United States District Court, S.D. New York
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, New York, NY.
For Moving Defendants: Ira Lee Sorkin, Esq., Amit Sondhi, Esq., Lowenstein Sandler PC, New York, NY.
OPINION AND ORDER
SHIRA A. SCHEINDLIN, U.S.D.J.
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 Defendants, " Defendants" ). 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.
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). Defendants move under Federal Rule of Civil Procedure 12(b)(6) to dismiss the SEC's claims for violation of Section 10(b) and 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. 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.
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. 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. 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.
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.'"  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.
Rule 144 permits a purchaser to resell unregistered securities if the purchaser has held the securities for a " holding period," usually of one year. If certain criteria are met, the purchaser can satisfy the holding period by " tacking" back to the date the original stockholder acquired the unregistered security. 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" ). 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. Defendants then promptly sold the unrestricted shares on the market. 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 ...