Securities & Exchange Commission v. Farnsworth

Background

The Securities and Exchange Commission brought an enforcement action against Theodore J. Farnsworth, J. Mitchell Lowe, and Khalid Itum. The SEC alleged that Farnsworth, while chairman and chief executive officer of Helios and Matheson Analytics Inc. (HMNY), and Lowe, while chief executive officer of MoviePass, made materially false or misleading statements from 2017 through 2019. The alleged statements concerned whether MoviePass’s $9.95 subscription price could be profitable, HMNY’s data-analytics capabilities, non-subscription revenue, customer ticket-usage rates, and the Companies’ access to capital.

The SEC also alleged that Farnsworth and Lowe coordinated measures that restricted heavy users’ access to MoviePass services while publicly describing the reduced usage as a natural decline in demand. Separately, the SEC alleged that Itum, with help from Farnsworth and Lowe, used inaccurate invoices and supporting documents involving Kaleidoscope Ventures, LLC, to divert approximately $310,000 for Itum’s personal benefit and to cause HMNY and MoviePass records to misstate transactions and expenses.

The defendants moved to dismiss under Federal Rule of Civil Procedure 12(b)(6), which tests whether a complaint adequately states a legally plausible claim. The court accepted the complaint’s well-pleaded factual allegations as true for purposes of deciding the motions and applied the heightened pleading standard for fraud claims.

Claims Against Farnsworth and Lowe Under the Securities Laws

The court held that the SEC adequately pleaded many claims under Section 10(b) of the Securities Exchange Act, Rule 10b-5, and Sections 17(a)(1) and 17(a)(3) of the Securities Act. The alleged statements could have mattered to reasonable investors because they addressed the Companies’ profitability, revenue prospects, business model, customer usage, and funding. The court also concluded that the statements were specific enough not to be mere corporate boasting and were not protected by the “bespeaks caution” doctrine, which can apply to certain forward-looking statements accompanied by warnings.

The court found that the SEC adequately pleaded scienter, meaning an intent to deceive or reckless disregard for the truth. The complaint alleged that Farnsworth and Lowe knew, or should have known, information contradicting their public statements, including information about MoviePass’s financial condition, data capabilities, usage controls, and funding problems. The court also found that the complaint adequately connected the statements to purchases or sales of HMNY securities.

The court further held that the alleged effort to restrict heavy users’ ticket access, while portraying the resulting usage decline as natural, adequately pleaded scheme liability. According to the allegations, the measures created a misleading appearance about MoviePass’s business model and generated misleading information for investors.

The court reached a different conclusion on the Section 17(a)(2) claims. That provision requires allegations that the defendant obtained money or property through the misleading statements. The SEC alleged only generally that Farnsworth and Lowe received bonuses or increased compensation and did not provide facts connecting those benefits to the alleged fraud. The court therefore dismissed the Section 17(a)(2) claims against both defendants.

Aiding-and-Abetting Claims Involving Lowe

The SEC also alleged that Lowe aided and abetted securities-law violations. The court held that the complaint adequately alleged that Lowe aided and abetted Farnsworth’s primary violations. Lowe allegedly participated in joint interviews, supported Farnsworth’s statements, and knew or recklessly disregarded information contradicting them.

The court dismissed, however, the aiding-and-abetting claims based on alleged primary violations by HMNY. HMNY was not named as a defendant, and the SEC did not specifically identify which Farnsworth statements should be attributed to HMNY. The court dismissed those claims without prejudice.

Claims Concerning Books, Records, and Auditors

The court held that the SEC adequately pleaded Section 13(b)(5) and Rule 13b2-1 claims against Farnsworth and Itum in some respects, but not against Lowe. Section 13(b)(5) prohibits knowingly falsifying an issuer’s books, records, or accounts, while Rule 13b2-1 prohibits directly or indirectly falsifying such records.

As to Itum, the complaint adequately alleged that he created inaccurate invoices and related documents concerning the Sundance and Coachella events. As to Farnsworth, the complaint adequately alleged his involvement with the Second Sundance Invoice, which was presented as an expense overage but allegedly served to pay Itum a bonus. The court found insufficient allegations tying Farnsworth to the First Sundance Invoice or adequately showing that he knew the Coachella Invoice was fraudulent. The court also found that the complaint did not specifically allege how Lowe contributed to or knew about the falsification of the invoices.

The court dismissed claims based on the February 26, 2018 Invoice because the complaint did not clearly allege that the invoice was incorporated into HMNY’s books and records. The court also dismissed Rule 13b2-2 claims against Lowe and Itum because the complaint did not adequately allege that they were officers of HMNY, as that rule requires. The Rule 13b2-2 claim against Farnsworth survived because the complaint alleged that he knew the Second Sundance Invoice would be provided to an auditor and that HMNY’s auditor relied on the invoices and related records.

The court separately found that the SEC adequately pleaded that HMNY violated Section 13(b)(2)(A), which requires an issuer to keep books and records that accurately reflect its transactions. The court held that Farnsworth and Itum were adequately alleged to have aided and abetted that violation, but the allegations against Lowe were insufficient.

Disposition

Judge Katherine Polk Failla concluded that the defendants’ motions were granted in part and denied in part. Farnsworth’s motion was denied as to the Section 10(b), Rule 10b-5, and Sections 17(a)(1) and 17(a)(3) claims; granted as to the Section 17(a)(2) claims; and denied as to the Section 13(b) claims except for claims relying on the February 26, 2018 Invoice or the First Sundance Invoice, as to which it was granted.

Lowe’s motion was denied as to the Section 10(b), Rule 10b-5, and Sections 17(a)(1) and 17(a)(3) claims; granted as to the Section 17(a)(2) and Section 13(b) claims; and denied as to the Section 20(e) aiding-and-abetting claims involving Farnsworth as the primary violator, but granted as to those involving HMNY as the primary violator. Itum’s motion was denied except as to claims based on the February 26, 2018 Invoice and the Rule 13b2-2 claim, as to which it was granted.

The court stated that all dismissed claims were dismissed without prejudice and granted the SEC leave to replead. The amended complaint was due on or before October 6, 2023.