Securities & Exchange Commission v. SG Ltd.

United States Court of Appeals
For the First Circuit

Nos. 01-1176
01-1332
SECURITIES AND EXCHANGE COMMISSION,

Plaintiff, Appellant,

v.

SG LTD. ET AL.,

Defendants, Appellees.

APPEALS FROM THE UNITED STATES DISTRICT COURT

FOR THE DISTRICT OF MASSACHUSETTS

[Hon. Joseph L. Tauro, U.S. District Judge]

Before

Boudin, Chief Judge,

Selya and Lipez, Circuit Judges.

Mark Pennington, Assistant General Counsel, with whom David
M. Becker, General Counsel, Jacob H. Stillman, Solicitor, and
Meyer Eisenberg, Deputy General Counsel, were on brief, for
appellant.
Daniel I. Small, with whom Meaghan E. Barrett and Butters,
Brazilian & Small, LLP were on brief, for appellees.

September 13, 2001
 SELYA, Circuit Judge. These appeals — procedurally,

there are two, but for all practical purposes they may be

treated as one — require us to determine whether virtual shares

in an enterprise existing only in cyberspace fall within the

purview of the federal securities laws. SG Ltd., a Dominican

corporation, and its affiliate, SG Trading Ltd. (collectively,

"SG" or "defendants"), asseverate that the virtual shares were

part of a fantasy investment game created for the personal

entertainment of Internet users, and therefore, that those

shares do not implicate the federal securities laws. The

Securities and Exchange Commission ("the SEC"), plaintiff below

and appellant here, counters that substance ought to prevail

over form, and that merely labeling a website as a game should

not negate the applicability of the securities laws. The

district court accepted the defendants' view and dismissed the

SEC's complaint. SEC v. SG Ltd., 142 F. Supp. 2d 126 (D. Mass.

2001). Concluding, as we do, that the SEC alleged sufficient

facts to state a triable claim, we reverse.

I. BACKGROUND

We take the facts as alleged in the SEC's first amended

complaint (shorn, however, of empty rhetoric). Aulson v.

Blanchard, 83 F.3d 1, 3 (1st Cir. 1996).

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 The underlying litigation was spawned by SG's operation

of a "StockGeneration" website offering on-line denizens an

opportunity to purchase shares in eleven different "virtual

companies" listed on the website's "virtual stock exchange." SG

arbitrarily set the purchase and sale prices of each of these

imaginary companies in biweekly "rounds," and guaranteed that

investors could buy or sell any quantity of shares at posted

prices. SG placed no upper limit on the amount of funds that an

investor could squirrel away in its virtual offerings.

The SEC's complaint focused on shares in a particular

virtual enterprise referred to by SG as the "privileged

company," and so do we. SG advised potential purchasers to pay

"particular attention" to shares in the privileged company and

boasted that investing in those shares was a "game without any

risk." To this end, its website announced that the privileged

company's shares would unfailingly appreciate, boldly

proclaiming that "[t]he share price of [the privileged company]

is supported by the owners of SG, this is why its value

constantly rises; on average at a rate of 10% monthly (this is

approximately 215% annually)." To add plausibility to this

representation and to allay anxiety about future pricing, SG

published prices of the privileged company's shares one month in

advance.

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 While SG conceded that a decline in the share price was

theoretically possible, it assured prospective participants that

"under the rules governing the fall in prices, [the share price

for the privileged company] cannot fall by more than 5% in a

round." To bolster this claim, it vouchsafed that shares in the

privileged company were supported by several distinct revenue

streams. According to SG's representations, capital inflow from

new participants provided liquidity for existing participants

who might choose to sell their virtual shareholdings. As a

backstop, SG pledged to allocate an indeterminate portion of the

profits derived from its website operations to a special reserve

fund designed to maintain the price of the privileged company's

shares. SG asserted that these profits emanated from four

sources: (1) the collection of a 1.5% commission on each

transaction conducted on its virtual stock exchange; (2) the

bid-ask spread on the virtual shares; (3) the "skillful

manipulation" of the share prices of eight particular imaginary

companies, not including the privileged company, listed on the

virtual stock exchange; and (4) SG's right to sell shares of

three other virtual companies (including the privileged

company). As a further hedge against adversity, SG alluded to

the availability of auxiliary stabilization funds which could be

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tapped to ensure the continued operation of its virtual stock

exchange.

SG's website contained lists of purported "big

winners," an Internet bulletin board featuring testimonials from

supposedly satisfied participants, and descriptions of incentive

programs that held out the prospect of rewards for such

activities as the referral of new participants (e.g., SG's

representation that it would pay "20, 25 or 30% of the referred

player's highest of the first three payments") and the

establishment of affiliate websites.

At least 800 United States domiciliaries, paying real

cash, purchased virtual shares in the virtual companies listed

on the defendants' virtual stock exchange. In the fall of 1999,

over $4,700,000 in participants' funds was deposited into a

Latvian bank account in the name of SG Trading Ltd. The

following spring, more than $2,700,000 was deposited in Estonian

bank accounts standing in the names of SG Ltd. and SG Perfect

Ltd., respectively.

In late 1999, participants began to experience

difficulties in redeeming their virtual shares. On March 20,

2000, these difficulties crested; SG unilaterally suspended all

pending requests to withdraw funds and sharply reduced

participants' account balances in all companies except the

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privileged company. Two weeks later, SG peremptorily announced

a reverse stock split, which caused the share prices of all

companies listed on the virtual stock exchange, including the

privileged company, to plummet to 1/10,000 of their previous

values. At about the same time, SG stopped responding to

participant requests for the return of funds, yet continued to

solicit new participants through its website.

The SEC undertook an investigation into SG's

activities, which culminated in the filing of a civil action in

federal district court. The SEC's complaint alleged, in

substance, that SG's operations constituted a fraudulent scheme

in violation of the registration and antifraud provisions of the

federal securities laws. See Securities Act of 1933 § 5(a),

(c), 15 U.S.C. § 77e(a), (c) (offer, sale, or delivery of

unregistered securities); id. § 17(a), 15 U.S.C. § 77q(a) (fraud

in offer or sale of securities); Securities Exchange Act of

1934 § 10(b), 15 U.S.C. § 78j(b); SEC Rule 10b-5, 17 C.F.R.

240.10b-5 (fraud in connection with purchase or sale of

securities). The SEC sought injunctive relief, disgorgement,

and civil penalties.

The district court entered a temporary restraining

order (subsequently converted to a preliminary injunction)

blocking SG's operation of the website pendente lite. The court

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also instituted an asset freeze that infrigidated approximately

$5,500,000. The SEC's success was short-lived; after some

skirmishing, not relevant here, the district court granted SG's

motion to dismiss the complaint for failure to state a

cognizable claim on the ground that the virtual shares were a

clearly marked and defined game lacking a business context. See

SEC v. SG Ltd., 142 F. Supp. 2d at 131. The SEC immediately

appealed, and we issued a stay keeping both the preliminary

injunction and the asset freeze in place for the time being.

These appeals hinge on whether the district court erred

in ruling that transactions in the privileged company's shares

did not constitute transactions in securities. In the pages

that follow, we explore the makeup of that particular type of

security known as an investment contract; examine the district

court's rationale; and apply the tripartite "investment

contract" test to the facts as alleged. Because the lower court

dismissed the SEC's first amended complaint for failure to state

a claim upon which relief might be granted, Fed. R. Civ. P.

12(b)(6), we conduct a de novo review, "accepting as true all

well-pleaded factual averments and indulging all reasonable

inferences in the plaintiff's favor." Aulson, 83 F.3d at 3. If

the facts contained in the complaint, viewed in this favorable

light, justify recovery under any applicable legal theory, we

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must set aside the order of dismissal. Conley v. Gibson, 355

U.S. 41, 45-46 (1957); Aulson, 83 F.3d at 3.

II. THE LEGAL LANDSCAPE

These appeals turn on whether the SEC alleged facts

which, if proven, would bring this case within the

jurisdictional ambit of the federal securities laws.

Consequently, we focus on the type of security that the SEC

alleges is apposite here: investment contracts.

A. Investment Contracts.

The applicable regulatory regime rests on two

complementary pillars: the Securities Act of 1933, 15 U.S.C. §§

77a-77aa, and the Securities Exchange Act of 1934, 15 U.S.C. §§

78a-78mm. These statutes employ nearly identical definitions of

the term "security." See Securities Act of 1933 § 2(a)(1), 15

U.S.C. § 77b(a)(1); Securities Exchange Act of 1934 § 3(a)(10),

15 U.S.C. § 78c(a)(10). Congress intended these sweeping

definitions, set forth in an appendix hereto, to encompass a

wide array of financial instruments, ranging from well-

established investment vehicles (e.g., stocks and bonds) to much

more arcane arrangements. SEC v. C. M. Joiner Leasing Corp.,

320 U.S. 344, 351 (1943). Included in this array is the

elusive, essentially protean, concept of an investment contract.

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 Judicial efforts to delineate what is — and what is not

— an investment contract are grounded in the seminal case of SEC

v. W. J. Howey Co., 328 U.S. 293 (1946). The Howey Court

established a tripartite test to determine whether a particular

financial instrument constitutes an investment contract (and,

hence, a security). This test has proven durable. Under it, an

investment contract comprises (1) the investment of money (2) in

a common enterprise (3) with an expectation of profits to be

derived solely from the efforts of the promoter or a third

party. Id. at 298-99. This formulation must be applied in

light of the economic realities of the transaction. United

Hous. Found., Inc. v. Forman, 421 U.S. 837, 851-52 (1975);

Tcherepnin v. Knight, 389 U.S. 332, 336 (1967); Futura Dev.

Corp. v. Centex Corp., 761 F.2d 33, 39 (1st Cir. 1985). In

other words,

substance governs form, and the substance of
an investment contract is a security-like
interest in a "common enterprise" that,
through the efforts of the promoter or
others, is expected to generate profits for
the security holder, either for direct
distribution or as an increase in the value
of the investment.

Rodriguez v. Banco Cent. Corp., 990 F.2d 7, 10 (1st Cir. 1993)

(citations omitted).

The Supreme Court has long espoused a broad

construction of what constitutes an investment contract,

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aspiring "to afford the investing public a full measure of

protection." Howey, 328 U.S. at 298. The investment contract

taxonomy thus "embodies a flexible rather than a static

principle, one that is capable of adaptation to meet the

countless and variable schemes devised by those who seek the use

of the money of others on the promise of profits." Id. at 299.

The Howey test has proven to be versatile in practice.

Over time, courts have classified as investment contracts a

kaleidoscopic assortment of pecuniary arrangements that defy

categorization in conventional financial terms, yet nonetheless

satisfy the Howey Court's three criteria. See, e.g., id.

(holding that sale of citrus groves, in conjunction with service

contract, qualifies as an investment contract); Teague v.

Bakker, 35 F.3d 978, 981, 990 (4th Cir. 1994) (same re purchase

of life partnership in evangelical community); Long v. Shultz

Cattle Co., 881 F.2d 129, 132 (5th Cir. 1989) (same re cattle-

feeding and consulting agreement); Miller v. Cent. Chinchilla

Group, 494 F.2d 414, 415, 418 (8th Cir. 1974) (same re

chinchilla breeding and resale arrangement).

B. The District Court's Rationale.

We pause at this juncture to address the district

court's rationale. Relying upon a dictum from Howey discussing

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"the many types of instruments that in our commercial world fall

within the ordinary concept of a security," 328 U.S. at 299

(quoting legislative history), the district court drew a

distinction between what it termed "commercial dealings" and

what it termed "games." SEC v. SG Ltd., 142 F. Supp. 2d at 131.

Characterizing purchases of the privileged company's shares as

a "clearly marked and defined game," the court concluded that

since that activity was not part of the commercial world, it

fell beyond the jurisdictional reach of the federal securities

laws. Id. In so ruling, the court differentiated SG's

operations from a classic Ponzi or pyramid scheme on the ground

that those types of chicanery involved commercial dealings

within a business context. Id.

We do not gainsay the obvious correctness of the

district court's observation that investment contracts lie

within the commercial world. Contrary to the district court's

view, however, this locution does not translate into a dichotomy

between business dealings, on the one hand, and games, on the

other hand, as a failsafe way for determining whether a

particular financial arrangement should (or should not) be

characterized as an investment contract. Howey remains the

touchstone for ascertaining whether an investment contract

exists — and the test that it prescribes must be administered

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without regard to nomenclature. See Int'l Bhd. of Teamsters v.

Daniel, 439 U.S. 551, 561 (1979); see also Forman, 421 U.S. at

851-52 (warning against reliance on "the names that may have

been employed by the parties" to identify a particular

investment); cf. William Shakespeare, Romeo & Juliet, act 2, sc.

2 (circa 1597) ("A rose by any other name would smell as

sweet."). As long as the three-pronged Howey test is satisfied,

the instrument must be classified as an investment contract.

Howey, 328 U.S. at 301. Once that has occurred, "it is

immaterial whether the enterprise is speculative or non-

speculative or whether there is a sale of property with or

without intrinsic value." Id. It is equally immaterial whether

the promoter depicts the enterprise as a serious commercial

venture or dubs it a game.

A fairly recent Supreme Court opinion demonstrates that

the "commercial world" to which the Howey Court alluded actually

encompasses the total universe of financial instruments

available to investors, rather than the subset of financial

instruments envisioned by the district court (i.e., "commerce"

as opposed to "games"). In that case, Justice Marshall wrote:

In defining the scope of the market that it
wished to regulate, Congress painted with a
broad brush. It recognized the virtually
limitless scope of human ingenuity,
especially in the creation of "countless and
variable schemes devised by those who seek

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 the use of the money of others on the
promise of profits," and determined that the
best way to achieve its goal of protecting
investors was "to define 'the term
"security" in sufficiently broad and general
terms so as to include within that
definition the many types of instruments
that in our commercial world fall within the
ordinary concept of a security.'" Congress
therefore did not attempt precisely to cabin
the scope of the Securities Acts. Rather,
it enacted a definition of "security"
sufficiently broad to encompass virtually
any instrument that might be sold as an
investment.

Reves v. Ernst & Young, 494 U.S. 56, 60-61 (1990) (citations

omitted). This expansive language, coupled with Congress's

sweeping definitions of "security," persuade us to reject the

district court's use of Howey's "commercial world" reference as

a limiting principle.

To sum up, Howey supplies the appropriate template for

identifying investment contracts within the overarching ambit of

the federal securities laws. Contrary to the district court's

conclusion, this template admits of no exception for games or

gaming. Thus, 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.

III. ADMINISTERING THE TRIPARTITE TEST

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 What remains is to analyze whether purchases of the

privileged company's shares constitute investment contracts. We

turn to that task, taking the three Howey criteria in sequence.

A. Investment of Money.

The first component of the Howey test focuses on the

investment of money. The determining factor is whether an

investor "chose to give up a specific consideration in return

for a separable financial interest with the characteristics of

a security." Daniel, 439 U.S. at 559. We conclude that the

SEC's complaint sufficiently alleges the existence of this

factor.

To be sure, SG disputes the point. It argues that the

individuals who purchased shares in the privileged company were

not so much investing money in return for rights in the virtual

shares as paying for an entertainment commodity (the opportunity

to play the StockGeneration game). This argument suggests that

an interesting factual issue may await resolution — whether

participants were motivated primarily by a perceived investment

opportunity or by the visceral excitement of playing a game.

Nevertheless, this case comes to us following a dismissal under

Rule 12(b)(6), and the SEC's complaint memorializes, inter alia,

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SG's representation that participants could "firmly expect a 10%

profit monthly" on purchases of the privileged company's shares.

That representation plainly supports the SEC's legal claim that

participants who invested substantial amounts of money in

exchange for virtual shares in the privileged company likely did

so in anticipation of investment gains. Given the procedural

posture of the case, no more is exigible to fulfill the first

part of the Howey test.

B. Common Enterprise.

The second component of the Howey test involves the

existence of a common enterprise. Before diving headlong into

the sea of facts, we must dispel the miasma that surrounds the

appropriate legal standard.

1. The Legal Standard. Courts are in some disarray

as to the legal rules associated with the ascertainment of a

common enterprise. See generally II Louis Loss & Joel Seligman,

Securities Regulation 989-97 (3d ed. rev. 1999). Many courts

require a showing of horizontal commonality — a type of

commonality that involves the pooling of assets from multiple

investors so that all share in the profits and risks of the

enterprise. See SEC v. Infinity Group Co., 212 F.3d 180, 187-88

(3d Cir. 2000), cert. denied, 121 S. Ct. 1228 (2001); SEC v.

Life Partners, Inc., 87 F.3d 536, 543 (D.C. Cir. 1996); Wals v.

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Fox Hills Dev. Corp., 24 F.3d 1016, 1018 (7th Cir. 1994); Revak

v. SEC Realty Co., 18 F.3d 81, 87 (2d Cir. 1994); Curran v.

Merrill Lynch, Pierce, Fenner & Smith, 622 F.2d 216, 222, 224

(6th Cir. 1980), aff'd on other grounds, 456 U.S. 353 (1982).

Other courts have modeled the concept of common enterprise

around fact patterns in which an investor's fortunes are tied to

the promoter's success rather than to the fortunes of his or her

fellow investors. This doctrine, known as vertical commonality,

has two variants. Broad vertical commonality requires that the

well-being of all investors be dependent upon the promoter's

expertise. See Villeneuve v. Advanced Bus. Concepts Corp., 698

F.2d 1121, 1124 (11th Cir. 1983), aff'd en banc, 730 F.2d 1403

(11th Cir. 1984); SEC v. Koscot Interplanetary, Inc., 497 F.2d

473, 478-79 (5th Cir. 1974). In contrast, narrow vertical

commonality requires that the investors' fortunes be "interwoven

with and dependent upon the efforts and success of those seeking

the investment or of third parties." SEC v. Glenn W. Turner

Enters., 474 F.2d 476, 482 n.7 (9th Cir. 1973).

Courts also differ in the steadfastness of their

allegiance to a single standard of commonality. Two courts of

appeals recognize only horizontal commonality. See Wals, 24

F.3d at 1018; Curran, 622 F.2d at 222, 224. Two others adhere

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exclusively to broad vertical commonality.1 See Villeneuve, 698

F.2d at 1124; Koscot, 497 F.2d at 478-79. The Ninth Circuit

recognizes both horizontal commonality and narrow vertical

commonality. See Hocking v. Dubois, 885 F.2d 1449, 1459 (9th

Cir. 1989) (en banc). To complicate matters further, four

courts of appeals have accepted horizontal commonality, but have

not yet ruled on whether they also will accept some form of

vertical commonality. See Infinity Group, 212 F.3d at 187 n.8;

Life Partners, 87 F.3d at 544; Teague, 35 F.3d at 986 n.8;

Revak, 18 F.3d at 88. At least one of these courts, however,

has explicitly rejected broad vertical commonality. See Revak,

18 F.3d at 88.

Thus far, neither the Supreme Court nor this court has

authoritatively determined what type of commonality must be

present to satisfy the common enterprise element. We came close

in Rodriguez, in which we hinted at a preference for horizontal

commonality. There, promoters selling parcels of land made

"strong and repeated suggestions that the surrounding area would

develop into a thriving residential community." 990 F.2d at 11.

Although we held that the financial arrangement did not

1We note that broad vertical commonality is an expansive
concept which typically overspreads other types of commonality.
See Mordaunt v. Incomco, 469 U.S. 1115, 1115-16 (1985) (White,
J., dissenting from denial of certiorari).

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constitute a security, we implied that an actual commitment by

the promoters to develop the community themselves, coupled with

the buyers' joint financing of the enterprise, could constitute

a common enterprise. See id.

The case at bar requires us to take a position on the

common enterprise component of the Howey test. We hold that a

showing of horizontal commonality — the pooling of assets from

multiple investors in such a manner that all share in the

profits and risks of the enterprise — satisfies the test. This

holding flows naturally from the facts of Howey, in which the

promoter commingled fruit from the investors' groves and

allocated net profits based upon the production from each tract.

See Howey, 328 U.S. at 296. Adopting this rule also aligns us

with the majority view and confirms the intimation of Rodriguez.

Last, but surely not least, the horizontal commonality standard

places easily ascertainable and predictable limits on the types

of financial instruments that will qualify as securities.2

2. Applying the Standard. Here, the pooling element

of horizontal commonality jumps off the screen. The defendants'

website stated that: "The players' money is accumulated on the

2 Since the complaint in this case alleges facts sufficient
to establish horizontal commonality, see infra Part III(B)(2),
we take no view as to whether vertical commonality, in either of
its iterations, also may suffice to satisfy the "common
enterprise" requirement.

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SG current account and is not invested anywhere, because no

investment, not even the most profitable one, could possibly

fully compensate for the lack of sufficiency in settling

accounts with players, which lack would otherwise be more

likely." Thus, as the SEC's complaint suggests, SG

unambiguously represented to its clientele that participants'

funds were pooled in a single account used to settle

participants' on-line transactions. Therefore, pooling is

established.

Of course, horizontal commonality requires more than

pooling alone; it also requires that investors share in the

profits and risks of the enterprise. The SEC maintains that two

separate elements of SG's operations embody the necessary

sharing. First, it asserts that SG was running a Ponzi or

pyramid scheme dependent upon a continuous influx of new money

to remain in operation,3 and argues that such arrangements

3
While the terms "Ponzi" and "pyramid" often are used
interchangeably to describe financial arrangements which rob
Peter to pay Paul, the two differ slightly. In Ponzi schemes —
named after a notorious Boston swindler, Charles Ponzi, who
parlayed an initial stake of $150 into a fortune by means of an
elaborate scheme featuring promissory notes yielding interest at
annual rates of up to 50% — money tendered by later investors is
used to pay off earlier investors. In contrast, pyramid schemes
incorporate a recruiting element; they are marketing
arrangements in which participants are rewarded financially
based upon their ability to induce others to participate. The
SEC alleges that SG's operations aptly can be characterized
under either appellation.

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inherently involve the sharing of profit and risk among

investors. Second, the SEC construes SG's promise to divert a

portion of its profits from website operations to support the

privileged company's shares as a bond that ties together the

collective fortunes of those who have purchased the shares.

While we analyze each of these theories, we note that any one of

them suffices to support a finding of commonality.

We endorse the SEC's suggestion that Ponzi schemes

typically satisfy the horizontal commonality standard. In

Infinity Group, investors contributed substantial sums of money

to a trust established by the defendants and received in

exchange a property transfer agreement guaranteeing stupendous

annual rates of return. 212 F.3d at 184-85. The economic

guarantees were based upon the trust's purported performance

experience, financial connections, and ability to pool large

amounts of money. Id. at 185. Participants were promised that

investing in the trust was a risk-free proposition, and that

their cash infusions would be repaid in full upon demand. Id.

at 184-85. Expected profits were a function of the number of

"capital units" held pursuant to the contract with the trust; in

turn, the number of capital units allocated to each investor was

directly proportional to the size of his or her investment. Id.

at 188-89. On these facts, the Third Circuit held that

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horizontal commonality existed, emphasizing that under the

plan's terms each investor was entitled to receive returns

directly proportionate to his or her investment stake. Id. at

188.

SG's virtual shares bear striking factual similarities

to the financial instruments classified as investment contracts

in Infinity Group. SG's flat 10% guaranteed return applied to

all privileged company shares, expected returns were dependent

upon the number of shares held, the economic assurances were

based on the promoter's ability to keep the ball rolling, the

investment was proclaimed to be free from risk, and participants

were promised that their principal would be repaid in full upon

demand. Like the Third Circuit, we think that these facts

suffice to make out horizontal commonality.

In all events, SG's promise to pay referral fees to

existing participants who induced others to patronize the

virtual exchange provides an alternative basis for finding

horizontal commonality. The SEC argues convincingly that this

shows the existence of a pyramid scheme sufficient to satisfy

the horizontal commonality standard. The most instructive

comparison is to SEC v. Int'l Loan Network, 968 F.2d 1304 (D.C.

Cir. 1992). A key element of the defendants' elaborate,

multifaceted, financial distribution network in that case was a

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pyramid sales program in which participants stood to receive 50%

commissions on membership fees paid by individuals whom they

recruited, plus lesser commissions on sales by those recruited

by their recruits. Id. at 1306. The court of appeals ruled

that this structure satisfied the requirements of horizontal

commonality. Id. at 1308. In the process, it relied heavily

upon the fact that the network generated income only through

constant expansion of membership, which depended on individual

recruiting and the appeal of the promoter's larger marketing

campaign. Id.

Like the investors in Int'l Loan Network,

StockGeneration participants who recruited new participants were

promised bonuses worth 20%-30% of the recruit's payments.

Taking as true the SEC's plausible allegation that the sine qua

non of SG's operations was the continued net inflow of funds,

the investment pool supporting the referral bonus payments was

entirely dependent upon the infusion of fresh capital. Since

all participants shared in the profits and risks under this

pyramidal structure, it furnishes the sharing necessary to

warrant a finding of horizontal commonality.

We will not paint the lily. We conclude, without

serious question, that the arrangement described in the SEC's

complaint fairly can be characterized as either a Ponzi or

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pyramid scheme, and that it provides the requisite profit-and-

risk sharing to support a finding of horizontal commonality.

Taking as true the SEC's allegation that SG's ability to fulfill

its pecuniary guarantees was fully predicated upon the net

inflow of new money, the fortunes of the participants were

inextricably intertwined. As long as the privileged company

continued to receive net capital infusions, existing

shareholders could dip into the well of funds to draw out their

profits or collect their commissions. But all of them shared

the risk that new participants would not emerge, cash flow would

dry up, and the underlying pool would empty.

SG's most perfervid argument against a finding of

horizontal commonality consists of a denial that its operations

comprise a Ponzi or pyramid scheme. It says that any such

scheme requires a material misrepresentation of fact and some

element of fraud or deception, and adds that those additional

features are lacking here; to the contrary, the rules of

StockGeneration were fully and accurately disclosed to all

participants. We do not gainsay that considerable disclosure

occurred. SG emphasized that new participants constituted the

sole source of all financial income for its StockGeneration

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website.4 Indeed, in describing the structure and mechanism of

its virtual stock exchange, SG drew a colorful analogy between

the privileged company's shares and an enormous card table with

a mountain of money. According to SG, thousands of participants

continuously threw money onto the table by purchasing shares in

the privileged company, while other participants simultaneously

sold their shares back to the exchange to retrieve their

winnings from the table. SG remarked that the system would

remain stable so long as the size of the mountain either

remained constant or continued to grow.

Despite the fact that SG was relatively candid in

pointing out the fragile structure of the venture, its argument

lacks force. Even if we assume, for argument's sake, that

misrepresentations of fact and badges of fraud are necessary for

the existence of a Ponzi or pyramid scheme, the SEC's complaint

contains allegations sufficient, as a matter of pleading, to

establish both elements. First, the complaint alleges that SG

materially misrepresented the nature of the enterprise by

concealing the fact that the supply of new participants

inevitably would be exhausted, causing the scheme to implode and

4
SG specifically addressed this issue on its website,
declaring that: "New players: that is the only source of all
financial income to any game. It does not and cannot have other
sources of income. Otherwise, the game becomes unprofitable and
therefore simply pointless."

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all existing participants to lose their money.5 Second, the

SEC's complaint plausibly characterized SG's flat guarantee of

a 10% monthly return on the privileged company's shares and its

assurances that it would support those shares as material

misrepresentations of fact. Third, the SEC alleged that SG

deceived participants by failing to disclose its intent to keep

investor money for itself.

Of course, given its "this was only a game" defense,

SG may well have colorable arguments anent materiality and

reliance (i.e., that, based upon its explicit disclosures, no

reasonable investor should have been deceived or misled). But

it is not this court's place to resolve such fact-sensitive

questions in the context of a Rule 12(b)(6) motion for

dismissal. See Cruz v. Melecio, 204 F.3d 14, 21-22 (1st Cir.

2000). For present purposes, it is enough that the SEC's

5As the SEC points out, SG specifically represented on its
website that SG was not a pyramid scheme that would "collapse
inevitably as soon as the inflow of new players stops." It went
on to state:
This is not a pyramid. The similarities are
purely superficial here. A whale might look
like a fish, but there are millions of years
of evolution between the two. The main
fundamental difference is the lack of
critical points in time, namely those of
mass payments. By manipulating profit, an
optimal way of spreading them in time is
successfully found.

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allegations, taken as true, satisfy the common enterprise

component of the Howey test.6

C. Expectation of Profits Solely From the Efforts of Others.

The final component of the Howey test — the expectation

of profits solely from the efforts of others — is itself

divisible. We address each sub-element separately.

1. Expectation of Profits. The Supreme Court has

recognized an expectation of profits in two situations, namely,

(1) capital appreciation from the original investment, and (2)

participation in earnings resulting from the use of investors'

funds. Forman, 421 U.S. at 852. These situations are to be

contrasted with transactions in which an individual purchases a

commodity for personal use or consumption. Id. at 858. The SEC

posits that SG's guarantees created a reasonable expectancy of

profit from investments in the privileged company, whereas SG

maintains that participants paid money not to make money, but,

6
If more were needed — and we doubt that it is — SG's
promise to divert a portion of profits from website operations
to support share prices if the need arose also warrants a
finding of horizontal commonality. Through this arrangement, SG
provided participants with the opportunity to share income
derived from website operations on a pro rata basis. The SEC's
complaint notes these facts and alleges in substance that a
percentage of participants' funds were pooled; that participants
were told of their entitlement to support from this monetary
pool; and that they collectively stood to gain or lose
(depending on whether they received the guaranteed return on
their shares). In and of themselves, these averred facts boost
the SEC across the legal threshold for horizontal commonality.

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rather, to acquire an entertainment commodity for personal

consumption. Relying heavily on Forman, the district court

accepted SG's thesis. SEC v. SG Ltd., 142 F. Supp. 2d at 130-

31. We do not agree.

In Forman, apartment dwellers who desired to reside in

a New York City cooperative were required to buy shares of stock

in the nonprofit cooperative housing corporation that owned and

operated the complex. Based on its determination that

"investors were attracted solely by the prospect of acquiring a

place to live, and not by financial returns on their

investments," the Forman Court held that the cooperative housing

arrangement did not qualify as a security under either the

"stock" or "investment contract" rubrics. Id. at 853. The

Court's conclusion rested in large part upon an Information

Bulletin distributed to prospective residents which stressed the

nonprofit nature of the cooperative housing endeavor. Id. at

854 (emphasizing that "[n]owhere does the Bulletin seek to

attract investors by the prospect of profits resulting from the

efforts of the promoters or third parties").7

7
The Court reiterated this conclusion in dismissing the
possibility that the co-op would lease commercial facilities,
professional offices, parking spaces, and communal washing
machines. Noting that the Information Bulletin made no
reference to the prospect of any such income as a means of
offsetting rental costs, the Court concluded "that investors
were not attracted to Co-op City by the offer of these potential

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 We think it noteworthy that the Forman Court contrasted

the case before it with Joiner. In that case, economic

inducements made by promoters in conjunction with the assignment

of oil well leases transformed the financial instrument under

consideration from a naked leasehold right to an investment

contract. 320 U.S. at 348. The Joiner Court found dispositive

advertising literature circulated by the promoters which

emphasized the benefits to be reaped from the exploratory

drilling of a test well. Id. ("Had the offer mailed by

defendants omitted the economic inducements of the proposed and

promised exploration well, it would have been a quite different

proposition.").

The way in which these cases fit together is

instructive. In Forman, the apartment was the principal

attraction for prospective buyers, the purchase of shares was

merely incidental, and the combination of the two did not add up

to an investment contract. 421 U.S. at 853. In Joiner, the

prospect of exploratory drilling gave the investments "most of

their value and all of their lure," the leasehold interests

themselves were no more than an incidental consideration in the

transaction, and the combination of the two added up to an

investment contract. 320 U.S. at 349. This distinction is

rental reductions." Forman, 421 U.S. at 856.

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crucial, see Forman, 421 U.S. at 853 n.18, and it furnishes the

beacon by which we must steer.

Seen in this light, SG's persistent representations of

substantial pecuniary gains for privileged company shareholders

distinguish its StockGeneration website from the Information

Bulletin circulated to prospective purchasers in Forman. While

SG's use of gaming language is roughly analogous to the

cooperative's emphasis on the nonprofit nature of the housing

endeavor, SG made additional representations on its website that

played upon greed and fueled expectations of profit. For

example, SG flatly guaranteed that investments in the shares of

the privileged company would be profitable, yielding monthly

returns of 10% and annual returns of 215%. In our view, these

profit-related guarantees constitute a not-very-subtle form of

economic inducement, closely analogous to the advertising

representations in Joiner. In the same way that the prospect of

profitable discoveries induced investors to buy oil well leases,

the prospect of a sure-fire return lured participants to buy

shares in the privileged company (or so it can be argued).

This is not to say that SG's gaming language and

repeated disclaimers are irrelevant. SG has a plausible

argument, forcefully advanced by able counsel, that no

participant in his or her right mind should have expected

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guaranteed profits from purchases of privileged company shares.

But this argument, though plausible, is not inevitable. In the

end, it merely gives rise to an issue of fact (or, perhaps,

multiple issues of fact) regarding whether SG's representations

satisfy Howey's expectation-of-profit requirement.

2. Solely from the Efforts of Others. We turn now to

the question of whether the expected profits can be said to

result solely from the efforts of others. The courts of appeals

have been unanimous in declining to give literal meaning to the

word "solely" in this context, instead holding the requirement

satisfied as long as "the efforts made by those other than the

investor are the undeniably significant ones, those essential

managerial efforts which affect the failure or success of the

enterprise." Turner Enters., 474 F.2d at 482; accord Rivanna

Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d 236, 240

n.4 (4th Cir. 1988) (adopting this holding and listing eight

other circuits which have held to like effect). This liberal

interpretation of the requirement seemingly comports with the

Supreme Court's restatement of the Howey test. See Forman, 421

U.S. at 852 (explaining that "the touchstone is the presence of

an investment in a common venture premised on a reasonable

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expectation of profits to be derived from the entrepreneurial or

managerial efforts of others").8

We need not reach the issue of whether a lesser degree

of control by a promoter or third party suffices to give rise to

an investment contract because SG's alleged scheme meets the

literal definition of "solely." According to the SEC's

allegations, SG represented to its customers the lack of

investor effort required to make guaranteed profits on purchases

of the privileged company's shares, noting, for example, that

"playing with [the] privileged shares practically requires no

time at all." SG was responsible for all the important efforts

that undergirded the 10% guaranteed monthly return. As the sole

proprietor of the StockGeneration website, SG enjoyed direct

operational control over all aspects of the virtual stock

exchange. And SG's marketing efforts generated direct capital

investment and commissions on the transactions (which it pledged

to earmark to support the privileged company's shares).

SG's payment of referral bonuses to participants who

introduced new users to the website does not require a different

result. Even if a participant chose not to refer others to the

StockGeneration website, he or she still could expect, based on

8We caution, however, that the Forman Court explicitly
reserved judgment on adoption of the Turner Enterprises
formulation. See 421 U.S. at 852 n.16.

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SG's profit-related guarantees, to reap monthly profits from

mere ownership of the privileged company's shares. Accordingly,

the SEC's complaint makes out a triable issue on whether

participants expected to receive profits derived solely from the

efforts of others.

IV. CONCLUSION

We need go no further. Giving due weight to the

economic realities of the situation, we hold that the SEC has

alleged a set of facts which, if proven, satisfy the three-part

Howey test and support its assertion that the opportunity to

invest in the shares of the privileged company, described on

SG's website, constituted an invitation to enter into an

investment contract within the jurisdictional reach of the

federal securities laws. Accordingly, we reverse the order of

dismissal and remand the case for further proceedings consistent

with this opinion. The preliminary injunction and asset freeze

shall remain in force pending conclusion of the proceedings

below.

Reversed and remanded.

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 APPENDIX A

Securities Act of 1933 § 2(a)(1), 15 U.S.C.
§ 77b(a)(1):

The term "security" means any
note, stock, treasury stock,
security future, bond,
debenture, evidence of
indebtedness, certificate of
interest or participation in
any profit-sharing agreement,
collateral-trust certificate,
preorganization certificate or
subscription, transferable
share, investment contract,
voting-trust certificate,
certificate of deposit for a
security, fractional undivided
interest in oil, gas, or other
mineral rights, any put, call,
straddle, option, or privilege
on any security, certificate
of deposit, or group or index
of securities (including any
interest therein or based on
the value thereof), or any
put, call, straddle, option,
or privilege entered into on a
national securities exchange
relating to foreign currency,
or, in general, any interest
or instrument commonly known
as a "security," or any
certificate of interest or
participation in, temporary or
interim certificate for,
receipt for, guarantee of, or
warrant or right to subscribe
to or purchase, any of the
foregoing.

Securities Exchange Act of 1934 § 3(a)(10),
15 U.S.C. § 78c(a)(10)

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The term "security" means any
note, stock, treasury stock,
security future, bond,
debenture, certificate of
interest or participation in
any profit-sharing agreement
or in any oil, gas, or other
mineral royalty or lease, any
collateral-trust certificate,
preorganization certificate or
subscription, transferable
share, investment contract,
voting-trust certificate,
certificate of deposit for a
security, any put, call,
straddle, option, or privilege
on any security, certificate
of deposit, or group or index
of securities (including any
interest therein or based on
the value thereof), or any
put, call, straddle, option,
or privilege entered into on a
national securities exchange
relating to foreign currency,
or in general, any instrument
commonly known as a
"security"; or any certificate
of interest or participation
in, temporary or interim
certificate for, receipt for,
or warrant or right to
subscribe to or purchase, any
of the foregoing; but shall
not include currency or any
note, draft, bill of exchange,
or banker's acceptance, which
has a maturity at the time of
issuance of not exceeding nine
months, exclusive of days of
grace, or any renewal thereof
the maturity of which is
likewise limited.

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