In SEC v. Shields, No. 12-1438, 2014 U.S. App. LEXIS 3369 (10th Cir. Feb. 24, 2014), the United States Court of Appeals for the Tenth Circuit reversed the district court’s order granting defendants’ motion to dismiss, holding that the complaint alleged sufficient facts to (1) raise a plausible claim that the interests at issue involved are securities, and (2) rebut the presumption that an investment labeled as a “general partnership” is a “security.”  The Tenth Circuit’s holding reaffirms that although an investment may be labeled as a “general partnership” interest, courts must look beyond the labels to determine whether the investment constitutes a “security.”

The Securities & Exchange Commission (“SEC”) filed a civil enforcement action against Jeffory Shields a/k/a Jeffrey D. Shields, Geodynamics, Inc. (“Geodynamics”), four joint ventures and others, alleging violations of Sections 5(a) and 17(a) of the Securities Act of 1933, 15 U.S.C. §§ 77e(a), 77e(c), 77q(a); Sections 10(b) and 16(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78o(a); and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5.  The SEC alleged that Shields, managing partner of Geodynamics, offered and sold over $5 million of interests in oil and gas exploration and drilling joint ventures to sixty investors across 28 states.  The money collected was used to fund GeoDynamics.  Shields allegedly marketed the oil and gas drilling ventures to individuals with little experience in the oil and gas exploration business by making cold calls to thousands of people and promising annual returns of between 256% and 548%.  The SEC alleged that Shields denied investors access to information, lied to investors to keep them misinformed and comingled funds.

Shields provided potential investors with offering documents which stated explicitly that the investors had the rights of general partners, and that the joint venture interests were not securities.  In addition, the documents provided the investors with the power to remove the managing venturer, GeoDynamics, the right to terminate the partnership, and the right to inspect records.  However, unlike GeoDynamics, the investors did not have the power to bind the joint ventures by executing contracts, spending funds, or interpreting contracts.  Additionally, the investors were required to sign drilling and completion contracts, thereby locking themselves into contracts with GeoDynamics, who unilaterally set the contract price.

Defendants moved to dismiss the SEC’s complaint.  Defendants asserted that the investments at issue were general partnership interests, as stated in and evidenced by the agreements, not securities.  Because they were not securities, defendants argued, the SEC failed to state a claim upon which relief could be granted. The United States District Court for the District of Colorado granted defendants’ motion to dismiss.  The district court reasoned that the SEC’s allegations were “insufficient to state a plausible claim that the joint venture interests at issue” were securities.  The SEC appealed.

The Tenth Circuit reversed. The Court acknowledged that an investment contract, which is a type of security, exists where there is “(1) an investment, (2) in a common enterprise, (3) a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  The Court focused solely on the third requirement.  The third requirement is satisfied, the Court explained, when the efforts of individuals other than the investor significantly affect the “success or failure of the enterprise.” Additionally, the Court acknowledged that while there is a general presumption that a general partnership is not a security, this presumption is rebuttable.  The Court looked to Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981), which provided examples of situations when a general partnership can be a security, such as when the agreement leaves little power in the partner’s hands, when the partner lacks experience and knowledge that he or she is incapable of exercising his or her partnership powers, or where the partner is so dependent on a unique entrepreneurial or managerial ability that he or she cannot replace the manager or exercise his or her partnership powers.

Based upon these principles, the Tenth Circuit held that the allegations in the complaint raised a plausible claim that the interests involved were securities.  Specifically, the SEC raised issues of fact regarding whether the investors were relying upon the efforts of GeoDynamics and Shields to “significantly affect the outcome of the ventures.”  Additionally, the Court held that the SEC alleged sufficient facts to “rebut the presumption that the purported general partnerships here [were] not securities.”  The Court reasoned that the complaint satisfied the factors in Williamson to rebut the presumption, as the SEC alleged facts to show that the investors had limited power to control or manage the investment — even if they removed GeoDynamics as the manager, they were still locked into contracts with GeoDynamics.  These contracts were the key ways in which the investors would make profits.  Thus, the investors were required to rely on GeoDynamics for the success of their joint venture.

Also, the SEC alleged that the investors had little or no experience in the oil and gas drilling business, which meant that they relied upon Shields to provide them with the necessary information.  The Court held that this raised a factual issue as to whether their voting rights, which were provided in the agreements, were illusory or a sham.  Additionally, the SEC alleged that Shields marketed GeoDynamics as having a unique expertise in the oil and gas industry, so much so that he was able to offer annual profits of 256% and 548%.  The Court held that the investors’ lack of experience in the industry combined with the GeoDynamics’ expertise, forced the investors to completely rely upon GeoDynamics, thereby raising an issue of fact as to whether the investors had any other alternative than to continue with GeoDynamics.  Thus, the investors lacked the control or management abilities of general partners.

The Court in Shields held that the district court erred because it “focused only on the form of the [joint venture agreements] . . . without considering the economic realities of the transactions and the investors’ lack of access to information needed in order to actually use the powers reserved to them under the [agreements].”  Although an agreement may expressly state that the parties involved are general partners and that the interests are not securities, such interests may still be considered securities and subject to federal securities regulations if the agreement is found to be an investment contract or the facts show that the presumption that a general partnership is not a security is rebutted.  As confirmed by Shields, parties may be subject to federal securities regulations even if they explicitly state in their agreements that the interests involved are general partnerships and not securities.