Securities & Exchange Commission v. SG Ltd

Decision Date02 August 2001
Docket NumberNos. 01-1176,s. 01-1176
Citation265 F.3d 42
Parties(1st Cir. 2001) SECURITIES AND EXCHANGE COMMISSION, Plaintiff, Appellant, v. SG LTD. ET AL., Defendants, Appellees. & 01-1332 Heard
CourtU.S. Court of Appeals — First Circuit

APPEALS FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MASSACHUSETTS

[Hon. Joseph L. Tauro, U.S. District Judge]

[Copyrighted Material Omitted] Mark Pennington, Assistant General Counsel, with whom David M. Becker, General Counsel, Jacob H. Stillman, Solicitor, and Meyer Eisenberg, Deputy General Counsel, were on brief, for appellant.

Daniel I. Small, with whom Meaghan E. Barrett and Butters, Brazilian & Small, LLP were on brief, for appellees.

Before Boudin, Chief Judge, Selya and Lipez, Circuit Judges.

SELYA, Circuit Judge.

These appeals -- procedurally, there are two, but for all practical purposes they may be treated as one -- require us to determine whether virtual shares in an enterprise existing only in cyberspace fall within the purview of the federal securities laws. SG Ltd., a Dominican corporation, and its affiliate, SG Trading Ltd. (collectively, "SG" or "defendants"), asseverate that the virtual shares were part of a fantasy investment game created for the personal entertainment of Internet users, and therefore, that those shares do not implicate the federal securities laws. The Securities and Exchange Commission ("the SEC"), plaintiff below and appellant here, counters that substance ought to prevail over form, and that merely labeling a website as a game should not negate the applicability of the securities laws. The district court accepted the defendants' view and dismissed the SEC's complaint. SEC v. SG Ltd., 142 F. Supp. 2d 126 (D. Mass. 2001). Concluding, as we do, that the SEC alleged sufficient facts to state a triable claim, we reverse.

I. BACKGROUND

We take the facts as alleged in the SEC's first amended complaint (shorn, however, of empty rhetoric). Aulson v. Blanchard, 83 F.3d 1, 3 (1st Cir. 1996).

The underlying litigation was spawned by SG's operation of a "StockGeneration" website offering on-line denizens an opportunity to purchase shares in eleven different "virtual companies" listed on the website's "virtual stock exchange." SG arbitrarily set the purchase and sale prices of each of these imaginary companies in biweekly "rounds," and 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 squirrel away in its virtual offerings.

The SEC's complaint focused on shares in a particular virtual enterprise referred to by SG as the "privileged company," and so do we. 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 website announced that the privileged company's shares would unfailingly appreciate, boldly proclaiming that "[t]he share price of [the privileged company] is supported by the owners of SG, this is why its value constantly rises; on average at a rate of 10% monthly (this is approximately 215% annually)." To add plausibility to this representation and to allay anxiety about future pricing, SG published prices of the privileged company's shares one month in advance.

While SG conceded that a decline in the share price was theoretically possible, it assured prospective participants that "under the rules governing the fall in prices, [the share price for the privileged company] cannot fall by more than 5% in a round." To bolster this claim, it vouchsafed that shares in the privileged company were supported by several distinct revenue streams. According to SG's representations, capital inflow from new participants provided liquidity for existing participants who might choose to sell their virtual shareholdings. As a backstop, SG pledged to allocate an indeterminate portion of the profits derived from its website operations to a special reserve fund designed to maintain the price of the privileged company's shares. SG asserted that these profits emanated from four sources: (1) the collection of a 1.5% commission on each transaction conducted on its virtual stock exchange; (2) the bid-ask spread on the virtual shares; (3) the "skillful manipulation" of the share prices of eight particular imaginary companies, not including the privileged company, listed on the virtual stock exchange; and (4) SG's right to sell shares of three other virtual companies (including the privileged company). As a further hedge against adversity, SG alluded to the availability of auxiliary stabilization funds which could be tapped to ensure the continued operation of its virtual stock exchange.

SG's website contained lists of purported "big winners," an Internet bulletin board featuring testimonials from supposedly satisfied participants, and descriptions of incentive programs that held out the prospect of rewards for such activities as the referral of new participants (e.g., SG's representation that it would pay "20, 25 or 30% of the referred player's highest of the first three payments") and the establishment of affiliate websites.

At least 800 United States domiciliaries, paying real cash, purchased 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. On March 20, 2000, these difficulties crested; 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 peremptorily 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 website.

The SEC undertook an investigation into SG's activities, which culminated in the filing of a civil action in federal district court. The SEC's complaint alleged, in substance, that SG's operations constituted a fraudulent scheme in violation of the registration and antifraud provisions of the federal securities laws. See Securities Act of 1933 § 5(a), (c), 15 U.S.C. § 77e(a), (c) (offer, sale, or delivery of unregistered securities); id. § 17(a), 15 U.S.C. § 77q(a) (fraud in offer or sale of securities); Securities Exchange Act of 1934 § 10(b), 15 U.S.C. § 78j(b); SEC Rule 10b-5, 17 C.F.R. 240.10b-5 (fraud in connection with purchase or sale of securities). The SEC sought injunctive relief, disgorgement, and civil penalties.

The district court entered a temporary restraining order (subsequently converted to a preliminary injunction) blocking SG's operation of the website pendente lite. The court also instituted an asset freeze that infrigidated approximately $5,500,000. The SEC's success was short-lived; after some skirmishing, not relevant here, the district court granted SG's motion to dismiss the complaint for failure to state a cognizable claim on the ground that the virtual shares were a clearly marked and defined game lacking a business context. See SEC v. SG Ltd., 142 F. Supp. 2d at 131. The SEC immediately appealed, and we issued a stay keeping both the preliminary injunction and the asset freeze in place for the time being.

These appeals hinge on whether the district court erred in ruling that transactions in the privileged company's shares did not constitute transactions in securities. In the pages that follow, we explore the makeup of that particular type of security known as an investment contract; examine the district court's rationale; and apply the tripartite "investment contract" test to the facts as alleged. Because the lower court dismissed the SEC's first amended complaint for failure to state a claim upon which relief might be granted, Fed. R. Civ. P. 12(b)(6), we conduct a de novo review, "accepting as true all well-pleaded factual averments and indulging all reasonable inferences in the plaintiff's favor." Aulson, 83 F.3d at 3. If the facts contained in the complaint, viewed in this favorable light, justify recovery under any applicable legal theory, we must set aside the order of dismissal. Conley v. Gibson, 355 U.S. 41, 45-46 (1957); Aulson, 83 F.3d at 3.

II. THE LEGAL LANDSCAPE

These appeals turn on whether the SEC alleged facts which, if proven, would bring this case within the jurisdictional ambit of the federal securities laws. Consequently, we focus on the type of security that the SEC alleges is apposite here: investment contracts.

A. Investment Contracts.

The applicable regulatory regime rests on two complementary pillars: the Securities Act of 1933, 15 U.S.C. §§ 77a-77aa, and the Securities Exchange Act of 1934, 15 U.S.C. §§ 78a-78mm. These statutes employ nearly identical definitions of the term "security." See Securities Act of 1933 § 2(a)(1), 15 U.S.C. § 77b(a)(1); Securities Exchange Act of 1934 § 3(a)(10), 15 U.S.C. § 78c(a)(10). Congress intended these sweeping definitions, set forth in an appendix hereto, to encompass a wide array of financial instruments, ranging from well-established investment vehicles (e.g., stocks and bonds) to much more arcane arrangements. SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943). Included in this array is the elusive, essentially protean, concept of an investment contract.

Judicial efforts to delineate what is -- and what...

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