When is an investor buying a security versus purchasing a partnership in a joint venture?
It depends on some very specific but basic facts typically available only in a full trial, according to the U.S. Court of Appeals for the Fifth Circuit.
A three-judge panel ruled Thursday that the determination of whether “interests sold” in a business operation is an official security or a partnership in a JV rests on several factors related to the investors, including how much control or power the investors have in the project, whether they are sufficiently informed to make decisions and how sophisticated they are to make decisions.
The only way to weigh those factors, according to the Fifth Circuit, is to allow the parties to call witnesses and present evidence in a little thing called a jury trial.
Legal experts say the Fifth Circuit opinion is significant in the world of so-called oil and gas wildcatting for multiple reasons, including because it requires the SEC to develop more detailed and substantive evidence to prove its case.
“The decision signals that the SEC may have to do more work and develop more proof before it brings its cases and that the SEC is less likely to prevail on summary judgment regarding whether the interest is a security,” said Haynes and Boone partner Kit Addleman, a former regional director of the SEC’s Atlanta office.
“This opinion also provides insight on how small operators can set up funds or ventures in energy projects that are not regulated by the SEC,” Addleman said. “It is a very thoughtful and straight-forward opinion.”
Bracewell partner Joe Cox, who represents defendants Alfredo Gonzalez and AMG Energy in this case, said the decision requires the SEC to actually introduce evidence and witnesses and not just rely on a small number of preliminary affidavits and statements that face no cross-examination or scrutiny.
“The jury trial is a sacred right in this country and too often parties lose without ever having the chance to have the case decided by a jury,” Cox told The Texas Lawbook. “Here, the Fifth Circuit seems to breathe life back into the notion that defendants are entitled to their day in court with a jury deciding whether the actual facts, when applied to the law, amount to a violation of that law.”
In a 37-page opinion authored by Fifth Circuit Chief Judge Carl Stewart, the appellate court reversed a federal judge in Dallas’ finding that the operators and managers of several oil and gas drilling projects violated federal securities laws when they failed to register the interests in the projects they sold to nearly 400 investors as securities.
The case, Securities and Exchange Commission v. Arcturus Corporation, Aschere Energy, et al, will now go back to U.S. District Judge Ed Kinkeade for a full trial.
The dispute started in 2013, when the SEC’s Fort Worth Regional Office charged Leon Ali Parvizian and three Dallas companies he started, Arcturus, Aschere and AMG Energy, with operating a fraudulent oil and gas investment scheme. The SEC also named investment advisors Alfredo Gonzalez, Robert Balunas and R.A. Thomas as defendants.
The SEC claimed that Parvizian and his companies illegally offered and sold unregistered securities. The SEC claimed that the defendants raised $22 million from 380 investors between 2007 and 2011.
Lawyers for the defendants argued that they did not violate federal securities laws because they were not selling securities. They said they were selling interests in joint ventures, which they argued are exempt from federal securities regulations.
Judge Kinkeade granted summary judgment to the SEC, finding that the investors had no real power to control the operation, were inexperienced and lacked expertise in oil and gas as a result of cold-calling marketing techniques employed by the defendants and relied completely on management for all their information about the business.
Judge Kinkeade levied civil penalties and disgorgement payments of $15.5 million against the defendants.
But the Fifth Circuit disagreed.
“While the managers had significant power, the investors, at least formally, were not without countervailing powers,” Chief Judge Stewart wrote. “Most importantly, the investors have the power to remove Arcturus and Aschere as managers with a 60% vote – a power this court has called ‘an essential attribute of a general partner’s authority.’”
The appellate court also rejected the SEC’s argument that investors were forced to rely almost entirely on information from the managers to make their decisions. The judges pointed to numerous emails from investors saying that they were constantly being updated on developments, were provided a 24-hour video surveillance system and were given raw data from drilling operators.
“If the investors and managers had access to the exact same data, the investors could draw their own conclusions about the prospect wells,” Chief Judge Stewart wrote. “The SEC does not point to any facts showing that the consultants presented biased information. Nor does the SEC point to any facts showing that the managers misled the investors with false or altered information.”
The Fifth Circuit also rejected the SEC’s claim – and the trial court’s finding – that the investors were inexperienced about oil and gas drilling investments.
“Through competing summary judgment motions, both parties asked the court to determine that a pool of over 340 investors had or lacked experience based on limited evidence about roughly 25 [investors],” Chief Judge Stewart wrote. “At summary judgment, the court cannot make factual inferences about roughly 340 investors based on such limited evidence, especially when the evidence is mixed.”
Chris Kratovil, a partner and appellate law expert at Dykema in Dallas, said the Fifth Circuit is making it clear that these kinds of cases are “inherently fact-specific” and require a more in-depth review of the evidence that is “difficult to determine at the summary judgment level.”
“This is a very complicated area of law, but Chief Judge Stewart has provided a roadmap for the SEC and entities looking to offer these kind of investment opportunities within the bounds of the law,” said Kratovil, who is not involved in this litigation.