LG Capital Funding Loses Motion to Dismiss
On November 13, 2023, United States District Judge William F. Kuntz, II, of the United States District Court of the Eastern District of New York made his decision in LG Capital Funding LLC’s Motion to Dismiss the Securities & Exchange Commission’s complaint against LG Capital.
On June 7, 2022, the SEC filed a complaint against Defendants LG Capital and John Lerman (50% owner and managing partner), as well as against Daniel Gellman (25% owner and managing partner), Boruch Greenberg (25% owner and managing partner), and Eli Safdieh for alleged violations of Section 15(a)(1) of the Exchange Act of 1934, 15 U.S.C. § 78o(a)(1) (the “Exchange Act” or the “Act”).
The Complaint generally alleges the defendants acted as securities dealers, engaged in the business of buying and selling large volumes of penny stocks for their own account, without being registered with the SEC and without Lerman, LG Capital’s control person, associating with an SEC-registered dealer.
Specifically, the SEC claims that “LG Capital’s business model – which was carried out under Lerman’s direction and control – involved purchasing convertible promissory notes from penny stock issuers for the exclusive benefit of Lerman and its two other principals,” often by executing debt purchase agreements (“DPAs”) or stock/securities purchase agreements (“SPAs”), and by “later converting those notes into unrestricted, newly issued shares of penny stocks at a substantial discount to the then-prevailing market price … and [quickly re-selling] the post-conversion shares into the public markets to capture the benefit of the discount.”
The SEC further alleges that between January 1, 2016 and December 31, 2021, the defendants bought or funded roughly 330 convertible notes from more than 100 different penny stock issuers and converted approximately 150 of these 330 notes into 23 billion unrestricted, newly issued shares of common stock, a portion of which the defendants sold.
Altogether, the SEC claims that the defendants’ post-conversion sale of shares generated at least $30 million in proceeds and roughly $20 million in profits.
In support of their Motion to Dismiss, the defendants argued (1) the instrument at issue here—convertible redeemable notes—are not securities, and (2) LG Capital is not a “broker” or a “dealer” within the meaning of the Act and thus the defendants are exempt from the SEC’s registration requirements pursuant to 15 U.S.C. § 78o(a)(5)(B).
Argument #1 – Convertible Redeemable Notes are not Securities
Judge Kuntz weighed four main factors when deciding how to rule on this matter:
(1) Motivation of the Parties to the Note;
(2) Plan of Distribution;
(3) Reasonable Perception of the Investing Public; and
(4) Alternate Regulatory Schemses or Other Risk Reducing Factors, and, in each case, found in favor of the SEC.
Judge Kuntz rejected each of the defendant’s arguments, determining that:
(1) nothing in the notes supported the notes being made for anything other than an investment strategy;
(2) there were basically no limitations as to how the defendants could transact with the broader public in the secondary market once the notes were converted, supporting the argument that they were transacting in securities;
(3) it is entirely plausible that the public would perceive the defendants as transacting in securities; and
(4) the defendants failed to show the existence of an alternative regulatory scheme that would render the application of the federal securities laws unnecessary.
Argument #2 – LG Capital is not a “broker” or a “dealer” within the meaning of the Act and thus the defendants are exempt from the SEC’s registration requirements pursuant to 15 U.S.C. § 78o(a)(5)(B)
Prior to the Court’s decision on this argument, the Court allowed Alternative Investment Management, Ltd., National Association of Private Fund Managers, and Trading and Markets Project, Inc. (collectively, “Amici”) to file in support of the defendant’s Motion to Dismiss. Amici argued that (1) Investment advisors and funds, such as LG Capital, operate and are regulated differently from dealers; (2) The Court should hold that, within the meaning of the Exchange Act, a “dealer” executes customer orders “as part of a regular business”; and (3) At a minimum, the Court should render a decision grounded in the SEC’s published guidance on how to distinguish “dealers” from registered investment advisors and funds.
Again, Judge Kuntz rejected each of the defendant’s arguments. Judge Kuntz largely determined that the cases the defendants and Amici relied on to argue that LG Capital is not a “dealer” fell short of being persuasive because they did not deal with the Act’s definition of a “dealer” — or even with securities regulation at all, and Judge Kuntz leaned hard on precedent from previous cases brought by the SEC against penny stock financiers that dealt in convertible notes, which determined that the way the defendants operated does, in fact, fall under the definition of a “dealer”.
In conclusion, the Court found that the SEC has plausibly alleged the defendants were engaged in the regular business of buying and selling securities while not registered with the SEC as dealers, and while control person Lerman was not associated with a separate registered dealer, in contravention of the Act’s registration requirements. Thus the Court DENIED the defendants’ Motion to Dismiss.
To speak with a Securities Attorney, please contact Brenda Hamilton at 200 E Palmetto Rd, Suite 103, Boca Raton, Florida, (561) 416-8956, or by email at [email protected]. This securities law blog post is provided as a general informational service to clients and friends of Hamilton & Associates Law Group and should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. Please note that the prior results discussed herein do not guarantee similar outcomes.
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