MEMORANDUM & ORDER
LORETTA A. PRESKA, Senior United States District Judge:
In this securities case, the United States Securities and Exchange Commission ("SEC") alleges that Defendants Magna Management, LLC, Magna Equities II, LLC, MG Partners, LTD., Jason Sason, Marc Manuel (together, the "Magna Defendants"), Kautilya Sharma, Perian Salviola, and Pallas Holdings, LLC (together, the "Pallas Defendants") engaged in a raft of fraudulent and illegal transactions in unregistered securities. (Complaint dated Feb. 15, 2019 ("Compl.") [dkt. no. 1].) The SEC asserts claims for primary and secondary violations of the antifraud provisions in Section 17(a) of the Securities Act of 1933 ("Securities Act"), Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), and the corresponding Rule 10b-5, as well as violations of the registration provisions contained in Section 5 of the Securities Act.
The Magna Defendants and Pallas Defendants have both moved to dismiss the Complaint under Rules 12(b)(6) and 9(b) of the Federal Rules of Civil Procedure. (Magna Defendants' Notice of Motion to Dismiss dated May 6, 2019 [dkt. no. 49]; Pallas Defendants' Notice of Joint Motion to Dismiss dated May 6, 2019 [dkt. no. 53].) As explained below, the motions to dismiss are GRANTED in part and DENIED in part.
The following facts are taken from the Complaint and assumed to be true for purposes of deciding Defendants' motions.
Magna's Business Model
Magna Management, LLC ("Magna"), Magna Equities II, LLC ("Hanover"), and MG Partners, Ltd. ("MGP," and together with Magna and Hanover, the "Magna Entities") were three companies whose businesses involved acquiring and liquidating common stock in publicly-traded microcap companies. (Compl. ¶ 39.) Jason Sason was the owner and CEO of Magna and Hanover and an owner and director of MGP. (
As part of their business strategy, the Magna Entities would often acquire stock by buying debt and converting it into stock, often at prices pre-agreed with the issuer, and then sell the stock to public investors. (
b. Relevant Registration Exemptions
As discussed below, the Complaint alleges that the Magna Defendants fraudulently structured transactions so they would facially appear to qualify for the registration exemptions provided by Securities Act §§ 4(a)(1) and 3(a)(10).
Section 4(a)(1) provides an exemption for "transactions by any person other than an issuer, underwriter, or dealer." Compl. ¶ 30; 15 U.S.C. § 77d(a)(1). Under a safe harbor created by Securities Act Rule 144, if a person holds unregistered securities in microcap issuers for at least six months, that person is not considered an "underwriter" and therefore qualifies for the § 4(a)(1) exemption from the registration requirement. (Compl. ¶¶ 32-33); 17 C.F.R. § 230.144.
For purposes of meeting the Rule 144 holding period requirement, parties may "tack" the prior owner of the stock's holding time onto their own. (Compl. ¶ 34.) Tacking is only permitted, however, if the purchaser buys the securities from a person who is not affiliated with the issuer. (
In addition to the § 4(a)(1) exemption, Securities Act § 3(a)(10) creates an exemption for the sale of securities issued in exchange for bona fide claims against the issuer. (
The first set of challenged transactions involves a mining company called Lustros, Inc. ("Lustros") and a fraudulent scheme to sneak unregistered Lustros stock through the § 4(a)(1) exemption. During the time period at issue in the Complaint, Lustros was run by a man named Izak Zirk de Maison ("Zirk"), who later pleaded guilty to criminal bribery and market manipulation charges related to Lustros and other companies he ran and is now serving a 151-month prison sentence. (
Magna was introduced to Lustros in late 2012 when Lustros was in the process of lining up financing for its mining operations. (
In December 2012, Zirk and Manuel met one-on-one to discuss the details of the financing. (
Because Lustros had no outstanding debt that could tee up a future § 4(a)(1) exemption, Zirk and Manuel devised a workaround: Zirk would transfer the debt Lustros owed him and/or Suprafin to a purportedly non-affiliated third party so it would look like that party, and not Zirk,
After the December 2012 meeting, Zirk had Lustros' CFO create a fake convertible note purportedly issued by Lustros to Zirk, Suprafin, and Company-1, with a face value of roughly $550,000 (the "Lustros I Note"). (
Around the time Lustros' CFO created the Lustros I Note, she also created a fake instrument assigning to Company-1 Zirk's and Suprafin's share of the note. (
Later, in June 2013, Magna bought another tranche of purported Lustros convertible debt held by Company-1. (
After buying the Lustros Notes, Magna exchanged them for newly issued convertible debt from Lustros, then converted the debt to stock and secured legal opinions stating that the stock qualified for the § 4(a)(1) exemption. (
The Lustros deals were marked by red flags beyond those noted above indicating that that Company-1 was affiliated with Zirk and Lustros, making the § 4(a)(1) exemption inapplicable. For instance, when running deal diligence, Magna directed all its questions about Company-1 to Lustros and received emails indicating that Company-1's principal was Zirk's assistant or a Lustros employee. (
Further Unregistered Lustros Stock Deals
In addition to the Lustros Notes transactions, Magna also bought a block of Lustros shares (the "Lustros Block") from Company-1, an affiliate of Lustros, which Magna then sold in allegedly illegal unregistered offerings. (
The second set of challenged transactions involves another alleged scheme to sell illegally unregistered shares, this time
Beginning in 2012, NewLead undertook to expand its shipping business to include mining services. (
NewLead I and III
The NewLead I Note required NewLead to pay Pallas $15 million for the Viking Mine, and the NewLead III Note required it to pay Pallas $24 million as partial consideration for the Viking Plant. (
The SEC alleges, on information and belief, that the parties knew NewLead would not be able to make payments in cash, thereby forcing NewLead to pay Pallas in stock, which Pallas would then sell to the investing public. (
NewLead II Note
The NewLead II Note involved different pattern of transactions and included Hanover, one of the Magna Entities, and an allegedly fraudulent scheme to exploit the § 3(a)(10) registration exemption. The note, which NewLead issued to Pallas in October 2013 but backdated by several weeks, had a face value of $6 million and a maturity date of October 21, 2013. (
After acquiring the NewLead II Note, Hanover entered into an agreement with NewLead to settle the debt—along with other NewLead debt Hanover acquired in unrelated transactions—in exchange for newly-issued NewLead stock. (
As with the Lustros deals, the SEC alleges that red flags accompanied the NewLead II Note transactions and signaled that the note did not truly reflect a bona fide debt. For example, the NewLead II Note stated that it was consideration for the Viking Mine and attached the Viking Mine sale contract as an exhibit, but the Viking Mine had already been sold via the NewLead I Note. (
II. Legal Standard
On a Rule 12(b)(6) motion to dismiss, all factual allegations in the complaint are accepted as true and all inferences are drawn in favor of the pleader.
In addition, securities fraud claims must satisfy the heightened pleading standard of Federal Rule of Civil Procedure 9(b).
In two preliminary attacks, the Magna Defendants contend that the SEC's claims are precluded by the SEC's noncompliance with purported timing restrictions imposed by the Dodd-Frank Act and barred by the applicable statute of limitations. (
i. Dodd-Frank Act
Section 929U of the Dodd-Frank Act contains a timing provision stating that "[n]ot later than 180 days after the date on which Commission staff provide a written Wells notification to any person, the Commission staff shall either file an action against such person or provide notice to the Director of the Division of Enforcement of its intent to not file an action." 15 U.S.C. § 78d-5(a)(1).
Based on Section 929U, the Magna Defendants argue that the Complaint should be dismissed because the SEC filed it over 180 days after sending them a Wells notice. (Magna Br. at 9-10.) But the Magna Defendants cite no on-point authority in support of their view that failure to comply with the 180-day clause requires dismissal, and the Court is aware of none. To the contrary, the cases analyzing the issue have unanimously held that expiration of the 180-day period is an "internal directive" for the SEC and "not a jurisdictional bar" to suit.
Statute of Limitations
The Magna Defendants next contend that the SEC's claims concerning Lustros I are barred by the five-year statute of limitations contained in 28 U.S.C. § 2462. (Magna Br. at 11-13.) Courts may decide a statute of limitations defense "on a Rule 12(b)(6) motion if the defense appears on the face of the complaint."
Taking into account the tolling agreement the Magna Defendants entered with the SEC, the parties agree that all claims that accrued before February 16, 2013 are time-barred. (Magna Br. at 12; SEC's Memorandum of Law in Opposition to Defendants' Motion to Dismiss, dated June 5, 2019 ("Opp.") [dkt. no. 61] at 9.) They diverge, however, on how that bookend affects the timeliness of claims arising from the Lustros I scheme, parts of which fall before February 16, 2013, parts of which fall after. In particular, the December 2012 meeting where Zirk and Manuel allegedly agreed to pass off a Zirk-controlled company as a non-affiliated entity occurred outside the limitations period (Compl. ¶¶ 55-60), while at least some Magna's sales of the Lustros stock that flowed from that agreement took place within the period. (
The Court agrees with the SEC that given the alleged timeline, the SEC may pursue claims predicated on post-February 16, 2013 stock sales arising from Lustros I. "[T]he standard rule is that a claim accrues when the plaintiff has a complete and present cause of action."
Lustros I and II Transaction: Scheme Liability
With respect to the Lustros I and II transactions, the SEC asserts claims against Magna and Manuel under Exchange Act § 10(b), Rule 10b-5(a) and (c), and Securities Act §§ 17(a)(1) and (3). (Compl. ¶¶ 165-70; Opp. at 10-14, 17-18.)
Exchange Act § 10(b) and Rule 10b-5(a) and (c) prohibit using any "device, scheme, or artifice to defraud" or any "act, practice, or course of business which operates... as a fraud or deceit upon any person, in connection with the purchase or sale of any security." 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5. Likewise, Securities Act §§ 17(a)(1) and (3) prohibit any "device, scheme, or artifice to defraud" and any "transaction, practice, or course of business which operates ... as a fraud or deceit." 15 U.S.C. § 77q(a)(1), (3).
Together, Exchange Act § 10(b), Rule 10b-5(a) and (c), and Securities Act § 17(a)(1) and (3) "create what courts have called `scheme liability' for those who, with scienter, engage in deceitful conduct."
Deceptive or Manipulative Conduct
Manuel and Magna argue that the scheme liability claims against them should be dismissed as to Lustros I and II because neither Defendant engaged in any deceptive or manipulative conduct. (Magna Br. at 13 n.6, 13-15.) The Court disagrees. Although Zirk and his associates were the ones who allegedly created the fake Lustros documents, the Complaint need not establish that Magna and Manuel "participated in each and every aspect of the fraudulent scheme" to withstand a Rule 12(b)(6) motion.
Scheme liability under § 17(a)(1) and Rule 10b-5(a) and (c) requires alleging scienter or facts giving rise to a "strong inference of fraudulent intent."
The SEC may establish scienter either by alleging "that defendants had both motive and opportunity to commit fraud" or "strong circumstantial evidence of conscious misbehavior or recklessness."
In the Complaint, the SEC does not allege scienter through an improper motive theory, relying instead on circumstantial evidence of conscious misbehavior and recklessness.
Disregarding the allegations pleaded on information and belief, the Court finds that the SEC has adequately alleged scienter against Magna and Manuel with respect to the Lustros I and II transactions.
Whether the SEC Alleged that Purchasers Were Defrauded Under § 17(a)(3)
The Magna Defendants also argue that the § 17(a)(3) claims fail because the SEC does not allege that the Lustros transactions "operate[d] ... as a fraud or deceit on the purchaser," as the statute requires. 15 U.S.C. § 77q(a)(3); (Magna Br. at 22-24; Magna Reply at 7-8). But as the Magna Defendants acknowledge, the SEC pleads that they sold stock to investors who were "unaware that the new shares were flooding the market as a result of transactions that violated the federal securities laws." (Compl. ¶ 3.) That is sufficient under § 17(a)(3).
Nor is there merit to the Magna Defendants' claim that if the Court finds their alleged conduct to fall within § 17(a)(3)'s purview, it would convert every § 5 claim into a fraud claim. (Magna Br. at 23-24.) Section 5 is a strict liability statute, meaning even unwitting sales of impermissibly unregistered stock constitute violations.
NewLead II Transactions: Fraud Claims
With respect to the NewLead II transactions, The SEC asserts scheme liability claims against Hanover, MGP, Manuel, and the Pallas Defendants under Exchange Act § 10(b), Rule 10b-5(a) and (c), and Securities Act §§ 17(a)(1) and (3). (Compl. ¶¶ 165-170;
The Court finds that the SEC's NewLead II scheme liability claims do not adequately allege deceptive acts or scienter. Those claims are therefore dismissed.
1. Deceptive or Manipulative Conduct
As noted above, stating a claim for scheme liability requires pleading that the defendants contributed to a deceptive or sham transaction.
The key to the NewLead II scheme was an alleged agreement whereby NewLead would issue a fake $6 million note to Pallas that NewLead never intended to pay down, knowing the debt would be sold to Hanover at face value and then exchanged for NewLead stock, and that Pallas would kick back to NewLead part of the $6 million it received from Hanover. (
Cutting out its conclusory allegations, the Complaint primarily alleges that the NewLead II Note's fraudulence is exposed by inconsistencies about which asset—the Viking Plant or Mine—was being sold in exchange for the note. For example, the NewLead II Note allegedly stated that it was payment for the Viking Mine and attached the mine sale contract as an exhibit, but the mine had already been sold in the NewLead I transaction. (Compl. ¶¶ 135-36.) Relatedly, when Hanover bought the NewLead II Note, NewLead told Manuel that the plant, not the mine, was the underlying asset. (
The Court finds that these and related allegations do not support a plausible inference of fraud. The Court reaches this conclusion for a few reasons. First, notwithstanding the mixed signals about what consideration supported the NewLead II Note, the SEC itself pleads that the note represented "$6 million in financing related to the Viking Prep Plant," not the Viking Mine. (
With the foregoing in mind, the Court concludes that the confusion in the NewLead II documents regarding the underlying asset reflects a significant abnormality but, without more, does not plausibly support the SEC's much larger inference that "there was no $6 million debt" and that the
The SEC also alleges that on September 26, 2013—the date that appears on the face of the NewLead II Note—NewLead published a press release stating that it had only entered "advanced negotiations" concerning the Viking Plant. (Compl. ¶ 135, 143.) Building on those allegations, the SEC implies that the NewLead II Note could not have been consideration for the plant, as the note was allegedly issued before negotiations for the plant were complete. (
The Complaint also falls short in pleading a strong inference of fraudulent intent. The allegations against Pallas, Sharma, and Salviola hinge on the inconsistencies examined above regarding what asset underlies the NewLead II Note and are otherwise entirely conclusory. (
As to Manuel and Hanover, the SEC also alleges that NewLead sent Manuel an email calling the NewLead II Note "cash" and that Manuel deliberately or recklessly failed to review NewLead press releases regarding the Viking asset transactions and to perform diligence on Sharma, who had a prior fraud conviction. (Compl. ¶¶ 142-47.) But the SEC does not allege any facts as to why the "cash" reference was suspicious, and, with respect to the diligence failures, even if the SEC had plausibly alleged that the NewLead II transactions formed part of a deceptive scheme, alleging that Manuel "would have uncovered the truth" if he "had performed due diligence adequately" establishes "negligence at best," not scienter.
The SEC asserts that Sason and Hanover violated § 10(b), Rule 10b-5(b), and § 17(a)(2) by misrepresenting that the NewLead debts were legitimate in an affidavit Sason submitted at the fairness proceedings for the § 3(a)(10) exemption.
To state a claim under § 10(b) and Rule 10b-5(b), the SEC must allege that Sason made a material representation or omission with scienter in connection with the purchase or sale of securities.
The SEC's misstatement claims fail for two reasons. First, as held above, the SEC failed plausibly to allege that the NewLead II Note was a sham. That finding is fatal to the misstatement claims because Sason's representation as to the bona fides of the NewLead II debt cannot have been false or misleading unless the note was illegitimate. Second, with respect to the § 10(b) and Rule 10b-5(b) claims, the SEC failed to allege that Sason and Hanover acted with scienter. As with the scheme liability claim against Manuel, the SEC tries to predicate scienter on Sason's alleged failure to review the NewLead II documents and diligence file. (Compl. ¶¶ 149-51.) Those allegations, however, fall short of establishing intentional or reckless misconduct.
Aiding and Abetting Liability
The SEC asserts aiding and abetting claims against Manuel and the Pallas Defendants in connection with the NewLead II transactions. To state an aiding and abetting claim, the plaintiff must plead: "(1) the existence of a securities law violation by the primary (as opposed to the aiding and abetting) party; (2) knowledge of this violation on the part of the aider and abettor; and (3) substantial assistance by the aider and abettor in the achievement of the primary violation."
Section 5 Claims
To state a claim for a violation of § 5, the SEC must allege that (1) no registration statement was in effect for the securities at issue; (2) the defendant sold or offered the securities; and (3) interstate transportation, communication, or the mails were used in connection with the offer or sale.
Defendants may violate § 5 even if they themselves do not offer or sell securities, provided they were "necessary participant[s]" in the unregistered distribution.
The Magna and Pallas Defendants do not dispute that the SEC discharged its prima facia burden by alleging that the
First, the Court concludes that Sason and Manuel were necessary participants in each distribution because they played key roles in the chain of debt and stock acquisitions needed to bring the distributions to fruition. Among other things, Sason approved each of those transactions (Compl. ¶¶ 70, 83, 99, 148) and Manuel either originated, negotiated, or assisted in them (
The Court also rejects the Pallas Defendants' argument as to the applicability of an exemption. As noted above, the SEC is only required to establish a prima facie § 5 violation, which it has done. "Once a prima facie case has been made, the defendant bears the burden of proving the applicability of an exemption."
Control Person Liability
The SEC asserts control person liability against Sason under Exchange Act § 20(a) for the Magna Entities' violations of § 10(b) and Rule 10b-5. To state a claim for control person liability, the SEC must plead facts showing: "(1) a primary violation by the controlled person, (2) control of the primary violator by the defendant, and (3) that the defendant was, in some meaningful sense, a culpable participant in the controlled person's fraud."
With respect to the Lustros fraud claims, the SEC has established a primary violation by Magna (
The SEC has also failed to establish Sason's control person liability for the alleged NewLead II fraud. As discussed above, the SEC has not stated a primary violation of the securities laws with respect to the NewLead II transactions. (
To the extent they are not addressed above, the Court has considered the parties' other arguments and finds them unavailing. Defendants' motions to dismiss are GRANTED in part and DENIED in part. The scheme liability claims under Exchange Act § 10(b), Rule 10b-5(a) and (c), and Securities Act §§ 17(a)(1) and (3) are sustained as to the Lustros I and II Note transactions, and the § 5 claims are sustained as to all transactions. All other claims are dismissed. The Clerk of the Court is directed to close the open motions [dkt. nos. 49, 53].