The Securities and Exchange Commission brought an action against the CEO of a publicly traded company (the Company) alleging that he violated, inter alia, Section 5 of the Securities Act of 1933 by using stock registered under Form S-8 to raise capital for the Company. The SEC argued that stock registered under Form S-8 could only be used to compensate consultants for bona fide consulting services not connected to raising capital.
The shares in question were issued to a co-defendant who had been engaged to help the Company identify new business opportunities at a time when the Company was having difficulty making payments to its investment partners. Despite the consultant having only limited resources, the CEO caused the Company to issue the shares in exchange for the consultant’s execution of a $1.25 million promissory note. Several months later, in response to the CEO’s demand that the consultant repay the note, the consultant sold the shares to a purchaser that the CEO identified pursuant to an agreement that the Company’s attorney prepared. The Company used the proceeds of the sale to repay amounts due to its investment partners.
The CEO opposed the Section 5 claim by arguing that, at the time the stock was issued to the consultant, it was intended to provide compensation for bona fide consulting services and, thus, was properly registered under Form S-8. While the Ninth Circuit found the question of whether the initial issuance was bona fide under Form S-8 presented a question of fact that prevented the resolution of the SEC’s securities fraud claims on summary judgment, it affirmed the District Court’s grant of summary judgment to the SEC on the Section 5 claim. The Court held that even if the initial issuance of stock was permitted under Form S-8, because of the significant role the CEO and the Company played in the consultant’s resale of the stock – including choosing the date of the sale, choosing the buyer, providing an attorney to prepare the sale agreement, etc. – the S-8 registration ceased to be effective once the Company sought to use the shares for a capital raising purpose. Accordingly, because no additional registration statement was filed, the transaction constituted an unregistered sale of securities in violation of Section 5 of the Securities Act of 1933. (SEC v. Phan, 2007 WL 2429365 (9th Cir. Aug. 29, 2007))