Re: 9/13/01 - [Stockgeneration.com] SEC: First Circuit Reverses Lower Court's Dismissal of SEC Action Against Internet "Virtual Stock Exchange" Scheme Operators; AP/Law.com: SEC Can Pursue Securities Fraud Charges Against Internet Stock Game; Law.com: Virtual Investment Gaming Leads to Real Life SEC Prosecution; Reuters: Appeals court sides with SEC, lets SG case proceed
FIRST CIRCUIT REVERSES LOWER COURT'S DISMISSAL OF SEC ACTION AGAINST INTERNET "VIRTUAL STOCK EXCHANGE" SCHEME OPERATORS
The Commission announced that on September 13 the United States Court of Appeals for the First Circuit issued a ruling that allowed the SEC to proceed with its fraud action against SG Limited. The SEC had alleged that SG violated federal securities laws by offering investments in a "virtual company" on its "StockGeneration" website and by falsely representing that investors in the company would receive a guaranteed profit of 10% per month. The Court of Appeals ruling reversed a lower court's decision that dismissed the case on the basis that the SG investment was not a security. The Court of Appeals ruled that the lower court had erred and that the investment scheme as described in the SEC's complaint was an investment contract, a form of security covered by the federal securities laws.
The SEC's case, originally filed on June 9, 2000, in the United States District Court for the District of Massachusetts, alleged that SG Limited, an offshore entity, operated a massive Internet pyramid scheme under the name "StockGeneration." SG allegedly described the StockGeneration program as a "virtual stock exchange" offering investments in the stock of several "virtual companies," including one identified as the "privileged company" whose shares "only rise" and generate a risk-free, guaranteed return of 10% per month, or 215% per year. The Commission further alleged that investors in this privileged company did not receive the guaranteed return and have not even been able to recover their initial investments.
The District Court initially granted the Commission's motions for a temporary restraining order and a preliminary injunction halting SG's alleged fraudulent activities and imposing an asset freeze through which the SEC was able to protect over $5,000,000 of investor funds held in banks in the U.S., Estonia and Cyprus. (The freeze remained in effect pending the appeal.) On January 25, 2001, however, the court granted SG's motion to dismiss the SEC's complaint, concluding that SG's "virtual stock exchange" program fell outside the scope of the federal securities laws because SG's website clearly marked and defined the activity as a game and therefore it was not within the ordinary concept of a security in the commercial world.
The First Circuit Court of Appeals reversed the District Court, emphasizing that the substance of an instrument, not the name applied to it, determines whether it constitutes a security. The Court held that "the language on SG's website emphasizing the game-like nature of buying and selling virtual shares of the privileged company does not place such transactions beyond the long reach of the federal securities laws." The Court noted that the SG scheme as described in the SEC's complaint could be characterized as a Ponzi or pyramid scheme that allegedly "played upon greed and fueled expectations of profit," and that the facts, if proven at trial, satisfied the three-part legal test for an "investment contract" constituting a security. The First Circuit for the first time expressly ruled that "horizontal commonality" satisfies the "common enterprise" element of the three-part test and held that the element is met by a program such as SG's, that pools assets from multiple investors in such a way that they share in the profits and risk of the enterprise. The First Circuit remanded the case for further proceedings, during which the preliminary injunction and asset freeze preserving over $5.5 million of investor funds will remain in effect.
The Commission's complaint alleged that SG Limited violated the general antifraud and securities registration provisions of the federal securities laws - that is, Sections 5(a) and (c) and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission's complaint also charged two affiliated companies: SG Perfect Limited and SG Trading Limited, as relief defendants who were unjustly enriched through the receipt of money raised from the StockGeneration scheme. The Commission is seeking an order permanently enjoining SG from violating the antifraud and registration provisions of the federal securities laws, requiring defendants to disgorge funds received through their violations of the securities laws, and imposing civil monetary penalties on SG.
For further information, see Litigation Release Nos. LR-16616 (June 30, 2000) and LR-16590 (June 15, 2000). [SEC v. SG Limited, et al., United States Court of Appeals for the First Circuit, Nos. 01-1176 and 01-1332] (LR-17129)
sec.gov
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SEC Can Pursue Securities Fraud Charges Against Internet Stock Game
Lisa Lipman
The Associated Press
September 19, 2001
The Securities and Exchange Commission can pursue fraud charges against an Internet gambling site that ran a "virtual stock exchange," a federal appeals court has ruled.
The case involves a Web site called StockGeneration, where "investors" sent money and bought "stocks" in fictitious companies.
The player wins or loses money based on the company's value. There is no computerized method for the "stock" going up or down; it was done entirely at the whim of the game's managers.
The SEC filed a complaint in June 2000 alleging that the investment offerings were nothing more than a pyramid scam that violated federal securities laws.
A U.S. District Court judge sided with the company in January because it did not offer, buy or sell securities, and because it presented itself as a game.
But the 1st U.S. Circuit Court of Appeals ruled against the company Sept. 13, agreeing with the SEC that the language of the site essentially represented a type of investment contract.
"We're very disappointed at the court's decision," said Daniel Small, the attorney for SG Limited and SG Perfect Limited, which ran the site.
"The court of appeals has given the SEC the green light for a fishing expedition," he said.
The site will not operate and the company's $6.5 million in assets will remain frozen until the matter is resolved.
SEC District Administrator Juan Marcel Marcelino said that if the commission prevails, "we will seek to reimburse the investors for any losses."
The company said StockGeneration, run from the Caribbean island of Dominica, had more than 325,000 players from more than 70 countries, and had paid out millions of dollars before it was shut down. Players were promised a guaranteed annual return of 215 percent.
Copyright 2001 Associated Press. All Rights Reserved.
law.com
interactive.wsj.com
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E-Legal: Virtual Investment Gaming Leads to Real Life SEC Prosecution
Eric J. Sinrod
Special to Law.com
September 25, 2001
In yet another example of real world legal consequences being brought to bear in cyberspace, a federal appellate court, in the case SEC v. SG, Ltd., has ruled that virtual shares in an enterprise existing only in cyberspace fall within the federal securities laws and can lead to enforcement actions by the SEC.
SEC FACTUAL ALLEGATIONS
In considering whether the SEC's action could proceed under the federal securities laws, the appellate court examined the following SEC allegations:
SG operated a "StockGeneration" Web site offering the opportunity online to purchase shares in eleven different virtual companies listed on the Web site's virtual stock exchange. SG arbitrarily set the purchase and sale prices of each of these imaginary companies in biweekly rounds. SG guaranteed that investors could buy or sell any quantity of shares at posted prices. SG placed no upper limit on the amount of funds that an investor could put toward virtual offerings.
The SEC's complaint focused on shares in a particular virtual enterprise referred to by SG as the "privileged company." SG advised potential purchasers to pay particular attention to shares in the privileged company and boasted that investing in those shares was a game "without any risk." To this end, its Web site announced that the privileged company's shares would appreciate at a rate of 10 percent monthly. SG's Web site also contained lists of purported big winners and an Internet bulletin board featuring testimonials from supposedly satisfied participants
At least 800 people in the United States used real cash to purchase virtual shares in the virtual companies listed on the defendants' virtual stock exchange. In the fall of 1999, over $4,700,000 in participants' funds was deposited into a Latvian bank account in the name of SG Trading Ltd. The following spring, more than $2,700,000 was deposited in Estonian bank accounts standing in the names of SG Ltd. and SG Perfect Ltd., respectively.
In late 1999, participants began to experience difficulties in redeeming their virtual shares. In March 2000, these difficulties peaked and SG unilaterally suspended all pending requests to withdraw funds and sharply reduced participants' account balances in all companies except the privileged company. Two weeks later, SG announced a reverse stock split, which caused the share prices of all companies listed on the virtual stock exchange, including the privileged company, to plummet to 1/10,000 of their previous values. At about the same time, SG stopped responding to participant requests for the return of funds, yet continued to solicit new participants through its Web site.
TRIAL COURT PROCEEDINGS
The SEC undertook an investigation into SG's activities, which led to the filing of a civil action in a federal trial court. The SEC's complaint alleged that SG's operations constituted a fraudulent scheme in violation of the registration and antifraud provisions of the federal securities laws. The federal trial court dismissed the SEC's complaint and the SEC appealed.
THE APPEAL
The key issue on appeal was whether the particular scheme involved an "investment contract" under the federal securities laws. The appellate court determined that an investment contract could be found if the following elements could be satisfied: (1) the investment of money (2) in a common enterprise (3) with an expectation of profits to be derived solely from the efforts of the promoter or a third party.
INVESTMENT OF MONEY
Regarding the investment of money prong of the analysis, SG argued that the individuals who purchased shares in the privileged company were not so much investing money in return or rights in the virtual shares as paying for an entertainment commodity (the opportunity to play the StockGeneration game).
However, the appellate court found greater significance in the SEC's allegation that SG represented that participants could firmly expect a 10 percent monthly profit on purchases of the privileged company's shares. That representation "plainly supports the SEC's legal claim that participants who invested substantial amounts of money in exchange for virtual shares in the privileged company likely did so in anticipation of investment gains," according to the court.
COMMON ENTERPRISE
As to the common enterprise part of the analysis, the appellate court found that the arrangement described in the SEC's complaint "fairly can be characterized as either a Ponzi or pyramid scheme, and that it provides the requisite profit-and-risk sharing to support a finding of horizontal commonality." Indeed, the court found that all of the participants shared the risk that new participants would not emerge, cash flow would dry up, and the underlying pool would be empty.
EXPECTATION OF PROFITS
Regarding the third prong of the inquiry, the appellate court noted that the SEC alleged that SG flatly guaranteed that investments in the shares of the privileged company would be profitable, yielding monthly returns of 10 percent. The appellate court found that "these profit-related guarantees constitute a not-very-subtle form of economic inducement." Further noteworthy to the appellate court were the SEC's allegations that SG was responsible for all the important efforts that undergirded the 10 percent guaranteed monthly return. As the sole proprietor of the StockGeneration Web site, SG enjoyed direct operational control over all aspects of the virtual stock exchange.
AT THE END OF THE DAY
The appellate court held that all three prongs of the investment contract analysis were satisfied; accordingly, the SEC's legal action may proceed under the federal securities laws against SG with respect to its virtual investment game. This should be yet another lesson teaching that online actions can lead to real world legal consequences.
Eric J. Sinrod is a partner in the San Francisco office of Duane Morris, where he focuses on technology and litigation matters. His Web site is sinrodlaw.com and his firm's site is Duane Morris. Mr. Sinrod may be reached by e-mail at EJSinrod@duanemorris.com
law.com
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Appeals court sides with SEC, lets SG case proceed
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WASHINGTON, Sept 17 (Reuters) - In a victory for the Securities and Exchange Commission, an appeals court has reversed a lower court decision and allowed an SEC lawsuit to proceed against a Caribbean company accused of running an online pyramid scheme.
The SEC said on Monday that the Boston-based First Circuit Court of Appeals allowed the continuation of an SEC complaint against SG Limited, based on the Caribbean island of Dominica, alleging it violated U.S. securities laws by offering investments in a "virtual company" on its StockGeneration Web site and by guaranteeing profits of 10 percent a month.
SG allegedly described itself as a "virtual stock exchange" offering investments in "virtual companies," including one referred to as the "privileged company" whose shares "only rise" and generate the guaranteed 10 percent monthly return, the commission claimed.
The appeals court ruling on September 13 reversed a lower court's decision in January that dismissed the case on the basis that the SG investment was not a security, the SEC said.
It also said that the lower court, the U.S. District Court for Massachusetts, had erred and that the alleged investment scheme was an investment contract, a type of security covered by U.S. laws, the commission added.
The SEC sued SG in June 2000 alleging its investment program, which raised hundreds of thousands, if not millions, of dollars, "was actually nothing more than a classic pyramid scheme," the complaint said.
The investor protection agency further alleged that investors did not get the promised guaranteed return and have not been able to recover their money.
SG's Boston-based lawyer did not immediately return a call seeking comment.
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Copyright © 2001 Reuters Limited. All rights reserved.
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