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United States v. Kahlon

United States Court of Appeals, Fifth Circuit

October 16, 2017

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 damages in favor of the SEC. Kahlon and the company timely filed this appeal as to both determinations. We AFFIRM.


         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 ¶ Management Group ("¶M"), a New York limited liability company created in 2003. In 2005, ¶M acquired 100 acres of vacant property in Dallas, Texas, which has never been used for TJM's operations. That same year, Kahlon registered ¶M in Texas as a foreign limited liability company, hired a registered agent in Texas, and obtained a Texas mailing address for ¶M. 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 ¶M 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. ¶M 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[.]" ¶M was issued stock certificates without legends restricting their resale. Notwithstanding its representation 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.


         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 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).

         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.

         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 ...

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