Court tackles rules on securities
When is a financial investor buying “securities” versus purchasing a partnership in a joint venture?
The answer, which goes to the heart of scores of securities law violation cases brought by federal agents each year, is determined less by broad principles and standards and much more by specific facts of each case, according to a new court decision in a long-running Texas case.
In a little-noticed opinion issued last week, the U.S. Court of Appeals for the 5th Circuit rewrote the rules determining whether “interests sold” in a business operation are official securities or active partnerships. That rests on 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 appropriate way to weigh those factors is to allow prosecutors and defense lawyers to call witnesses and present evidence in a jury trial, according to the appeals court.
“The decision signals that the SEC may have to do more work and develop more proof before it brings its cases,” said Haynes and Boone partner Kit Addleman, a former regional director of the Securities and Exchange Commission’s Atlanta office.
Legal experts say the appeals court decision is especially significant in the world of oil and gas wildcatting investigations by the SEC. Many small oil and gas operators still use so-called boiler rooms to cold-call potential investors to raise money to fund their projects. Such efforts have led the SEC to file more than a dozen cases alleging securities fraud during the past two years.
In a 37-page opinion, the New Orleans-based appellate court rejected findings of a federal judge in Texas that the operators and managers of several oil and gas drilling projects in Texas violated federal securities laws when they failed to register the interests in the projects they sold to nearly 400 investors as securities.
The dispute started in 2013, when the SEC’s Fort Worth Regional Office charged Leon Ali Parvizian and three Dallas companies he started, Arcturus Corp., Aschere Energy and AMG Energy, with operating a fraudulent oil and gas investment scheme. The SEC also named investment advisers Alfredo Gonzalez, Robert Balunas and R.A. Thomas as co-defendants.
What’s in a name?
The SEC claimed that Parvizian and his companies illegally offered and sold unregistered
securities. The agency also claimed that the defendants raised $22 million from 380 investors between 2007 and 2011. The SEC defines securities as stocks, bonds, notes or warrants representing an ownership share.
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 or so-called partnerships, which they argued are exempt from federal securities regulations.
The federal judge in Texas ruled in favor of 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. The investors also relied completely on management for all their information about the business.
The judge levied civil penalties and disgorgement payments of $15.5 million against the defendants.
But a three-judge panel for the 5th Circuit disagreed.
“While the managers had significant power, the investors, at least formally, were not without countervailing powers,” Chief Judge Carl Stewart wrote.
The appeals court ruled that the investors have the power to remove Arcturus and Aschere as managers.
In addition, the investors were constantly updated on developments, were provided a 24-hour video surveillance system and were given raw data from drilling operators.
Joe Cox, a partner at Bracewell who represents defendants Gonzalez and AMG Energy in the case, said the decision requires the SEC to 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 SEC, in this and other cases, relied on a small sampling of the investors to base its charges. The court said that is insufficient.
‘Sacred right’
The SEC based its case on less than a half dozen investors experiences with the managers. The defense presented more investors that had more positive experiences.
“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 said. “Here, the 5th 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.”