Tag: General partnership

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

Is a General Partnership Interest a Security?

Looks like a great investment?

When the SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler, I was a bit troubled by the structure of the investments in question. The firm had structured the real estate investment vehicles as general partnerships. The presumption is that a general partnership interest is not a security. So if the investments are not securities, then there can’t be securities fraud, and the Securities and Exchange Commission loses the case.

During the temporary restraining order hearing, the court was willing to accept that the interests could be securities and granted the temporary injunction and asset freeze. The court recently ruled on whether to convert the temporary restraining order into a preliminary injunction. The ruling has a detailed discussion of the law on when a general partnership interest is considered a security. In my ongoing quest to find the line between what’s a security and what’s not, I spent a few minutes looking at the decision.

The defendants make the argument that “the case law over many decades has consistently held that there is a presumption that (1) interests in general partnerships are not securities, and (2) interests in raw land held solely for market appreciation are not securities.”  The court agreed and cited three key cases.

  1. SEC v. Merchant Capital, LLC, 483 F.3d 747, 755 (11th Cir. 2007) “A general partnership interest is presumed not to be an investment contract because a general partner typically takes an active part in managing the business and therefore does not rely solely on the efforts of others.”
  2. Shiner, 268 F.Supp.2d at 1340 “The general rule is that units in general partnerships are not investment contracts and therefore not securities under federal law.”)
  3. McConnell v. Frank Howard Allen & Co., 574 F.Supp. 781, 784 (N.D. Cal. 1983) “There is persuasive authority for the position that if an investor in a real estate syndicate expects profits to come solely from the general appreciation of property values, then the investment is not a security.”

But like any presumption, the presumption that general partnership interests aren’t securities can be overcome.  The securities laws define “security” to include an “investment contract” and general partnership interest could be considered an investment contract.  The Supreme Court, in 1946, defined an investment contract as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” SEC v. W.J. Howey Co., 328 U.S. 293(1946). The requirement that profits be expected “solely” from the efforts of the promoter has been given a liberal reading and has largely dropped the term “solely” from the investment contract test.

The Court summarizes the law on when general partnership interests qualify as securities and labels Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir. 1981) as the seminal case. In Williamson, the Court devised a three part operational test for an investment contract.

A general partnership or joint venture interest can be designated a security if the investor can establish, for example, that
(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 manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

In application of that test to this case, the SEC failed to meet the requirements of the first two tests, leaving the last test as the finale in the decision. Western Financial argued “that there’s no possibility for dependency because all the general partners do is invest in raw land and wait for it to appreciate in value.”

The SEC countered by focusing on the exit, arguing that it was up to Schooler and his firm to find suitable purchasers of the property. The defendants fought back and said that any offer to purchase would be forwarded to the partners to approve. In a telling piece of testimony, the Western Pacific employee said that was the procedure, but he had never put it to test because he had “never seen an offer during my time with Western ever come out.” That’s bad, but not necessarily securities fraud.

Ultimately, the court was most influenced by the parcels of land being owned by more than one partnership sponsored by Western Financial. The effect is that the partnership only owns a fractional interest in the land, making each partnership more dependent on Western and Schooler to manage the investment, at least with respect to the inter-partnership dealings.

At least for this court, the interests in a general partnerships that hold raw land are more likely to be considered not securities. Developed land has an operational side that would required management.  But having multiple general partnerships own the undeveloped land in common swings the interests back to the securities side.

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