SEC Prevails In Tenth Circuit

by Dorsey & Whitney LLP

The SEC prevailed in the Tenth Circuit Court of Appeals, securing a reversal of the district court’s order granting a motion to dismiss its complaint. The central issue in the case was if instruments which claimed to be partnership interests and expressly disclaimed being securities were in fact an investment contract under the federal securities laws. SEC v. Shields, No. 12-1438 (10th Cir. Decided Feb. 24, 2014).

The Commission filed an action against Jeffory Shields, GeoDynamics, Inc.. and several other business entities affiliated with Mr. Shields. The defendants are alleged to have raised over $5 million selling interest in four purported oil and gas exploration and drilling joint ventures to sixty investors in twenty eight states. The interests were marketed through cold calls. Investors were promised annual returns that ranged from 256% to 548%. The investors solicited had little or no experience in the oil and gas business but were told about the unique qualifications of GeoDynamics as an experienced oil and gas driller and operator.

Investors who expressed interest in the program received a packet of offering documents. The materials represented that partners would have all the rights and liabilities of a General Partner under Texas law. GeoDynamics would be the managing partner and would have responsibility for the day-to-day operations with broad power to bind the joint ventures, raise and spending funds and interpret the agreements. No investor had any power to bind the joint venture although they did have the right to vote on certain matters, remove the managing partner and terminate the partnership. Investors also had the right to inspect the accounting records and reports. Funds raised for each venture would be maintained in separate accounts and used to pay for drilling and completing wells under the turnkey contracts executed by GeoDynamics, according to the papers.

The SEC claims that despite the terms of the contracts, investor funds were in fact comingled. Investors had no access to the books and records and much of the money raised was used by the defendants for their own purposes. Only a little over $600,000 of the investor funds went to oil and gas development. The complaint alleged fraud.

The District Court granted defendants’ Motion to Dismiss under Federal Rule 12(b)(6), concluding that the limited partnership interests were not securities. In reaching that conclusion the Court relied primarily on the offering documents. The Circuit Court reversed.

Here the critical question is not the form of the instrument but its substance. In determining if an instrument is an investment contract, and thus subject to the federal securities laws, the classic test is whether the scheme “involved an investment of money in a common enterprise with profits to come solely from the efforts of others.” (internal citations omitted). In applying this test the Tenth Circuit has adopted a “strong presumption that an interest in a general partnership is not a security . . . because the partners-the investors-are ordinarily granted significant control over the enterprise.” While the SEC argued that this presumption should be disregard, it has in fact been adopted by other circuits the Court noted, citing decisions from the Third, Fourth, Fifth, Sixth and Eleventh Circuits.

Three factors to be considered when evaluating if the presumption has been overcome that are consistent with the definition of an investment contract: 1) Whether the agreement leaves so little power in the hands of the partner that it in fact distributes power as would a limited partnership; or 2) the partner is so inexperienced and unknowledgeable that he or she is incapable of intelligently exercising the partnership powers; or 3) the partner is so dependent on some unique entrepreneurial or managerial ability of the promoter that he or she cannot replace the manager or otherwise exercise meaningful partnership or venture powers.

An analysis of these factors in this case demonstrates that the SEC has overcome the presumption. The first point concerns the agreements. While the joint venture agreements granted the investors certain rights, in fact investors were still required to rely on GeoDynamics. The turnkey contracts were the key to the success of enterprise and profits “because they were the only way these oil and gas investments could generate money.” This conclusion is consistent with the fact that the interests were marketed to those who had no experience in the oil and gas industry. This point, along with the fact that purchasers relied on the promoters as their sole source of information – both of which also go to the second factor — presents a fact issue as to whether the voting rights given investors were “illusory or a sham.”

Those factors also tie to the third point of consideration – whether the investors are dependent on the unique managerial skills of the promoter. Here the defendants emphasized the “unique expertise of GeoDynamics in the oil and gas industry” to investors in soliciting their funds. This factor, coupled with the first two, demonstrates that while the form of the documents may suggest a partnership, in substance the facts suggest otherwise. Accordingly, the order dismissing the action is reversed and remanded to the District Court for further proceedings.

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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