Securities regulators will generally find that recipients of transaction-based compensation relating to the sale of securities are acting as securities brokers. The Securities Exchange Act of 1934 defines “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”
John R. Fahy, Whitaker, Chalk, Swindle & Sawyer LLP, Fort Worth
Federal and state securities laws can ensnare unsuspecting persons helping companies raise equity funds for oil and gas E&P projects. Once ensnared by these laws, an unregistered broker can face significant exposures, including criminal prosecution. Further, paying unregistered brokers presents legal and regulatory risks for the issuer, including voiding a claimed Regulation D exemption, receiving a Cease and Desist Order, and providing a legal claim for investors to rescind their investment. So, it is important to know what activities constitute the sale of securities and acting as a securities broker.
Are oil and gas project interests securities?
Equity investments in E&P projects generally are securities. Courts likely will find that limited partnership interests are securities in the form of an investment contract, which is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” Further, even if the program is a joint venture or general partnership, the interest will likely be found to be a security as a fractional interest in a mineral estate in many jurisdictions.
The Securities Act of 1933, which governs the issuance of securities in interstate commerce, defines “security” to include “fractional undivided interest in oil, gas, or other mineral rights.” The Securities Exchange Act of 1934, which governs broker-dealers and the interstate distribution of securities, defines “security” to include “certificate of interest or participation in. . . any oil, gas, or other mineral royalty or lease.”
The US Supreme Court interpreted these provisions in 1943 in SEC v. C.M. Joiner Leasing Corporation. In that case C.M. Joiner attempted to circumvent the fractional mineral interest provisions by selling whole subleases involving as little as two (2) acres rather than selling fractional interests in a larger property. The Supreme Court held that these whole interests, no matter how small, were not securities as fractional mineral interests. But, the court also found that these interests were securities in the form of investment contracts because the widely-dispersed small investors relied upon C.M. Joiner to develop their mineral rights.
Since the C.M. Joiner case, the Third, Fifth, and Tenth Circuits Courts of Appeals, which cover 12 states, have held that fractional mineral interests are securities. In 1988 the Fifth Circuit held that a 25% working interest purchased by a sophisticated oil and gas industry investor was a security in Adena Exploration v. Sylvan. In 1990 the Tenth Circuit held in Cascade Energy and Metals Corporation v. Banks, et. al., that fractional mineral interests sold by a joint venture were securities.
Moreover, all states but Wyoming have definitions of “security” that include fractional mineral interests. For example, Texas, a state integral to oil and gas project financing, defines “security” to include: “certificate or any instrument representing any interest in or under an oil, gas or mining lease, fee or title.”
Texas courts have long held that fractional working interests are securities. In 1940 the Texas Supreme Court held in Kadane v. Clark that commission contracts relating to the sale of oil and gas interests were unenforceable for unregistered broker-dealers. In 1989 an intermediate appellate court held that a 50% working interest in a joint venture was a security in Manley v. State.
In sum, fractional oil and gas interests can be securities. This has three results. First, persons who sell these interests can be subject to the broker-dealer requirements. Second, these interests may need to be registered or sold under a registration exemption. Finally, the anti-fraud provisions of the state and federal securities laws may apply to the transaction. This article addresses only the broker-dealer issue.
What activities require broker-dealer registration?
Securities regulators will generally find that recipients of transaction-based compensation relating to the sale of securities are acting as securities brokers. The Securities Exchange Act of 1934 defines “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” The SEC’s Market Regulation Division states that whether a broker fits this definition depends on several factors, including:
Does the person “participate in important parts of the securities transaction, including solicitation, negotiation, or execution of the transaction?”
Does the compensation depend on the success or size of the transaction?
Is the person otherwise engaged in effecting or facilitating securities transactions?
Securities regulators will focus on transaction-based payments, even if the recipient performed other services, such as advising on investment banking issues. Securities regulators will also look at whether this transaction was a one-time event, or part of a routine business that involves the receipt of transaction-based compensation.
But, significant exemptions exist. Federal law exempts banks and securities broker-dealers that do not sell to out-of-state investors from the broker-dealer requirements. However, there is no broker-dealer exemption for selling solely to institutional investors or oil and gas industry participants.
On the state level, Texas exempts persons who sell to institutions from broker-dealer registration, but does not exempt those who sell to wealthy individuals. California exempts those who reside outside of California and sell to California institutions, but does not exempt California residents who sell to institutional investors.
Florida and New York laws, like federal law, have no broker-dealer exemption for sales to institutional investors. Similarly, some states, including California, Michigan, Mississippi, Oklahoma, and Texas, have varied exemptions for industry deals. Check on the availability of such an exemption with an attorney licensed in that state.
Effects of unregistered securities brokers
Issuers who pay transaction-based compensation to non-exempt, unregistered broker-dealers incur several risks. Many states have summary cease and desist authority, meaning they can issue cease and desist orders without hearing to issuers and unregistered brokers. The order recipients then may challenge the order in a hearing.
These cease and desist orders have several negative effects. First, the issuer may be required to disclose the order in future offerings. Second, states can seek to enforce Cease and Desist Orders in court. Such a court order may prevent the issuer from using the Regulation D Rule 505 registration exemption for five years from the date of the order. Third, the issuer might not be able to sell securities in that state in the future. Finally as to the brokers, many states have criminal prohibitions against selling securities without a license.
Issuers may also face risks from private litigants. Almost all states prohibit paying compensation to non-exempt unregistered broker-dealers as a requirement for private offering exemptions. Thus, paying transaction-based compensation to unregistered persons may lead to a claim that the issuer sold unregistered securities with no exemption, and the investor can seek to rescind the investment.
Becoming registered
Since 1938 Congress has delegated the responsibility for registering broker-dealers and their personnel to the National Association of Securities Dealers (NASD), a self-regulatory organization funded by its members that acts under the SEC’s oversight. If a person becomes licensed with a NASD-member broker-dealer, that person is licensed to sell securities under federal law.
The NASD requires that persons who obtain a securities license pass a background check and an exam. Persons who want to sell oil and gas interests can pass either the Series 7 (General Securities Representative) exam or the Series 22 (Direct Participation Program Limited Representative) exam.
All 50 states will also accept registrants licensed through the NASD who pay the NASD certain fees forwarded to that state. Registered personnel must become licensed in their home states and in states where they have investors. Some states may also accept applications directly without applying through the NASD. But, this is infrequently done because persons registered through the state will be unable to offer securities to out-of-state investors.
New proposals: broker-dealer “light” registration
Recently, several proposals have been made to lessen the registration burden on persons who sell only private offerings. First, in May 2005, the American Bar Association’s Task Force on Private Placement Broker-Dealers published a report and recommendations to the SEC. The task force noted that there is a huge “gray market” for persons helping issuers raise less than $5 million in investor funds populated by promoters, advisors, consultants, “merchant bankers,” and “investment bankers,” few of whom are registered as securities brokers.
The task force proposed that the SEC adopt a limited broker-dealer registration for persons who receive transaction-based compensation in private placement transactions. The registration would include a narrower scope of information on a qualifying exam and fewer record-keeping and net capital requirements. To date the SEC has not acted upon the proposal, and securities brokers who operate across state lines need to continue to comply with SEC securities broker-dealer requirements.
Second, states have begun to create lesser registration requirements for finders. Finders are persons who introduce investors to investment proposals then back away and do not participate in the sales negotiations or make representations on behalf of the issuer. They typically receive transaction-based compensation and thus would fall within the ambit of the definition of securities broker or dealer.
The Michigan Securities Act defines “finder” and requires them to register as investment advisors, which generally is less of an administrative burden than registering as a securities broker, although a finder does not really render investment advice.
In March 2006, Texas proposed a limited securities broker registration for finders that waived the exam requirement and lessened the record-keeping burden. This proposal remains under consideration by the Texas State Securities Board.
In sum, regulatory reforms are being offered. But regulatory processes move slowly, and it will likely be years before there is any consensus on the regulatory solutions. In the meanwhile, issuers seeking equity financing for oil and gas projects should be aware of the risks that unregistered securities broker-dealers bring to the projects.
The author
John R. Fahy [[email protected]] is a securities attorney in private practice in Fort Worth with Whitaker, Chalk, Swindle & Sawyer LLP. He has worked for the US Securities and Exchange Commission’s Fort Worth District Office, managed the Texas State Securities Board’s Houston office, and served as general counsel for two NASD-registered broker-dealers. He previously held the Series 7, 24, and 66 licenses. Fahy earned his law and masters degrees from the University of Texas and his undergraduate degree from Yale.
