SEC v. Phan
500 F.3d 895, 2007 WL 2429365 (2007)
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Rule of Law:
A Form S-8 registration statement, which is used to register securities issued to employees or consultants for compensatory purposes, does not cover the subsequent resale of those securities to the public if the issuer controls or directs the resale for the purpose of raising capital. Such a resale is considered an unregistered distribution of securities in violation of Section 5 of the Securities Act of 1933.
Facts:
- Alan Phan was the CEO of Hartcourt Companies Inc., a publicly traded company that was experiencing financial difficulty in 1999.
- To find business opportunities in China, Hartcourt engaged Yan Wu as a consultant.
- On August 23, 1999, Hartcourt entered into an agreement to grant Wu an option to purchase one million shares of Hartcourt stock at the current market price, purportedly as compensation for her consulting services.
- Hartcourt filed a Form S-8 with the SEC to register these shares, a form designated for employee and consultant compensation, not for raising capital from the public.
- Contrary to the filed option agreement, Hartcourt issued the one million shares to Wu immediately without her paying the $1.25 million purchase price, accepting a promissory note instead.
- A few months later, at Phan's direction, Wu sold most of the shares to the public through an investment group Phan had suggested.
- Phan instructed Wu to wire the proceeds from the stock sales, totaling approximately $761,000, directly to Hartcourt's creditors to satisfy the company's outstanding debts.
Procedural Posture:
- The Securities and Exchange Commission (SEC) filed a civil complaint against Alan Phan, Yongzhi Yang, and Hartcourt Companies Inc. in federal district court.
- The complaint alleged violations of Section 5 of the 1933 Act (unregistered securities sale) and various antifraud provisions.
- Both the SEC and the defendants filed motions for summary judgment.
- The district court granted summary judgment in favor of the SEC on all claims.
- The district court imposed a permanent injunction, a civil fine, and a bar from serving as an officer or director of a public company against Phan.
- Phan, as appellant, appealed the district court's judgment to the U.S. Court of Appeals for the Ninth Circuit; the SEC is the appellee.
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Issue:
Does the resale of securities by a consultant violate Section 5 of the Securities Act of 1933 when the shares were originally registered on a Form S-8 for compensatory purposes, but the resale is directed by the company's CEO to raise capital for the company?
Opinions:
Majority - Berzon
Yes. The resale of the securities violates Section 5 because the Form S-8 registration was not in effect for the transaction, which was a capital-raising event, not a compensatory one. Even if the initial issuance of shares to the consultant was for a legitimate compensatory purpose, the S-8 registration ceases to be effective when the company subsequently uses those shares for a capital-raising purpose. SEC regulations prohibit the use of Form S-8 when the issuer controls or directs the resale of securities in the public market or indirectly receives the proceeds from such resales. Here, Phan, on behalf of Hartcourt, directed Wu to sell the shares to repay her debt to the company and instructed her to send the proceeds to Hartcourt's creditors. This demonstrates both that Hartcourt controlled the resale and indirectly received the proceeds, making the resale an unregistered public offering. Because Phan was a 'necessary participant' and 'substantial factor' in the illegal sale, he is liable under Section 5. However, summary judgment on the securities fraud claims was improper because the materiality of the misstatement regarding the payment terms in the S-8 form is a question of fact for a jury, not a matter of law.
Analysis:
This decision reinforces the SEC's strict interpretation of the use of Form S-8, clarifying that its purpose is limited to bona fide employee compensation and cannot be used as a conduit for capital-raising. The court's analysis separates the initial issuance of shares from their subsequent resale, establishing that even a legitimate initial compensatory grant can become an illegal unregistered distribution if the company later directs the resale to raise capital. This holding puts corporate executives on notice that the substance of a transaction, not its form, will determine its legality under Section 5. The ruling also underscores the high threshold for deciding the issue of materiality on summary judgment in fraud cases, preserving it as a fact-intensive question typically reserved for the jury.
