Federal Court Calls General Partnership Interest A Security

by Gray Reed & McGraw
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Are general partnership agreements for oil and gas exploration considered “securities” governed by federal securities regulations?

The U.S. Court of Appeals for the 10th Circuit  thinks they could be. In SEC v. Jeffory D. Shields and Geodynamics, Inc. et al., the court reversed a trial court ruling which dismissed the SEC’s claims that general partnership agreements for oil and gas exploration were actually federal securities. The appellate court adopted a three-factor test adopted from the federal Fifth Circuit to gauge whether a general partnership interest can be a “security.” If any of those factors are met, an investor may overcome the “strong presumption” that a general partnership interest is not a security.

The Analysis

Three key factors were considered by the court:

  • The agreement between the parties leaves so little power in the partners’ hands that it essentially acts as a limited partnership;
  • The partners are so inexperienced and unknowledgeable in the particular business that they are incapable of exercising partnership or venture powers: and
  • The partners depend on unique abilities of the promoter or manager such that they cannot replace the manager or otherwise exercise meaningful partnership or venture powers.

The court found that all three factors were present.

It is important to note that this decision does not mean these investments were actually securities—the court simply ruled that the SEC’s claims were enough to overcome a motion to dismiss for failure to state a claim. The court sent the case back to the trial court for further proceedings and factual development.

Bad Facts Make Bad Law

It is also worth noting that the defendant Shields was in prison for fraud at the time the opinion was issued.  Other facts were also present. Among the most egregious:

  • Of the roughly $5 million raised from investors, only $613,494 went to oil and gas development with the rest goint to Shields directly or to his company;
  • The money was commingled with other investor funds;
  • The drilling was never finished;
  • No oil or gas was ever produced; and
  • The general partners never received any funds.

The Takeaway

Merely crafting an oil and gas investment as a general partnership interest will not automatically insulate it from scrutiny and attack under federal securities regulations. If the “general partners” effectively cannot exercise power, and are at the mercy of the manager of the venture for its expertise, or other egregious facts exist, substance may trump form and federal securities laws may apply.

The 10th Circuit hears cases from Oklahoma, Kansas, New Mexico, Colorado, Wyoming, and Utah. The 5th Circuit hears cases from Texas, Louisiana and Mississippi.

Today’s musical interlude is dedicated to the defendant/jailbird Mr. Shields

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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