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Securities and Exchange Commission v. Sason

United States District Court, S.D. New York

January 14, 2020




         In this securities case, the United States Securities and Exchange Commission ("SEC") alleges that Defendants Magna Management, LLC, Magna Eguities 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. 4 9]; 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.

         I. Background

         The following facts are taken from the Complaint and assumed to be true for purposes of deciding Defendants' motions.

         a. 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. (Id. ¶ 20.) Marc Manuel was a Magna executive who negotiated and ran diligence on deals for the Magna Entities. (Id. ¶¶ 2, 21.)

         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. (Id. ¶¶ 40-41.) To minimize the risk of market volatility, the Magna Entities only pursued transactions where they could unload their stock right after acquiring it. (Id. ¶¶ 42-43.) For this to work when dealing in unregistered stock, the Magna Entities needed to take advantage of exemptions from the requirements imposed by Securities Act § 5, which prohibits parties from selling securities unless they are first registered with the SEC. (Id. ¶ 29; 15 U.S.C. § 77e.)

         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. 1 34.) Tacking is only permitted, however, if the purchaser buys the securities from a person who is not affiliated with the issuer. (Id. ¶ 34.) If the prior owner was an affiliate, the six-month holding clock restarts when the buyer acquires the securities. (Id.)

         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. (Id. ¶ 38.) For a party to utilize the § 3(a)(10) exemption, a court must first approve the fairness of the terms and conditions of the claims-for-securities exchange. (Id.)

         c. Lustros Transactions

         i. Lustros Notes

         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. (Id. ¶¶ 28, 48.)

         Magna was introduced to Lustros in late 2012 when Lustros was in the process of lining up financing for its mining operations. (Id. ¶¶ 50-51.) Consistent with the business model discussed above, Magna proposed as one financing option the possibility of purchasing up to $550, 000 in convertible Lustros notes. (Id. ¶ 52.) To set the table for a future § 4(a)(1) exemption, Magna stipulated that it would need to buy the notes from an unaffiliated third party who had held them for six months, even though that an arrangement would seemingly not have satisfied Lustros'' financing needs, as Magna would be paying the third party-not Lustros-to acquire the debt. (Id. ¶ 53-54.)

         In December 2012, Zirk and Manuel met one-on-one to discuss the details of the financing. (Id. ¶ 55.) Zirk indicated to Manuel that the purchasing arrangement Magna had proposed was not viable because Lustros had no non-affiliated debt holders and no outstanding convertible debt. (Id. ¶¶ 57-58.) Zirk told Manuel, however, that Lustros owed approximately $550, 000 to Zirk and/or one of his affiliated companies, Suprafin Ltd. ("Suprafin"). Zirk's description of that $550, 000 debt matched disclosures Lustros had made in prior SEC filings. (Id. ¶ 56.)

         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, held the debt. (Id. ¶ 59.) Following their meeting, Zirk told Manuel that another of Zirk's entities, "Company-1," would stand In as the unaffiliated party. (Id. ¶ 61.) To disguise Zirk's control of Company-1, Zirk instructed his personal assistant to pretend to serve as its sole owner, officer, and director. (Id. ¶ 62.)

         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"). (Id. ¶ 63.) The CFO backdated the Lustros I Note to make it appear as if the debt Lustros previously disclosed in its SEC filings had always been held, in part, by Company-1. (Id. ¶¶ 64-65.) Although Zirk's debt had no stock conversion rights, the fake note did. (Id. ¶ 66.) Zirk signed the note on behalf of all its purported holders, including Company-1, even though Zirk's assistant was Company-l's only purported owner and executive. (Id. ¶ 67.)

         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. (Id. ¶ 68.) The assignment was backdated so it looked like Company-1 had been holding the debt for six months, thereby paving the way for a § 4(a)(1) exemption. (Id. ¶ 68.) After the fake documents were in place, Magna bought the Lustros I Note from Company-1. (Id. ¶ 69.)

         Later, in June 2013, Magna bought another tranche of purported Lustros convertible debt held by Company-1. (Id. ¶ 71.) The schematic for this transaction was largely the same as the first: Lustros' CFO created a fake note (the "Lustros II Note") and assignment, backdating both to cover the scheme, and then Magna bought the note from Company-1. (Id. ¶¶ 72-83.)

         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. (Id. ¶¶ 84-85.) Magna eventually sold over 2.5 million Lustros shares to the public for total proceeds of roughly $900, 000. (Id. ¶¶ 88-89.)

         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. (Id. ¶¶ 107-08.) Similarly, when Magna asked where the Lustros I Note was disclosed in Lustros' SEC filings, Lustros pointed to a disclosure showing only that Zirk and/or Suprafin held Lustros debt. (Id. ¶¶ 109.) And although Magna was buying the Lustros Notes from Company-1, Lustros told Magna on several occasions what Lustros planned to do with the cash from the transaction and confirmed to Magna that Lustros had received the funds purportedly wired to Company-1. (Id. ¶¶ 78-82.) The SEC therefore alleges that Magna knew or should have known that the Lustros Notes were phony and that the unregistered Lustros stock sales did not qualify for the § 4(a)(1) exemption. (See, e.g., id. ¶¶ 2, 69, 79.)

         i. 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. (Id. ¶¶ 93-104.)

         d. NewLead Transactions

         The second set of challenged transactions involves another alleged scheme to sell illegally unregistered shares, this time in a shipping company named NewLead Holdings Ltd. ("NewLead"). (Id. ¶ 113.) Although the Magna Defendants were marginally involved in these transactions, the key participants were the other group of Defendants: Kautilya Sharma, Perian Salviola, and their company, Pallas Holdings, LLC ("Pallas"), which operated a mining business in Kentucky. (Id. ¶¶ 25-27.)

         Beginning in 2012, NewLead undertook to expand its shipping business to include mining services. (Id. ¶ 113.) In 2013, it entered an agreement with Pallas to purchase two of Pallas' mining assets for a total price of $45 million: $15 million for a coal mine (the "Viking Mine") and $30 million for a coal prep plant (the "Viking Plant"). (Id. ¶ 117-19.) The Complaint alleges that NewLead never had the ability to pay that price in cash, so it hatched a scheme with the Pallas Defendants to use fake promissory notes as subterfuge for raising capital through public offerings of NewLead stock. (Id. ¶¶ 120-21, 124-25.) The SEC asserts claims related to three promissory notes: one issued on September 13, 2013 (the "NewLead I Note"), a second on October 13, 2013 (the "NewLead II Note"), and a third on December 9, 2013 (the "NewLead III Note"). Because the claims regarding the NewLead I and NewLead III Notes are similar, the Court will discuss them together.

         i. 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. (Id. ΒΆΒΆ 122-23.) Both notes ...

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