Circuit Court Rejects SEC Claims on Howey Security Test

A central question in all of the crypto currency actions brought by the Commission is whether the interests being offered to investors are in fact securities. The seminal decision is, of course, the 1946 decision of the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 23. If the interests being offered to investors meet the Howey test they are investment contracts which come within the definition of the term security in the Securities Act as well as the Exchange Act. While that test can appear straight forward, in practice its application can be difficult as illustrated by a recent decision by Fifth Circuit, centered on whether the interests being sold in an oil and gas offering were securities. SEC v. Arcturus Corporation, No. 17-10503 (5th Cir. Jan. 7, 2019).


The Commission’s complaint named as defendants Leon Ali Parvizian and his entities, Arcturus Corporation and Aschere Energy LLC. Also named as defendants were promoters Alfredo Gonzalex, AMG Energy, LLC, Robert Balunas and R. Thomas & Co. LLC. Over a period of about four years, beginning in 2007, Parvizian, through Arcturus and Aschere, raised about $22 million from 380 investors. The funds were for interests in oil and gas joint ventures. Defendants did not disclose to investors that the companies were engaged in material litigation. Yet much of the money raised was used to fund that litigation, according to the complaint. Indeed, Mr. Parvizian prematurely called for completion funds on two projects when funding for the litigation was depleted. The complaint alleged violations of Securities Act sections 5(a), 5(c) and 17(a) and Exchange Act sections 10(b) and 15(a). SEC v. Arcturus Corporation, Civil Action No. 3:13-cv-04861 (N.D. Tex. Filed Dec. 12, 2013).

The district court granted summary judgment in favor of the agency. The court concluded that Mr. Prvizian and his entities violated the two fraud sections by offering and selling interests in a drilling project in which they had no rights to share in the profits. The court also found that all of the defendants engaged in the offer and sale of unregistered securities in violation of section 5 of the Securities Act. Messrs. Parvizian, Gonzalex and Balunas, along with AMG Energy and R. Thomas & Co., also acted as unregistered brokers, according to the Court’s March 24, 2016 ruling.

The Circuit Court opinion

The Fifth Circuit reversed and remanded the case to the district court for trial. The critical question on appeal was whether a security was involved in the offerings within the meaning of section 5 of the Securities Act. The investment contract analysis of Howey centers on three critical elements: 1) investment of money; 2) in a common enterprise; 3) based on an expectation of profits to be made solely from the efforts of others. In assessing the question of “solely” through the efforts of others, the issue typically focuses on whether the efforts made by those other than the investor are undeniably significant and essential to the success or failure of the enterprise based on the economic reality of the manner in which the enterprise operated.

Partnership interests such as those involved here may be securities within the meaning of Howey. Typically, however, interests in general partnerships fail the test – investors have sufficient authority and powers negating the need for the protections of the securities laws. Limited partners are different. Their authority is limited. Without significant power they become more like a shareholder and their interest may be viewed as a security.

The line between the two types of partnerships when considering the question of if a security is involved can be assessed by considering three factors set forth in Williamson v Tucker, 645 F. 2d 404 (5th Cir. 1981). Under that test a partner is dependent “solely” on the efforts of a third party manager when: 1) an agreement among the parties leaves so little power in the hands of the partner that the person essentially becomes a limited partner; or 2) the partner is so inexperienced that he is incapable of intelligently exercising his authority; or 3) the partner is so dependent on some unique entrepreneurial or managerial ability of the promoter that he cannot replace the person or exercise any meaningful partnership or venture powers.

The first Williamson factor centers on whether the arrangement deprives investors of power. This requires in the first instance a careful assessment of the legal documents as wells as the economic reality of the situation – how the arrangement functioned in practice. An analysis of the documents demonstrates in this matter demonstrates that “at least formally, [they] give the investors significant control over the drilling projects” which were the focus of the investments. Virtually, all of the “Managers’ powers are subject to an affirmative vote by the investors.”

The authority conferred by the documents to the investors is confirmed by the facts. Fifteen investors submitted affidavits declaring that they had the power to, and did, vote on a variety of decisions. Those claims are confirmed by the record which “does not show that Areturus or Aschere took any significant actions without the investors’ prior approval.”

The court also considered three other factors in assessing the position of the investors: The voting structure, the source of the investors’ information and the number of investors. The evidence on each of these factors undercuts the district court’s decision. While the SEC claimed that the voting structure created a “Hobson’s choice – follow the manager’s recommendation or you are out” in fact those provisions “do not operate like the SEC suggests.” The agency argued that investors who oppose the Manager’s recommendations were kicked out. The Court could not locate any provision in the offering documents supporting this claim. Rather, the documents essentially split the drilling operations between the initial and drilling phases, requiring a vote and payment to continue to completion. Thus, for example, if “an investor votes for completion, he does not lose power because he must pay for completion costs. If the investor thinks the well is a lost cause, then allowing him to abandon his interest also does not strip him of power.”

Sources of power are only important in assessing the overall situation “when the investors do not receive enough information to make an educated decision,” the Court stated. Here that is not the case – investors had “numerous sources of information.” There are a number of emails and other materials illustrating this point which the district court failed to analyze, raising a significant factual issue. And, the number of investors here – 35 to 108, depending on the well, is not so large that it effectively diluted authority. Collectively, an analysis of each of these factors demonstrates that investors had formal authority and used their power. The decision of the district court must be reversed.

Analysis of the second and third Williamson factors does not change the result. While the SEC argues that the investors were so inexperienced that they were essentially dependent on the managers – the second factor – the record does not support this claim. The SEC is correct that a cold call process was used to recruit investors and some admitted to being inexperienced. Other evidence demonstrates that many had experience with oil and gas drilling, raising factual issues. Those facts are consistent with the representations defendants insisted investors make, stating that they are capable of exercising their managerial authority.

Finally, the evidence is not as clear as SEC contends on the question of whether the managers were irreplaceable – the final factor. The arrangements were complex to be sure. That, however, is not sufficient. Nor is the fact that the managers controlled the funds adequate to support this point. The investors “sunk their capital into an exploratory drilling project knowing that they would not get it back unless the well became productive.” Overall the defendants have offered sufficient evidence on the irreplaceable point to establish that there is a genuine issue of fact. Accordingly, the decision of the district court was reversed, and the case remanded for further proceedings.

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