Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981) (referred to herein as “Williamson”) stands for the proposition that owner’s interests in joint ventures organized as general partnerships where the general partners participate in the management of the assets involved should not be treated as “securities” for regulation under federal and state law. Many courts have interpreted Williamson to create a “presumption” that general partnership interests are not securities. As indicated in Williamson itself in 1981, that interpretation is not accurate but, as is usually the case with difficult questions before the courts, “depends on the facts and circumstances.”
Howey and Williamson – The Cornerstones
In Williamson, the Fifth Circuit began its analysis to determine whether the joint venture interests were securities “where all analyses of investment contracts start, with SEC v. W. J. Howey Co., 328 U.S. 293 (1946).” In deciding Howey, the Court defined an investment contract as follows:
In other words, an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of a promoter or a third party.
The transaction in question in Williamson involved real estate joint ventures formed as general partnerships under Texas law which had three complaining partners. The first two Howey factors were easy for the Williamson court to find – (1) the investment of money (2) in a common enterprise. The Fifth Circuit found that while showing that general partnership or joint venture interests are securities may be difficult based on the third Howey factor (reliance on the efforts of others), that conclusion can be reached based on a facts and circumstances test if the complaining investor can establish one of three factors:
- The agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership;
- The partner or venturer is so inexperienced and unknowledgeable in business affairs that he or she is incapable of exercising his or her partnership or venture powers; or
- The partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he or she cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.
In Williamson, the Fifth Circuit determined that securities were not involved in that arrangement based on the plaintiffs’ inability to show the existence of one of the three Williamson factors.
Many subsequent cases reciting Williamson have significantly different facts than the limited number of investors involved in the original Williamson case. In Colorado, the Colorado Securities Division, through an administrative action that started in May 2002 and followed by litigation in state court that was filed in 2009, attempted to enjoin HEI Resources from selling joint venture interests in a number of oil and gas exploration projects. As in Williamson, the joint ventures were formed as Texas general partnerships. Unlike Williamson, however, HEI Resources had agents cold call a number of investors throughout the country with whom HEI Resources had no prior relationship, with nominal knowledge about oil and gas activities. When challenged by the Colorado Division of Securities, HEI Resources and the other defendants asked the Colorado courts to dismiss the litigation based on the Williamson “strong presumption” that general partnership interests were not securities.
In the 2002 administrative action, the Colorado Securities Commissioner did not find sufficient evidence to determine whether a security was involved. In two (2012 and 2013) district court decisions after the state litigation was filed, the judges applied the presumption and found that securities were not involved. In 2014 the Colorado Court of Appeals reversed the trial courts, holding that the Williamson presumption was “inconsistent with the economic realities test.” In April 2016 after retrial, the Denver District Court concluded that the joint venture interests in question were securities under Colorado law and that the defendants did in fact offer and sell securities. A trial on the remaining issues was held and in 2018 the Denver District Court reaffirmed its conclusion that the oil and gas joint venture interests were securities. That decision was, however, reversed by a Court of Appeals panel in 2020. The Court of Appeals said that it was “convinced that the prior division’s decision [was] out of step with the applicable law,” and reversed and remanded the case to the trial court to determine “whether the joint venture interests constitute investment contracts based on the record developed to date.”
The Colorado Supreme Court Speaks
In June 2022, the Colorado Supreme Court finally looked at the issues in Chan v. HEI Resources, Inc. The Supreme Court discussed Williamson at length and concluded that Colorado courts had previously given too much emphasis to the so-called “Williamson presumption.”
In its 2022 Order, the Colorado Supreme Court decided that the “strong presumption” set forth in a number of cases interpreting Williamson does not apply in Colorado. The Court specifically stated that while the Williamson presumption that general partnership interests are not securities in Colorado may apply, this is not a “strong presumption” which increases the plaintiff’s burden of proof above the normal “preponderance of the evidence burden generally applicable in civil litigation.” Based on the Court’s ruling, the Williamson presumption is merely the requirement that the plaintiff bears the burden of proof of showing that the joint venture interests involved in HEI Resources were securities.
Again, the first two Howey factors were not an issue – the joint ventures were clearly an investment of money in a common enterprise. In analyzing the third Howey factor (reliance on the efforts of others) and after considering the further explanation provided in the three Williamson factors, the Colorado Supreme Court determined that:
- The first Williamson factor was not at issue because the joint venture agreements at issue did not leave “little power” in the hands of the investors. The agreements provided expansive power as is typical of general partnerships.
- The Commissioner’s interpretation of the “business sophistication” requirement in the second Williamson factor was too restrictive. The Commissioner argued that it should be interpreted as being “industry specific” knowledge, but the Supreme Court held that such an approach “would be too narrow.” While there may be instances where specialized knowledge (or the lack thereof) may be relevant, it is not always required. The Court also set out a number of questions that courts should consider when determining whether investors possess sufficient knowledge or experience “in evaluating the economic realities of a venture.”
- In considering the third Williamson factor (whether the operation of the venture required specialized knowledge), the Court recognized that partners could “delegate day-to-day management responsibilities but still retain ultimate control over the business.” Further the partners “do not themselves need to have the skills to manage the venture in place of the manager.” On remand, the Colorado Supreme Court directed the lower courts to consider “whether the general partners can realistically, in accordance with their partnership powers, find a reasonable replacement for the manager.”
Importantly, the Colorado Supreme Court recognized that the three Williamson’s factors that the Fifth Circuit had set forth were not themselves “exhaustive.” Other factors could be considered – such as the Colorado Securities Commissioner’s economic realities approach as redefined by the Colorado Supreme Court:
“[A]pplication of a presumption beyond the established burden of proof ignores a core tenet of securities law: Courts should look to the substantive, economic realities of a particular instrument, scheme, or transaction when determining whether it fits the definition of a security. . . . [T]he obligation to look at economic realities requires an examination not only of form but also of the substance of a particular venture.”
“An overly expansive approach to “economic realities” would effectively undermine the value of applying Williamson to the particular context of general partnership interests. As may be clear by now, we find the logic of the Williamson framework compelling, and we consider the framework bound by both the principles of general partnerships and the Howey test.”
In summarizing, the Colorado Supreme Court stated that courts “evaluating whether a general partnership is an investment contract under the [Colorado Securities Act (the “CSA”)] should not start with any presumption beyond that necessarily created by the fact that the plaintiff carries the burden of proof to demonstrate that a particular interest is a security.” Instead:
“When faced with an assertion that an interest in a general partnership is an investment contract and thus within the CSA’s definition of a “security,” the plaintiff bears the burden of proving this claim by a preponderance of the evidence. No presumption beyond that burden applies. Accordingly, we reverse the court of appeals’ judgment on the question of whether courts should apply a “strong presumption,” and we remand the case to the trial court for further findings consistent with this opinion.”
In its June 2022 Opinion, the Colorado Supreme Court recognized that the question as to whether these particular respondents (“HEI Resources” and the other defendants) had sold securities has been disputed for a significant period of time. Nonetheless, the Court went on to say that “[t]oday, we do not resolve that factual dispute. The question before us is not whether these particular interests are securities. Rather, the question is a broader one: How should a court assess a plaintiff’s claim that a particular ‘general partnership’ . . . is in fact operating as an investment contract and thus is a security under the CSA?”
“In remanding this case for proceedings consistent with this opinion, we focus on three aspects of that application. First, a court evaluating whether general partners lack the ability to direct the venture may find that their general business knowledge and expertise is in fact sufficient to permit them to exercise their partnership powers. While industry-specific experience may be relevant, if the general partners lack such experience, that fact alone does not make the partnership an investment contract. Second, if general partners themselves would not be able to serve in the place of the manager, that does not necessarily make the partnership an investment contract; rather, a plaintiff must prove that the general partners cannot realistically replace the manager at all. Third, we conclude that a particular venture’s “economic realities” can appropriately be considered as part of the Williamson framework.”
It is likely that on remand the Colorado court will consider the facts set forth in the order issued by the district court in January 2018 which reached the conclusion that the joint venture interests were securities. Among the facts set forth in that order were the following:
- HEI Resources sold undivided interests in at least seven oil and gas drilling joint ventures organized as general partnerships under the Texas Revised Partnership Act.
- The interests were offered to potential investors who were located in a number of states with whom neither HEI Resources nor its salespeople had any significant pre-existing relationship (except to the extent that a person called was already an investor in an HEI Resources joint venture).
- After the cold call, HEI Resources would mail a “preview package” to those who expressed interest. There were demonstrable overstatements and omissions in the preview package – including that the project production for the new joint ventures was at a rate HEI Resources had never met for any of the 73 previous wells it (and its affiliates) managed.
- After a person decided to invest, HEI Resources would send that person a confidential information memorandum (“CIM”) including information about HEI Resources, legal disclosures, and a personal questionnaire regarding the investor. A prospective investor was required to sign the CIM, complete the questionnaire, and return the documents with the investment funds to HEI Resources. The CIM included disclosure of risks, the investor questionnaire, the turnkey drilling contracts, and other information. Pursuant to the turnkey drilling contracts, investment funds were placed into separate accounts for each venture and then quickly paid to HEI Resources. The investors were never made aware of the compensation that HEI Resources derived from the turnkey drilling contracts.
- After the investment and during the operations, HEI Resources received daily reports on the well drilling activities as well as related financial information. HEI Resources passed those reports on to the investors but did not include the financial information. Contrary to what the court found to be an industry custom, the CIM did not include a risk analysis computation for the wells at various stages of drilling, nor did it disclose that there were a number of dry holes in the area of the proposed wells. Even when the geologic information was questionable regarding completion of the wells, HEI Resources recommended completion. [2018 Order, ¶ III.5.] The CIM also did not disclose that one of the HEI Resources principals had an SEC injunction against him. The CIM also did not disclose that HEI Resources itself had various state proceedings that were ongoing against it.
- The CIM did not disclose the commissions that HEI Resources paid its sales representatives The CIM stated that HEI had a working interest in the properties without disclosing that HEI actually owned a carried working interest, not a full working interest, and thus was not itself responsible for paying any costs for the drilling and development operations.
- In the 2018 order, the court recited testimony from twelve joint venture partners. Common among the investor’s testimony was that they were never clearly advised of the possibility of a dry hole and were assured by the callers of a return on their investment. Most of the investors testified that they reviewed the CIM and knew, or were advised by the callers, that the joint venture was a high risk or speculative investment. In all cases, the initial communication received was a cold call by sales representatives to prospective investor who had no prior relationship with HEI or the caller. The court’s description of the testimony included the joint venture partners describing information that they would like to have known before making their investment, none of which was disclosed by the callers or in the CIM.
The trial court on remand will undoubtedly consider other factors when considering whether the joint venture interests offered by HEI were securities for the purposes of Colorado law. These questions will likely include whether the Williamson analysis is intended to exempt from securities regulation:
- Interests offered to more than eighty investors (compared to sixteen investors in Williamson),
- Where the investors purchased relatively small interests, and
- Where the investors had no real method of control without combining forces with people they do not know living in other states.
Additionally, as pointed out by the Supreme Court, the offerees received inadequate and incomplete information in making their decision to invest.
Conclusion
The HEI Resources saga continues with the remand to the trial court to again determine whether the joint venture interests that have been at issue since 2002 are securities subject to regulation under the CSA. The Court left both Williamson and the “economic realities” tests in place, holding that “the logic of the Williamson framework is compelling,” but the plaintiff (in this case, the Commissioner) “bears the burden of proving this claim by a preponderance of the evidence. No presumption beyond that burden applies.” The Colorado Supreme Court held that the three tests described in Williamson are “nonexhaustive – they are examples of the unusual situations in which a general partnership meets the Howey test, and they were the tests that were relevant (and unsatisfied) in that particular case.” Nothing in the Court’s 2022 order limits the trial court’s consideration of other potentially relevant factors.
The important test here is that if the courts find that the plaintiff Colorado Securities Commissioner does not bear her burden of proof in establishing that the HEI Resources joint venture interests are investment contracts under Howey, Williamson, and the new interpretations the Supreme Court laid out, the Securities Commissioner has no jurisdiction to regulate HEI Resources’ activities.
Nevertheless, in all cases, cautious lawyers should still advise their clients to carefully structure all investment transactions. Full and accurate disclosure is the best course of action, especially when establishing legitimate joint ventures that are not subject to securities regulation, between persons who are substantially equals – each capable of negotiating their own arrangements – found without general public solicitation, and who truly share decision-making power. As Justice Louis Brandeis said in 1914, “Sunlight is said to be the best of disinfectants; electric light is the most efficient policeman…” This is still true in business disclosure 108 years later, whether securities are involved or not.
Herrick Lidstone, Jr., is a shareholder in the law firm of Burns, Figa, and Will PC, where he practices in the areas of business transactions, including taxation, limited liability company and corporate formation and organization, mergers and acquisitions, ethics, and securities.
This post was adapted from his paper, “Chan v. HEI Resources, Inc., The Continuing Saga of Joint Venture Interests as Securities,” available on SSRN.
