Case: 16-41431 Document: 00514197518 Page: 1 Date Filed: 10/16/2017
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
No. 16-41431 October 16, 2017
Lyle W. Cayce
Clerk
UNITED STATES SECURITIES AND EXCHANGE COMMISSION,
Plaintiff - Appellee
v.
YOSSEF KAHLON, also known as Jossef Kahlon; TJ MANAGEMENT
GROUP, L.L.C.,
Defendants - Appellants
Appeal from the United States District Court
for the Eastern District of Texas
Before DAVIS, JONES, and SOUTHWICK, Circuit Judges.
PER CURIAM:
This case revolves around the purchases and sales of “penny stocks” 1 by
Yossef Kahlon and one of his solely owned companies. In 2012, the United
States Securities and Exchange Commission (“SEC”) filed a complaint against
Kahlon and his company for the purchase and resale of unregistered securities.
The district court granted summary judgment on liability and later on
1“The term ‘penny stock’ generally refers to a security issued by a very small company
that trades at less than $5 per share,” and “[p]enny stocks generally are quoted over-the-
counter.” U.S. Sec. & Exch. Comm’n, Penny Stock Rules, https://www.sec.gov/fast-
answers/answerspennyhtm.html (last visited October 13, 2017); see also 17 C.F.R.
§ 240.3a51-1 (technical definition).
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damages in favor of the SEC. Kahlon and the company timely filed this appeal
as to both determinations. We AFFIRM.
BACKGROUND
The facts of this case are not in dispute. Section 5 of the Securities Act
of 1933 (“Securities Act”), 15 U.S.C. § 77e, requires that a detailed registration
statement be filed with the SEC, unless an exception applies, before the offer
or sale of securities to the public through interstate commerce. The exception
on which the penny-stock investor relies in this case is Rule 504(b)(1)(iii),
17 C.F.R. § 230.504(b)(1)(iii), the Seed Capital Exemption, which is designed
for small companies to raise limited amounts of capital more easily by selling
unregistered securities to accredited investors.
Yossef Kahlon is the sole owner, officer, and employee of TJ Management
Group (“TJM”), a New York limited liability company created in 2003. In 2005,
TJM acquired 100 acres of vacant property in Dallas, Texas, which has never
been used for TJM’s operations. That same year, Kahlon registered TJM in
Texas as a foreign limited liability company, hired a registered agent in Texas,
and obtained a Texas mailing address for TJM. Kahlon administered TJM’s
operations with a New York bank account out of either his office in New York
City or his home on Long Island.
Kahlon then started to invest in unregistered penny stocks through TJM
based on Rule 504(b)(1)(iii) and the corresponding Texas state exemption,
7 TEX. ADMIN. CODE § 109.4. Kahlon would identify penny stock companies
that needed investment funds via alternative means of financing. TJM would
purchase large blocks of shares at a discount, while signing subscription
agreements that provided the purchases were for “investment purposes and
not with a view towards distribution[.]” TJM was issued stock certificates
without legends restricting their resale. Notwithstanding its representation
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to the issuer, TJM would then sell the stocks on the open market as soon as
possible to generate a profit. For all but one of the 11 companies TJM invested
in, resales of stock began within five days of its first purchase. All told,
between May 2008 and 2010, Kahlon invested in 11 companies and purchased
and sold over 18 billion unregistered shares for a gross trading gain of over
$7.7 million.
In May 2011, after the SEC advised Kahlon that it was considering
charges against him, he stopped conducting this form of transaction. In August
2012, the SEC filed a complaint in United States District Court for the Eastern
District of Texas against Kahlon for TJM’s unregistered sales. Two years later,
both the SEC and Appellants filed motions for summary judgment. The
district court granted the SEC’s motion for summary judgment as to liability,
denied Kahlon’s motion, and ordered briefing on damages. The district court
then held that Kahlon and TJM lacked the requisite geographic connection to
Texas to take advantage of the state’s blue-sky laws. The court did not reach
the SEC’s other theory of the case, that Kahlon and TJM were underwriters
and therefore the unregistered securities were not freely transferable. The
SEC moved for summary judgment on damages, and the district court granted
relief in September 2016. The court ordered a permanent injunction against
future Section 5 violations, disgorgement of over $7.7 million gross trading
revenue plus prejudgment interest, a $200,000 first-tier civil penalty, and a
lifetime penny-stock trading bar against Kahlon and TJM.
Kahlon and TJM timely filed this appeal and assert that the district
court erred in granting summary judgment on liability and abused its
discretion when awarding damages.
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DISCUSSION
We review a district court’s grant of summary judgment on liability de
novo, and this court “may affirm the district court’s decision on any basis
presented to the district court” and argued in the district court. Am. Family
Life Assurance Co. of Columbus v. Biles, 714 F.3d 887, 896 (5th Cir. 2013). The
evidence is viewed in the light most favorable to the non-movants with all
reasonable inferences drawn in their favor. Distribuidora Mari Jose, S.A. de
C.V. v. Transmaritime, Inc., 738 F.3d 703, 706 (5th Cir. 2013).
The district court’s damages and penalty determinations are reviewed
for an abuse of discretion. SEC v. Blatt, 583 F.2d 1325, 1334 (5th Cir. 1978)
(injunctive relief); SEC v. AMX, Int’l, Inc., 7 F.3d 71, 73 (5th Cir. 1993)
(disgorgement); Wolf v. Frank, 477 F.2d 467, 479 (5th Cir. 1973) (pre-judgment
interest); R&W Tech. Servs. Ltd. v. CFTC, 205 F.3d 165, 177 (5th Cir. 2000)
(civil penalties).
I. Compliance with Rule 504(b)(1)(iii)
To establish that Appellants – 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). Because these elements are undisputed, the burden
shifts to the Appellants to show that the sales fell under an exception to the
registration requirements. Id. at 156.
Appellants rely on Rule 504(b)(1)(iii), which allows offerings and sales to
avoid registration requirements if they are conducted “[e]xclusively according
to state law exemptions from registration that permit general solicitation and
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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). Texas law exempts
from registration the offer and sale of any securities to institutional accredited
investors, as defined in 7 TEX. ADMIN. CODE § 107.2; to qualified institutional
buyers, as defined in federal Rule 144A(a)(1) promulgated under the Securities
Act; or to corporations and other entities with a net worth greater than $5
million. 7 TEX. ADMIN. CODE § 109.4 (West 2017).
The district court held that Rule 504(b)(1)(iii) requires compliance with
“those state-law exemptions where the securities are offered or sold[.]” It found
“no evidence that the transactions at issue took place exclusively under Texas
law[.]” The court discussed the recent identical holding of another district
court, which had cited the established principle that state securities laws (blue-
sky laws) have survived constitutional challenges because “they only regulated
transactions occurring within the regulating States” and because they are to
that extent protected from preemption by Section 28(a) of the Securities
Exchange Act. See SEC v. Bronson, 14 F. Supp. 3d 402, 408, 415 (S.D.N.Y.
2014) (citing Edgar v. MITE Corp., 457 U.S. 624, 641 (1982)). Accordingly, an
investor can only take advantage of a state’s exemption if that state has the
power to regulate the transaction to begin with.
Appellants complain that this enforcement proceeding is an effort to
“‘imply’ an additional requirement into the exemption,” “an impermissible use
of enforcement to do what rulemaking did not,” and that an SEC Compliance
Guide issued in 2017 should govern. The SEC Compliance Guide was issued
after the events herein, but in any event, it does more harm than good for their
position. 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. 20, 2017) (emphasis added).
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Rule 504(b)(1)(iii) allows an exemption from registration for “offers and
sales of securities . . . that are made . . . [e]xclusively according to state law
exemptions from registration that permit general solicitation and 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). 2 The Bronson court held that
the regulation’s use of the term “exclusively” “plainly require[s] that the offers
or sales [be] exempt in each state where they occur[].” 14 F. Supp. 3d at 414.
If not, one state would be able to exempt transactions occurring nationwide,
despite another state’s differing regulatory regime. The Supreme Court has
indicated otherwise. 3 Thus general principles of federalism and the language
of the regulation support the Bronson holding.
2There are three exemptions in 17 C.F.R. § 230.504(b)(1), and while only the third is
in dispute in this case, it is helpful to view all three to put the relevant one in context.
(1) General conditions. To qualify for exemption under this § 230.504,
offers and sales must satisfy the terms and conditions of §§ 230.501 and
230.502 (a), (c) and (d), except that the provisions of § 230.502 (c) and
(d) will not apply to offers and sales of securities under this § 230.504
that are made:
(i) Exclusively in one or more states that provide for the
registration of the securities, and require the public filing and
delivery to investors of a substantive disclosure document before
sale, and are made in accordance with those state provisions;
(ii) In one or more states that have no provision for the
registration of the securities or the public filing or delivery of a
disclosure document before sale, if the securities have been
registered in at least one state that provides for such
registration, public filing and delivery before sale, offers and
sales are made in that state in accordance with such provisions,
and the disclosure document is delivered before sale to all
purchasers (including those in the states that have no such
procedure); or
(iii) Exclusively according to state law exemptions from
registration that permit general solicitation and general
advertising so long as sales are made only to “accredited
investors” as defined in § 230.501(a).
3Since a trio of cases in 1917, the Supreme Court “has upheld the authority of States
to enact ‘blue-sky’ laws against Commerce Clause challenges on several occasions. . . . The
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Appellants argue that “the obligations ‘implied’ by the SEC and adopted
by the district court are impossible to follow,” amounting to “a repeal of the
exemption[.]” While Rule 504(b)(1)(iii) erects a higher bar than simply
allowing a seller to adhere to a particular state’s exception and then resell
unregistered securities anywhere, it is not a destruction of the rule –
purchasers of the stock may hold the stock, may resell exclusively within the
state, or may resell in compliance with the rules of the purchaser’s state or
other subdivisions of Rule 504(b)(1).
Only one company that issued stock to TJM and Kahlon in this case was
located in Texas. The other ten issuing companies were located in other states
or China. Kahlon and TJM offered no summary judgment evidence that any
of their transactions actually occurred in Texas. Because states cannot
regulate securities transactions occurring outside their borders, there is no
reason to think that Texas’s exemptions should apply to transactions occurring
outside Texas. As Appellants fail to identify anything in the summary
judgment record that would show the transactions occurred in Texas, we affirm
the summary judgment as to liability against TJM and Kahlon.
II. Remedies ordered by the district court
The district court permanently enjoined Kahlon and TJM from violating
Section 5 of the Securities Act, ordered disgorgement of the gross revenue from
the purchase and sale of unregistered securities and prejudgment interest,
assessed a first-tier civil penalty, and permanently barred Kahlon and TJM
from trading in penny stocks. Appellants seek to overturn all these rulings,
but the first-tier civil penalty is not seriously challenged.
Court’s rationale for upholding blue-sky laws was that they only regulated transactions
occurring within the regulating States.” Edgar, 457 U.S. at 641.
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A. Bar on trading in penny stocks
We now examine the permanent bar on trading in penny stocks. Such
stocks must be for sale at less than $5 per share on the open market. Further,
regulations define penny stock as “any equity security other than a security”
that meets any of various potential requirements. 17 C.F.R. § 240.3a51-1. Just
considering the stock price, it is evident that penny stocks can gain or lose that
classification over time. Always being conscious of whether a particular
transaction involves penny stocks is one of the obligations the injunction
necessarily places on Kahlon.
Penny-stock transactions and those under Rule 504(b)(1)(iii) are not
coterminous. That subpart of Rule 504(b)(1) allows an exemption from
registration for “offers and sales of securities . . . that are made” “[e]xclusively
according to state law exemptions from registration that permit general
solicitation and 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).
We now examine the district court’s explanation for why Kahlon should
be barred from penny-stock transactions and not just those exempted by Rule
504(b)(1)(iii). The district court’s explanation partly relies on its prior analysis
for injunctive relief, so we review both. In two separate sections of the
remedies opinion, the district court identified lists of factors to consider. The
court used the first set of factors to determine whether there was a reasonable
likelihood of future violations and thus a need for a permanent injunction. The
second set of factors concerned the propriety of a bar for future penny-stock
transactions. We quote the first list, which the district court took from SEC v.
Calvo, 378 F.3d 1211, 1216 (11th Cir. 2004):
[1] egregiousness of the defendant's actions, [2] the isolated or
recurrent nature of the infraction, [3] the degree of scienter
involved, [4] the sincerity of the defendant's assurances against
future violations, [5] the defendant's recognition of the wrongful
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nature of the conduct, and [6] the likelihood that the defendant's
occupation will present opportunities for future violations.
The district court also cited a district court opinion to support the factors. See
SEC v. Offill, No. 3:07–CV–1643–D, 2012 WL 1138622, at *4 (N.D. Tex. Apr.
5, 2012) (Fitzwater, C.J.).
The second list used by the district court is quite similar and also has six
factors. Chief Judge Fitzwater’s Offill opinion was again cited. We mention
the only factors from the list the district court used in deciding on a penny-
stock bar that differ in substance from the first list: “the defendant’s ‘role’ or
position when he engaged in the fraud” and “the defendant’s economic stake in
the violation . . . .” These factors center on characteristics of the violator that
are missing from the first list. This second list comes from a Second Circuit
opinion addressing whether an individual was unfit to serve as an officer or
director of a publicly traded company. SEC v. Patel, 61 F.3d 137, 141 (2d Cir.
1995) (citing Jayne W. Barnard, When is a Corporate Executive “Substantially
Unfit to Serve”?, 70 N.C. L. REV. 1489, 1492–93 (1992)). Such a bar is not our
issue, and these two factors do not further our analysis.
When analyzing a case, lists of factors such as in Patel generally are not
exclusive, nor is each factor always relevant. Circumstances can alter what
facts should be evaluated. Factors are meant to guide courts as they consider
evidence in a case and form remedies. We quoted one of the lists the district
court used because it is the articulation adopted by this court in a 1978 opinion,
with instructions to trial courts that they were to consider these “factors in
deciding whether to issue an injunction in light of past violations” of SEC
regulations and related statutes. Blatt, 583 F.2d at 1328 & n.29. The Blatt
list is appropriate to use here on the question of the form of the injunction.
The district court analyzed some of the six factors taken, ultimately,
from the Second Circuit Patel opinion, but it did not discuss those that differ
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from the list we adopted in Blatt presumably because they had no relevance.
The court concluded that a permanent bar on trading in penny stocks was
appropriate. The written explanation was not extensive:
The court finds that a penny stock bar is warranted “for essentially
the same reasons that support entry of an injunction[.]” Offill,
2012 WL 1138622, at *5. Since the Defendants sold unregistered
securities, either intentionally or with reckless disregard for the
registration requirements, at a volume that netted over $100,000
a month at their peak, the court finds that the entry of a
permanent penny stock bar is warranted because the Defendants
“could easily repeat this conduct.” Id.
The court’s explanation of its penny-stock bar says it was justified for reasons
similar to those supporting an injunction, which leads us back to the district
court’s use of the Blatt factors.
In its application of the Blatt factors, the district court considered
Kahlon’s argument that he lacked scienter. The district court rejected this
argument both in its opinion on liability and the one on remedies. In both, the
court wrote:
Defendant contends that the fact that the SEC had interviewed
and requested documents from Kahlon in connection with two
other investigations but did not bring this enforcement action until
much later somehow means that the SEC “explicitly permit[ted]”
his conduct. Defendant has put forth no evidence showing the SEC
had previously interpreted the exemption on which he relies in a
manner that is contrary to the interpretation which it asserts here.
“As stated by one court, ‘neither a good faith belief that the offers
or sales in question were legal, nor reliance on the advice of
counsel, provides a complete defense to a charge of violating
Section 5 of the Securities Act.’”
The court concluded that Kahlon acted either intentionally or with reckless
disregard for the legal requirements.
To support at least recklessness and perhaps also intent, the district
court described the SEC’s argument that Kahlon, in seeking an attorney
opinion letter blessing his actions, had not been candid in explaining his plans
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to counsel. Particularly, as the district court found in the remedies opinion,
Kahlon and TJM had failed to explain “(1) their intent to publicly distribute
shares as soon possible, or (2) the suggestion that the Defendants’ operations
and investment decisions were based in Texas.” Though the district court did
not then explicitly rely on those facts, the court did find that the evidence
supported that Kahlon had acted intentionally or recklessly. The district court
expressed a similar concern in the opinion on liability. It 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 both characterizations to be contradicted by
his deposition.
Even if it is fair to characterize the violations as “technical,” meaning we
suppose that they did not lead to any specific economic loss to anyone, they are
still reckless and quite likely knowing violations. We see no innocent straying
across hidden limits but instead a well-planned march beyond the boundaries
that were sufficiently marked for investors.
In our review, we acknowledge that the district court found Kahlon and
TJM liable only for violations of Rule 504 yet barred further transactions of
penny stocks. Despite Kahlon’s argument that a bar on Rule 504 transactions
was sufficient, the district court determined that the SEC’s request for a bar
on all penny-stock transactions was more appropriate. Our review of the
details of the injunction is for an abuse of discretion. Blatt, 583 F.2d at 1334.
We find few clear limits on the district court’s discretion. Some cases
arguably present more wide-ranging violations than occurred here. SEC v.
Curshen, 372 F. App’x 872, 875 (10th Cir. 2010) (“Curshen’s conduct violated
15 U.S.C. § 78j(b) (“§ 10(b)”), 15 U.S.C. § 77q(a) (“§§ 17(a)(1)–(3)”), 15 U.S.C. §
77q(b) (“§ 17(b)”), and 17 C.F.R. § 240.10b–5 (“Rule 10b–5”).”); SEC v.
Simmons, 241 F. App’x 660, 662 (11th Cir. 2007) (“Siciliano had committed
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securities fraud and violated the registration provisions of the securities
laws.”). Here, Kahlon and TJM’s misconduct was limited to one kind of
violation. Still, the district court had a choice on the form of injunction based
on the fact that these parties had violated a particular rule when conducting a
particular kind of transaction. Perhaps the district court considered that
Kahlon and TJM had evidenced sufficient sophistication in conducting penny-
stock transactions as to raise legitimate concerns that other limits on those
transactions might be violated in the future. The district court did not give us
much to go on, but it did make a finding of reckless and potentially intentional
misconduct while engaging in penny-stock transactions.
We find no abuse of discretion in barring all future transactions.
B. Injunction from future securities law violations
We also affirm the permanent injunction from future securities law
violations. This permanent injunction is tailored to the precise misconduct as
it proscribes Kahlon and TJM “from violating Section 5 of the Securities Act.”
SEC v. Zale Corp., 650 F.2d 718, 720 (5th Cir. Unit A July 1981). We find no
abuse of discretion in ordering the permanent injunction.
C. Disgorgement of all revenue
Turning next to the district court’s order that Kahlon and TJM disgorge
all gross revenues and the corresponding prejudgment interest, we affirm.
“The court’s power to order disgorgement extends only to the amount with
interest by which the defendant profited from his wrongdoing. Any further
sum would constitute a penalty assessment.” Blatt, 583 F.2d at 1335. “The
purpose of disgorgement is not to compensate the victims of the fraud, but to
deprive the wrongdoer of his ill-gotten gain.” Id. The question in this case is
whether the district court erred in determining that profit was best measured
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as gross revenue and not net profit. “[T]he overwhelming weight of authority
hold[s] that securities law violators may not offset their disgorgement liability
with business expenses.” SEC v. United Energy Partners, Inc., 88 F. App’x 744,
746 (5th Cir. 2004) (quoting SEC v. Kenton Capital, Ltd., 69 F. Supp. 2d 1, 16
(D.D.C. 1998)). We hold that the district court did not abuse its discretion.
AFFIRMED.
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EDITH H. JONES, Circuit Judge, dissenting:
I respectfully dissent from the majority’s decision to throw the book at
these defendants—approving an injunction, a lifetime ban on all “penny stock”
trades, a civil penalty, and disgorgement of gross revenues. Yet no fraudulent
injury occurred to the sophisticated actors with whom they traded or the penny
stock market more generally. The district court’s perfunctory analysis of the
six factors used to justify such harsh penalties is insufficient. There is no
justification for a lifetime penny stock bar under the circumstances of this case.
Finally, the requirement of disgorging gross revenues conflicts with SEC v.
Blatt, 583 F.2d 1325 (5th Cir. 1978), the principal authority cited by the panel
majority.
The SEC acknowledges that this is a strict liability violation for which
no proof of scienter was required. Moreover, only one meaningful district court
precedent, which postdated these appellants’ trades, spoke to the required
location of the transactions controlling the Rule 504(b)(1)(iii) exemption. The
panel majority must stretch to infer from the district court’s opinions that
Kahlon and TJM committed “reckless and quite likely knowing violations” of
the Rule. The majority admit that the district court’s findings were not
“extensive,” not “explicit,” and “did not give us much to go on.” Because SEC
was not required to bear a burden of proving scienter for the initial violation,
and no evidentiary hearing took place, it is at best conjecture that Kahlon and
TJM were intentional or willful violators. There is no evidence that they have
been repeat securities law offenders: while they used this Rule’s exemption in
the same way many times, once the SEC notified him that it was considering
charges, Kahlon and TJM immediately ceased engaging in these Rule 504
transactions. There is no evidence that such misconduct will recur now that
the transactions have been adjudicated deficient. Also of significance, there
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was no proof of fraud committed upon the entities from which Kahlon and TJM
purchased stock or upon the sophisticated markets in which they sold. There
were, in sum, no egregious underlying securities violations.
For the technical violations that occurred, however, I agree that several
sanctions, including the permanent injunction against further securities law
violations and the civil penalty, should be upheld.
But the ban against these appellants’ ever engaging in penny stock
trades, in my view, far exceeds the district court’s discretion. Disturbingly, the
panel majority purports to “find few clear limits on the district court’s
discretion” in issuing this ban. That is not consistent with SEC v. Blatt,
583 F.2d 1325, 1334 (5th Cir. 1978). In Blatt, the court held that:
the critical question in issuing the injunction and also the ultimate
test on review is whether defendant’s past conduct indicates that
there is a reasonable likelihood of further violations in the future.
To obtain injunctive relief the Commission must offer positive
proof of the likelihood that the wrongdoing will recur. SEC v.
Commonwealth Chemical Securities, Inc., 574 F.2d 90, 99-100(2d
Cir. 1978). The Commission needs to go beyond the mere fact of
past violations. Id.
Id. (emphasis added). In Blatt, unlike this case, the defendants violated SEC
Rule 10b-5 by engaging in blatant and misleading nondisclosures during a
contested acquisition. In Blatt, unlike this case, the appellate court reviewed
factual findings made following a trial. The record here, I respectfully submit,
fails to go “beyond the mere fact of past violations.”
In addition to the lack of “proof positive” compatible with Blatt, the bar
on any future penny-stock trades is overbroad because it places these
defendants at risk under circumstances wholly beyond their control. The
majority acknowledges that not all penny stock transactions are Rule 504
transactions. Kahlon’s and TJM’s abuse of the rule governing purchases of
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unregistered securities directly from companies should not bar them
permanently from investing in over-the-counter securities.
To begin, the price of a stock can fluctuate above or below $4.99/share on
the open market, so a penny stock today may not be one tomorrow, and vice
versa. Moreover, the regulations define penny stock as “any equity security
other than a security” that meets any of a number of potential requirements.
These extrinsic factors create more ways for a penny stock to become not a
penny stock and vice-versa. 1 17 C.F.R. 240.3a51-1. Given the amount of
legitimate trading activity this ban will proscribe, a broad permanent penny
stock bar is an abuse of the district court’s discretion. 2
As the relevant factors imply, any ban on trading must be tailored to the
degree of misconduct. This is not a case where Kahlon and TJM have
systematically abused penny stock offerings, resulting in numerous regulatory
1 The regulation governing what is a penny stock includes qualifications entirely in
the hands of the issuer (17 C.F.R. 240.3a51-1(g)). For example, Kahlon could purchase stock
from a one year old issuer with two million dollars in net tangible assets, but if in year two
the issuer dips below two million in net tangible assets, the stock becomes a penny stock.
Other qualifications are left entirely in the hands of the marketplace (240.3a51-1(d)). Finally,
whether a stock can qualify as a penny stock may be determined by certain securities
exchanges, e.g., if the stock is removed from the exchange, if the exchange decides to stop
reporting certain information, or the stock fails to meet other ongoing qualification
requirements (240.3a51-1(a), (e)). Obviously, if Kahlon purchased a stock valued at $6/share,
but it declined to $4/share, he would be barred from selling or trying to sell it. But his risk
goes well beyond market value fluctuations to the other rules governing these stocks.
2 “The impact of a Penny Stock Bar is that the individual is barred from acting as a
promoter, finder, consultant or agent or otherwise engaging in activities with a broker,
dealer, or issuer for the purpose of the issuance or trading in any penny stock, or inducing or
attempting to induce the purchase or sale of any penny stock.” Brenda Hamilton, What is a
Penny Stock Bar?, Securities Lawyer 101 (August 2, 2014),
https://www.securitieslawyer101.com/2014/penny-stock-bar/. See also David Smyth, Don’t
Even Think About Violating That Penny Stock Bar, The National Law Review (June 13,
2016), https://www.natlawreview.com/article/don-t-even-think-about-violating-penny-stock-
bar (Wise violated a penny stock bar when he “solicited several private companies to issue
publicly trading shares, pitched the offerings to a New York-based hedge fund, and helped
the private companies prepare to offer the shares to the public.”).
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violations; instead, they exploited one rule to conduct their transactions. In
other cases, the defendants violated multiple provisions of the Securities Act
and the Exchange Act, notably including allegations of fraud, while trading
penny stocks, so a broad penny stock bar was warranted. See S.E.C. v.
Gillespie, 349 F. App'x 129, 130 (9th Cir. 2009) (“Gillespie violated Section
17(a) of the Securities Act and Section 10(b) of the Exchange Act.”); S.E.C. v.
Curshen, 372 F. App'x 872, 875 (10th Cir. 2010) (“Mr. Curshen's conduct
violated 15 U.S.C. § 78j(b) (“ § 10(b)”), 15 U.S.C. § 77q(a) (“§§ 17(a)(1)–(3)”),
15 U.S.C. § 77q(b) (“ § 17(b)”), and 17 C.F.R. § 240.10b–5 (“Rule 10b–5”).”);
S.E.C. v. Simmons, 241 F. App'x 660, 662 (11th Cir. 2007) (“Siciliano had
committed securities fraud and violated the registration provisions of the
securities laws.”). In the Offill case, the district court tailored a penny stock
ban, limiting it to seven years for some defendants to protect the public without
“over-punishing these defendants . . . .” S.E.C. v. Offill, No. 3:07-CV-1643-D,
2012 WL 1138622, at *5 (N.D. Tex. Apr. 5, 2012). The court imposed a
permanent penny stock ban only on the former SEC lawyer whose “knowledge
and experience as a securities regulator make him especially dangerous to the
investing public.” Id. at *6. No nuanced findings or balancing occurred here.
Because Kahlon and TJM violated one provision, were not found guilty
of fraud, immediately ceased Rule 504 transactions after being singled out by
the SEC, and have agreed not to engage in any further transactions based on
that rule, a tailored ban would only prevent them from engaging in any
Rule 504 transactions.
Next, I turn to the disgorgement and prejudgment interest calculation,
which are based not on lost profits but on the gross revenues received by the
appellants. This court observed only in an unpublished, non-precedential
decision that “the overwhelming weight of authority hold[s] that securities law
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violators may not offset their disgorgement liability with business expenses.”
SEC v. United Energy Partners, Inc., 88 F. App’x 744, 746 (5th Cir. 2004). This
statement is overbroad at best: the “overwhelming majority” of SEC
enforcement actions involve fraud, where the SEC has proven an offender’s
scienter and the harm done to others. Even more pointedly, the Blatt case, on
which the majority relies, did not result in disgorgement based on gross
revenue achieved by a securities law violator, but only on “the profits that he
had realized through violation of the [SEC] Act…” Blatt, 583 F.2d at 1327.
(Compare Id. at 1328, noting the sale of Pullman’s stock for $375,000, yielding
an approximate profit of $315,000; only the latter amount was required to be
disgorged.) Disgorgement, if appropriate at all, should be remanded for
reduction in line with Blatt.
As an aside, the district court appears to have adopted remedies relying
on the underwriter theory of the case, on which it did not rule, rather than the
Rule 504 transactions on which it actually found liability. Had Kahlon and
TJM been prosecuted and held liable as underwriters this sweeping range of
punishment would have made more sense. Underwriters, after all, are
responsible for distributing securities into the market at large. Because the
district court decision is based only on a technical strict liability violation, I
consider the aggregate of these penalties an abuse of discretion.
Finally, I find it troubling that Kahlon and TJM never had a chance to
present their case orally before the district court. A pretrial order set the
timetable leading to the trial on remedies, and it was followed until about a
week before trial. Then counsel for both parties informed the court that they
were only planning to offer arguments at the remedy phase, but no additional
evidence. The district court not only cancelled the trial, but also denied
Kahlon’s specific request to permit argument, and accepted every bit of SEC’s
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punitive remedies—a civil penalty, injunction against future SEC violations,
disgorgement of gross revenue gained plus interest, and the lifetime penny
stock trade ban.
The panel majority’s insistence on this plethora of punishments,
including the disgorgement of gross revenues plus interest treats this case,
inappositely, as if Kahlon and TJM had stolen from widows and retirees.
Equally inapt, in light of Blatt, is the nostrum that “there are few clear limits
on the district court’s discretion.” If federal courts decline to exercise
proportionality in penalizing technical regulatory violations, then one can only
hope that a federal agency with such enormous power as the SEC will learn to
better fit the punishments to the crime. I respectfully dissent.
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