SECURITIES AND EXCHANGE COMMISSION
LITIGATION RELEASE NO. 17129 / September 14, 2001
First Circuit Reverses Lower Court's Dismissal of SEC Action Against Internet "Virtual Stock Exchange" Scheme Operators
SECURITIES AND EXCHANGE COMMISSION v. SG LIMITIED et al. (United States Court of Appeals for the First Circuit, Nos. 01-1176 and 01-1332) (September 13, 2001)
The Commission announced that yesterday, September 13, 2001, the United States Court of Appeals for the First Circuit issued a ruling that allowed the SEC to proceed with its fraud action against SG Limited. The SEC had alleged that SG violated federal securities laws by offering investments in a "virtual company" on its "StockGeneration" website and by falsely representing that investors in the company would receive a guaranteed profit of 10% per month. The Court of Appeals ruling reversed a lower court's decision that dismissed the case on the basis that the SG investment was not a security. The Court of Appeals ruled that the lower court had erred and that the investment scheme as described in the SEC's complaint was an investment contract, a form of security covered by the federal securities laws.
The SEC's case, originally filed on June 9, 2000 in the United States District Court for the District of Massachusetts, alleged that SG Limited, an offshore entity, operated a massive Internet pyramid scheme under the name "StockGeneration." SG allegedly described the StockGeneration program as a "virtual stock exchange" offering investments in the stock of several "virtual companies," including one identified as the "privileged company" whose shares "only rise" and generate a risk-free, guaranteed return of 10% per month, or 215% per year. The Commission further alleged that investors in this privileged company did not receive the guaranteed return and have not even been able to recover their initial investments.
The District Court initially granted the Commission's motions for a temporary restraining order and a preliminary injunction halting SG's alleged fraudulent activities and imposing an asset freeze through which the SEC was able to protect over $5,000,000 of investor funds held in banks in the U.S., Estonia and Cyprus. (The freeze remained in effect pending the appeal.) On January 25, 2001, however, the court granted SG's motion to dismiss the SEC's complaint, concluding that SG's "virtual stock exchange" program fell outside the scope of the federal securities laws because SG's website clearly marked and defined the activity as a game and therefore it was not within the ordinary concept of a security in the commercial world.
The First Circuit Court of Appeals reversed the District Court, emphasizing that the substance of an instrument, not the name applied to it, determines whether it constitutes a security. The Court held that "the language on SG's website emphasizing the game-like nature of buying and selling virtual shares of the privileged company does not place such transactions beyond the long reach of the federal securities laws." The Court noted that the SG scheme as described in the SEC's complaint could be characterized as a Ponzi or pyramid scheme that allegedly "played upon greed and fueled expectations of profit," and that the facts, if proven at trial, satisfied the three-part legal test for an "investment contract" constituting a security. The First Circuit for the first time expressly ruled that "horizontal commonality" satisfies the "common enterprise" element of the three-part test and held that the element is met by a program such as SG's, that pools assets from multiple investors in such a way that they share in the profits and risk of the enterprise. The First Circuit remanded the case for further proceedings, during which the preliminary injunction and asset freeze preserving over $5.5 million of investor funds will remain in effect.
The Commission's complaint alleged that SG Limited violated the general antifraud and securities registration provisions of the federal securities laws - that is, Sections 5(a) and (c) and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission's complaint also charged two affiliated companies: SG Perfect Limited and SG Trading Limited, as relief defendants who were unjustly enriched through the receipt of money raised from the StockGeneration scheme. The Commission is seeking an order permanently enjoining SG from violating the antifraud and registration provisions of the federal securities laws, requiring defendants to disgorge funds received through their violations of the securities laws, and imposing civil monetary penalties on SG.