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Custodianship Shells

By Expert Author: Brenda Hamilton

A new form of fraudster is distinguishing himself among the bottom feeders who prey upon small, financially distressed public companies and their shareholders. These fraudsters, who are often securities professionals including transfer agents, accountants and lawyers, engage in corporate takeovers using custodianship and/or receivership actions that DTC are based on fabricated pleadings filed under the penalties of perjury.

The participants in these schemes file fraudulent pleadings in custodianship and/or receivership actions in order to trick a state court judge into providing them with an order appointing a custodian or receiver. They take several carefully planned steps to carry out their scheme. These types of proceedings have become a microcap epidemic. While methods used by the fraudsters vary, the end goal is the same: to obtain control of a public shell company (“public shell”) and sell it in a reverse merger transaction.

Public shells illegally taken over in these proceedings have been featured in reverse merger transactions for some of the most notorious pump and dump schemes in the history of the microcap markets. Fraudsters have literally hijacked hundreds of dormant public shell companies using state court proceeding to obtain inventory for reverse merger transactions. The participants are the suppliers of public shells to unregistered brokers, sleazy investor relations firms and promoters who acquire the vehicles for use in the fraudulent schemes that have caused hundreds of millions of dollars in investor losses.

Who Are the Fraudsters?

These schemes have four participants, at least two of whom are attorneys:

♦ A participant (the “bogus shareholder”) who buys or purports to buy shares of the target public shell so that he can serve as a plaintiff in the bogus state court action;

♦ A participant who is a corrupt or incompetent securities lawyer (the “SEC lawyer”) who provides legal opinions, prepares corporate amendments for reverse splits, domicle changes and name changes, and submits other information to the relevant Secretary of State, transfer agents, FINRA and the SEC;

♦ A participant who serves as a receiver (the “receiver”) often a lawyer; and

♦ A lawyer who files the necessary state court action and receives a default judgment.

How They Pull it Off

When a corporate entity is incorporated, it is required to file a one page annual report with the Secretary of State each year that lists its officers, directors, contact information and registered agent. If the corporate entity fails to file the required report, the relevant Secretary of State “administratively” dissolves the entity. Unlike other types of corporate dissolution, an administratively dissolved entity can be reinstated at any time by paying a nominal fee and sending in a new one page annual report listing the corporation’s officers and directors. Any publicly traded corporation that fails to file its annual report is vulnerable to the scheme. Some schemes involve the fraudsters simply reinstating the corporation and listing themselves or other participants as the officers and/or directors.

What The Hijackers Do To Get Control of the Public Shell l the Florida Example

The scheme varies somewhat from state to start but always involves a bogus shareholder action based upon fraudulent state court pleadings. In Florida for example, the participants rely upon Florida Statutes which allows a shareholder of a Florida corporation to petition the court to appoint a receiver under limited circumstances to manage the corporation’s affairs if the board of directors is deadlocked and the shareholders are unable to break the deadlock. In Florida, the fraudsters file bogus pleadings stating the directors are deadlocked and the shareholders cannot break the deadlock. In reality, no matters were presented to the corporation’s directors or shareholders for a vote.

The Fraud

To pull off their plan, the participants make false statements to a state court judge about the supposed “deadlock” of the board of directors that the shareholders of the corporation cannot break. Most importantly, the participants must swear under the penalties of perjury to these false statements. Needless to say, the participants have no information at all about the affairs of the company or its board of directors, or of actions taken or not taken by majority shareholders including whether there was a deadlock. Additionally, in order to obtain the order from the state court judge, the participants omit various material facts including that they have no intention of seeking a final order for judicial dissolution and that the appointment of the receiver is only to allow them to obtain control of a public entity. The participants simply fabricate the allegations in the verified pleadings. Upon filing the action, the participants typically fail to effect proper service of process on the legitimate management of the corporation enabling them to receive default judgments. Once the action is filed, the participants petition for a hand picked receiver who is a participant to be appointed. Upon appointment, the receiver then causes the issuance of sufficient shares of stock to provide the participants with control of the public entity. After obtaining control but prior to the judge executing the final order for dissolution of the corporate entity, the participants dismiss the action.

How They Get Away With It

Because they participants receive a default judgment, there is no review of their actions. The participants lie to FINRA and the SEC about the true facts of how they obtained control of the relevant public entity. Legitimate shareholders and management of the targeted public shell are not given notice of the bogus proceedings. In order to avoid detection and prevent the legitimate shareholders from filing responses to the bogus legal action, the participants file actions in obscure local courts where they’re going public unlikely to be seen by anyone but the courthouse staff. Because no proper notice of the action is given to the legitimate shareholders and management, the participants receive default judgments, their fraudulent pleadings rubber-stamped by state court judges.

Once the participants receive the order appointing the receiver, they present it to:

♦ the Florida Secretary of State, so that they can list themselves or their designees as officers and directors;

♦ the SEC and FINRA, pursuant to Rule 6490, when they sell the public shell or amend its articles of incorporation; and

♦ the public shell’s transfer agent, to cause it to issue the illegally obtained shares representing control.

The bottom line is that the participants get away with the scheme because nobody ever looks at the pleadings to determine whether the board of directors and shareholders voted.

How the Hijackers Harm the Legitimate Shareholders

Once the receiver is appointed, he sees to it that the corporation issues sufficient shares of stock to the bogus shareholder to ensure the participants’ control of the shell. Typically, the participants change the corporate name and domicile making it difficult for the legitimate shareholders to locate the hijacked entity. Once that’s accomplished, the legitimate shareholders’ interests are impaired by reverse stock splits or other restructurings designed to eliminate or reduce their ownership. The purpose of these corporate actions is to create a more appealing reverse merger candidate for the scheme. By the time the shell is sold, legitimate shareholders may have no idea who controls the company. The participants, on the other hand, will have lined their own pockets with the big fat profits from the scheme.

For further information about this article, please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 202 N, Boca Raton Florida,
at 561-416-8956 or visit http:www.securitieslawyer101.com.

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