Are Oil and Gas Investments “Securities”?

oil well and compliance

The Securities and Exchange Commission brought an enforcement action against Jeffory D. Shields, GeoDynamics, Inc., and several other business entities affiliated with Mr. Shields, alleging securities fraud. The businesses are oil and gas exploration and drilling ventures and Mr. Shields, as managing partner of GeoDynamics, marketed the interests Joint Venture Agreements. The district court granted defendants’ motion to dismiss and the SEC appealed. The point of contention was that despite their labels, are the JVs actually “investment contracts” and therefore “securities” subject to federal securities regulations.

The District Court dismissed the action because it concluded that the JVs were not investment contracts. The appeals court was not willing to draw a bright line in the sand that the JVs were not “investment contracts.” The SEC wins the appeal and goes back to court to prove that the JVs are securities.

It sounds like Mr. Shield’s strategy was fraudulent. Even the appeal court call his business a “boiler room” making hundreds of calls a day promising annual returns between 256% and 548%. But the SEC does not have jurisdiction over all frauds. It only has jurisdiction over securities fraud.

The investment was structured as a general partnership with GeoDynamics as the managing venturer. The offering documents state that the interests are not securities. The partners grant broad powers to GeoDynamics with the sole power to bind the partnerships.

Investors had the right, by 51% vote to remove GeoDynamics as the managing venturer and to terminate the partnership. The investors also had certain right to call meetings and to inspect records.

The court goes back to the Howey test of “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” (328 U.S. at 301). It uses the variation on the third prong of whether the investment was “premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” Hous. Found., Inc. v. Forman, 421 U.S.  at 852.

The court starts with a strong presumption that a general partnership interest is not a security. But then goes on to three examples of when a general partnership interest can be a security:

(1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or

(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or

(3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manger of the enterprise or otherwise exercise meaningful partnership or venture powers.

The appeals court found enough to state that the presumption that investments were not securities. It did not go so far as state that the investments were securities or that they were not securities. It’s back to court with a small victory for the SEC. The case offers a great summary of the testing of general partnership interests as securities.

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Image is Pumpjack located south of Midland, Texas by Eric Kounce

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