June 26, 2019

Tenth Circuit: SEC Asserted Sufficient Evidence that Defendants Were Operating Ponzi Scheme

The Tenth Circuit Court of Appeals issued its opinion in Securities and Exchange Commission v. Traffic Monsoon, LLC on Thursday, January 24, 2019.

The district court ordered the appointment of a receiver and granted a preliminary injunction enjoining Defendants from continuing business. On interlocutory appeal, the Tenth Circuit Court of Appeals affirmed the district court’s preliminary rulings.

Traffic Monsoon is a Utah-based company that allegedly makes most of its money selling internet advertising packages to its members. Members who purchase the “Adpack” package also qualify to share in Traffic Monsoon’s revenue. Approximately 90% of Traffic Monsoon’s members reside outside the United States, and presumably bought the Adpacks while in their home countries.

The SEC alleged that the sale of the Adpacks constituted an illegal Ponzi scheme in violation of § 10(b) of the Exchange Act and § 17 of the Securities Act. The SEC asserted that, regardless of where the transactions had occurred, the Dodd-Frank amendments allowed the SEC to pursue its claims based on significant, allegedly wrongful conduct in the United States.

The SEC obtained from the district court an order for the appointment of a receiver over Defendants’ business and assets, and a preliminary injunction enjoining Defendants from continuing business. On interlocutory appeal, Defendants challenged the district court’s preliminary rulings on three theories.

First, Defendants argued that the antifraud provisions of the federal securities acts do not reach Traffic Monsoon’s sales of, or offers to sell, Adpacks to people living outside the U.S., which amounted to 90% of Traffic Monsoon’s Adpack sales.

The Court noted that while the originally enacted federal securities acts did not address the extraterritorial reach of the acts’ antifraud provisions, courts had historically applied the acts’ antifraud provisions extraterritorially when the “conduct-and-effects” test was satisfied, and treated the issue as a matter of subject-matter jurisdiction. However, Morrison v. National Australia Bank limited the substantive scope of the federal securities laws to U.S. based transactions, and held that the extraterritorial extent of U.S. law is not a jurisdictional issue, instead the issue goes to the substance of the securities laws.

The Court noted that the initial versions of the Dodd-Frank amendments had been drafted before the Morrison decision, and while Congress is deemed to be familiar with Supreme Court precedent when it enacts legislation, in the instant case it was more reasonable to assume that Morrison was issued too late in the legislative process to reasonably permit Congress to react to it.

The Court concluded that Congress had intended the Dodd-Frank amendments to allow the SEC and the United States to sue based on conduct or effects within the United States, regardless of where the securities transactions occurred. In other words, the SEC may bring an enforcement action based on allegedly foreign securities transactions involving non-U.S. residents if sufficient conduct occurred in the United States. The Court therefore applied the “conduct-and-effects” test, and concluded that the SEC’s allegations satisfied the test. Defendants had operated in the United States while allegedly defrauding foreign investors.

Second, Defendants argued that Adpacks are not “securities” and are therefore not subject to federal securities laws. The Court first found that the Adpack is an investment because it offered its purchasers an opportunity to share in Traffic Monsoon’s revenue in addition to the purchased advertising service, and the revenue sharing was in fact the primary drive for purchasing the Adpack. Next, the Court found that the Adpack is a common enterprise, because the shared revenue was generated from the sale of Traffic Monsoon’s advertising services. Finally, the Court found that the revenue Adpack purchasers share is derived almost exclusively from Defendants’ efforts to sell advertising services. The Court therefore concluded that the Adpacks qualified as securities because they met the three-part test for investment contracts.

Finally, Defendants argued that the SEC could not show that Defendants engaged in a fraudulent securities scheme with the requisite scienter. The Court rejected this argument, and found that the SEC had presented sufficient evidence that Defendants were operating an illegal Ponzi scheme with the required scienter, as Defendant’s were operating a Ponzi scheme, which is inherently deceptive because it gives the false appearance of profitability by using money from new investors to generate returns for earlier investors.

In a concurring opinion, Justice Briscoe rejected the premise that the Adpacks were foreign sales outside of the U.S., abating the need to address whether the antifraud provisions of the securities act apply extraterritorially. Instead, the SEC’s allegations satisfied Morrison’s transactional test, because Defendants had sold their products over the internet and had incurred irrevocable liability in the United States to deliver the products to the buyers, wherever located. Therefore, the SEC had sufficiently established that the Defendants sold securities in the United States in violation of the antifraud provisions of the securities acts.

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