August 24, 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The Court noted that while the originally enacted federal securities acts did not address the extraterritorial reach of the acts’ antifraud provisions, courts had historically applied the acts’ antifraud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.

Tenth Circuit: Overly Optimistic Reporting Not Enough to Prove Scienter

The Tenth Circuit Court of Appeals issued its opinion in Anderson v. Spirit AeroSystems Holdings, Inc. on Tuesday, July 5, 2016.

Spirit AeroSystems Holdings, Inc., agreed to manufacture parts for two Gulfstream aircraft and a Boeing 787. Spirit managed the production of the parts through three projects, each of which encountered production delays and cost overruns. Nevertheless, Spirit executives expressed optimism to investors about the company’s ability to break even. However, in October 2012, Spirit announced the projected loss of hundreds of millions of dollars on the three projects. The investors brought a class action against Spirit and four of its executives—CEO and president Jeffrey Turner, CFO Philip Anderson, Oklahoma Senior Vice President Alexander Kummant, and Vice President Terry George, who was overseeing the Boeing 787 project—for violating § 10(b) of the Securities Exchange Act and SEC Rule 10b-5. Plaintiffs alleged that Spirit and the executives misrepresented and failed to disclose cost overruns and project delays. Defendants moved to dismiss, arguing that the plaintiffs failed to allege facts showing misrepresentations or omissions that were false or misleading and material, and failed to show scienter. The district court granted defendants’ motion, in part agreeing that plaintiffs had failed to show scienter. Plaintiffs appealed.

The Tenth Circuit compared the evidence set forth by plaintiffs to show scienter with the defendants’ explanations, noting that the inference of scienter would only suffice if it were at least as cogent and compelling as any other inference that could be drawn from the facts. Plaintiffs alleged that defendants knew throughout the class period that the projects were experiencing setbacks and generating so much in additional costs that a loss would be inevitable, yet they failed to warn investors of the forward loss until October 2012. Defendants argued that despite the setbacks, they were optimistic that the projects would meet the original cost forecasts, and expected revenues to exceed total costs. When Spirit realized that a loss was likely, it promptly announced a forward loss on the three projects. The Tenth Circuit found Spirit’s explanation that it was overly optimistic more compelling than an inference that the executives intentionally misrepresented or recklessly ignored economic realities. The Tenth Circuit noted that the plaintiffs presented little evidence to presume malevolence over benign optimism.

The Tenth Circuit approved of the district court’s consideration of a lack of a motive to commit securities fraud as a mitigating factor against scienter. Although the plaintiffs did not need to show a motive, the absence of one was relevant. The plaintiffs also proposed testimony by corroborating witnesses, but the Tenth Circuit determined the witnesses were too far removed from the executives to have been able to testify as to the executives’ state of mind. Plaintiffs also alleged that the defendants had a duty to disclose project overruns and delays, but the Tenth Circuit refused to infer scienter from the defendants’ failure to disclose, finding instead that there was no evidence that the defendants knew they needed to disclose more or were reckless in their failure to disclose. The Tenth Circuit disposed of plaintiffs’ remaining claims, characterizing them as “fraud by hindsight” but not securities fraud. Plaintiffs argued that Spirit’s recovery plan for the 787 project supported an inference of scienter, but the Tenth Circuit again accepted the defendants’ explanations of innocent optimism. The plaintiffs also argued that the sheer magnitude of the loss supported an inference of scienter, but the Tenth Circuit noted that the plaintiffs failed to show that the executives knew that their public reports were too encouraging or had recklessly failed to heed red flags from problem reports.

The Tenth Circuit affirmed the district court’s dismissal. Judge McHugh concurred in part and dissented in part; she would have found that Anderson and Turner made materially false statements, therefore satisfying the scienter element.

Tenth Circuit: Rehearing Denied in Securities Fraud Case

The Tenth Circuit Court of Appeals reissued its opinion in United Food & Commercial Workers Local 880 Pension Fund v. Chesapeake Energy Corp. on Wednesday, November 12, 2014. Appellants requested panel rehearing and rehearing en banc, which was denied. However, the panel sua sponte made one small amendment on page 18 of the original opinion. The Legal Connection summary of the original opinion is available here.

Tenth Circuit: Total Mix of Disclosures Adequately Advised Investors of Risks

The Tenth Circuit Court of Appeals issued its opinion in United Food & Commercial Workers Union Local 880 Pension Fund v. Chesapeake Energy Corp. on Friday, August 8, 2014.

Chesapeake Energy Corporation was one of the country’s largest producers of natural gas, and in July 2008, it sold 25 million shares of common stock in a public offering. Later in 2008, the financial crisis hit, and Chesapeake suffered badly. A group of investors led by United Food and Commercial Workers Union Local 880 Pension Fund filed suit against Chesapeake in the Southern District of New York, citing violations of §§ 11, 12(a)(2), and 15 of the Securities Act and alleging that the Registration Statement for the offering was materially false and misleading because Chesapeake should have disclosed that it had a risky gas price hedging strategy and that Chesapeake’s CEO, Aubrey McClendon, had pledged substantially all his stock as security for margin loans. On Chesapeake’s motion, the case was transferred to the Western District of Oklahoma. Chesapeake moved for summary judgment, which the district court granted, finding that (1) the Registration Statement disclosed the risks associated with Chesapeake’s hedging strategy; (2) Chesapeake had adequately disclosed that McClendon had pledged most of his shares for collateral; and (3) additional disclosures about McClendon’s financial resources would be unreasonable because they would require speculation. The plaintiffs appealed.

The Tenth Circuit examined Chesapeake’s disclosures prior to the stock offering and found they adequately conveyed that Chesapeake was engaging in risky hedging strategies. The Registration Statement included general information about Chesapeake’s hedging strategy and conveyed Chesapeake’s anticipated future losses due to the strategy. Additionally, SEC filings incorporated in the Registration Statement disclosed information about Chesapeake’s “knockout swaps,” which were their most risky hedge investment. Plaintiffs allege that because Chesapeake disclosed some information about its knockout swaps, it had a duty to update that information, but the Tenth Circuit disagreed. The Tenth Circuit found that the information was provided in several SEC filings, and the total mix of information available to a reasonable investor revealed sufficient information about Chesapeake’s knockout swaps.

Next, the Tenth Circuit looked at Chesapeake’s disclosures regarding McClendon’s pledging of stock for margin loans. Plaintiffs alleged that the Registration Statement did not adequately disclose McClendon’s investments. The Tenth Circuit disagreed, noting that the Registration Statement contained disclosures required by Item 403(b) and further disclosure was not required or reasonable.

The Tenth Circuit affirmed the district court’s grant of summary judgment.

Tenth Circuit: Issue of Fact Existed Concerning Whether Investments Were “Investment Contracts” Under Securities Law

The Tenth Circuit Court of Appeals published its opinion in SEC v. Shields on Monday, February 24, 2014.

The Securities and Exchange Commission (“SEC”) brought this civil enforcement action against Defendant-Appellees Jeffory D. Shields, GeoDynamics, Inc. (“GeoDynamics”), and several other business entities affiliated with Mr. Shields, alleging securities fraud in connection with four oil and gas exploration and drilling ventures Mr. Shields, as managing partner of GeoDynamics, marketed to thousands of investors nationwide as Joint Venture Agreements (“JVAs”). The district court granted defendants’ Fed. R. Civ. P. 12(b)(6) motion to dismiss. The SEC appealed, contending that despite their labels as JVAs, the investment agreements were actually “investment contracts” and thus “securities” subject to federal securities regulations as defined by the Securities Act of 1933 and the Securities Exchange Act of 1934 (collectively, the “Securities Acts”).

The central issue raised on appeal was whether the investments sold by Mr. Shields as managing partner of GeoDynamics were “investment contracts” and thus “securities” subject to federal securities regulations.

Congress painted with a broad brush in defining a “security.” Coverage of the antifraud provisions of the securities laws is not limited to instruments traded at securities exchanges and over-the-counter markets, but extends to uncommon and irregular instruments. Although the Securities Acts broadly define a security, neither act specifically defines an “investment contract.” The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.

The parties confined their argument to whether the investment was premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The joint venture agreements here were denominated general partnerships, and the Tenth Circuit applies a strong presumption that an interest in a general partnership is not a security, mainly because the partners – the investors – are ordinarily granted significant control over the enterprise. But presumptions are not per se rules, and the court recognized that the presumption can be rebutted by evidence that the general partners were rendered passive investors because they were somehow precluded from exercising their powers of control and supervision. Access to information about the investment, and not managerial control, is the most significant factor in determining whether investors are in need of the protections of the securities acts.

The Tenth Circuit agreed with the SEC that the allegations in the complaint were clearly sufficient to rebut the presumption that the purported general partnerships were not securities, and raised a fact issue concerning whether investors were relying on the efforts of Mr. Shields and GeoDynamics to significantly affect the success or failure of the ventures. The allegations also raised a fact issue as to whether the investors actually had the type of control reserved under the agreements to obtain access to information necessary to protect, manage, and control their investments at the time they purchased their interests. The allegations were sufficient to defeat a motion to dismiss on the issue of whether the investors lacked meaningful control over their interests. They raised a plausible claim that the joint venture agreements, in substance as opposed to form, actually distributed powers similar to a limited partnership, which is usually held to be a security.

Because it could not be said as a matter of law that the investments at issue were not “investment contracts,” the Tenth Circuit REVERSED and REMANDED for further proceedings consistent with this opinion.

Crowdfunding Securities Under the CROWDFUND Act

Andrew SchwartzBy Andrew A. Schwartz, Associate Professor of Law, University of Colorado

The “crowdfunding” of securities is poised to democratize the financing of startups, small businesses, farmers and others. Securities crowdfunding, defined as the sale of unregistered securities over the Internet to large numbers of retail investors, each of whom contributes a small amount, had previously been banned by federal law, but this prohibition was overturned by Congress in 2012. This new marketplace will go live once the SEC issues regulations to govern it. Although those rules were officially due in late 2012, they were just proposed on Oct. 23, 2013, and are likely to go into effect in 2014.

Securities crowdfunding has its origins in “reward” crowdfunding, practiced on websites like Kickstarter and IndieGoGo. In reward crowdfunding, artists, entrepreneurs and others ask “the crowd” to contribute capital to their ventures, generally in exchange for the fruits of the project, such as a book or CD. The investors never receive stock, bonds or other securities, however, because federal securities law effectively banned the crowdfunding of securities.

This all changed in 2012, when Congress amended the federal securities laws to overturn this prohibition. In Title III of the Jumpstart Our Business Startups (JOBS) Act—the “CROWDFUND Act”—Congress established a new exemption from the registration requirement for crowdfunded securities. President Obama signed the JOBS Act into law in April 2012, and it will go into effect once the SEC completes its rulemaking process.

The purpose of the CROWDFUND Act is twofold. First, it is designed to liberate startup companies, small businesses and others to use peer networks and the Internet to obtain modest amounts of business capital at very low cost. Second, Congress sought to democratize the market for financing speculative startup companies by allowing investors of modest means to make investments that had previously been offered solely to wealthy, “accredited” investors.

The new CROWDFUND Act has important limitations and places significant obligations on participants in this new marketplace. Under the statute, issuers may only raise up to $1,000,000 annually via securities crowdfunding. Issuers also must state a minimum amount and can only collect the proceeds of the offering if they reach or exceed that target.

Issuers must provide some very basic disclosures to the SEC, designated intermediaries, and potential investors. The financial disclosures depend on the size of the offering: For offerings of $100,000 or less, income tax returns for the last fiscal year and unaudited financial statements certified as accurate by the principal executive officer are required. For offerings of between $100,000 and $500,000, financial statements reviewed by an independent public accountant must be provided. And for offerings of between $500,000 and the maximum of $1 million, audited financial statements are mandated. Finally, following a crowdfunding round, an issuer must annually file with the SEC, and make available to investors, a report on the results of operations.

As for investors, the maximum annual aggregate amount of crowdfunded securities that any one investor may purchase depends on her wealth and income: If an investor’s net worth or annual income is under $100,000, she can invest the greater of $2,000, or five percent of her annual income, in crowdfunded securities each year. If her net worth or annual income is over $100,000, she can invest 10% of her annual income each year.

The Act provides that crowdfunding transactions may not be consummated directly between issuer and investor. Rather, they must be executed via a financial intermediary registered with the SEC as either a broker-dealer or a “funding portal,” a creation of the Act. The Act imposes a number of serious obligations on these financial intermediaries, such as a requirement that they take measures to reduce the risk of fraud, including obtaining a background check on officers, directors and substantial investors in crowdfunding issuers.

As for a secondary market, the Act provides that crowdfunded securities may not be transferred or sold by investors for one year after the date of purchase, unless being transferred to the issuer, an accredited investor, a family member of the purchaser, or as part of an offering registered with the SEC.

The CROWDFUND Act expressly pre-empts state law regarding registration or qualification of securities. That said, states must be provided with notice of crowdfunded offerings, and they retain the right to bring enforcement actions for fraud or other violations of state securities law not relating to registration.

To police fraudulent behavior, the Act expressly authorizes civil actions against an issuer, its directors and officers, if they make an untrue statement of a material fact. In addition, the SEC is granted examination, enforcement and other rulemaking authority over funding portals, and presumably retains authority to enforce the various statutory and regulatory mandates for both issuers and intermediaries.

How securities crowdfunding will play out in practice remains to be seen, and depends greatly on the rules that the SEC just proposed on October 23, 2013. Those proposed rules, called “Regulation Crowdfunding,” are available online, and the SEC invites comments from the public before they become final.

In short, the CROWDFUND Act represents an opportunity for enterprising and creative practitioners to shape a brand new market for securities.

Editor’s Note: This article originally appeared in the October 2013 CBA Business Law Section newsletter.

Andrew A. Schwartz is an associate professor of law at the University of Colorado, where he teaches and publishes on Contracts, Corporations and other aspects of business law.  He is a graduate of Brown University and Columbia Law School, where he served on the Columbia Law Review.  Prior to entering academia, he clerked for two federal judges and practiced with Wachtell, Lipton, Rosen & Katz in New York.  His most recent law review article is Crowdfunding Securities, published in the Notre Dame Law Review earlier this year.

The opinions and views expressed by Featured Bloggers on CBA-CLE Legal Connection do not necessarily represent the opinions and views of the Colorado Bar Association, the Denver Bar Association, or CBA-CLE, and should not be construed as such.

Tenth Circuit: Defendant’s Instruments in Ponzi Scheme Met Definition of “Securities” Under Family Resemblence Test

The Tenth Circuit Court of Appeals published its opinion in Sec. Exch. Comm’n v. Thompson on Friday, October 4, 2013.

This appeal arose out of a civil-enforcement action brought by the Securities and Exchange Commission (“SEC”) against Defendant-Appellant Ralph W. Thompson, Jr., in connection with an alleged Ponzi scheme Thompson ran through his company, Novus Technologies, L.L.C. (“Novus”). Novus made a total of 138 of its “loans” to around sixty holders.

The district court granted summary judgment in the SEC’s favor on several issues, including the issue of whether the instruments Novus sold investors were “securities,” as that term is defined under the Securities Act of 1933 and the Securities Exchange Act of 1934.

Thompson’s sole claim on appeal was that the district court ignored genuine disputes of material fact on the issue of whether the Novus instruments were securities, and that he was entitled to have a jury make that determination. The Tenth Circuit concluded, under the test articulated by the Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990), that the district court correctly found that the instruments Thompson sold were securities as a matter of law.

In Reves, the United States Court adopted a version of the Second Circuit’s “family resemblance” test, under which a note is presumed to be a “security,” and that presumption may be rebutted only by a showing that the note bears a strong resemblance to one of the categories of instrument identified by the Second Circuit in Exchange Nat’l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1137 (2d Cir. 1976).

To provide guidance to courts considering whether an instrument “bears a strong resemblance” to the instruments on the list, the Court prescribed application of the following four factors: (1) the motivations that would prompt a reasonable seller and buyer to enter into the transaction; (2) the ‘plan of distribution’ of the instrument, with an eye on whether it is an instrument in which there is common trading for speculation or investment; (3) the reasonable expectations of the investing public; and (4) whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary. The factors are to be considered as a whole. The court held that, in the context of a civil case where the “security” status of a “note” is disputed, the ultimate determination of whether the note is a security is one of law.

After applying the four factors, the court held that the instruments Thompson sold were securities.  Thompson could not rebut the presumption that the Novus Instruments were securities.

AFFIRMED.

SEC Issues Report on Social Media Disclosures

TrevorCrow

By Trevor A. Crow

The Securities and Exchange Commission (SEC) recently issued a report of its investigation relating to a Facebook post by Reed Hastings, the CEO of Netflix, which stated Netflix’s monthly online viewing had exceeded 1 billion hours. The SEC’s investigation was to determine whether Hastings or the Company violated Regulation FD under the Securities Exchange Act through the posting of this information.

In general, Regulation FD prohibits public companies, or persons acting on their behalf, from selectively disclosing material, nonpublic information to certain securities professionals, or shareholders, where it is reasonably foreseeable that they will trade on that information, before it is made available to the general public. Here, the SEC decided not to initiate an enforcement action against Netflix or Hastings. However, the report also offers guidance to public companies on the application of Regulation FD to disclosures made through social media.

The report explains that, under certain circumstances, public companies may disseminate material, nonpublic information through social media without violating Regulation FD if investors previously have been notified that specific social media will be used to spread such information. The report states that the framework set forth in theSEC’s August 2008 Guidance on the Use of Company Websites should be used when analyzing communications made through social media. Specifically, “the central focus of this inquiry is whether the company has made investors, the market, and the media aware of the channels of distribution it expects to use, so these parties know where to look for disclosures of material information about the company or what they need to do to be in a position to receive this information.”

The report also explained that without prior notice to investors, it is unlikely that a corporate officer’s personal social media site used to disseminate corporate information would qualify as a method “reasonably designed to provide broad, non-exclusionary distribution of the information to the public” as required under Regulation FD. In the Netflix inquiry, Hastings’ Facebook page had never been previously used to announce company metrics, yet the SEC still chose not to initiate an enforcement action against Netflix or Hastings.

Bottom Line: Public companies should have social media policies in place for their directors and executive officers to educate them about Regulation FD. Before a representative of the company posts any material and nonpublic information on a social media platform, the company should take steps to ensure that investors, the market, and the media are aware of this channel of distribution.

Trevor A. Crow is an associate in Dufford & Brown’s corporate transactions group. He focuses on public company securities compliance, M&A, entity formation, and startup company financing. He has counseled clients on a variety of business issues including entity selection, formation, finance, acquisitions, and numerous operating transactions. Trevor’s LLM in taxation makes him uniquely qualified to handle complex issues regarding business transactions and tax planning.

Trevor received his J.D. and LL.M. in Taxation from the University of Denver’s Sturm College of Law.  He is a member of the American, Colorado, and Denver bar associations; an executive member of the Colorado Bar Association Tax Section; he belongs to the Denver Metro Chamber Impact Denver Class of 2012; and he is a member of the Colorado Association of Business Intermediaries (CABI). He writes for the CBA Business Law Section newsletter, where this article originally appeared.

The opinions and views expressed by Featured Bloggers on CBA-CLE Legal Connection do not necessarily represent the opinions and views of the Colorado Bar Association, the Denver Bar Association, or CBA-CLE, and should not be construed as such.