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In yet another example of real world legal consequences being brought to bear in cyberspace, a federal appellate court, in the case SEC v. SG, Ltd., has ruled that virtual shares in an enterprise existing only in cyberspace fall within the federal securities laws and can lead to enforcement actions by the SEC. SEC FACTUAL ALLEGATIONS In considering whether the SEC’s action could proceed under the federal securities laws, the appellate court examined the following SEC allegations: SG operated a “StockGeneration” Web site offering the opportunity online topurchase shares in eleven different virtual companies listed on the Web site’s virtual stock exchange. SG arbitrarily set the purchase and sale prices of each of these imaginary companies in biweekly rounds. SG 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 put toward virtual offerings. The SEC’s complaint focused on shares in a particular virtual enterprise referred to by SG as the “privileged company.” 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 Web site announced that the privileged company’s shares would appreciate at a rate of 10 percent monthly. SG’s Web site also contained lists of purported big winners and an Internet bulletin board featuring testimonials from supposedly satisfied participants At least 800 people in the United States used real cash to purchase 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. In March 2000, these difficulties peaked and SG unilaterally suspended all pending requests to withdraw funds and sharply reduced participants’ account balances in all companies except the privileged company. Two weeks later, SG 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 Web site. TRIAL COURT PROCEEDINGS The SEC undertook an investigation into SG’s activities, which led to the filing of a civil action in a federal trial court. The SEC’s complaint alleged that SG’s operations constituted a fraudulent scheme in violation of the registration and antifraud provisions of the federal securities laws. The federal trial court dismissed the SEC’s complaint and the SEC appealed. THE APPEAL The key issue on appeal was whether the particular scheme involved an “investment contract” under the federal securities laws. The appellate court determined that an investment contract could be found if the following elements could be satisfied: (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. INVESTMENT OF MONEY Regarding the investment of money prong of the analysis, SG argued that the individuals who purchased shares in the privileged company were not so much investing money in return or rights in the virtual shares as paying for an entertainment commodity (the opportunity to play the StockGeneration game). However, the appellate court found greater significance in the SEC’s allegation that SG represented that participants could firmly expect a 10 percent monthly profit 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,” according to the court. COMMON ENTERPRISE As to the common enterprise part of the analysis, the appellate court found that the arrangement described in the SEC’s complaint “fairly can be characterized as either a Ponzi or pyramid scheme, and that it provides the requisite profit-and-risk sharing to support a finding of horizontal commonality.” Indeed, the court found that all of the participants shared the risk that new participants would not emerge, cash flow would dry up, and the underlying pool would be empty. EXPECTATION OF PROFITS Regarding the third prong of the inquiry, the appellate court noted that the SEC alleged that SG flatly guaranteed that investments in the shares of the privileged company would be profitable, yielding monthly returns of 10 percent. The appellate court found that “these profit-related guarantees constitute a not-very-subtle form of economic inducement.” Further noteworthy to the appellate court were the SEC’s allegations that SG was responsible for all the important efforts that undergirded the 10 percent guaranteed monthly return. As the sole proprietor of the StockGeneration Web site, SG enjoyed direct operational control over all aspects of the virtual stock exchange. AT THE END OF THE DAY The appellate court held that all three prongs of the investment contract analysis were satisfied; accordingly, the SEC’s legal action may proceed under the federal securities laws against SG with respect to its virtual investment game. This should be yet another lesson teaching that online actions can lead to real world legal consequences. Eric J. Sinrod is a partner in the San Francisco office of Duane Morris, where he focuses on technology and litigation matters. His Web site is sinrodlaw.com and his firm’s site is Duane Morris.Mr. Sinrod may be reached by e-mail at [email protected]

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