|YBM MAGNEX INTERNATIONAL INC.,|
IN THE MATTER OF THE SECURITIES ACT
R.S.O. 1990, c.S.5, as amended
YBM MAGNEX INTERNATIONAL INC.,
HARRY W. ANTES, JACOB G. BOGATIN, KENNETH E. DAVIES,
IGOR FISHERMAN, DANIEL E. GATTI, FRANK S. GREENWALD,
R. OWEN MITCHELL, DAVID R. PETERSON, MICHAEL D. SCHMIDT,
LAWRENCE D. WILDER, GRIFFITHS MCBURNEY & PARTNERS,
NATIONAL BANK FINANCIAL CORPORATION
(formerly known as First Marathon Securities Limited)
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IN THE MATTER OF THE SECURITIES ACT
R.S.O. 1990, c.S.5, as amended
YBM MAGNEX INTERNATIONAL INC.,
HARRY W. ANTES, JACOB G. BOGATIN, KENNETH E. DAVIES,
IGOR FISHERMAN, DANIEL E. GATTI, FRANK S. GREENWALD,
R. OWEN MITCHELL, DAVID R. PETERSON, MICHAEL D. SCHMIDT,
LAWRENCE D. WILDER, GRIFFITHS MCBURNEY & PARTNERS,
NATIONAL BANK FINANCIAL CORPORATION
(formerly known as First Marathon Securities Limited)
STATEMENT OF ALLEGATIONS OF STAFF OF THE ONTARIO SECURITIES COMMISSION
Staff of the Ontario Securities Commission (the "Commission") make the following allegations:
I. The Respondents
1. YBM Magnex International Inc. ("YBM" or the "Company") was incorporated on March 16, 1994, in Alberta, Canada as Pratecs Technologies Inc. On October 5, 1995 the Company changed its name to YBM. YBM became a reporting issuer in Ontario on January 22, 1996. YBM shares were listed and posted for trading on The Toronto Stock Exchange on March 7, 1996. On May 13, 1998 the Commission issued a temporary cease trade order in respect of YBM shares, which order remains in effect. On December 8, 1998, pursuant to an order of the Court of Queens Bench of Alberta, a Receiver was appointed respecting the present and future assets, property and undertaking of YBM.
2. During the period May 1, 1996 to May 13, 1998 (the "material time"), there were eight members of the YBM Board of Directors (the "Directors"), two of whom were officers of the Company. The remaining six directors were not officers of YBM. The Directors were:
a) Harry W. Antes ("Antes"), Chairman of the Board of YBM and a member of the YBM Audit Committee; appointed director on April 29, 1996; a retired Vice President of a technology company;
b) Jacob G. Bogatin ("Bogatin"), President and Chief Executive Officer of YBM; appointed director on April 4, 1994;
c) Kenneth Davies ("Davies"), appointed director on April 4, 1994; a principal of a mineral exploration company;
d) Igor Fisherman ("Fisherman"), Chief Operating Officer of YBM; appointed director on April 29, 1996;
e) Frank S. Greenwald ("Greenwald"), a member of the YBM Audit Committee; appointed director on April 29, 1996; a retired Vice President of an engineering company;
f) R. Owen Mitchell ("Mitchell"), a member of the YBM Audit Committee; appointed director on January 26, 1996; a Vice President and Director of First Marathon Securities Limited (now known as National Bank Financial Corporation),
g) David R. Peterson ("Peterson"), appointed director on April 29, 1996; a partner with a Toronto-based law firm; and
h) Michael D. Schmidt ("Schmidt"), appointed director on April 4, 1994; an independent businessman.
3. Daniel E. Gatti ("Gatti") was the Vice President of Finance and Chief Financial Officer of YBM during the material time, appointed an officer on January 26, 1996.
4. Lawrence D. Wilder ("Wilder") is a partner with the law firm Cassels Brock and Blackwell which was the Canadian general counsel to YBM during the material time. Wilder had primary responsibility for the YBM engagement which commenced on or about September 1995 and ended on August 19, 1998.
5. On or about May 6, 1997, YBM entered into an agreement with two Canadian securities dealers to act as co-lead underwriters (the "Co-Lead Underwriters") for a financing being contemplated at that time by YBM. The Co-Lead Underwriters, and the percentage of the YBM offering each was ultimately obligated to purchase, were:
a) National Bank Financial Corp., known during the material time as First Marathon Securities Limited ("FMSL") which during the material time was, and continues to be, registered under the Securities Act as a Broker and Investment Dealer (35%); and
b) Griffiths McBurney & Partners ("GMP") which during the material time was, and continues to be, registered under the Securities Act as a Broker and Investment Dealer (35%).
6. In addition to FMSL and GMP, there were three "junior" members of the underwriting syndicate for YBM's 1997 public offering, which in accordance with the terms of an Underwriting Agreement dated November 17, 1997 were obligated to purchase the remaining 30% of the YBM offering.
7. During the material time when Mitchell acted as a Director of YBM, he was also the principal representative of FMSL in the underwriting syndicate.
II. Overview of Staff's Allegations
8. There are six specific allegations being advanced by Staff of the Ontario Securities Commission ("Staff"), which may be summarized as follows:
a) that YBM filed a preliminary prospectus dated May 30, 1997, and a final prospectus dated November 17, 1997, that failed to contain full, true, and plain disclosure of all material facts relating to the securities offered; specifically, material facts respecting the mandate, information obtained by and findings of the Special (Independent) Committee created by the YBM Board of Directors on August 29, 1996;
b) that the Directors, Chief Executive Officer and Chief Financial Officer of YBM authorized, permitted or acquiesced in YBM filing a preliminary prospectus dated May 30, 1997 and a final prospectus dated November 17, 1997 that failed to contain full, true and plain disclosure of all material facts relating to the securities offered; specifically, material facts respecting the mandate, information obtained by and findings of the Special (Independent) Committee created by the YBM Board of Directors on August 29, 1996;
c) that the Co-Lead Underwriters signed a certificate to a preliminary prospectus dated May 30, 1997 and a final prospectus dated November 17, 1997 which prospectuses, to the best of their knowledge, did not contain full, true and plain disclosure of all material facts relating to the securities offered; specifically, material facts respecting the mandate, information obtained by and findings of the Special (Independent) Committee created by the YBM Board of Directors on August 29, 1996;
d) that YBM failed to comply with its continuous disclosure obligations by not issuing a news release forthwith disclosing the nature and substance of a material change in the affairs of YBM; specifically, that the auditor for YBM, Deloitte & Touche LLP (U.S.) ("D&T"), had advised YBM by no later than April 20, 1998 that it would not perform any further services for YBM, including the rendering of an audit opinion in respect of YBM's 1997 annual financial statements, until YBM had completed an in-depth forensic investigation addressing specific concerns to the satisfaction of D&T;
e) that the members of the YBM Audit Committee (Antes, Greenwald and Mitchell), the Chief Executive Officer (Bogatin), the Chief Financial Officer (Gatti) and the Chief Operating Officer (Fisherman) of YBM authorized, permitted or acquiesced in YBM failing to comply with its continuous disclosure obligations by not issuing a news release forthwith disclosing the nature and substance of a material change in the affairs of YBM; specifically, that the auditor for YBM, D&T, had advised YBM by no later than April 20, 1998 that it would not perform any further services for YBM, including the rendering of an audit opinion in respect of YBM's 1997 annual financial statements, until YBM had completed an in-depth forensic investigation addressing specific concerns to the satisfaction of D&T; and
f) that Wilder made statements to Staff of the Commission during the course of Staff's review of YBM's preliminary prospectus that, in a material respect and at the time and in the light of the circumstances under which the statements were made, were misleading or untrue or did not state a fact that was required to be stated or that was necessary to make the statements not misleading; specifically, statements contained in a letter from Wilder to Staff dated July 4, 1997 concerning the results of due diligence conducted in respect of YBM.
III. YBM's Corporate Structure During the Material Time
9. Although YBM was a Canadian company during the material time, as of May 1, 1997 it had no Canadian operations. YBM's head office was located in the United States, the location of its wholly-owned subsidiary YBM Magnex Inc ("YBM Inc."). YBM Inc. controlled 100% of the "ordinary" shares of Arigon Company Ltd. ("Arigon"), an Alderney, Channel Islands company, with offices in Budapest, Hungary. YBM Inc. also controlled 100% of the "ordinary" shares of United Trade Limited ("UTL"), a Cayman Islands company. On or about April 1, 1996, Arigon assigned its assets and business to UTL, also with offices in Budapest, Hungary. The assets and business assigned to UTL included approximately 99.9% of the shares of Magnex RT ("RT"), a Hungarian corporation also located in Budapest, Hungary. On April 1, 1996 YBM divested itself of another subsidiary, Arbat International, Inc. ("Arbat"), a Russian trading company. On or about August 22, 1997, YBM completed the acquisition of Crumax Magnetics, a magnet manufacturer located in the United States.
10. According to YBM's public disclosure as of May 1, 1997, YBM was a manufacturer and distributor of magnets. YBM also bought and sold oil. YBM's magnet manufacturing process was conducted by RT which owned manufacturing facilities in Budapest, Hungary. Pursuant to agreements entered into between RT and Arigon in September 1992, Arigon transferred to RT machinery and equipment necessary for the manufacture of magnets. Arigon also became responsible for securing all applicable clearances for production purchases and delivery of materials and supplies to RT. Arigon also became responsible for arranging for the marketing, sale and distribution of the products manufactured by RT as well as the marketing, sale and distribution of products manufactured by others. Arigon was also responsible for the purchase and sale of oil. On or about April 1, 1996, these responsibilities were assumed by UTL. Fisherman, who was the President of Arigon, and other officers and directors of Arigon, resigned their positions at Arigon and assumed the same appointments with UTL.
11. On April 29, 1996, the newly constituted Board of Directors of YBM (elected by the YBM shareholders at the annual meeting held earlier that day) held a meeting attended by all of the Directors and YBM's Canadian general counsel. During the meeting the Directors discussed the reasoning for the divestiture of Arbat and the relocation of Arigon. The minutes of the meeting record the following:
The Chairman [Bogatin] updated the board as to various other matters including the Company's plans to sell Arbat International Inc. to a group of arm's length purchasers for consideration equal to approximately (US) $250,000. The Chairman indicated that the rationale for the sales [sic] was that the Company's operations in Eastern Europe were difficult to supervise and exposed it to certain potential liability. The Chairman confirmed that Arbat will continue to render services to the Company but only on a contractual basis.
The Chairman also advised the board of a proposal to relocate the Company's wholly-owned subsidiary, Arigon Co. Ltd. from the Channel Islands U.K. to the Cayman Islands. The Chairman explained that the rationale for such move was to bring Arigon's operations closer to the Company's North American headquarters. The Chairman advised that the Royal Bank of Canada was assisting the Company and Arigon in this move. The Chairman also advised that upon completion of such move, Arigon's name will most likely be changed to United Trade Limited. The Chairman advised that this move would be accomplished by way of a tax free reorganization of assets.
IV. The Alleged Failure to Make Full, True and Plain Disclosure of All Material Facts
i) What Was Disclosed by YBM?
12. On May 30, 1997 YBM filed a short-form preliminary prospectus with the Commission.
13. The preliminary prospectus contained a Certificate which was signed by Bogatin and Gatti in their capacity as CEO and CFO respectively, and by Antes and Peterson on behalf of the Board of Directors. The Certificate stated that:
The foregoing together with documents incorporated herein by reference, constitutes full, true and plain disclosure of all material facts relating to the securities offered by this prospectus as required by the securities laws of the provinces of...Ontario...
14. The preliminary prospectus also contained a Certificate signed by each of the underwriters (including the Co-Lead Underwriters) stating that:
To the best of our knowledge, information and belief, the foregoing, together with the documents incorporated herein by reference, constitutes full, true and plain disclosure of all material facts relating to the securities offered by this short form prospectus as required by the securities laws of the provinces of...Ontario...
15. YBM's Annual Information Form, dated May 1, 1997 ("AIF"), was incorporated by reference in the preliminary prospectus. The AIF stated, in part, under the heading "Business Risks, Risks Associated with Activities in Eastern Europe", that:
The Company's manufacturing operations are located in Hungary. Additionally, 47% of consolidated net sales are concentrated in Eastern Europe. Economic, political and general business conditions in these regions are highly inflationary and are potentially unstable.
The evolving market economies in Eastern Europe are characterized by a high level of cash transactions as well as less rigorous financial controls. The Company has and continues to implement recommendations made by independent public accountants and others with expertise in these regions to improve the Company's operations in these regions.
Over the last two years the Company became aware of concerns that had been expressed in the media and by government authorities generally concerning companies doing business in Eastern Europe and, particularly, in Russia. To this end, the Company has taken a number of steps to address these concerns, including:
1. The divestiture in the first quarter of 1996 of Arbat International Inc. ("Arbat"), the Company's Russian trading company which distributed a variety of consumer goods and materials through Eastern Europe and Russia. Upon a review of Arbat's operations, management was not satisfied that adequate customer and sales representative acceptance procedures could be implemented, including monitoring the propriety of sales commissions paid to sales representatives; and
2. the establishment of an independent committee of the Board of Directors who retained experts knowledgeable with political, social and economic issues in Eastern Europe to review the Company's operations to ensure that they are consistent with the standards applicable to Canadian public companies. Recommendations resulting from such review are being implemented by the Company. The Board of Directors, through the Audit Committee, will monitor ongoing compliance by the Company with such recommendations.
16. On June 3, 1997 a meeting was held between Staff responsible for the review of the preliminary prospectus, Canadian general counsel for YBM, counsel for the underwriters (Fogler, Rubinoff) and senior officers of the Co-Lead Underwriters. The purpose of the meeting was to discuss the time frame for Staff's review of the preliminary prospectus. During the course of the meeting Staff was informed that YBM had hired The Fairfax Group, a firm located in the United States, to look into rumours and innuendo surrounding the Company. Staff was informed at this meeting that Fairfax could not find any evidence to substantiate the rumours. Staff was also informed that YBM's Canadian general counsel did not look into whether the authorities in the United States had any concerns with the Company, but understood that the United States Justice Department approved the Crucible [Crumax Magnetics] transaction which gave Canadian general counsel comfort.
17. Staff issued its first comment letter in respect of the preliminary prospectus on June 16, 1997. Among the comments made by Staff in respect of the AIF was the following:
On page 6, under the heading "Risks Associated with Activities in Eastern Europe", reference is made to new standards for business practices being implemented by the Board. Please describe the circumstances respecting the review [by the Independent Committee of the Board of Directors referred to in the AIF] of the Company's operations. What recommendations are being implemented? Describe the "standards applicable to Canadian companies". [emphasis added]
18. On June 18, 1997 YBM, through their Canadian general counsel, in a letter copied to counsel for the underwriters, responded to Staff's first comment letter and, in connection with Staff's request for information in respect of the "Circumstances Surrounding the Review of the Company's Operations", stated as follows:
Over the past year, the Company has had some difficulty in being issued certain business visas for employees. As a result, the Company decided to investigate this further in order to resolve the problem. The Company's efforts confirmed that U.S. law enforcement agencies had placed a priority on uncovering infiltration of organized crime from the former Soviet Union into U.S. businesses. Given the roots of the Company and its affiliates in Russia, and the involvement of former Russian nationals as shareholders and managers of the Company, the Company believes that it may have been examined as part of any such investigation. The visas which prompted the concerns were subsequently issued by the U.S. Government without comment.
As noted in the AIF, the Company took a number of steps to address any possible concerns, including the divestiture in the first quarter of 1996 of Arbat International Inc., the Company's Russian trading company, and the establishment of a special committee of the board to review the operations of the Company in Eastern Europe.
Special Committee Recommendations
The Special Committee made the following recommendations which have been or are being implemented by the Company's management:
- Establishment of improved cash controls at the Company's Hungarian facilities;
- Establishment of more detailed customer and agent approval criteria;
- Establishment of a more accurate data base on these customers and agents;
- Establishment of new management information systems; and
- Consolidation of accounting control at the Company's Newtown, Pennsylvania, head office through establishment of integrated information systems at each site of the Company's operations.
Standards Applicable to Canadian Companies
The reference in the AIF to "standards applicable to Canadian companies" refers to internal controls and financial reporting requirements normally found in diversified Canadian public companies. [emphasis added]
19. On June 24, 1997 Staff requested that YBM undertake an independent audit of YBM's income statement for the year ended December 31, 1996 and requested that the assignment be performed by a "Big Six" accounting firm. In response to Staff's proposal, by letter dated July 4, 1997, Wilder informed Staff as follows:
As discussed above, the Confirming Accountant will be in a position to deliver its report to you no later than Tuesday, July 8, 1997. Based upon the results reported to date, we believe that the report will represent a continuation of the series of favourable due diligence results pertaining to the business of YBM conducted by independent parties. This stands in stark contrast to the rumors and innuendo to which YBM has been subject and which , based upon the information provided to us to date, have not been subject to any outside scrutiny or independent verification whatsoever.
As discussed previously, the Company, its advisors, as well as the underwriters and their advisors have made every effort to address each concern raised to date in order to complete this financing and allow the Company to complete its acquisition transaction which is crucial to its continued success. Needless to say, YBM's inability to proceed with this financing despite the efforts of all the parties concerned and referenced herein would have serious and lasting negative consequences to the Company and its shareholders. We respectfully submit that such an occurrence would not be in the public interest in view of the extensive due diligence completed to date and the uniformly positive results thereof. [emphasis added]
20. On October 13, 1997 D&T issued an unqualified audit opinion in respect of YBM's financial statements as of December 31, 1996. The audited financial statements formed part of a material change report issued by YBM dated November 13, 1997.
21. On November 17, 1997 Bogatin and Gatti, in their capacity as CEO and CFO respectively, and Antes and Peterson, on behalf of the Board of Directors, signed the Certificate to YBM's final prospectus representing that the prospectus, together with the documents incorporated by reference therein, constituted full, true and plain disclosure of all material facts. Each of the underwriters (including the Co-Lead Underwriters) signed a Certificate representing that, to the best of their knowledge, information and belief, the prospectus and the documents incorporated by reference therein, constituted full true and plain disclosure of all material facts.
22. On November 20, 1997 YBM received a receipt for the final short-form prospectus dated November 17, 1997. Pursuant to the final prospectus YBM distributed 3.2 million common shares for gross proceeds of $52.8 million. In addition, the final prospectus qualified the distribution of an additional 4 million common shares issuable upon the conversion of $48 million of secured convertible notes which YBM had previously distributed, on a prospectus-exempt basis, on or about August 21, 1997. The underwriters' fee, exclusive of any over-allotment option, was $2,376,000. In addition, subsequent to the closing of the public offering, YBM paid to FMSL and GMP $600,000 each for advisory services rendered in connection with the $48 million private placement noted above.
23. The final prospectus continued to incorporate by reference YBM's AIF. Also incorporated by reference was the November 13, 1997 material change report. In respect of the review of the Company's operations conducted by the independent committee of the YBM Board of Directors and experts retained by it, as referred to in the AIF, the only additional disclosure contained within the final prospectus, or any document incorporated by reference therein, was the following, as stated in the final prospectus:
In order to address the special risks inherent in carrying on business in Hungary in particular and Eastern Europe in general, YBM:
(a) has established improved cash controls at its Hungarian facilities;
(b) has developed more detailed end user and distributor approval criteria;
(c) is in the process of establishing a more accurate database respecting its distributors and end users;
(d) is in the process of implementing new management information systems; and
(e) is in the process of improving and centralizing controls over all of its international accounting activities at its Newtown, Pennsylvania head office.
The intent of the foregoing initiatives is to ensure that despite the fact that YBM carries on a substantial portion of its activities in Eastern Europe, its internal controls and financial reporting standards will be in accordance with those otherwise generally applicable to Canadian public companies...
ii) What Was Not Disclosed?
24. On August 15, 1996 the Board of Directors of YBM held a meeting at the YBM offices in Newtown, Pennsylvania. All of the Directors were in attendance along with Gatti, Wilder, and YBM counsel from the United States ("U.S. Counsel"). According to the minutes of the August 15, 1996 meeting, the following was discussed:
Jacob Bogatin and Daniel Gatti discussed the largely publicized interest of the United States government in companies doing business in Eastern Europe. They indicated that it is likely that the United States government has an interest in YBM because of the degree of scrutiny employees receive traveling to and from YBM's Hungarian operations and because of comments made to management in pursuing reasons for such delays. In addition, YBM Magnex has sponsored a number of employees (Hungarian and Russian nationals) in obtaining visas and has assisted many of them with US Immigration Laws. They informed the board that management in the past six months, had tried to establish closer ties to U.S. embassys [sic] abroad. They also indicated that the U.S. government, probably as a matter of policy, looks at any company with ties to Eastern Europe. Management does not believe such interest will be alleviated until the market economies in Eastern Europe are fully developed and business relationships between the East and West become routine. [emphasis added]
25. Among the "comments made to management in pursuing reasons for such delays" were comments made by U.S. Counsel for YBM to Bogatin on August 2, 1996. U.S. Counsel reported on inquiries made of the United States Attorney for the Eastern District of Pennsylvania, stating as follows:
Peter called the U.S. Attorney and requested a meeting and offered the Company's full cooperation. The U.S. Attorney returned Peter's call and said he could not meet with us [YBM]. He confirmed that the Department of Justice was conducting a "highly sensitive" criminal investigation of YBM Magnex and that it would be inappropriate to meet with us. He told Peter that nothing we could offer would be appropriate at this time. He said he could not discuss the nature of the investigation because it is "especially sensitive".
In view of the fact that, for the first time, we have a confirmation that YBM Magnex is the target of a federal criminal investigation, we must advise that this information be immediately made known to the Board of Directors. Peter and I are willing to meet with your Board and make a full report, if you believe it would be helpful. The Board may wish to consider undertaking a full internal investigation, although we have previously discussed the difficulties of investigating when we are unaware of the nature of the specific allegations against the Company.
I believe we have exhausted our efforts to obtain information about the nature of the concerns that the federal government has about YBM Magnex. We have no idea how long this cloud may continue to linger over the Company. We do know, however, that the situation is serious. [emphasis added]
26. On August 29, 1996 a Special Meeting of the YBM Board of Directors was held in Toronto. Minutes of this meeting have not been identified. Attending this meeting were: Antes, Davies, Greenwald, Mitchell, Peterson, Wilder and U.S. Counsel for YBM. The Board concluded that a Special (Independent) Committee should be formed to investigate the situation. It was further decided that no further discussions would be held or attempted with U.S. authorities until the Special Committee provided a final report. Members of the Board appointed to the Special Committee were Mitchell (Chair), Davies and Schmidt.
27. On November 1, 1996 the Board of Directors held a meeting via conference call. No minutes or notes of this meeting have been identified. However, the Special Committee prepared an Interim Report entitled "Report of the Special Committee to the Board of Directors" (the "Interim Report") on or about November 1, 1996. The Interim Report included the following comments:
In August 1996, the management of [YBM] were made aware of a pending investigation of the Company and its activities through the U.S. Attorney's office in Philadelphia. The focus of the investigation was not disclosed, however, discussions with counsel confirmed that U.S. law enforcement agencies had placed a priority on uncovering infiltration of Organized Crime from the Former Soviet Union into U.S. business. Given the roots of YBM and its affiliates in Russia and the involvement of former Russian nationals as shareholders and managers of the Company it was viewed to be a reasonable expectation that this would be the basis of such investigation.
28. The Interim Report described the mandate of the Special Committee as being to "independently investigate possible areas of concern" and to "report back to the Board on findings and recommended further actions". The Interim Report also indicated that the Special Committee "was given clear authority to undertake any independent actions or investigations which it felt were appropriate". Among the further actions proposed by the Special Committee was to engage a "professional East European investigator to provide [the Special Committee] with a background dossier on certain individuals who were original shareholders of YBM and/or who have acted as commissioned salespeople receiving material compensation from the Company".
29. On or about November 8, 1996, at the recommendation of Peterson, YBM retained the services of an independent company, The Fairfax Group, Ltd. ("Fairfax"). Fairfax, now known as Decision Strategies/Fairfax International LLC, is an international investigative and security firm that conducts corporate investigations. The Fairfax officials responsible for the YBM investigation consisted of three senior officials: a lawyer who was a former Special Prosecutor; a forensic accountant; and a retired U.S. Ambassador and former senior official with the U.S. State Department. A Retainer Agreement was entered into on or about November 14, 1996 signed on behalf of YBM by Mitchell. Fairfax's initial assignment was to "assist the client by undertaking a due diligence and internal investigation of YBN [sic] Magnex, International located in Philadelphia and Hungary".
30. In conducting its investigation, Fairfax performed extensive background checks on various persons and companies associated with YBM relying on various data bases and a network of sources located throughout the world. They also attended at offices of YBM and its subsidiaries in Philadelphia and Budapest, spoke with members of senior management, reviewed company records and met with some of the original shareholders of YBM. In the period December 1996 to March 21, 1997 Fairfax regularly briefed Mitchell on the status of its investigation, including an extensive briefing on March 3, 1997 at a meeting in Chapel Hill, North Carolina during which Mitchell informed Fairfax that he would write a report reflecting the information provided by Fairfax.
31. On March 21, 1997 Fairfax reported orally on the results of its investigation to date at a meeting in Toronto. Participating in this meeting on behalf of YBM were Mitchell and Wilder in person, and Antes and Schmidt via telephone. At the conclusion of Fairfax's presentation, Mitchell requested Fairfax to make the same presentation at a meeting in Philadelphia the following day. Participating in the March 22, 1997 meeting on behalf of YBM were Mitchell, Antes, Bogatin, Gatti, Wilder and YBM's U.S. Counsel.
32. Among the information conveyed by Fairfax during the meetings on March 21 and 22, 1997 was the following:
a) that reliable Fairfax sources in several agencies of the United States Government had indicated that the visa problems being experienced by YBM personnel were due to issues involving national security and organized crime;
b) that the original shareholders of YBM were confirmed as being members of the same Russian organized crime syndicate (the "Organization"), with interests in Europe (East and West), the Middle East and North America;
c) that among the companies which reliable sources had identified as being owned or controlled by the Organization were Arbat in Russia, Arigon in the United Kingdom and "Magnek" in Hungary;
d) that a review of YBM records had revealed that sales commissions in excess of $2.5 million had been paid by Arigon to a principal leader of the Organization and his chief assistant in the years 1993 to 1996;
e) that the equipment sold by the original shareholders to RT for approximately $14 million may have been overvalued, the equipment having been purchased for one-tenth of the value recorded on the books of RT, and that the records documenting this transaction may be false;
f) that the sale of Arbat on or about April 1, 1996 for $250,000 (of which only $150,000 was received by YBM) was to two persons who were identified as being members of the Organization and as having received sales commissions from Arigon/UTL in 1996 totaling in excess of $150,000;
g) that UTL was using a bank account, in the name of a company which was not part of YBM's publicly disclosed corporate structure, as its main operating account; that transactions involving millions of dollars went through the account; and that this account was controlled by one of the YBM original shareholders who was neither an officer nor an employee of UTL;
h) that there were indications that certain books and records had been falsified;
i) that in the opinion of Fairfax all of the "ingredients" were present for YBM to be used for money laundering activities; and
j) that in respect of companies with which YBM was doing business, some of these companies were shells, others were shells within shells, others did not exist, and still others were owned by persons who had received sales commissions from Arigon/UTL.
33. At both the March 21 and 22, 1997 meetings, Fairfax made it clear that in their view the key issue confronting YBM was that there were a number of organized crime figures involved in the operations in Hungary and that this was a serious problem. Fairfax made a number of recommendations for YBM's consideration.
34. On April 9, 1997 Mitchell sent to Fairfax for their review and comment a document, drafted by Mitchell and Wilder, entitled "Report of the Special Committee to the Board of Directors YBM Magnex International Inc. April 2, 1997". Fairfax had significant reservations respecting the contents of this document which included a section entitled "Results of the Fairfax Review". Fairfax provided their comments to Mitchell in a telephone conference call on April 10, 1997. Fairfax informed Mitchell that the report was inaccurate and that it did not reflect Fairfax's findings and the information which had been conveyed to Mitchell. Subsequently, Fairfax did not receive any further information as to what, if anything, Mitchell may have reported to the YBM Board of Directors.
35. On April 13, 1997 at the request of YBM, Fairfax attended a meeting in Philadelphia. Bogatin, Gatti and Mitchell attended this meeting on behalf of YBM. At this meeting Bogatin attempted to refute the information provided by Fairfax indicating that there was no clear proof. Fairfax stood by its findings. Mitchell indicated that Fairfax might receive a call from certain underwriters.
36. At no time prior to May 13, 1998 was Fairfax contacted by anyone to discuss the work which they undertook on behalf of YBM. In particular, Fairfax was not contacted by any Director of YBM who did not participate in the meetings noted above. Nor was Fairfax contacted by any person identifying themselves as a representative of the underwriters. At no time did Fairfax express to YBM or its advisors any reluctance to speak with underwriters or any other third parties at the direction of YBM.
37. A copy of the "Report of the Special Committee to the Board of Directors YBM Magnex International Inc. April 2, 1997" was provided to FMSL and to counsel for the underwriters. The word "Draft" is written on the upper right-hand corner of the document. According to counsel for the underwriters, the contents of this report were fully and fairly described by Mitchell at a meeting attended by a representative of GMP. Information contained within this report may be summarized as follows:
a) U.S. Counsel for YBM was advised "off the record" by the U.S. Attorney's Office that there was an "ongoing investigation" involving YBM; while unable to uncover further particulars counsel confirmed that U.S. law enforcement agencies had placed a priority on uncovering infiltration of organized crime from the former Soviet Union into U.S. business; on August 15, 1996 YBM management informed the Board of Directors of its discussions, through counsel, with the U.S. Attorney's Office;
b) on August 29, 1996 a Special Committee was formed to investigate the situation; counsel for YBM advised that due to a lack of clarity surrounding the matter, public disclosure should not be made at that time;
c) the mandate of the Special Committee was to independently investigate possible areas of concern arising out of the Company's business operations to attempt to determine the basis for any investigation and to recommend further action to address any problems or potential problems uncovered;
d) the initial review of the Special Committee focused on shareholder and employees/commissioned salespeople, and on contractual arrangements with customers; these two areas were chosen as a focus "because the greatest threat to the Company would be an investigation which questioned the legitimacy of its core business";
e) the Special Committee reviewed the original shareholders list; this review did not raise any concerns, but the Special Committee nevertheless undertook a further review;
f) there is no evidence that the existence of any investigation has impacted on trading whatsoever; "Accordingly, the Committee assumes that, to date, in accordance with the strict direction of the Board, the information has not been disclosed to parties outside the Company, its Board and advisors";
g) the initial review of the Special Committee identified very substantial commission payments paid by Arbat which seemed inconsistent with Arbat's business;
h) the Special Committee was concerned about one set of parallel records which showed substantial payments to a person on one set and the exact same payments to a corporate entity with a different name on another; later a third version was identified and had different amounts and payees; management of YBM had no explanation for this;
i) on November 1, 1996 the Special Committee reported to the Board on the initial review recommending that further investigation of the original shareholders be undertaken and that commissions paid also be reviewed; it was recommended that experts in this type of investigation be engaged as soon as possible;
j) the Special Committee retained Fairfax, a large U.S. consulting organization operated by former senior Justice Department, State Department and F.B.I. officials; Fairfax came highly recommended and exhibited a strong track record with respect to dealings in Eastern Europe;
k) Fairfax was requested by the Special Committee to: discover more details respecting the "ongoing investigation"; do background checks on management and the original shareholders; do background checks on recipients of commissions; randomly examine business transactions recorded in the records of the Company to ascertain if bona fide; and review YBM operations and make recommendations regarding improved controls;
l) the Results of the Fairfax review [as reported in the "Report of the Special Committee to the Board of Directors YBM Magnex International Inc. April 2, 1997" which was provided to FMSL] included the following:
i) initial background checks on management showed no concerns regarding Bogatin or other managers located in the United States; in Eastern Europe, however, a number of concerns arose; recipients of Arbat commissions in 1993-95 had clear ties to Russian organized crime; another recipient of commissions from Arbat was incarcerated in Switzerland; the basis of these payments appears to be unsupportable; even though Arbat was sold it was under the operating control of one of the original shareholders; Arbat was identified as an alleged vehicle for criminal acts;
ii) the original transaction respecting the acquisition of the equipment "was not as originally described"; prices paid were not as recorded on invoices; invoices were prepared well after the fact; the price paid by original shareholders for the equipment "is a fraction of the face value taken back by the original shareholders in preferred shares";
iii) "A second area of concern raised by Fairfax was the commingling of the business activities of Magnex RT, United Trade (the offshore sales arm of YBM) and those of the original shareholders resident in Budapest. The same office building was being used to transact activities for all the businesses and [one original shareholder] in particular was actively involved in activities related to United Trade and Magnex RT despite not being an officer or employee of either company. There was a bank account (since terminated) through which Company business was transacted to which [this original shareholder] was a signing officer. Management has already taken steps to relocate office activities and ensure proper separation"; this same original shareholder has a long-standing friendship with YBM's Chief Operating Officer; "foreign sources also connect the original shareholders with criminal activities including prostitution although none have been convicted or are wanted by authorities";
iv) there were a substantial number of cash transactions, in particular payment of salaries and commissions; there was a large volume of cash on hand; management has already taken steps to severely restrict the use of cash payments; and
v) the customer lists were reviewed and it was very difficult to establish end users for the products because of the use of intermediate agents for most sales;
m) the Conclusions of the Special Committee included the following:
i) there is no evidence that "senior management of YBM is in any way involved in any illegal or improper activities";
ii) that in respect of the questions surrounding the original shareholders, "it is not surprising that allegations should be made at successful businessmen of Russian origin trading between the Former Soviet Union and the West";
iii) the original shareholders, in aggregate, control over 40% of YBM common stock; "the existence of this block of shareholders is of concern to the Committee. This concern will be reduced following the completion of the equity issue to fund the Crucible acquisition..."; and
iv) the Committee directed management to eliminate any ties to the original shareholders in the "day-to-day operations of the Company";
n) the Recommendations of the Special Committee were as follows:
"a) Provide the Board with an action plan to address each of the following areas:
- Elimination of commingling of business activity with that of Company shareholders in Europe;
- Establish operational controls to ensure that management remains operationally independent from the founding shareholders;
- Establishment of improved cash controls in Hungary;
- The setting of more detailed customer and agent approval criteria;
- The establishment of an accurate data base on these customers and agents;
- Consolidation of accounting control in Newtown; and
- Engage a major accounting firm for the completion of future audits.
b) Establish a permanent subcommittee of the Board or the Audit Committee to supervise compliance with these recommendations and other issues surrounding corporate ethics in the future.
c) Advise the underwriters financing the acquisition of Crucible as to the background and results of this investigation.
d) Consider the establishment of a voluntary escrow of the Original Shareholders' shares until the completion of the acquisition and the clearance of the associated Special Warrants." [emphasis added]
38. On April 25, 1997 there was a meeting of the YBM Board of Directors held in Toronto. The meeting was attended by all of the Directors with the exception of Fisherman. Among others in attendance were Gatti and Wilder. Among the items on the agenda for this meeting was the "Report of Special Committee", which discussion was to be led by Mitchell.
39. Mitchell has indicated that a version of the report marked "BOARD DISCUSSION DRAFT", substantially similar to the version of the report provided to FMSL summarized above, was presented to the Directors at the April 25, 1997 Board meeting. Approved minutes of this meeting have not been identified.
40. One set of draft minutes of t