Blurry Boundaries of Oil & Gas Joint Ventures Under the Securities Act and the Exchange Act

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In Sec. & Exch. Comm’n v. Sethi Petroleum, LLC, 4:15-CV-00338, 2017 WL 192666, at *1 (E.D. Tex. Jan. 17, 2017), the Eastern District of Texas, Sherman Division, issued an opinion that clarifies the often-blurry boundaries between selling interests in an oil and gas joint venture and selling securities, and when registration under the Securities Act and the Exchange Act is required.

A security is broadly defined under the Securities Act and the Exchange Act and includes, among other things, an “investment contract” but does not include a “joint venture.” An investment contract exists where: (1) individuals are led to invest money; (2) in a common enterprise; (3) with the expectation that they would earn a profit solely through the efforts of the promoter or of someone other than themselves. The issue before the Court was the third element: whether the potential investors had an expectation that they would earn a profit solely through the efforts of someone other than themselves.

FACTS:
As early as January 2014, Defendant Sameer Sethi and his company, Sethi Petroleum, LLC (“Sethi Petroleum”), began offering investors positions in the Sethi-North Dakota Drilling Fund-LVIII Joint Venture (“NDDF”). This purported “joint venture” offered investors returns from two sources: oil-and-gas revenues and tax benefits from oil-and-gas exploration and production activities. The NDDF was promoted primarily through two documents: a Confidential Private Placement Memorandum (“PPM”) and an Executive Summary (collectively, the “Offering Documents”).

Sethi Petroleum marketed NDDF interests through a twenty-person sales staff using cold calls, pitch scripts, and purchased lead lists. Sameer Sethi regularly visited the “boiler room” to provide sales tips and directions on statements to make to potential investors. Once salespeople determined that an investor was interested in NDDF and was “accredited,” Sethi Petroleum would send Offering Documents to the potential investor through the United States mails.1

In the PPM, Sethi Petroleum stated its intention to raise $10 million to purchase mineral interests and to participate in oil and gas development on 200,000 acres in the Williston Basin. Sethi Petroleum estimated that 70% of investor funds would be used for the acquisition, drilling, and completion of the wells and that the remaining 30% would be spent on legal, engineering, syndication, and management expenses. The PPM further stated that the investors’ funds would be used to purchase approximately 62.5% net working interest in at least twenty wells. The Offering Documents also stated that NDDF’s wells would be “operated by publicly traded and/or major oil and gas companies” such as Continental Resources, ExxonMobil, Hess Corporation, and ConocoPhillips.

The PPM alerted investors to various risk factors associated with the NDDF venture including: “The venture is newly formed and has limited financial resources”; “There is no minimum capitalization required before subscriptions will be utilized for venture operations”; “Our prior performance is not an indication of how the venture will perform”; “The prospect wells may not be productive”; “You may not recover your investment in the venture”; “We may profit from the venture’s operations even if the venture is not profitable”.

Attached to PPM was a Joint Venture Agreement (“JVA”). The JVA provided by Sethi Petroleum established the NDDF venture and appointed Sethi Petroleum as Managing Venturer. The JVA gave investors control of NDDF’s affairs and operations, but empowered Sethi Petroleum to manage the venture’s day-to-day operations. Among the powers granted to Sethi Petroleum were “sole and absolute discretion” to distribute NDDF profits to investors; authority to execute oil and gas operating agreements; power to take and hold title to NDDF’s property; and authority to hire all professionals on NDDF’s behalf. Certain significant actions—such as acquiring oil and gas interests or removing the Managing Venturer—required the majority vote of investors.

From January 28, 2014, through March 9, 2015, Sethi Petroleum raised over $4 million from ninety investors in twenty-eight states.

APPLICATION:
As stated above, an investment contract exists where: (1) individuals are led to invest money; (2) in a common enterprise; (3) with the expectation that they would earn a profit solely through the efforts of the promoter or of someone other than themselves. The Fifth Circuit has held that the term “solely” is interpreted in a flexible manner, and when evaluating whether an interest is a security, form should be disregarded for substance and courts should analyze the economic reality underlying a transaction, and not focus on the name appended thereto. Thus, the test is: whether the efforts made by those other than the investor are the undeniably significant ones – those essential managerial efforts which affect the failure or success of the enterprise.

A general partnership or joint venture interest may satisfy the third element if the investor can establish any one of the following factors, which are non-exhaustive: (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)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 manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

As to the first factor, 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, the Court determined that it was met, and as a result, the NDDF interests were securities. First, the offering documents gave Sethi Petroleum “sole and absolute discretion” to distribute NDDF profits to investors; authority to execute oil and gas operating agreements; power to take and hold title to NDDF’s property; and authority to hire all professionals on NDDF’s behalf, including engineers, geologists, and appraisers. Further, despite the fact that the JVA appeared to give the investors some discretion by requiring a majority vote for certain significant actions, such as acquiring oil and gas interests or removing the Managing Venturer, Sethi Petroleum solicited investors from across the country with no prior relationships to Sethi or each other. Moreover, Sethi did not provide access to its books or records, and did not provide contact information for other investors. Additionally, when investors took steps to exercise any powers, they were stymied by Sethi. Accordingly, because Sethi only gave investors the appearance of power and investors could not actually exercise any power, investors were expected to earn a profit solely through the efforts of Sethi and the NDDF joint venture was actually a security interest.

The second factor, the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers, was also met. The Court reasoned that Sethi made offerings by hundreds of cold calls per day via a nationwide network of investors with little, if any, experience in the oil and gas industry. The sheer breadth of indiscriminate solicitation makes the NDDF joint venture a security interest.

The third factor, the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers, was also met. In the NDDF PPM, Sethi touts its experience and ability to produce profit in the industry, and specifically in the Bakken Shale. Further, the Executive Summary stated that the Bakken Shale area had been monopolized such that only major oil companies could participate in drilling. This was enough to establish the third factor. Moreover, the fact that Sethi took the investments, placed them in an account Sethi exclusively controlled, and used the funds to pay for the costs associated with running Sethi’s office established that the investors were entirely dependent on Sethi.

The Court also found Sameer Sethi jointly and severally liable as a control person. He created, owned, managed, and controlled the company’s operations. He provided guidance as to the cold-calls and had control of the misstatements made to investors. He was the author of the Executive Summary and directed his salespeople to tell potential investors that Sethi is “partnered directly” with major oil companies.

1 An “accredited” investor is a person with a net worth over $1,000,000 independently or combined with a spouse or with individual income over $200,000 or joint income over $300,000.

2 Courts have made clear that this knowledge inquiry must be tied to the nature of the underlying venture, for example knowledge about the oil and gas industry.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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