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From Securities Regulation Daily, June 7, 2017

Chairman of failed internet startup loses securities fraud appeal

By R. Jason Howard, J.D.

On summary order, the Second Circuit Court of Appeals has upheld a 2015 district court judgment against the former chairman of a failed Long Island-based internet startup company, iShop, for securities fraud and selling unregistered securities (SEC v. Knight, June 6, 2017).

History. Through a series of unregistered stock offerings in late 1999 through mid-2000, iShop raised approximately $2.3 million from investors. The Commission initially filed an enforcement action in 2004 and the claims against the former chairman went to trial in 2015. After a 14-day trial, the jury returned a verdict in favor of the SEC.

On appeal, the former chairman challenged the jury findings and the remedies imposed by the district court and each was addressed in turn.

Claims. The former chairman first claimed that the SEC’s claims were time-barred but the court explained that the claims did not accrue until the alleged violations, the earliest of which was September 21, 1999, and because the SEC’s complaint was filed on September 20, 2004, the SEC’s claims were not barred under 28 U.S.C. § 2462, which provides a five-year period in which to bring certain causes of action.

The former chairman also raised various challenges to the jury’s findings, the first of which was that the SEC failed to present sufficient evidence of materiality as to alleged misrepresentations and omissions in two confidential offering memoranda drafted by him because the memoranda contained warnings that iShop was a startup and, therefore, an inherently risky investment. This argument was also dismissed as the court explained that "general disclosures about ‘why a security, as described, might perform poorly cannot overcome’ proof that the ‘description of that security was materially inaccurate."

Second, the former chairman asserted that there was "insufficient evidence of scienter because he reasonably relied on the advice of counsel when drafting the memoranda." The court however, said that based on its review of the evidence presented at trial, a jury could reasonably have found that the former chairman failed to make a "complete disclosure to counsel" and, therefore, properly rejected the reasonable-reliance defense.

The former chairman’s third contention was that, under the Supreme Court’s decision in Janus Capital Grp., Inc. v. First Derivative Traders, 564 U.S. 135 (2011), he could not be held liable for the alleged misstatements and omissions in the two memoranda because iShop was the "maker" of the statements in the memoranda. Again, the court explained that the SEC presented sufficient evidence that the former chairman was in fact the "maker" of other fraudulent statements.

The fourth argument was that the district court erred by allowing video deposition into evidence because his attorneys received no notice of the deposition. However, SEC counsel taking the deposition stated on the record that the former chairman’s attorneys had advised that they would not appear. Any error, explained the court, was harmless.

Finally, the former chairman challenged the jury’s finding that he violated Section 5, arguing that the stock offerings were exempt from registration under Rule 506, 17 C.F.R. § 230.506. After reviewing the record, the court concluded that despite the "challenges to the trial and jury instructions with respect to unaccredited investors who allegedly participated in the stock offerings, the jury could have reasonably concluded that the stock offerings were public offerings" and that he was therefore ineligible for a Rule 506 exemption on that ground alone.

The court also found no error in the district court’s choice of remedies. The decision of the district court was affirmed.

The case is No. 15-2951-cv.

Attorneys: Alexander M. Vasilescu for the SEC. Douglas T. Burns (Shaw, Licitra, Gulotta, Esernio & Schwartz, P.C.) for, Inc.

Companies:, Inc.

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