Where There’s Smoke There’s Fyre

Home » Our Firm » Published » Where There’s Smoke There’s Fyre

2019 Issue One
CapitalMasthead

Where There’s Smoke, There’s Fyre:  Spotting and Stamping Out Securities Fraud Exposure Before It Ignites

By: Evan Kirkham

In 2017, twenty-six year old Billy McFarland was being heralded as the next Mark Cuban—a genius entrepreneur with unmatched charisma and a knack for connecting with millennial consumers. His latest and greatest enterprise was Fyre Media, a mobile booking platform promising to connect aspiring and established music artists with agents and venues. McFarland had the team, the product, and some initial users. What remained to be done was squarely in his wheelhouse—creating buzz and securing additional financing. McFarland’s plan was bold; host an exceedingly luxurious and exclusive musical festival on a private island in the Bahamas formerly owned by Pablo Escobar.

McFarland visited the island with a collection of close friends, employees, hired supermodels, and the rapper, Ja Rule. The group shot a promotion video that took social media by storm. The festival almost immediately sold out. But, with only one year to prepare for the festival, McFarland had his work cut out—the island lacked electricity, plumbing, and the promised “luxury tents,” among other basic amenities. His fix was to raise over twenty-five million dollars and build it all from scratch.

McFarland found a way to raise the money, but couldn’t deliver on his promises. When the guests arrived on the island, they were horrified to find out they would be sleeping on soggy mattresses in repurposed hurricane shelters without electricity or running water, would be fed two slices of bread with a single piece of cheese (the now notorious “cheese sandwich”), and had no way off of the island. The Fyre Festival was such a disaster that two documentaries were released in 2019 cataloging the catastrophe: Hulu’s Fyre Fraud and Netflix’s Fyre: The Greatest Party that Never Happened.

On July 24, 2018, the SEC filed an enforcement action against McFarland, Fyre Media, Magnesis (another of McFarland’s ventures), Grant Margolin (Fyre Media’s CMO), and Daniel Simon (a contractor hired by McFarland for the sole purpose of inflating financial reports), alleging violations of Sections 5(a) and 17 of the Securities Act and Sections 10(b) and 15(a) of the Securities Exchange Act. The SEC’s complaint alleged the defendants made material misrepresentations and omissions to investors about the financial strength of Fyre companies, had created documents fraudulently inflating key metrics, including revenue and income, and had altered stock ownership statements to falsely suggest the existence of collateral for securitized investments. The evidence against McFarland was insurmountable as he had bald-faced lied to financiers about the performance of his companies. The lesson from McFarland’s fraud is obvious—don’t lie to prospective investors about company financials. The lessons from the allegations against Margolin are more nuanced.

The SEC alleged Margolin substantially assisted McFarland’s fraud by fashioning company reports that inflated the operational and financial metrics of Fyre Media, all without investigating the accuracy of the information provided by McFarland. Specifically, in September 2016, McFarland sent Margolin a falsified report showing 15 “accepted” Fyre Media bookings totaling $5.4 million, an average of $360,000 per booking. The report included million dollar “accepted” bookings from A-list artists such as Jennifer Lopez ($1.75 million), the Foo Fighters ($1.5 million), and Selena Gomez ($1 million). Margolin was sent a second report by Fyre Media’s CTO, generated directly from the fyreapp.com booking platform, which, by contrast, showed 33 “accepted” Fyre Media bookings totaling just $275,800, on average, less than $8,400 per booking. As directed by McFarland, Margolin combined the two reports to create a new booking report—showing 42 “accepted” Fyre Media bookings totaling $5.6 million. Margolin asked no questions and failed to investigate the discrepancies. He simply followed McFarland’s orders, creating a false report ultimately distributed to prospective investors.

Eight days after the SEC filed suit, Margolin folded. He settled with the SEC for $35,000 and a promise to restrain from acting as an officer or director of any issuer of securities for seven years. Margolin simply couldn’t deny he had “unreasonably assist[ed] McFarland in creating false and misleading statements . . . [and engaged in conduct that was] sloppy and ill-calculated.” But why so soon? After all, Margolin never interfaced with prospective investors, was not explicitly told McFarland’s booking reports were fraudulent, and was only following orders. Though we can only speculate about Margolin’s liability calculation, exploring his vulnerabilities reveals two interesting insights legal practitioners ought to consider when defending clients who may have “substantially assisted” a securities fraudster.

Perhaps Margolin’s early settlement had something to do with the knowledge requirement of Securities Act Section 17(a). Unlike Rule 10b-5 of the Securities Exchange Act and Section 17(a)(1) of the Securities Act, Sections 17(a)(2) and (3) do not require proof of scienter—only proof of negligence. Aaron v. SEC, 446 U.S. 680, 691 (1980) (violation of Section 10b-5 requires defendant to have acted with scienter); SEC v. Seghers, 298 Fed. Appx. 319, 327 (5th Cir. 2008) (“Violations of Section 17(a)(1) require proof that the defendant acted with scienter); SEC v. Farmer, 2015 WL 5838897, at *6 (S.D. Tex. Oct. 7, 2015) (“[T]o show that the defendant has violated Section 17(a)(2) or Section 17(a)(3), the SEC need only prove that the defendant acted with negligence.”). Functionally, the SEC would not need to prove Margolin knew McFarland’s booking report was fraudulent before he incorporated it into the combined report. The SEC would only need to prove Margolin did not adhere to a standard of reasonable care in performing his functions as Chief Marketing Officer. Practitioners should be acutely aware of exposure arising from the otherwise indistinguishable 17(a)(2) and (3), because, outside of the pesky knowledge requirements, the “basic precepts of Section 17(a) . . . and Rule 10b-5 are the same” and claims arising “under the two provisions are often analyzed as one.” Farmer, 2015 WL 5838867, at *12.

Still, Margolin might have been aware of his duty to investigate, a duty which, if ignored, would establish the knowledge required to find him liable under any of the aforementioned provisions. If the court had determined the booking reports were “inconceivable on [ ] face,” Margolin would have been hard pressed to combat a finding of requisite knowledge. SEC v. Asset Recovery and Mgmt. Trust, No. 2:02–CV–1372-WKW, 2008 WL 4831738, at *8 (M.D.Ala. Noc. 3, 2008); S.E.C. v. Deyon, 977 F. Supp. 510, 517–18 (D. Me. 1997), aff’d, 201 F.3d 428 (1st Cir. 1998). He would have been held to a “heightened duty to investigate” and would not have been exonerated even if he could have proved his reliance on McFarland’s representations about the accuracy of the booking reports. Sec. & Exch. Comm’n v. CKB168 Holdings, Ltd., 210 F. Supp. 3d 421, 448-49 (E.D.N.Y. 2016) (Promoters of multi-national pyramid scheme acted with scienter to commit securities fraud because the promoters were confronted with obvious signs of fraud and failed to investigate, relying instead on the founder’s communications disputing the illegitimacy of the scheme). Practitioners should be aware their client’s could be found having the requisite knowledge to support the full panoply of statutory securities fraud causes of action if they fail to investigate representations that are inconceivable on face. A defendant’s plea of ignorance is unlikely to negate proof of knowledge, especially as the fraudulent scheme becomes less and less believable, or as in this case, contradicted by incontrovertible computer generated reports.

Thousands of patrons, hundreds of event staffers, tens of investors, and a few key executives were all burned by the Fyre Festival—perhaps none as swiftly as Grant Margolin. And though the festival began and ended with an underwhelming cheese sandwich, the ensuing lawsuit did raise some interesting questions and observations about exposure to latent securities fraud liability. Practitioners ought to be conscious of the ease by which the SEC can make a case against otherwise peripheral parties because of the absence of a knowledge requirement in Sections 17(a)(1) and (2) and because of defendants’ heightened duty to investigate frauds that are inconceivable on face.