Friday, January 11, 2019

Questions are raised about investors' profit expectations

By Rodney F. Tonkovic, J.D.

A Fifth Circuit panel remanded a civil enforcement action after finding that there was an issue of fact as to whether partnership interests were really securities. The panel concluded that there were issues of material fact as to whether the investors had any real power over their investments, if they had relevant business experience, or if the managers were effectively irreplaceable (SEC v. Arcturus Corporation, January 7, 2019, Stewart, C.).

In this case, a group of promoters, including Arcturus Corporation, sold interests in oil gas projects to investors. The interests were not registered as securities, and the SEC filed this action in December 2013, alleging violations of the antifraud and registration provisions of the securities laws.

Joint ventures were securities? After about a year and a half of discovery, both parties filed for summary judgment. The district court ruled in favor of the Commission, finding that the interests qualified as securities. The court rejected the promoters' argument that the investments were joint ventures, and thus not securities, because the investors lacked any real power, were inexperienced, and were dependent on the promoters to control the ventures.

Joint ventures were not securities. On appeal, the circuit court reversed and remanded the district court's decision due to significant issues of material fact. Before the district court, the parties agreed that only one Howey factor was at issue: whether the investors expected to profit solely from the efforts of the defendants. In the Fifth Circuit, analysis of this factor is governed by Williamson v. Tucker (5th Cir. 1981), and, as noted, the district court concluded that the drilling interests qualified as securities under the three Williamson factors; a party needs to satisfy only one factor.

The first Williamson factor examines whether the investors had any real power to control the drilling projects. Here, the panel examined the documents setting up the arrangement and how that arrangement functioned in practice. The court concluded that the record showed: (1) the investors had formal powers, (2) they used these powers, (3) the voting structure was not necessarily coercive, (4) the investors received information, (5) they communicated with each other, and (6) the number of investors was not so high that it eliminated all of their power.

The second factor looks at whether the investors were so inexperienced that they could not intelligently exercise their powers. The Commission pointed to the defendants' cold-calling campaign that did not specifically seek experienced investors and to statements by four investors that they lacked experience in drilling investments. The record showed, however, that the investors not only had experience in oil and gas drilling, but that the promoters made it clear that only qualified investors were eligible. Taken together, these facts raised an issue about the investors' knowledge and experience, the court said.

Finally, the third Williamson factor concerns how dependent the investors are on any unique capabilities that the managers possess. Despite the SEC's arguments to the contrary, the panel was not convinced by the record that the managers were contractually irremovable. And, while the managers controlled the investors' funds, with no ability to recoup, this did not make them irreplaceable because the investors knew they would not get their money back unless the wells were productive. In addition, the investors were plausibly able to cut management out of contracts for operations subsequent to the exploratory phase of operations.

In sum, the panel concluded that the promoters raised issues of material fact that the district court failed to consider. The judgment was accordingly reversed and remanded.

The case is No. 17-10503.