE GRAHAM C. MULLEN UNITED STATES DISTRICT COURT JUDGE OCTOBER 24, 2007

Transcription

1 UNITED STATES DISTRICT COURT FOR THE WESTERN DISTRICT OF NORTH CAROLINA CHARLOTTE DIVISION SECURITIES AND EXCHANGE ) COMMISSION, ) ) Plaintiff, ) No. 3:06-CV-531 ) vs. ) ) JOHN F. MANGAN, JR., and ) HUGH L. McCOLL, III, ) ) Defendants. ) ) APPEARANCES: TRANSCRIPT OF PROCEEDINGS BEFORE THE HONORABLE GRAHAM C. MULLEN UNITED STATES DISTRICT COURT JUDGE OCTOBER 24, 2007 On Behalf of the Plaintiff: CATHERINE E. PAPPAS, ESQ. AMY J. GREER, ESQ. U.S. Securities Exchange Commission 701 Market Street, Suite 2000 Philadelphia, Pennsylvania On Behalf of the Defendant: GEORGE CARRUTHERS COVINGTON, ESQ. King & Spalding, LLP 301 McCullough Drive, 4th Floor Charlottte, North Carolina JAMES F. WYATT, III, ESQ. Wyatt & Blake, LLP 435 East Morehead Street Charlotte, North Carolina Cheryl A. Nuccio, RMR-CRR Official Court Reporter United States District Court Charlotte, North Carolina

2 2 1 P R O C E E D I N G S 2 THE COURT: All right. Good afternoon, counsel. 3 We're here on a motion to dismiss filed by the defendant, 4 Mr. Mangan. 5 And who's going to speak first for -- first of all, 6 how long you folks think you need? 7 MR. COVINGTON: Your Honor, George Covington on 8 behalf of the defendants and Mr. Wyatt. I think we'll 9 probably be half an hour or 40 minutes, assuming we follow the 10 script to the extent that we have one. 11 MS. PAPPAS: Your Honor, Cathy Pappas for the SEC, 12 and we're about the same. 13 THE COURT: Okay. You can each have one-half an 14 hour. If you wish to reserve any time for rebuttal, you can. 15 I'll shut you off -- that ought to be a gracious plenty 16 because believe it or not, I've actually read the stuff you've 17 all filed. More than once. 18 Okay. Mr. Covington, you can kick off. 19 MR. COVINGTON: Thank you, Judge Mullen. 20 Judge Mullen, by way of introduction, my client, 21 John Mangan, is a man who's been in the securities business 22 for over twenty years. He grew up in New York. Attended 23 college at the University of Georgia on a tennis scholarship. 24 Worked for a time with a company called Friedman, Billings and 25 Ramsey in Washington, D.C. He ended up marrying into a

3 3 1 Charlotte family. He and his wife moved to Charlotte in 1969, 2 and they are the proud parents of three daughters. And 3 Mr. Mangan and Mrs. Mangan are here in the court today. 4 For a time after moving to Charlotte, Mr. Mangan 5 continued as an employee of Friedman, Billings and Ramsey. He 6 also began some individual investment initiatives, including 7 some investments through partnerships that he formed with Hugh 8 McColl, a contemporary of Mr. Mangan's and also a personal 9 friend and a business friend. 10 One of the primary activities in which Mangan and 11 McColl engaged was the running of a hedge fund. Your Honor, 12 in simplest terms, a hedge fund involves a hedge: A position 13 that provides protection for the investor against those 14 occasions when the market goes against him. So in a hedge 15 fund, when a fund is long in a number of positions that it 16 likes, it will be short in other positions in an effort to 17 limit the effects of the market going against those positions. 18 Hedge fund, Your Honor, by definition requires a 19 short sale to create the hedge that is designed into the fund. 20 And as a result of his hedge fund experience, Mr. Mangan 21 routinely engaged in short selling and had a great deal of 22 experience in these trades. 23 The SEC has pointed to three specific short 24 transactions where Mr. Mangan directed trades for HLM, a 25 partnership whose initials are simply those of Mr. McColl,

4 4 1 Mr. Mangan's partner. And Your Honor, for that reason, in 2 referring to the trading activity of HLM which SEC's complaint 3 alleges Mr. Mangan directed, I may from time to time refer to 4 the trading as HLM or Mangan, and I'll use that 5 interchangeably. 6 The SEC in its complaint alleges that the three 7 short sale transactions that Mangan directed for HLM resulted 8 in a violation of the prohibition found at Section 5 of the 9 Securities Act of 1933 against the sale or offer to sell 10 unregistered securities. All of these transactions involve 11 stock of CompuDyne Corporation, and the complaint alleges 12 Mr. Mangan sold short on October 9th 50,000 shares of 13 CompuDyne and on October 12th 30,000 shares, for a total of 14 80,000 shares. 15 As I will discuss at greater length in a moment, 16 Mr. Mangan directed all of these trades for HLM during the 17 period after which HLM had signed the purchase agreement for a 18 CompuDyne PIPE offering that allocated at closing 80, shares of CompuDyne to HLM at $12 a share. 20 The first transaction that the SEC alleges violated 21 Section 5 was the short sale by HLM of 50,000 shares of 22 CompuDyne on October 9th. 23 Your Honor, in order to help the court and myself 24 follow this transaction, I put together some slides that I'd 25 like to walk through and they depict the steps in the first

5 5 1 50,000 share transaction on October 9th, then the 30,000 share 2 transaction on October 12th. And I've given copies of these 3 slides to opposing counsel. 4 As you can see, the first slide shows the seller, 5 Mangan, owning no shares of CompuDyne stock. In other words, 6 like in every short sale, Mangan, the seller, never owns the 7 shares that are subject to the short sale transaction. 8 Instead, he borrows those shares as shown at slide 2. 9 The lender of the shares is a registered broker THE COURT: Did he actually borrow those shares for 11 the short sale? 12 MR. COVINGTON: Yes, sir. 13 THE COURT: Okay. 14 MR. COVINGTON: Yes, sir. 15 MS. PAPPAS: That's -- excuse me, that would be 16 contested. 17 MR. COVINGTON: That's a fundamental -- I don't 18 believe it's contested anywhere in the pleadings, Your Honor. 19 MS. PAPPAS: In the pleadings it does say that he 20 neither borrowed nor owned the shares. I can get you a 21 paragraph number in the complaint. 22 MR. COVINGTON: Your Honor, the fundamental of any 23 shorting transaction requires that he borrow the shares and 24 that they be delivered THE COURT: Well, he either borrowed or it was a

6 6 1 naked short sale. If it was a naked short sale, you would 2 think maybe the SEC would have some allegation in all this 3 mess -- 4 MR. COVINGTON: Precisely, Your Honor. 5 THE COURT: -- that he was engaged in to make it 6 short. Those are illegal, aren't they? 7 MR. COVINGTON: Yes, sir. And there's no 8 allegation -- 9 THE COURT: Wait a minute. For the SEC. 10 MR. COVINGTON: I'm sorry. 11 THE COURT: Naked shorts are not legal, are they? 12 MS. GREER: No. No, they're just very risky, Your 13 Honor. 14 MS. PAPPAS: And Your Honor THE COURT: They're not illegal; they're just risky. 16 MS. GREER: Correct. Naked short sales are not 17 illegal; they're just risky, Your Honor. 18 THE COURT: Why in the world don't you all make them 19 illegal? Don't you understand what happens in the market when 20 you allow naked short selling to attack companies? I mean, do 21 you understand that? 22 MS. GREER: Your Honor, I think that that's an issue 23 for the United States Congress. I appreciate your concern THE COURT: Well MS. GREER: -- and I --

7 7 1 THE COURT: -- the answer to my question is, yeah, I 2 understand it or, no, I don't. 3 MS. GREER: I do understand your -- 4 THE COURT: Do not try -- okay. 5 MS. GREER: I do understand, Your Honor. 6 THE COURT: Thank you for understanding it. 7 MR. COVINGTON: Your Honor, one thing -- 8 THE COURT: Excuse the interruption. 9 MR. COVINGTON: No, sir. 10 THE COURT: Sit down, shut up, let the man talk. 11 I'm not going to let him introduce (sic) you. Last warning. 12 MS. PAPPAS: I'm sorry? 13 THE COURT: Sit down MS. PAPPAS: Yeah, I got that. 15 THE COURT: -- shut up, let the man talk. Last 16 warning. 17 MS. PAPPAS: Okay. 18 THE COURT: Understood? 19 MS. PAPPAS: Okay. 20 THE COURT: Excellent. 21 MR. COVINGTON: With all due respect, Your Honor THE COURT: And you don't interrupt her when she's 23 talking. 24 MR. COVINGTON: Yes, sir. 25 THE COURT: Proceed.

8 8 1 MR. COVINGTON: With all due respect, Your Honor, 2 one thing that happens in a naked short is that there's a 3 cancel of the trade if there's not delivery in three days. 4 There certainly is no allegation in this complaint of naked 5 short selling. That is something the SEC could pursue. It's 6 not in the complaint, so I will proceed. 7 He borrows the slide -- he borrows those shares as 8 shown in slide 2. The lender of the shares is a registered 9 broker/dealer who engages in stock lending. And at the time 10 of the short sale, it is the lender who must deliver 50, registered shares to the buyer. 12 And Your Honor, it's important to emphasize that 13 this transaction involves fully registered shares and delivery 14 must occur within three days of the transaction or it fails. 15 There is a failure of the transaction. There is no record, 16 nothing in this record, no allegation that this transaction 17 failed. If the shares don't deliver, there's a buyer down 18 there who's paying money that has to end up putting up his 19 hand. 20 As shown in slide 3, the buyer makes payment for 21 50,000 shares to the seller; in this case, Mangan or HLM. 22 And Your Honor, obviously, there has to be another 23 part of this transaction in order for things to even out 24 between Mangan and the lender from whom he borrowed the stock. 25 And in this case, as of October 9th, there exists between

9 9 1 Mangan and the lender a commitment to cover or return to the 2 lender at some point in the future fully registered borrowed 3 shares. This obligation is depicted at slide 4. 4 Your Honor, it's up to Mr. Mangan to determine on 5 his own when he wishes HLM to cover. But obviously, the goal 6 of the short sale transaction is to cover at some date in the 7 future with shares that at that future date have a market 8 value less than the market value of the date when the shares 9 were traded or shorted. 10 For example, if, after Mangan shorted CompuDyne in 11 this transaction on October 9th and in the other transaction 12 on the 12th, some catastrophic market development on the 20th 13 caused a 50 percent drop in the per price share of CompuDyne, 14 Mangan clearly could have chosen to go into the market on that 15 date, buy 50,000 shares at half the price for which he had 16 sold them short on the 9th, cover the 50,000 shares he 17 borrowed from his lender and realize a large profit. This 18 didn't happen, Your Honor, but it illustrates what was one of 19 the many alternatives available to Mangan for fulfilling that 20 yellow line obligation to cover the shares that it borrowed. 21 Slide 5 shows the October 12th transaction. I'll go 22 through it quickly because it's the same thing, Your Honor. 23 He does not own the shares. The borrower delivers them. Must 24 be done within three days. The purchaser, at slide 7, makes 25 30,000 registered -- makes payment on the shares. And as

10 10 1 shown in the last sale, there is a commitment to cover. 2 Those are the two transactions. You put them 3 together, Your Honor, as the slide shows, by October 12th 4 Mangan had caused HLM to short 80,000 shares of CompuDyne. A 5 lender had delivered 80,000 shares to the purchasers. HLM had 6 been paid for the 80,000 shares by the purchasers and had 7 commitments to cover the 80,000 shares it had borrowed from 8 its lender. 9 And it's important to note, Your Honor, that we're 10 dealing with a closed loop here. And every part of the 11 transactions shown at slide 9 involves nothing but registered 12 shares of CompuDyne. 13 Now, I want to go back to the CompuDyne PIPE 14 transaction and show you a timeline including -- indicating 15 where the short transactions stand in relation to that. And 16 that's at slide As you can see, the complaint states that Mangan 18 learned of the PIPE price of $12 a share, and that HLM signed 19 the stock purchase agreement on October 8th. 20 I think I've got a pointer on this thing if I can 21 figure it out. I don't know how to work it. But you can see 22 there October 8th for those two occurrences, Your Honor. 23 Between October 8th and October 29th, HLM has not 24 received or paid for any CompuDyne shares. And indeed, those 25 shares have not been issued by CompuDyne because the

11 11 1 registration has not been approved. 2 On October 29th, only after the SEC approved 3 registration, HLM then pays for the shares, takes delivery of 4 80,000 fully registered shares of CompuDyne. Prior to 5 October 29th, in that gap period in the interim, Your Honor, 6 HLM owned no shares of CompuDyne and it had no prospect of 7 ever owning any except for the contingent possibility it would 8 own them if the PIPE was successfully registered. A 9 contingent prospect for owning if that registration is 10 successful. 11 Your Honor, what the SEC is arguing here is that the 12 HL -- is that HLM's October 9th and 12th short sales were the 13 functional equivalent of HLM's offering to sell unregistered 14 securities at the time it made the short transaction because 15 Mangan ultimately covered those short sales with registered 16 shares that HLM got pursuant to the PIPE transaction. In 17 other words, the SEC would have the court find that when 18 Mangan shorted CompuDyne on October 9th and 12th, he violated 19 Section 5 because the shares he ultimately elected to use on 20 October 29th for covering the short transaction, even though 21 were fully registered when he elected to cover, were not 22 registered shares at the time when Mangan executed the short 23 sales. As best I can follow, Your Honor, that's their 24 argument. 25 Your Honor, the absurdity of this argument is the

12 12 1 SEC is equating Mangan's obligation to cover on its CompuDyne 2 short transactions with the sale or offer to sell unregistered 3 PIPE shares at a time when HLM didn't even own the shares, 4 might never own them, and indeed they didn't even exist. 5 Your Honor, the best statement of SEC's theory is 6 found at page 63 of the complaint, which I'll go to slide 12, 7 but I think this is the best summation there is. And as you 8 can see, it says, "By short selling CompuDyne securities 9 before the effective date of the resale registration statement 10 for the CompuDyne PIPE shares, and covering the short sales 11 with the shares HLM received from the PIPE offering after the 12 resale registration statement became effective on October 29, , Mangan effectively sold HLM's PIPE shares prior to their 14 registration." 15 Your Honor, I would submit to you that the word 16 "effectively" speaks volumes about the SEC's case, because 17 Mangan never in fact sold, delivered, purchased or did 18 anything else with any shares of unregistered CompuDyne stock. 19 He could not have because he never had any such shares. 20 The way, Your Honor, the SEC attempts to avoid this 21 inconvenient truth is that it would have you assume that when 22 Mangan shorted CompuDyne on the 9th and the 12th, he was 23 locked in or committed to only one option to covering those 24 borrowed shares with PIPE shares that would not become 25 available and registered until the 29th. Thus, his short sale

13 13 1 also had to implicitly include an offer to sell unregistered 2 PIPE shares because that's the only way he could cover with 3 his lender. 4 Your Honor, this position simply ignores the reality 5 of the full range of alternatives available to Mangan. 6 At slide 10 we have the four alternatives that 7 actually existed. 8 The first alternative, Your Honor, is that Mangan 9 could have covered the short transactions before the date for 10 the PIPE registration with fully registered market shares. 11 And there could be no dispute the SEC could not claim a 12 Section 5 violation here. That's the example I gave you 13 earlier of when the market might crater and he could decide 14 the price was right and go in and cover now. 15 Certainly, at bullet point 2, if the SEC approves 16 the registration, Mangan could cover with newly registered 17 PIPE shares, which is exactly what he did. 18 The third alternative is if the SEC approves 19 registration, Mangan could have held on to the PIPE shares and 20 covered with registered shares that he purchased at the 21 market. And if he'd done that, Your Honor, we wouldn't be 22 here today. 23 Then there's the fourth option. If the SEC had not 24 approved the PIPE registration, which is always THE COURT: We wouldn't be here today talking about

14 14 1 Section 5 maybe. Okay. You've used up about half your time. 2 Do you want to keep -- 3 MR. COVINGTON: Your Honor, I think one thing that's 4 clear, though, is the SEC is making assumptions about how the 5 market operates that are tied to your having to find that 6 Mangan at the time he is covering on his short transactions, 7 he is inextricably linked to having to cover with PIPE shares. 8 And what this demonstrates is that that's certainly not the 9 case. In fact, every possibility -- because of the contingent 10 nature of the PIPE, every possibility existed that he would 11 never have PIPE shares to cover with. 12 So the fiction that somehow when he shorted, he was 13 making at the same time an offer to sell unregistered 14 securities because at some point in the future he might be 15 covering with PIPE shares that at that time had not yet been 16 registered is about three fictions too far in terms of what 17 Section 5 actually prescribes. 18 I don't want to try and dignify the SEC's argument 19 by making it for them; but as I understand it, in reading 20 their papers, that's what it is. That's the strawman that 21 they've put up that we're shooting down here. 22 The other huge problem with it, Your Honor, has to 23 do with the purchase agreement. If you go to the purchase 24 agreement, it points out the very contingent nature of whether 25 Mr. Mangan would ever even get these PIPE shares. Until --

15 15 1 there's the purchase agreement at Section 2. Talks about the 2 agreement to sell; buyers agree to purchase. 3 At Section 3, delivery of the shares occur at 4 closing. Mr. Mangan doesn't have any shares under the 5 purchase agreement until closing occurs. And the closing 6 can't occur until the SEC has communicated the approval of the 7 registration statement. And at the closing, then the company 8 delivers fully registered shares to Mr. Mangan, and the 9 obligation to accept delivery and pay for the shares is 10 subject to the registration occurring. 11 Mr. Mangan can't buy these shares. Has no 12 obligation to take them or pay for them, doesn't take delivery 13 of them, doesn't own them until they are registered. And yet, 14 the SEC would have you believe that he somehow was tied ball 15 and chain to covering with unregistered shares. 16 It's a fiction, Your Honor. 17 THE COURT: Maybe you ought to start talking 18 about MR. COVINGTON: Notice? 20 THE COURT: You ought to be talking about 21 materiality. 22 MR. COVINGTON: Mr. Wyatt's going to handle that. 23 I'm happy to turn the floor over to him if you've heard 24 enough. I have a little bit of an argument THE COURT: You're burning into --

16 16 1 MR. COVINGTON: If you buy -- 2 THE COURT: You're burning into his time pretty 3 good. 4 MR. COVINGTON: All right. Well, let me hold some 5 time back because there is an issue with notice. If you buy 6 this sort of strained and fanciful argument, Your Honor, I'd 7 like to at least go on with some notice issues. But until I 8 hear differently, I'll yield the floor to Mr. Wyatt. 9 THE COURT: All right. Mr. Wyatt. 10 MR. WYATT: Yes, Your Honor, can I put up just 11 one THE COURT: Talk to me about material nonpublic 13 information. 14 MR. WYATT: All right, Your Honor. 15 After briefly highlighting a few facts for the 16 court, I will address two issues and present two arguments. 17 First, that the appropriate time frame for 18 determining materiality is when the buyer and seller of these 19 shares legally commit to each other to that purchase. And in 20 a public market transaction such as this one with a NASDAQ 21 listed stock, that time is when the shares -- the trade is 22 executed on the exchange. That would be at 9 -- no later than 23 9:54 a.m. on the morning of October 9th. 24 Secondly, because there was an absence of a 25 significant decline in the stock price immediately following

17 17 1 the PIPE announcement, which occurred at 11:44 that day, under 2 the standards adopted for an open and developed and efficient 3 market in the Third Circuit, that lack of price movement at 4 that time is determinative of the objective standard for 5 materiality. 6 THE COURT: Wasn't your client -- wasn't your 7 client's short sale executed at least a couple hours before 8 the PIPE was announced? 9 MR. WYATT: No -- yes, Your Honor. It was executed 10 after opening by 9:54 a.m. 11 THE COURT: So about an hour and 50 minutes before 12 the PIPE was announced. 13 MR. WYATT: That's correct, Your Honor. There's no 14 question that the trade occurred prior to the announcement of 15 the PIPE. 16 THE COURT: Okay. 17 MR. WYATT: But the issue before the court today is 18 whether the announcement of the PIPE, as the SEC claims in its 19 complaint, was material. That is an issue this court can 20 decide as a matter of law based on the relevant legal 21 standards. 22 If I can further expand on that timeline on the 9th 23 and use this chart, and I gave Ms. Koechley a copy of these 24 charts for the court and also the SEC. 25 First of all, if you look at the events leading up

18 18 1 to October 9th, 9/11, of course, occurred approximately one 2 month earlier. After 9/11 there were certain defense and 3 security and homeland security stocks that were hot stocks in 4 the market, and CDCY was one of those stocks. It's a company 5 that specialized in defense measures and security measures. 6 The trade -- it's a NASDAQ listed stock. We're not talking 7 about a pink sheet stock here or some nontraded stock. 8 Trading volume before the 9th ranged up as high as, I believe, 9 700,000 shares a day. 10 On October 8th, the stock closed at, I believe, 11 $17.28 a share. 12 On October 9th, the events show that at the opening 13 bell, the stock was at $ Now, with regard to the 9th, Your Honor, it's very 15 important to understand paragraphs 45 and 47 of the SEC's 16 complaint. What the SEC is alleging is that sometime 17 premarket, around 7:40 a.m. on the 9th, Mr. Mangan called an 18 in-house assistant. He did not call an execution broker at 19 that time. He did not call Merrill Lynch. He did not call 20 ABN AMRO. He called an in-house assistant and said I want to 21 short some CompuDyne stock. There is no allegation whatsoever 22 that he asked his assistant to try to do that premarket. And 23 the undisputed facts show that that trade, in fact, was not 24 executed until after the market opened and by 9:54 a.m. And 25 the price for those shares when that trade was executed was

19 19 1 $ Now, what the SEC is alleging in this case is a 3 couple of things. 4 First, they say the announcement of the PIPE was a 5 material negative event. It was negative because it diluted 6 the stock. It was negative because a large shareholder of the 7 stock was selling his stock in connection with the PIPE. So 8 they have premised their complaint on it being a material 9 negative event. 10 Second thing they allege, and they have stuck to in 11 their briefs, is they do not have to prove materiality at the 12 time the PIPE was announced. They have said in their briefs 13 very clearly and they have said in their complaint the only 14 time we have to prove materiality and the only time we allege 15 materiality is when Mr. Mangan called his in-house assistant 16 at 7:40 in the morning. So if this court decides that the 17 time for determining materiality is when the trade was 18 executed, then the SEC has essentially alleged itself out of 19 court here. 20 Now, with regard to the trades on October 9th, the 21 trade itself, the initial short occurred at 9:54 and the price 22 of the stock was $ The PIPE announcement occurred 23 approximately an hour and a half, an hour and 45 minutes 24 later, and the price at that time was $ Over a million 25 shares of CDCY stock is being sold on this day. There is no

20 20 1 question it's an efficient public market transaction. 2 What happens to the stock after the price 3 announcement? It goes up. It goes up in the three to four 4 hours after that announcement to as high as 15.20, and until 5 3:30 in the afternoon is above the price when the PIPE was 6 announced. At the end of the day, it barely trails off to 7 $ You compare the $14.25 price with the price at the 8 time of the execution of the trade, we're talking about a 9 3-cent difference in the price of the stock over the course of 10 the 9th when a million shares of this stock was traded and the 11 PIPE was publicly announced through press releases and the 12 wires at 11:44 a.m. 13 Now, to frame the argument, what we say, Your Honor, 14 is materiality has to be determined here when a buyer agreed 15 to the other side of the transaction with Mr. Mangan. It did 16 not occur when he called his assistant at 7:40 in the morning 17 before he boarded a plane to say I think we ought to short 18 this stock. One reason it didn't occur then is because 19 there's no legally binding contract between Mr. Mangan at that 20 time and the buyer of the stock, the person on the other side 21 of the transaction, the person who the securities laws want to 22 protect, the allegedly defrauded buyer in this case. 23 Now, what the SEC is saying, basically, is the night 24 before the stock was over $17; that that's the measuring point 25 because Mr. Mangan called someone in his office at 7:40. And

21 21 1 if you compare $17 to the closing price on the 9th, that's a 2 20 or 25 percent decline. 3 Well, we are arguing very clearly and the issue is 4 very clearly framed for this court because of the way the SEC 5 has made their allegations in this case is the time for 6 reference for materiality is right here at $14.28 a share. 7 And if the court adopts that, which is a standard well adopted 8 in other circuits, then there is not a material change in the 9 price. Because materiality is completely different from just 10 the timing issue of when things occurred. The SEC has to 11 establish materiality as a matter of law. 12 With regard to the case law relating to the time 13 when materiality should be determined, we have cited in our 14 brief several cases from other circuits. And on this issue as 15 well as the other other issue I'll address, there is no Fourth 16 Circuit precedent. So this court THE COURT: Yeah, I love it when that happens. 18 MR. WYATT: Well, this court has the opportunity to 19 make the most logical, common sense precedent in this case 20 because there is no precedent from the Fourth Circuit, which 21 the court may or may not agree with, and there are logical and 22 well reasoned cases from the other circuits. 23 With regard to that first issue, we have cited three 24 cases from other circuits, the Radiation Dynamics case, the 25 Michaels case, and the Castellano cases. Those cases are all

22 22 1 private stock transaction cases. In other words, some inside 2 holder of stock in a company was selling it to someone else in 3 the company. They happened to sell it in all those cases 4 right before there was a merger announced and so they lost a 5 lot of money by not holding their stock. And the basic issue 6 in those cases was what is the time for determining 7 materiality in those cases? And in a private market 8 transaction, those courts set forth the principle that also 9 controls a public market transaction and that is that it's at 10 the time when the parties legally commit to each other. When 11 they both sign that agreement to transfer shares and they are 12 legally committed to each other, that is the time the 13 materiality is determined. And that principle also applies in 14 the public market transaction. 15 Another case we've cited to the court, the Butler 16 case, which is a district court case from Pennsylvania where I 17 believe Ms. Pappas was counsel in that case. In that case the 18 court said -- didn't even have to think twice about the issue. 19 The court said it is axiomatic that materiality is determined 20 at the time of the trade. And the reason that makes sense, 21 Your Honor, is several policy reasons. 22 First, the securities laws are designed to protect 23 the defrauded buyer/investor. Until that defrauded 24 buyer/investor legally commits to the transaction with 25 Mr. Mangan, then they -- then what the securities laws is

23 23 1 designed to protect has not occurred yet. 2 Secondly, in our brief we put forth several examples 3 of what could have occurred under the SEC's theory here. 4 Let's assume that Mr. Mangan talks to his in-house assistant 5 at 7:40. Says we ought to short this stock. At 9:15 the PIPE 6 is announced and at 9:54 he buys the shares. His assistant 7 buys the shares and executes the trade. Theoretically, the 8 SEC would still have a case under their theory. 9 Let's assume that he tells his assistant in-house to 10 buy the stock. His assistant is busy with other matters that 11 morning and doesn't buy the shares until the afternoon. Under 12 their theory, they still have a case because he talked to his 13 assistant in his own office at 7:40 in the morning. That 14 doesn't make legal sense. It doesn't make common sense. And 15 it does not comport with the policies underlying Rule 10b Now, with regard to the issue of the lack of stock 17 price movement, again, there is no standard in this circuit. 18 Judge Alito, who is now on the Supreme Court, held in two 19 cases in the Third Circuit, the Oran case and the Burlington 20 case, that basically when you're dealing with an open and 21 developed securities market, there has to be an immediate 22 significant impact on the price of the stock in order for a 23 case to survive a motion to dismiss. 24 What Judge Alito said in the Burlington case was 25 "Ordinarily the law defines material information as

24 24 1 information that would be important to a reasonable investor 2 in making his or her investment decision." Of course, that's 3 Hornbook securities law. "In the context of an efficient 4 market, the concept of materiality translates into information 5 that alters the price of the firm's stock. This is so because 6 efficient markets are those in which information important to 7 reasonable investors (in effect, the market) is immediately 8 incorporated into stock prices. Therefore, to the extent the 9 information is not important to reasonable investors, it 10 follows that its release will have a negligible effect on the 11 stock price." 12 That is a standard that we urge the court to adopt 13 in this case because it makes eminent sense in terms of the 14 factual context of this case. You have a publicly traded 15 stock here. You do not have a pink sheet stock or a stock 16 with sporadic trading. You have over a million shares traded 17 on October 9th. You have the PIPE announced in a very public 18 way at 11:44 a.m. on October 9th. You have all of the 19 ingredients of an efficient market, a NASDAQ listed stock in 20 this case. 21 Now, that does not mean the court has to adopt that 22 standard for every case. Or there may be circumstances in 23 other cases where it does not make sense to adopt that 24 standard, for example with a pink sheet stock. But in this 25 case, with this stock, given its high visibility, it makes

25 25 1 eminent sense. And I think the reason Judge Alito engaged in 2 that standard is you have the absurd situation here where the 3 SEC is alleging it's a material negative event and the stock 4 goes up, and they're going to put Mr. Mangan through months 5 and months of litigation and expenses when you have the stock 6 price showing clearly it was not a negative event. 7 So there's good reason for the standard. As we 8 stated, there is no Fourth Circuit case on point. The 9 Greenhouse case, which I think the court is familiar with, 10 there was dicta there basically saying other courts have 11 adopted this standard. We don't have to adopt it at this time 12 or not adopt it, and it's pretty much thrown away dicta in 13 that case as to whether to adopt the standard or not. This 14 case will represent the first time in this circuit where a 15 court can give serious consideration as to whether to adopt 16 that standard or not. It makes eminent sense in terms of the 17 facts of this case, in terms of the legal authority and the 18 persuasiveness of it, and it means that the SEC's case should 19 be dismissed. 20 Now, once again, Your Honor, I'd like to just close 21 by highlighting what the SEC's allegations are in this case. 22 They have said in their briefs and they've said in 23 their complaint the only time we have to prove materiality is 24 7:40 in the morning. If the court determines that the 25 execution time is when materiality should be judged, they have

26 26 1 pled themselves out of court. But they have not even 2 attempted to plead that at the time of the PIPE announcement, 3 that this information was material. And indeed, I think the 4 reason they haven't is because if you look at that chart, you 5 can see there was a 3-cent decline in the price of the stock, 6 and the stock actually rose during the course of most of the 7 day. 8 So given the way they've pled this case, if the 9 court finds that the execution time is the appropriate time 10 for measurement, then it makes it a much cleaner and crisper 11 resolution in terms of granting this motion to dismiss which 12 we would urge the court to do. 13 THE COURT: Thank you very much. 14 Now let's hear from the government. 15 MS. PAPPAS: Good afternoon, Your Honor. 16 First, just as an aside so we can -- so I don't 17 forget to tell you, paragraph 61 is where we allege in the 18 complaint that he -- that Mr. Mangan neither owned or borrowed 19 the shares. And I don't believe -- you may determine it to be 20 relevant, but as I go through this, it's not necessarily a 21 controlling factor, although you may find it to be so. 22 This case is about a person who made a lot of money 23 by short selling unregistered shares of CompuDyne common stock 24 at a time when only he and a few other insiders knew that the 25 market would soon be flooded by new, cheaply issued shares.

27 27 1 We are before the court on the defendant's motion to dismiss. 2 THE COURT: Okay. 3 MS. PAPPAS: In other words, on a motion seeking to 4 show that the plaintiff can prove no -- I'm sorry. 5 THE COURT: What unregistered CompuDyne stock did he 6 sell when he sold short? 7 MS. PAPPAS: He sold the 80,000 shares of -- that he 8 acquired through the PIPE. And the reason we get there, Your 9 Honor, is -- and I can take you to that argument right away. 10 I was going to address insider trading first only because that 11 was fresh in your mind; but if you would like me to go to 12 Section 5, I'll explain that. 13 THE COURT: I'd like for you to respond seriatim to 14 what I've heard. Let's talk about Section 5 first and then 15 we'll talk about the insider trading. 16 MS. PAPPAS: Okay. We claim that Mangan's short 17 sales of 80,000 shares of stocks were -- stock were sales of 18 PIPE shares prior to the effective date of a registration 19 statement for such sales. Mangan -- Mr. Mangan claims that 20 because the registration statement had gone into effect prior 21 to his use of the PIPE shares to cover his prior sales, his 22 short sales did not violate Section 5. He's just wrong. 23 In this context, Section 5 of the Securities Act 24 requires that prior to Mangan's offer -- and I'm now going 25 directly from the statute. Prior to his offer to sell his

28 28 1 PIPE shares, a registration statement had to be filed with 2 respect to those securities. And prior to his sale of the 3 PIPE shares, the registration had to be effective. 4 THE COURT: Okay. 5 MS. PAPPAS: The -- I'm sorry. 6 THE COURT: Your argument assumes he's selling PIPE 7 shares. 8 MS. PAPPAS: Yes. 9 THE COURT: It may well be what he intended to do, 10 but was not the effect of an order to short causing the causing the sale of shares from wherever? You say -- you say 12 basically, in effect, a naked short because you say he didn't 13 own them and didn't borrow them and the transaction didn't 14 fail. 15 MS. PAPPAS: Well, okay, and you're buying into what 16 the defendants have said, but let me explain that. 17 Essentially, what we are saying is by the statute 18 itself you can't offer or sell. It does not use the word 19 cover. When in fact the Commission has wanted to use the word 20 cover, it has. A sale itself ultimately -- and let me explain 21 because I think the way to understand this is by the purpose 22 of Section 5. Section 5 is -- has been enacted in order to 23 make sure that buyers have full disclosure at the time of 24 their investment. 25 In this case the buyer bought on October 9th. The

29 29 1 buyer bought from the short sales. And because of that, it 2 was on October 9th that that buyer needed to know that the 3 shares that he ultimately bought, which in fact were the PIPE 4 shares, that buyer needed to know about those shares. 5 So the key here is the fact that it's not what he 6 might have done. The key here is the fact that Mr. Mangan in 7 fact used those 80,000 shares of PIPE stock to cover his short 8 sales made October 9th. It would strain the imagination to 9 see how, as argued by the defendant, the time of the cover of 10 the short sales as opposed to the time of the short sales 11 could be relevant for the analysis by the buyer in order to 12 make an informed investment decision. The buyer at the time 13 he bought those shares had no clue that 80,000 shares were 14 about to flood the market. That's the time when disclosure 15 must be made. This is not taking a leap, Your Honor. This is 16 in fact what the statute's saying. It's saying you got to 17 tell people what they're buying. And here the buyer bought 18 80,000 shares of PIPE -- of the PIPE that had not yet on the 19 first sales been released to the market, and in fact for which 20 no registration statement was effective until October 29th. 21 THE COURT: Is there any evidence that you guys have 22 that the people that bought -- that were on the buying end of 23 the short sale didn't get what they paid for, that is, shares 24 of CompuDyne stock? 25 MS. PAPPAS: The price went down. The price went

30 30 1 down significantly. So when that buyer bought -- 2 THE COURT: That's not -- wait, wait, wait. Listen. 3 MS. PAPPAS: I'm sorry. 4 THE COURT: That's not responsive to my question. 5 MS. PAPPAS: Okay. 6 THE COURT: Is there any evidence that buyers who 7 bought at the short sale didn't get what they paid for, that 8 is, shares of CompuDyne stock? 9 MS. PAPPAS: They bought shares of CompuDyne stock 10 at the existing market price. They did not buy shares of a 11 company which would soon have more than 200 percent more stock 12 in the market. 13 So as a buyer, I would -- I would just say no, I did 14 not get what I thought I was getting. I thought I was getting 15 the stock that had a 200 percent less public float than it 16 actually did. 17 THE COURT: How -- okay. Go ahead. 18 MS. PAPPAS: Rather, it was a time when Mangan 19 offered and short sold and unwitting buyers accepted and 20 purchased the 80,000 shares of CompuDyne PIPE stock that the 21 buyers needed to know about these new unregistered shares. It 22 was at that time and not the time of the cover that the buyers 23 had to make informed investment decisions. That is the point 24 here. 25 I will tell you that schedule -- just so you know,

31 31 1 that the registration statement as described by the securities 2 law is significant. Schedules A and B of the Securities Act 3 give 46 categories of information that must be disclosed to 4 investors in order for investors to make informed investment 5 decisions. Among them are the net proceeds, the use of the 6 proceeds, information about the company, financials, et 7 cetera. That was not available to these investors with 8 respect to these PIPE shares. 9 Mangan also claims that any finding of a violation 10 of Section 5 would violate his right to fair notice because no 11 official or unofficial construction of Section 5 existing in put him on notice that the conduct alleged would subject 13 him to liability for a Section 5 violation. Section 5 by its 14 own terms as just discussed prohibits the sales. He sold the 15 PIPEs to unwitting buyers prior to the effective date of the 16 registration statement. 17 Moreover, as we've gone into at great length in our 18 brief, for three decades the commission has been warning 19 people that this conduct indeed was prohibited by Section THE COURT: Why don't -- you all have rule making 21 authority. Why don't you just make a rule and say that? 22 MS. PAPPAS: We did. Section 5 does, sir. That is 23 what we are saying here. 24 THE COURT: Why did -- wait, wait. If that 25 statement from you is true, why did the SEC in December 2006

32 32 1 concede in the federal register asking for advice about such a 2 rule? 3 MS. PAPPAS: Well -- and let me explain. Let me -- 4 THE COURT: Why did that happen if what you're 5 telling me is true that there was a rule? How come they asked 6 for a comment about a rule and then -- and then you're telling 7 me, well, there was a rule? 8 MS. PAPPAS: In fact -- 9 MS. GREER: You know, I appreciate the fact that 10 you'd like to have that up there, but I would appreciate it if 11 you would take it down. Thank you. You can put up whatever 12 you'd like during your argument. 13 THE COURT: That's fine, ma'am. And guess what. 14 You don't get to do that. You can talk to me and I'll tell 15 him to do that. Have you been in court some? 16 MS. GREER: I apologize, Your Honor. 17 THE COURT: Outstanding. Don't do that again. 18 MS. GREER: I apologize. 19 THE COURT: I know you work for the government, 20 okay. I'm in charge here, not you. If you want to object to 21 something, you may address the court and I'll deal with it. 22 Okay? 23 MS. GREER: I understand, Your Honor, and I 24 apologize. 25 THE COURT: Outstanding. Please do understand.

33 33 1 MS. PAPPAS: Let me address your question. 2 THE COURT: Answer my question. 3 MS. PAPPAS: Let me address your question. 4 THE COURT: How come you got this extraordinary 5 publication in December addressing the very -- the very topic 6 that we're talking about here and now you tell me, well, don't 7 worry about that. Section 5 is the rule and it's violated. 8 MS. PAPPAS: Your Honor, I can give you a quick 9 answer and then I'm going to give you a little bit of history 10 because I think you need it. 11 But the quick answer is the publication you're 12 talking about is dealing with Regulation M which the 13 objection -- objective of which is the stock manipulation in 14 the market and therefore make the world safe for issuers and 15 to keep the prices stabilized. 16 The Section 5 that we have been talking about is a 17 disclosure rule. They are for different and unique purposes. 18 So there may be overlap as to the coverage. 19 THE COURT: But isn't Section 5 a statute? 20 MS. PAPPAS: It is. 21 THE COURT: Okay. And so I'm asking you how come 22 with rule making authority that gives you guys the power to 23 make a rule that says, Mr. Mangan, you can't do this kind of 24 thing MS. PAPPAS: Your Honor --

34 34 1 THE COURT: -- why -- 2 MS. PAPPAS: -- there is -- I don't think there -- 3 there is no regulation because we would have cited it that 4 says this. However, there are statutory interpretations that 5 we have cited in great length in our briefs. And quite 6 honestly, sir, even the Reg M thing that you are citing, the 7 Reg M release that you are citing, has a footnote, as has 8 every single release over the past 30 years that discusses Reg 9 M or Rule 144, which says Reg M and the interpretations 10 thereof do not affect the application of the registration and 11 prospectus delivery requirements of the Securities Act to 12 offers and sales of securities. 13 So every time we bring out one of these new regs 14 that discusses manipulation, we say just because you're clear 15 under here does not mean you're clear under there. We've been 16 very clear about this, Your Honor. This is not -- and it 17 would be the defendant's contention that if we regulate 18 something under one rule, we can't regulate it under another 19 or vice versa. That's not the case here. We have lots of 20 rules out there for disclosure. We have lots of rules out 21 there for other purposes. They may overlap, but the fact that 22 one covers here or does not cover here does not mean another 23 for purposes of disclosure does. 24 THE COURT: Okay. Your argument, as I understand 25 it, is because he knew about a PIPE that was planned but not

35 35 1 announced, the short sale was in effect selling the PIPE 2 shares before it was announced. Is that a good short -- 3 MS. PAPPAS: Not so much the announcement, sir. 4 It's the registration filing under Section 5. 5 THE COURT: Okay. Suppose -- 6 MS. PAPPAS: It's selling -- 7 THE COURT: Suppose it had never happened. Suppose 8 he does a short sale and the PIPE gets withdrawn. 9 MS. PAPPAS: We're here -- we're here, Your Honor, 10 on a motion to dismiss THE COURT: Let's talk about MS. PAPPAS: And that is in fact what had not 13 happened. What the key point here -- and this is where you 14 can get lost in what defendant is saying, but it is incorrect. 15 The point here is that he sold the shares on October 9th. In 16 fact, the shares that the investor who bought on October 9th 17 got were the PIPE shares. So he might have had choices to 18 take shares from anywhere; and if he had taken those shares, 19 maybe this would be a different case. That's not the case 20 here. He sold those 80,000 shares on October 9th. 21 THE COURT: How many -- well MS. PAPPAS: That is -- that is the point. 23 THE COURT: Okay. Let's talk about insider trading, 24 then. 25 MS. PAPPAS: Your Honor, I do want to -- I still

36 36 1 have a little bit of time on this half and I do want to 2 cover -- 3 THE COURT: No, I want you to talk about insider 4 trading. I want you to respond to what Mr. Wyatt talked 5 about. 6 MS. PAPPAS: Okay. 7 THE COURT: There's no issue of -- for the defense, 8 there is no issue of -- there's no question that the 9 information regarding the PIPE as of the time Mr. Mangan 10 called his in-house guy was not public. 11 MR. WYATT: That's correct. 12 THE COURT: Okay. 13 MS. PAPPAS: Okay. First, Mr. Mangan, as we've 14 stated and I'm going to say again, Mr. Mangan misstates the 15 law. Texas Gulf -- this is on the issue as to whether or not 16 the execution time is the proper time to look at when -- at 17 materiality. Mr. Mangan claims that if you look at the 18 CompuDyne price drop after the execution of Mangan's 7:40 a.m. 19 trade, it demonstrates that the information that Mangan had at 20 the time of his trade was immaterial as a matter of law. 21 THE COURT: Wait, wait. How did he trade at 7:40? 22 MS. PAPPAS: He placed his trade as we allege in the 23 complaint, not like Mr. Wyatt says, but rather, we allege 24 Mangan directed a trader to sell short 25,000 shares of stock. 25 That is what we allege in paragraph 45 of our complaint. He

37 37 1 directed a trader by phone because he was traveling. That 2 also is in the complaint. At that time he placed his order. 3 What Mr. Mangan contends is that it doesn't matter 4 because it wasn't executed by whatever broker until what they 5 say is 9:54. 6 In fact, the law says it is the time he placed the 7 trade, and I'll tell you that in a minute. Also, as I will 8 get to, regardless of what version law you follow, it's 9 material as a matter of numbers. 10 Texas Gulf Sulphur is the leading case on this 11 issue. It's a Second Circuit case, Court of Appeals. A 12 corporate insider directed his broker to purchase Texas Gulf 13 stock before an announcement of some import and the trade was 14 executed after the announcement. The court addresses this 15 point squarely, and I quote, "The effective protection of the 16 public from insider exploitation of advance notice of material 17 information requires that the time an insider places an order 18 rather than the time of its ultimate execution be 19 determinative for 10b-5 purposes." 20 The defendant tries to distinguish Texas Gulf using 21 three cited cases that Mr. Wyatt mentioned. Two of those 22 cases are from the same -- Second Circuit, and they quote 23 Texas Gulf and they say we are fully consistent with it. 24 But in both those cases -- turning first to 25 Radiation Dynamics, rather than the placement of an order with

38 38 1 a broker in a public transaction and the execution of the 2 order a short time later, there was here the signing of an 3 agreement and one month later the closing of that agreement. 4 The Second Circuit noted that in Texas Gulf, as in this case, 5 there was relatively speedy sale of securities so the court 6 could readily determine when the trade took place -- or when 7 the sale took place. The court then identified as consistent 8 with Texas Gulf but more workable where there is a deal 9 memorialized in a signed contract but yet closing some days, 10 weeks or months later as the commitment time. In sum, the 11 commitment of the parties to each other should be -- is the 12 date when an insider has committed himself to purchase the 13 stock. 14 Significantly, the court in Radiation Dynamics 15 expressly notes, "The formal closing date when the delivery 16 and payment are formally complete and cleared is not the 17 commitment date." Here the execution date under that 18 reasoning or time would not be the commitment date or time. 19 The other two cases, Castellano, Second Circuit 20 again, cites Radiation and Texas Gulf. Finds after months of 21 negotiation, the plaintiff committed when he signed the 22 severance agreement. 23 Michaels, Seventh Circuit, citing Radiation for the 24 commitment standard, found relevant the date on which 25 plaintiff signed an agreement and not the date of delivery and