Securities and Exchange Commission v. Garber et al

Filing 28

OPINION AND ORDER: re: 14 MOTION to Dismiss Portions of the First Amended Complaint. filed by Kenneth Yellin, The OGP Group L.L.C., Jordan Feinstein, Slow Train Holdings L.L.C., Rio Sterling Holdings L.L.C., Danny Garber. For the foregoing reasons, Defendants' motion to dismiss is denied.The Clerk of Court is directed to close this motion (Docket No. 14). SO ORDERED.(Signed by Judge Shira A. Scheindlin on 4/22/2013) (ama)

UNITED STATES DISTRICT COURT

SOUTHERN DISTRICT OF NEW YORK

.------------------------------------------------------------J(

SECURITIES AND EXCHANGE

COMMISSION,

Plaintiff,

v.

DANNY GARBER, MICHAEL MANIS,
KENNETH YELLIN, JORDAN FEINSTEIN,
ALUMA HOLDINGS LLC, AZURE TRADING
LLC, COASTAL GROUP HOLDINGS, INC.,
GREYHAWK EQUITIES LLC, LEONIDAS
GROUP HOLDINGS LLC, THE LEONIDAS
GROUP, LLC, NISMIC SALES CORP., THE
OGP GROUP LLC, PERLINDA
ENTERPRISES LLC, RIO STERLING
HOLDINGS LLC, SLOW TRAIN HOLDINGS
LLC, and SPARTAN GROUP HOLDINGS
LLC,

OPINION AND ORDER
12 Civ. 9339 (SAS)

Defendants .

.------------------------------------------------------------J(
SHIRA A. SCHEINDLIN, U.S.D.J.:
I.

INTRODUCTION
The Securities and Exchange Commission (''SEC'') brings this action

against, inter alia, Danny Garber, Kenneth Yellin, Jordan Feinstein (collectively,
"Individual Defendants"), the OGP Group LLC, Rio Sterling Holdings LLC, and
Slow Train Holdings LLC ("Entity Defendants" and, together with Individual

-1­

Defendants, “Defendants”).1 The SEC alleges that Defendants purchased over a
billion unregistered shares in dozens of penny stock companies (“the Penny Stock
Companies”) and resold the shares to the investing public without complying with
the registration provisions of the federal securities laws by falsely claiming that
their purchases were exempt from registration under either Rule 504(b)(1)(iii) of
Regulation D or Rule 144 of the Securities Act.2
The SEC asserts that Defendants’ conduct violated: Sections 5(a) and
5(c) of the Securities Act (Count One); Section 17(a) of the Securities Act (Count
Two); and Section 10(b) of the Exchange Act and Rule 10b-5 promulgated
thereunder (Count Three).3 Defendants move under Federal Rule of Civil
Procedure 12(b)(6)4 to dismiss the SEC’s claims for violation of Section 10(b) and
1

The SEC brings this action pursuant to its authority under
Section 20(b) of the Securities Act of 1933 (the “Securities Act”), 15 U.S.C. §
77t(b), and Section 21(d) of the Securities Exchange Act of 1934 (“Exchange
Act”), 15 U.S.C. § 78(u)(d). Additional defendants who do not join in this motion
are: Individual Defendant Michael Manis and Entity Defendants Aluma Holdings
LLC, Azure Trading LLC, Coastal Group Holdings, Inc., Greyhawk Equities LLC,
Leonidas Group Holdings LLC, The Leonidas Group LLC, Nismic Sales Corp.,
Perlinda Enterprises LLC, and Spartan Group Holdings LLC.
2

See First Amended Complaint (“FAC”) ¶¶ 2-3.

3

See id. ¶¶ 96-106.

4

After filing this motion to dismiss, defendants filed an Answer to the
Complaint (Dkt. No. 24). Non-moving defendants also answered the Complaint
(Dkt. No. 21).
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Rule 10b-5, and for violation of Section 17(a) based on the allegations regarding
Rule 144 because: (1) the SEC fails to adequately plead scienter; and (2)
Defendants did not “make” the misstatement that the underlying corporate debt
was a “security” as required to state a claim for fraud based on Rule 144.5 The
SEC argues that Defendants’ motion is premature because resolution in their favor
would not result in dismissal of any of the claims and, moreover, the allegations of
fraud relating to the Rule 144 transaction are adequately plead. For the following
reasons, Defendants’ motion is denied.
II.

BACKGROUND
The SEC’s allegations are as follows. Between at least 2007 and

2010, Defendants obtained and illegally resold the stock of dozens of Penny Stock
Companies.6 The stocks of these companies were penny stocks as defined by
Section 3(a)(51)(A) of the Exchange Act, meaning, inter alia, that they traded
below five dollars per share and were not listed on a national securities exchange.7
5

Memorandum of Law in Support of Defendants’ Motion to Dismiss
Allegations of Fraud Arising Out of the Rule 144 Transactions (“Def. Mem.”) at 2,
6.
6

See FAC ¶ 33. The Penny Stock Companies traded only on the “over
the counter” market and were quoted by OTC Markets Group, Inc., an electronic
quotation and trading system, and had limited assets, low share prices, and little or
no analyst coverage. Id.
7

See id. (citing 15 U.S.C. § 78c(a)(51(A)).
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No registration statements were filed in connection with either the initial issuance
of shares to the Defendants, or Defendants’ subsequent sale of shares to the public
and no exemptions from registration were available to Defendants for their sales of
those securities to the public.8
Defendants falsely claimed two exemptions from registration. Rule
504(b)(1)(iii) exempts from registration offers and sales of securities made
“[e]xclusively according to state law exemptions from registration that permit
general solicitation and general advertising so long as sales are made only to
‘accredited investors.’”9 Defendants do not, in the instant motion, contest the
SEC’s allegations with respect to Defendants’ Rule 504(b)(1)(iii) transactions (the
“Rule 504 Scheme”) and this Opinion therefore does not address them further.10
Rule 144 permits a purchaser to resell unregistered securities if the
purchaser has held the securities for a “holding period,” usually of one year.11 If
certain criteria are met, the purchaser can satisfy the holding period by “tacking”

8

See id. ¶ 34.

9

Id. ¶ 35 (quoting 17 C.F.R. § 230.501(a)).

10

See Def. Mem. at 2. The alleged misrepresentations pertain to certain
Entity Defendants’ principal place of business and the stated purpose of acquiring
the securities at issue. See FAC ¶¶ 37, 39-75.
11

See FAC ¶ 10 (citing 17 C.F.R. § 230.144).
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back to the date the original stockholder acquired the unregistered security.12 Rule
144 requires that the instrument held by the original stockholder be a “security.”
To evade Rule 144 requirements, Defendants made it appear that they had satisfied
the holding period, when in fact they were converting a debt to a security and
immediately reselling the stock (the “Convertible Debt Scheme”).13 This entailed
searching the market for convertible “aged debt,” – debt that had been on a penny
stock issuer’s books for the requisite Rule 144 holding period – purchasing the
debt from the long-term creditors at a discount, and obtaining attorney opinion
letters stating that the debts were securities and could be converted to stock
certificates without restrictive legends because the original debt had been
outstanding for over one year.14 Defendants then promptly sold the unrestricted
shares on the market.15 Defendants did not satisfy Rule 144 because the original
debt was not a security but rather was “akin to an ‘IOU’ for services rendered or
compensation owed to a current or former affiliate of the issuer.”16 The SEC
alleges that the “Individual Defendants, who were experienced securities
12

See id.

13

See id. ¶ 38.

14

See id. ¶ 91.

15

See id. ¶ 92.

16

Id. ¶ 93.
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professionals and sophisticated investors, knew or were reckless in not knowing
that the debts were not securities.”17
As relief for the alleged Convertible Debt and Rule 504 Schemes, the
Commission seeks permanent injunctions against future violations of the securities
laws, disgorgement of Defendants’ illegal profits plus pre-judgment interest,
accounting, civil penalties, penny stock bars and, as to Garber, a conduct-based
injunction.18
III.

STANDARD OF REVIEW
A.

Rule 12(b)(6) Motion to Dismiss
A pleading must contain “a short and plain statement of the claim

showing that the pleader is entitled to relief.”19 “Such a statement must [] ‘give the
defendant fair notice of what the plaintiff’s claim is and the grounds upon which it
rests.’”20 In deciding a motion to dismiss pursuant to Rule 12(b)(6), the court

17

Id. ¶ 91.

18

See id. ¶¶ 33-34.

19

Fed. R. Civ. P. 8(a)(2).

20

See Swierkiewicz v. Sorema N.A., 534 U.S. 506, 512 (2002) (quoting
Conley v. Gibson, 355 U.S. 41, 47 (1957), overruled in part on other grounds by
Bell Atl. Corp. v. Twombly, 550 U.S. 544, 561-563 (2007)).
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“must accept all non-conclusory factual allegations as true and draw all reasonable
inferences in the plaintiff’s favor.”21
The court evaluates the sufficiency of the complaint under the “twopronged approach” suggested by the Supreme Court in Ashcroft v. Iqbal.22 Under
the first prong, a court “‘can . . . identify[] pleadings that, because they are no more
than conclusions, are not entitled to the assumption of truth.’”23 Thus,
“[t]hreadbare recitals of the elements of a cause of action, supported by mere
conclusory statements, do not suffice” to withstand a motion to dismiss.24
Under the second prong of Iqbal, “[w]hen there are well-pleaded
factual allegations, a court should assume their veracity and then determine
whether they plausibly give rise to an entitlement for relief.”25 A claim is plausible

21

Simms v. City of New York, No. 11 Civ. 4568, 2012 WL 1701356, at
*1 (2d Cir. May 16, 2012) (citing Goldstein v. Pataki, 516 F.3d 50, 56 (2d Cir.
2008)).
22

556 U.S. 662, 678-79 (2009).

23

Hayden v. Paterson, 594 F.3d 150, 161 (2d Cir. 2010) (quoting Iqbal,
556 U.S. at 679). Accord Ruston v. Town Bd. for Town of Skaneateles, 610 F.3d
55, 59 (2d Cir. 2010).
24

Iqbal, 556 U.S. at 663 (citing Twombly, 550 U.S. at 555).

25

Id. at 679. Accord Kiobel v. Royal Dutch Petroleum Co., 621 F.3d
111, 124 (2d Cir. 2010).
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“when the plaintiff pleads factual content that allows the court to draw the
reasonable inference that the defendant is liable for the misconduct alleged.”26
B.

Heightened Pleading Standard under Rule 9(b)
Federal Rule of Civil Procedure 9(b), “requires that the circumstances

constituting fraud . . . shall be stated with particularity,’”27 but “[m]alice, intent,
knowledge, and other conditions of a person’s mind may be alleged generally.”28
IV.

APPLICABLE LAW
A.

Section 10(b) and Rule 10b-5
Section 10(b) of the Securities Exchange Act of 1934 makes it illegal

to “use or employ, in connection with the purchase or sale of any security . . . any
manipulative or deceptive device or contrivance in contravention of such rules and
regulations as the Commission may prescribe . . . .”29 Rule 10b-5 makes it
unlawful, in connection with the purchase or sale of a security, to: (a) “employ
devices, schemes or artifices to defraud;” (b) “directly or indirectly . . . make any

26

Iqbal, 556 U.S. at 678 (quotation marks omitted).

27

Meridian Horizon Fund, LP v. KPMG (Cayman), 487 Fed. App’x
636, 639 (2d Cir. 2012) (quoting ATSI Commc’ns, Inc. v. Shaar Fund, Ltd., 493
F.3d 87, 99 (2d Cir. 2007)).
28

Fed. R. Civ. P. 9(b).

29

15 U.S.C. § 78j(b).
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untrue statement of a material fact;” or (c) engage in transactions, practices or
courses of business which [operate] as fraud or deceit upon any person.”30
A Rule 10b-5 violation requires ‘an intent to deceive, manipulate or
defraud.”31 A plaintiff can plead scienter “‘either (a) by alleging facts to show that
defendants had both motive and opportunity to commit fraud, or (b) by alleging
facts that constitute strong circumstantial evidence of conscious misbehavior or
recklessness.’”32 The requisite “strong inference of fraudulent intent”33 may arise
where the complaint alleges “that the defendants: (1) benefitted in a concrete and
personal way from the purported fraud[;] (2) engaged in deliberately illegal
behavior[;] (3) knew facts or had access to information suggesting that their public
statements were not accurate [;] or (4) failed to check information they had a duty
to monitor.”34
B.

Section 17(a)

30

17 C.F.R. § 240.10b-5.

31

Ganino v. Citizens Utils. Co., 228 F.3d 154, 168 (2d Cir. 2000).

32

SEC v. Mudd, 885 F. Supp. 2d 654, 661 (S.D.N.Y. 2012) (quoting
Lerner v. Fleet Bank, N.A., 459 F.3d 273, 290-91 (2d Cir. 2006)).
33

Ganino, 228 F.3d at 169.

34

Novak v. Kasaks, 216 F.3d 300, 311 (2d Cir. 2000).
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The elements of a violation under Section 17(a)(1)-(3) are essentially
the same as those of Rule 10(b) except that no showing of scienter is required for
the SEC to obtain an injunction under subsections (a)(2) or (a)(3).35
V.

DISCUSSION
A.

Defendants’ Motion Is Not Clearly Premature
The SEC argues that Defendants’ motion does not implicate dismissal

of a particular claim for relief, but is rather akin to a motion to strike allegations of
scienter-based fraud arising out of the Convertible Debt Scheme.36 However, if the
Rule 144 allegations could expand the scope of the case or the relief, or serve as an
alternative theory of liability – and the Complaint does not rule this out – then a
motion to dismiss is an appropriate vehicle to address whether the SEC may
proceed on this theory.
B.

The Complaint Adequately Alleges Scienter
The allegations in the FAC more than suffice to establish a strong

inference of fraudulent intent. The FAC alleges that the Convertible Debt Scheme
enabled Defendants to sell unrestricted stocks for at least one million dollars in

35

SEC v. Monarch Funding Corp., 192 F.3d 295, 308 (2d Cir. 1999).

36

See Plaintiff SEC’s Opposition to Defendants’ Motion to Dismiss
Allegations of Fraud Concerning Rule 144 Transactions (“Pl. Opp.”) at 4.
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proceeds.37 The motives alleged are not generalized profit motives, but rather
suggest a “concrete and personal benefit to the individual defendants resulting
[directly] from the fraud.”38 Defendants also had the opportunity, defined as the
“means and likely prospect of achieving concrete benefits by the means alleged.”39
The FAC alleges that Defendants had the resources to scour the niche market of
Penny Stock Companies for aged debt, purchase that debt at a discount,40 retain
attorneys to opine that the debt was a security eligible for conversion to
unrestricted Penny Stock Company shares, and sell the securities promptly on the
market.41 The fact that the attorney letters were a precondition to the success of the
scheme does not undermine the allegations of opportunity to commit fraud –
rather, the fact of obtaining said letters, the sole purpose of which was to further
the alleged scheme, supports the allegations of fraudulent intent.

37

See FAC ¶ 92.

38

Kalnit v. Eichler, 264 F.3d 131, 139 (2d Cir. 2001).

39

Novak, 216 F.3d at 307.

40

The SEC alleges that “[i]t is unreasonable to think a vendor would sell
a note at more than a 90% discount [– the discount alleged as to one of the
transactions –] if the vendor had already satisfied the Rule 144 holding period and
thus could have converted the debt and sold the shares himself.” Pl. Opp. at 9-10
n.5 (citing FAC ¶ 94).
41

See FAC ¶¶ 91-95.
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In addition, the SEC’s allegations that Defendants are “experienced
securities professionals and sophisticated investors” with decades of collective
experience, and Garber’s previous conviction for securities fraud are circumstantial
evidence that Defendants were either conscious of or reckless in not knowing that
the debt in question was not a security for the purposes of the Rule 144
exemption.42 In sum, particularly in light of the allegations regarding the Rule
504(b) scheme, the viability of which Defendants do not contest, the overall picture
painted by the FAC creates a strong inference that Defendants possessed the
requisite fraudulent intent in carrying out the Convertible Debt Scheme.
C.

The Fact that the Alleged Misstatements Were Made By
Attorneys Does Not Bar the SEC’s Fraud Claims
Defendants argue that the SEC’s fraud claims fail because the alleged

misrepresentations were made, not by Defendants but by attorneys in the form of
opinion letters. They rely on Janus Capital Group, Inc. v. First Derivative
Traders, in which the Supreme Court held that only the “maker” of a missleading

42

See id. ¶¶ 17-20 (alleging that Garber, Yellin and Feinstein were each
registered representatives who held multiple relevant licenses and each had close to
twenty years of experience in the securities industry). As Defendants concede, the
fact that notes representing an open-account debt incurred in the ordinary course of
business are not securities has been established since the Supreme Court’s 1990
decision in Reves v. Ernst & Young, 494 U.S. 56, 65-66 (1990) – more than fifteen
years before the alleged scheme commenced. See Def. Mem. at 12.
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statement could be held liable under Rule 10b-5(b).43 This argument is unavailing
for several reasons.
Janus addressed Rule 10b–5(b), which prohibits the “mak[ing]” of an
untrue statement of material fact in connection with the purchase or sale of a
security. The textual basis for Janus does not extend to claims based on schemes
to defraud under Rule 10b–5(a) and (c), which do not focus on the “making” of an
untrue statement.44 By the same logic, Janus would not affect claims under Section
17(a)(1) which prohibits “employ[ing] any device, scheme, or artifice to
defraud.”45 While the SEC cannot bypass the elements necessary to impose
misstatement liability under subsection (b) by labeling the alleged misconduct a
43

131 S. Ct. 2296, 2301-02 (2011).

44

See SEC v. Pentagon Capital Mgmt. PLC, 844 F. Supp. 2d 377, 421
(S.D.N.Y. 2012), as amended (Aug. 22, 2012) (“Accordingly, while Defendants
were certainly aware of the misstatements made at their direction and behest by
TW & Co. personnel, the allegations here hinge on Defendants’ deceptive
conduct”) (citing cases). Accord SEC v. Boock, No. 09 Civ. 8261, 2011 WL
5417106, at *2 (S.D.N.Y. Nov. 9, 2011). But see SEC v. Kelly, 817 F. Supp. 2d
340, 344 (S.D.N.Y. 2011) (“Where the SEC is attempting to impose primary
liability under subsections (a) and (c) of Rule 10b–5 for a scheme based upon an
alleged false statement, permitting primary scheme liability when the defendant did
not ‘make’ the misstatement would render the rule announced in Janus
meaningless.”).
45

See SEC v. Stoker, 865 F. Supp. 2d 457, 465 (S.D.N.Y. 2012) (“Janus
implicitly suggests that Section 17(a)[] should be read differently from, and more
broadly than, Section 10(b)” both because of the wording and because of the
absence of a private right of action under 17(a)).
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“scheme,”46 the “core misconduct” here is not a misstatement.47 As Defendants
recognize, the basis for the Rule 144 fraud claims is that “the original debt was not
a security.”48 The attorney opinions were a mere instrumentality of the “inherently
deceptive act” of acquiring and illegally reselling the unregistered penny stock,
which involved numerous steps including buying the penny stocks at a discounted
price and dumping the penny stocks into the market.49
More importantly, assuming Janus does govern the SEC’s Rule 10b-5
allegations,50 the Supreme Court held that “the maker of a statement is the person
46

See SEC v. Alternative Green Techs., Inc., No. 11 Civ. 9056, 2012
WL 4763094, at *5 (S.D.N.Y. Sept. 24, 2011) (quoting Kelly, 817 F. Supp. 2d at
343).
47

Contrast with Kelly, 817 F. Supp. 2d at 344 (declining to find scheme
liability where “the alleged round-trip transactions by AOL between 2000 and
2003 are deceptive only because of AOL’s subsequent public misrepresentations”);
SEC v. KPMG LLP, 412 F. Supp. 2d 349, 377-78 (S.D.N.Y. 2006) (claims
involving “issuance of clean audit opinions despite significant distortions in the
issuer’s financial statements, present a classic misstatement case”) (distinguishing
SEC v. Zandford, 535 U.S. 813, 820 (2002) (looting clients’ brokerage accounts);
Affiliated Ute Citizens v. United States, 406 U.S. 128, 153 (1972) (acting as market
makers for securities sold at inflated prices)).
48

Def. Mem. at 16.

49

Kelly, 817 F. Supp. 2d at 343 (“Scheme liability under subsections (a)
and (c) of Rule 10b-5 hinges on the performance of an inherently deceptive act that
is distinct from an alleged misstatement.”).
50

It is disputed whether the restriction set forth in Janus applies in SEC
enforcement actions. See Pentagon, 844 F. Supp. 2d at 421 (“There is no
indication that the Court or Congress intended for actions brought by the SEC to be
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or entity with ultimate authority over the statement, including its content and
whether and how to communicate it.”51 Thus, the Supreme Court rejected the
notion that one who “provides the false or misleading information that another
person then puts into the statement” could be liable under Rule 10b-5(b).52
Specifically, although investment advisers may have been responsible for the
statements in their client’s prospectus, they could not be held liable under Rule
10b-5(b) because the client itself was the ultimate maker of the statement through
its issuance of the prospectus. The Supreme Court clarified that, “[o]ne who
prepares or publishes a statement on behalf of another is not its maker.”53
Drawing all reasonable inferences in favor of the SEC, the attorneys
appear analogous to the investment advisors in Janus and Defendants to the client,
whom Janus suggests was the maker of the statement. Defendants solicited the
advisory opinion and had “ultimate authority . . . over whether and how to

[] limited” by the Janus ruling which was “based on ‘the narrow scope that we
must give the implied private right of action’ under Rule 10b–5 to private plaintiffs
in contrast to the Commission.”); Stoker, 865 F. Supp. 2d at 465 (“Janus
implicitly suggests that Section 17(a)[] should be read differently from, and more
broadly than, Section 10(b)” both because of the wording and because of the
absence of a private right of action under 17(a)). Contra Kelly, 817 F. Supp. 2d at
343.
51

Janus, 131 S. Ct. at at 2302.

52

Id. at 2303.

53

Id. at 2302.
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communicate it," at least in the context of the alleged scheme. The issuance of the
advisory opinion at Defendants' behest did not further the scheme, it was only
when Defendants presented the information in support of their ability to sell the
penny stocks without registration that they had the intended effect. 54 Even under

Janus, the "making" of these statements could be attributed to Defendants.

v.

CONCLUSION
For the foregoing reasons, Defendants' motion to dismiss is denied.

The Clerk of Court is directed to close this motion (Docket No. 14).

SO ORDERED:

Q(/,i/
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/

;

Shira A. Scheindlin
U.S.D.J.

Dated:

54

New York, New York
April 22, 2013

See PI. Opp. at 13 (Defendants "used the incorrect opinion letters to

facilitate the improper issue of unrestricted shares"). See also Def. Mem. at 9 n.2
(noting that transfer agents require an attorney opinion letter to remove the
restricted legend from a Rule 144 stock).
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-Appearances-

For the Securities and Exchange Commission:
Paul G. Gizzi, Esq.
Andrew M. Calamari, Esq.
Haimavathi V. Marlier, Esq.
Michael D. Paley, Esq.
U.S. Securities and Exchange Commission
Three World Financial Center
New York, NY 10281
[phone]
For Moving Defendants:
Ira Lee Sorkin, Esq.
Amit Sondhi, Esq.
Lowenstein Sandler PC
1251 Avenue of the Americas
New York, NY 11020
[phone]

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