Circuit Court Rejects SEC Position on Section 5 Liability

 The Ninth Circuit rejected the SEC’s contention that a stock transfer agent and its principal are necessarily liable “by virtue of their position” for a company whose unregistered shares were sold in violation of Securities Act Section 5. SEC v. CMKM Diamonds, Inc., Nos. 11-17021, 11-17025 (9th Cir. Decided September 10, 2013) [an enhanced version of this opinion is available to lexis.com subscribers]. The Commission did prevail on a question of whether a stay should have been granted as to one defendant in the district court and on a question concerning disgorgement.

CMKM Diamonds claimed to be a gold and diamond mining company. In fact it had no legitimate business. Its shares were quoted in the Pink Sheets. They were not registered with the Commission. For about two years beginning in January 2003 at least eleven individuals and three entities participated in a scheme to issue billions of unregistered CMKM shares. The shares were sold to the public.

CEO Urban Casavant and director of “post merger Matters” John Edwards arranged to have the number of CMKM shares increased to 800 billion. Over the two year period about 622 billion shares were issued. The transfer agent was Global Stock Transfer, LLC and its owner Helen Bagley, both defendants. During 2003 and the first half of 2004 Ms. Bagley relied on opinion letters authored by attorney and defendant Brian Dvorak. Ms. Bagley testified in part that while it seemed strange that all the shares were being issued, as a transfer agent “That’s all we do. If we get proper paperwork, we do what needs to be done.”

In June 2004, however, Ms. Bagley requested that the Dvorak opinions be confirmed by another law firm, Edwards & Angell LLP. That firm issued a confirming opinion which stated in part that “we have relied upon opinions . . . of Dvorak & Associates, Ltd. for each of the Shareholders to the effect that the already issued shares as to which the Shares are being issued as dividends were issued more than two years ago and that the issuance of the Shares as dividends has been duly authorized.” The opinion went on to state that the firm had examined the pertinent documents and that “the Shares may be issued to the Shareholders . . . and that the certificates evidencing the Shares need bear no restrictive legend.”

The SEC filed a complaint against Mr. Dvorak, Global, Ms. Bagley and others. It alleged violations of Securities Act Section 5. Parallel criminal charges were brought against Mr. Dvorak and others. Subsequently, the Court granted the Commission’s motion for summary judgment as to Mr. Dvorak, Global and Ms. Bagley. As to Global and Ms. Bagley the Court concluded that they played more than a de minimis role in the scheme and that but for their participation in removing the restrictive legends there would not have been any unregistered sales of securities.

The Ninth Circuit reversed as to Global and Ms. Bagley. Section 5 of the Securities Act makes it unlawful for any person to sell or offer to sell an unregistered security. Liability under the Section is not limited to the person or entity who ultimately passes title. Rather, the Section reaches those who participate in the transaction. To be a participant the “defendant’s role in the transaction must be a significant one . . .” This test requires more than “but for” causation. To be a participant it must be established that the “person’s acts can be considered the proximate cause of a sale, his acts must also be a substantial factor in bringing about the transaction,” quoting SEC v. Murphy, 626 F. 2d 633, 650 (9th Cir. 1980) [enhanced version]. While the Supreme Court overruled the substantial factor test in Pinter v. Dahl, 486 U.S. 622 (1988) [enhanced version] that was based on Section 12 of the Securities Act. That Section provides that any person who offers or sells a security in violation of Section 5 is liable. Under that Section the “purchase from” requirement of the statute focuses on the relationship with the plaintiff-purchaser. Pinter is inapplicable here, the Court held, because Section 5 focuses on the degree of involvement in the “securities transaction and its surrounding circumstances.”

Here the undisputed facts do not establish that Global and Ms. Bagley were substantial participants as a matter of law. The firm and its owner reviewed the opinion letters of two law firms. It issued the unrestricted shares. Those facts, the Court held, are insufficient to establish “that Global and Bagley were substantial factors as a matter of law. Based upon this evidence, a reasonable jury could conclude that Global and Bagley were not substantial participants in the CMKM scheme.

In reaching this conclusion the Court rejected the SEC’s contention that the two defendants were necessarily liable under Section 5 given their role, concluding “A participant’s title, standing alone, cannot determine liability under Section 5, because the mere fact that a defendant is labeled as an issuer, a broker, a transfer agent, a CEO, a purchaser, or an attorney, does not adequately explain what role the defendant actually played in the scheme . . . “ The question of substantial participation is one of fact for the jury.

For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.

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