Whether or not certain interests in investment contracts qualify as securities have long been subject to the test set forth in SEC v. W.J. Howey, 328 U.S. 293 (1946). At the end of June, the Fifth Circuit provided additional guidance on one of the Howey factors—whether the investors expect to profit “solely from the efforts of” others.

Securities and Exchange Commission v. Arcturus Corp., et al, No. 17-10503, 2019 WL 2622534 (5th Cir. June 27, 2019) came to the Fifth Circuit on appeal from the district court’s grant of the SEC’s motion for summary judgment holding that the interests in oil and gas drilling joint ventures at issue were securities. The defendants had sold interests in several oil and gas drilling projects to investors, had not registered the interests as securities, and the SEC brought this civil enforcement action.

The Fifth Circuit’s analysis walks through the factors from Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981) used in determining whether investors expect to profit solely from a third-party’s efforts, analyzes how the facts of this case fit into those factors, concludes that fact issues precluding summary judgment, and reverses the grant of summary judgment and remands the case for trial.

Under Williamson, an investor is dependent solely on efforts of others when: “(1) an agreement among the parties leaves so little power in the hands of the partner or venture that the arrangement, in fact, distributes power as would a limited partnership; or (2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or (3) the partner or venture is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership of venture powers.” Williamson, 645 F.2d at 424. Here, the district court held investors had no real control because any powers granted were illusory, investors lacked experience because the interests were marketed through a broad cold-calling campaign, and investors were reliant on the managers because the manager controlled the assets and a replacement manager would not have access to those assets. Arcturus, No. 17-10502, 2019 WL 2622534 at *5.

The Fifth Circuit analyzed each of the Williamson factors at length, eschewing a cookie-cutter approach to applying the definition of “securities” and instead highlighting that the nuances and realities of a given business venture and its participants play key roles in determining whether the interest is a security.

For example, when evaluating the powers of the parties, the Court highlighted that the joint venture agreement allowed investors to remove the managers with a 60% vote and that almost all of the Managers’ powers were subject to veto by the investors. Arcturus, No. 17-10502, 2019 WL 2622534 at *8-9. The Court also highlighted that there was evidence that investors held votes and, in so doing, actually exercised the powers granted in the joint venture agreement. Id. at *9. The Court also evaluated the voting structure of the venture, how the investors received information, how the investors communicated with each other and the number of investors. Id. *9-12. Likewise for the other Williamson factors, the Court went into great factual detail and determined that fact issues existed to preclude summary judgment due to a mixed and/or incomplete record on issues such as the experience of the investors (there was only evidence in the summary judgment record as to the experience of about 25 of the 340 investors) and whether the managers were effectively irremovable due to their control of the assets. Id. at *13-18.

In short, the Arcturus opinion provides a map for transactions and litigation alike to explain the pertinent facts that would inform the determination of whether interests in a joint venture are securities. It provides a clear message that whether an interest is a security is an inquiry that must be made based on the facts of any given business arrangement and which litigants should be prepared to support with evidence in order to make their case.

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