SEC v. Kahlon, 5th Cir., filed 10/16/17: Court Upholds Lower Court’s Penalty of Permanent Injunction from Trading Penny Stocks.

The Court held the Appellants violated SEC regulations by improperly selling and trading penny stocks in Texas, a state with which Appellant had very limited contact.

Kahlon was the sole officer, owner, and employee of TJ Management (TJM), a New York limited liability company formed in 2003. In 2005, the company bought 100 acres of vacant property in Texas. That year, Kahlon registered TJM as a foreign limited liability company, hired a registered agent in Texas, and obtained a mailing address in Texas. The company’s operations were administered through a New York bank account. Kahlon then started investing in unregistered penny stocks based on the SEC Rule 504 exemption and the corresponding Texas blue-sky exemption.  Essentially he would buy these restricted stocks and then sell them on the open market in very short order (and not to accredited investors). The SEC was not pleased and brought this action.

To establish that Kahlon and TJM violated the registration provisions of section 5 of the securities act, the SEC must make out a prima facie showing that (1) no registration statement was in effect as to the securities, 2) the defendant sold or offered to sell these securities, and 3) interstate transportation or communication and the mails were used in connection with the sale or offer of sale.” SEC v. Cont’l Tobacco Co., 463 F.2d 137, 155 (5th Cir. 1972).  Kahlon and TJM relied on Rule 504(b)(1)(iii) which allows offerings and sales to avoid the SEC registration requirements if they are conducted “[e]xclusively according to state law exemptions from registration that permits general solicitation in general advertising so long as sales are made only to ‘accredited investors’ as defined in 230.501(a).  17 C.F.R. 230.504(b)(1)(iii).

The district court here found that Rule 501(b)(1)(iii) requires compliance with those state law exemptions where The securities are offered or sold. It found there was no evidence of the transactions at issue here took place exclusively under Texas law. The appellants here complained that this reading of the law implied an additional requirement into the exemption and argued that the SEC Compliance Guide, subsequently issued in 2017 and not in effect at the time of these violations, should govern. The court dismissed this argument since the Guide requires that “[i]ssuers must comply with state securities laws and regulations in the states in which securities are offered or sold.”  U.S. Sec. & Exch. Comm’n, Rule 504 of Regulation D:  A Small Entity Compliance Guide for Issuers (Jan. 2017).  Essentially the Court here is confirming what seems rather obvious– that you cannot take advantage of a state’s blue-sky laws by buying and selling securities elsewhere.

The real issue in this case are the remedies that the court imposed at the request of the SEC. The SEC ordered that the appellants should be permanently barred from trading in penny stocks, and not just securities offered pursuant to Rule 504.   To impose this hearty remedy, the district court considered a list of factors that the Eleventh Circuit identified and found compelling in SEC v. Calvo, 378 F.3d 1211, 1216 (11th Cir. 2004):

(1) The egregiousness of the defendant’s actions, (2) the isolated or recurrent nature of the infraction, (3) the degree of scienter (or mental state) involved, (4) the sincerity of the defendant’s assurances against future violations, (5) the defendant’s recognition of the wrongful nature of the conduct, and (6) the likelihood that the defendant’s occupation will present opportunities for future violations.

The Court additionally considered the defendant’s role or position when he engaged in the fraud and the defendants economic stake in the violation.  See SEC v. Patel, 61 F.3d 137, 141 (2nd Cir. 1995).

Applying these factors, the Court found that Kahlon acted intentionally or recklessly. It noted that the district court pointed out that Kahlon had misrepresented to brokerage houses and others who dealt with him that he had a presence in Texas and that he was purchasing the stock as an investment. The court found the basic characterizations to be contradicted by his deposition. Applying an abuse of discretion standard, the court did not find that the district court erred in banning Kahlon from engaging in the trade of penny stocks and not just Rule 504 placements.

The Court also found the district court’s injunction against future securities violations and disgorgement of all gross revenues to be well within the district court’s discretion.  I think the lesson here is fairly clear– if you’re not from Texas, don’t try to take advantage of Texas securities laws.