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From Securities Regulation Daily, February 25, 2014

Trial court to rethink holding that JVAs are not securities under evolved circuit law

By Mark S. Nelson, J.D.

The SEC will get another chance to bring civil fraud charges against Colorado resident, Jeffory D. Shields, now that the U.S. Court of Appeals for the Tenth Circuit has held that the oil and gas joint venture agreements (JVAs) Shields allegedly marketed to investors may be investment contracts within the meaning of “security” under the federal securities laws. The Tenth Circuit said the district court should have looked more closely at the JVAs’ economic realities and at investors’ lack of power over the ventures. The case was remanded to the district court (SEC v. Shields, et al, February 24, 2014, Seymour, S.).

The case is similar to one from the Ninth Circuit, in which that court held the opposite, that hotel room and rental agreements were not investment contracts or securities based on the economic realities of two distinct transactions and the lack of allegations that rental management agreements induced investors to buy properties. The SEC had argued as amicus curiae that the rooms and rental agreements should be treated as securities. The Supreme Court denied a petition for certiorari in the case yesterday (Salameh v. Tarsadia Hotel, No. 13-763, December 24, 2013).

Background. Shields formed GeoDynamics in Colorado in September 2009 in order to market interests in oil and gas joint ventures to investors. According to the SEC’s complaint and the offering documents, Shields was GeoDynamics’s managing partner or venturer and raised $5 million from 60 investors in 28 states. Shields’s solo operation had grown by 2010 to employ nearly a dozen salespersons who each made more than 400 daily cold calls to thousands of members of the general public touting the special skills Shields and GeoDynamics could use to generate outsized profits.

In its 2011 complaint, the SEC alleged that despite plying investors with documents that seemed to give them general partner-like powers, Shields and GeoDynamics instead locked investors into services contracts that stripped them of these powers. The SEC also alleged that investors’ funds were funneled into accounts held by Shields and then used by him to acquire luxury items, including private jets and helicopters, automobiles, homes, jewelry, and to make cash withdrawals. Other funds were used to pay business expenses in amounts that eclipsed those permitted to be reimbursed to the managing venturer.

The SEC had alleged that the JVAs were securities and that the activities of Shields and GeoDynamics violated applicable federal securities laws and regulations. The district court dismissed the SEC’s complaint because it said the form of the JVAs took them outside the scope of the federal securities laws. The Tenth Circuit reversed and remanded.

Colorado authorities previously sued Shields for fraud, and he is now jailed there. Although Shields represented himself in the Tenth Circuit, and did not formally reply to the SEC’s brief, he said in a letter filed with the court that he would oppose the SEC by joining the brief filed by amicus curiae The American Energy Joint Venture Association.

Fifth Circuit factors. The Tenth Circuit noted that while the Securities Act and the Exchange Act definitions of “security” are not perfectly matched, they are “essentially identical in meaning” (citing the Supreme Court’s 2004 opinion in SEC v. Edwards). Before the court could apply the Supreme Court’s Howey test for investment contracts, however, it had to decide if it should continue to follow Tenth Circuit precedent on when a venture structured as a general partnership can be an investment contract or security.

The Tenth Circuit adheres to a “strong presumption” that a general partnership is not a security because the partners all have power over the venture’s affairs. Here, the JVAs were set up as general partnerships. The SEC urged the court to abandon the Tenth Circuit presumption, but the court declined the invitation to reshape circuit law to that degree.

Instead, the Tenth Circuit opted to use the Fifth Circuit’s Williamson factors, also at the SEC’s urging. A prior Tenth Circuit opinion described Williamson as a means to look beyond the general partnership form if the venture’s power is arrayed more like a limited partnership than a general partnership, a partner in the venture is incapable of using his powers, or a venture partner is dependent on the promoter’s unique business skills.

As a result, the Tenth Circuit would let the SEC invoke the Williamson factors to rebut the circuit’s presumption against finding a general partnership to be a security. Said the court, “This case persuades us that, like a number of other circuits, we should adopt the Fifth Circuit’s approach in Williamson and apply its three non-exhaustive examples of how the presumption may be rebutted.” Williamson, the court said, may be used in addition to Supreme Court and Tenth Circuit law to show that a fact question existed about a venture’s security status.

Substance over form. The Tenth Circuit sided with the SEC on the issue of whether the facts here could rebut the presumption against finding a general partnership to be a security. In doing so, the court emphasized Howey’s third prong: whether the venture investors reasonably expected that others’ business skills would generate profits. The court also said the Williamson factors backed its conclusion.

At the SEC’s urging, the court found that the venturers here may not have enjoyed the degree of power typically held by general partners. The court noted that the venturers had to rely on “turnkey” contracts for drilling and other services with GeoDynamics to grow the business. These contracts would persist, said the court, even if the venturers could oust GeoDynamics as the managing venturer.

The Tenth Circuit next found that Shields had marketed the oil and gas JVAs nationally to “thousands” of investors, many of whom lacked any knowledge of the business-workings of joint ventures. As an example, Shields allegedly made hundreds of daily cold calls to prospective investors. Citing Williamson, the court said that the Fifth Circuit’s factors look at the investors’ knowledge, and not that of the venture’s leaders, to avoid a scenario in which potential fraudsters may use general partnership language to cloak a venture’s true purpose.

Moreover, the Tenth Circuit said that investors may have relied on the expertise allegedly possessed by Shields and GeoDynamics. Shields allegedly told prospective investors that his venture could yield annualized profits of 256 to 548 percent. Investors also had to rely on Shields and GeoDynamics due to their lack of savvy about oil and gas ventures.

“When the allegations here are instead viewed in their totality, they state a plausible claim that the powers were illusory, which is sufficient to rebut the presumption that a general partnership is not a security,” said the court.

On remand, the Tenth Circuit said the district court will need to look beyond the form of the JVAs and instead focus on the economic realities and the allegedly uneven power structure of the ventures.

The case is No. 12-1438.

Attorneys: Susan S. McDonald, Senior Litigation Counsel, for the SEC. Jeffory D. Shields a/k/a Jeffrey D. Shields, pro se. Paul H. Schwartz (Shoemaker Ghiselli & Schwartrz LLC) for The American Energy Joint Venture Association.

Companies: GeoDynamics, Inc., f/k/a or d/b/a GeoDynamics Exploration, Inc.; Johnston’s Corner #1 and #2 Joint Venture; GeoDynamics, Inc. Huskies #1 Joint Venture; GeoDynamics Exploration, Inc. Trumpeter #1 and #2 Joint Venture; GeoDynamics, Inc. EVDA #1 Joint Venture; Floribama Oil Corp.; Carbotech, Inc.; Triton Energy Asset Management, Inc., d/b/a Triton Energy Asset Management, LLC; GeoDynamics Property Management, LLC; T.E.A.M. Property Management, LLC, d/b/a T.E.A.M. Property Management; S & P Energy, LLC; Aurum Energy Associates, LLC; UNUM, LLC; The American Energy Joint Venture Association

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