Why a Judge Dismissed Cannava From SEC's 38 Studios Case

Brian Kelly

WASHINGTON – A federal judge on Friday dismissed Securities and Exchange Commission charges against Peter Cannava, a banker involved in an ill-fated private placement for startup video game company 38 Studios.

Judge Jack McConnell, who sits on the U.S. District Court for Rhode Island, ruled that there weren't enough facts to support the SEC's claims that Cannava aided and abetted defrauding investors.

However, Wells Fargo, which employed Cannava at the time and served as underwriter on the deal, and the Rhode Island Economic Development Corp., which issued the bonds, remain as defendants in the commission complaint.

McConnell denied a separate motion to dismiss from Wells Fargo, which had argued that the complaint only alleged two omissions, neither of which were misleading or material for investors.

Two former RIEDC employees have settled with the SEC.

"My client is tremendously relieved that the federal court dismissed everything that was pending against him," said Brian Kelly, a partner with Nixon Peabody. "He's relieved that it's over."

Kelly had argued in a memo supporting Cannava's motion to dismiss, along with Nixon Peabody lawyers Stephen LaRose and Kathleen Burns, that the complaint did not "support a finding that Mr. Cannava acted knowingly or recklessly, as is required to allege aiding and abetting a claim." He added that the SEC appeared "to desperately search for a scapegoat to blame for 38 Studios' failure even while it concedes no investor lost a cent."

However, Kathleen Burdette Shields, the lawyer who appeared in court on Friday for the SEC, said she would file an amended complaint to address the judge's concerns, according to AP.

Kelly said he would be prepared to challenge a new complain because there "aren't any facts to support" the SEC's contentions.

The SEC's complaint stems from a $75 million private placement the RIEDC made in November 2010 to help finance a multi-player video game that was to be developed by now-defunct 38 Studios, whose board chair and majority shareholder was former baseball player Curt Schilling.

Kelly's memo depicted Cannava as a 30-year-old mid-level banker at the time of the private placement "who did his job diligently and properly, was part of a larger team of professionals, reasonably relied on counsel, and had no involvement in the decision-making process of the [Rhode Island] legislature, the [RIEDC] or the [RIEDC's] board."

The RIEDC, as part of a state program intended to spur economic development and promote job growth, loaned $50 million of the bond proceeds from the private placement to 38 Studios. It used the rest to pay related bond offering expenses and establish a reserve fund and a capitalized interest fund. The state and investors expected 38 Studios would repay the loan with revenues generated from the video game. The SEC claimed in its complaint that the bond placement memo failed to inform investors that Massachusetts-based 38 Studios needed at least $75 million to produce the game and even more money to relocate to Rhode Island. The company never obtained the extra financing and eventually defaulted on the loan in 2012. The default has not cost investors though, as the investments were backed by a state moral obligation to pay and were insured.

The SEC alleged that Wells Fargo misled investors by not informing them that the firm had a side deal with 38 Studios that allowed it to receive almost double the amount of compensation that was disclosed. The additional compensation came from an earlier fee arrangement when Wells Fargo tried unsuccessfully to raise money for 38 Studios from an equity private placement. The arrangement created a conflict of interest, the commission said.

According to the SEC, Cannava had primary responsibility for Wells Fargo on the 38 Studios bond offering as well as the authority to sign contracts and agreements on behalf of Wells Fargo.

Kelly responded to those charges by saying that Cannava "did not play any role in the decision to provide 38 Studios with economic incentives to move to Rhode Island" and "did not cause 38 Studios to fail."

He also explained that the offering document for the bonds "disclosed in very clear terms the many risks underlying 38 Studios business," including: concerns over the viability of 38 Studios' untested and unknown products; the fact that the company had no revenue and therefore no track record; the real possibility that the company would not be able to make its loan payments; and a "going concern" that the company's auditors' had issued over whether the company would continue to exist as an operating business in the near future.

But that information was not even necessary, he argued, because the nature of the private placement, with backing from Rhode Island and insurance, made information about the state's fiscal health and details about the insurance backing all that was relevant to investors.

The private placement memo did not include any financial statements or financial information about the company, leading Kelly to conclude that "essentially, if the SEC's central point is accurate, the SEC must argue that all of these qualified, institutional investors decided to act on an investment in which they were provided none of the information that is material to their decision."

The RIEDC has not filed an answer to the SEC's complaint but under a previously approved motion for extension of time will have to do so within the 14 days following Friday's ruling.

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