The analysis and conclusions reached by the California appellate court in Consolidated Management Group v. Dept. of Corporations, ___ Cal. Rptr. 3d___, 2008 WL 1850310 (Cal. App. 1st 2008), are not necessarily new. But rarely has an opinion so thoroughly and effectively laid out the prevailing law and its application. In Consolidated, the California appellate court analyzes two issues: 1) whether federal law preempts the California Department of Corporations’ authority to issue a desist and refrain order against the appellants, and 2) whether the interests being sold by the appellants were “securities” for purposes of being covered by the applicable laws.

Detailed Commentary

Background

The petitioners—Consolidated Management Group, a Kansas company, and two of its Kansas-based general partnerships, Hugoton and Anadarko (collectively, “Petitioners”) – purchase oil and gas exploration and drilling equipment and lease the equipment to oil and gas operators. Petitioners offered for sale units of joint venture interests in Hugoton and Anadarko; they hired Guardian Capital Management, an investment management company, to raise capital in Northern California for the two ventures.

The California Department of Corporations (the “Department”) issued a desist and refrain order against Guardian, some of its employees, and Consolidated. The order charged that those named had engaged in general solicitation of the public for the offer and sale of Hugoton and Anadarko units, which were securities subject to qualification under California law, but which were offered and sold without qualification, in violation of the California Corporations Code, section 25110.

The petitioners requested a hearing regarding the Department’s order before an administrative law judge (ALJ), claiming that the order should be dismissed due to federal preemption, and that the joint venture interests were either not securities or, if they were, they were exempt from qualification under the California Code. The ALJ proposed upholding the order, and the Department adopted the ALJ’s decision. Petitioners then filed a petition for writ of administrative mandamus with a trial court in San Francisco, which denied the petition. The petitioners then appealed that decision to the California Court of Appeals, 1st District, which issued its decision upholding the decisions below in Consolidated Management Group LLC et al v. Dept. of Corporations, ___ Cal. Rptr. 3d ___, 2008 WL 1850310 (Cal. App. 1st 2008).

There is no federal preemption if the security has not qualified for a federal exemption

California Code, section 25110, prohibits the sale of securities in California without first qualifying the sale with the state, unless that sale is exempt. Securities are exempt under the California law if they are exempt from registration under the federal law, pursuant to Section 18(b)(4)(D) of the Securities Act of 1933. (Cal. Stat. 25102.1(d)). Even then, offers and sales that are exempt under federal law can only sell in California if a Form D and fees are paid to the state – it’s undisputed that the petitioners filed Form D and paid the fees. (Consolidated, Slip op. p.5).

The federal statute exempts securities if they comply with certain requirements for limited private placements – general solicitations are prohibited under those requirements. (17 C.F.R. §§ 230.506 and 230.502(c) (2007)). It’s undisputed that petitioners made their offers through general solicitations, in violation of the rules for exempt private offerings. (Consolidated, Slip op. p. 5).

Petitioners argued that California is preempted by federal law from requiring qualification of a security in a transaction that is exempt from registration under federal law. Id. They argued that the National Securities Markets Improvement Act of 1996 (NSMIA) preempts state laws requiring registration or qualification of covered securities, including transactions that are exempt under federal law. Id.

Petitioners claimed that their filing of Form D with the state, purporting to be an exempt transaction under federal law, is sufficient to establish preemption in California; any subsequent inquiry as to whether or not the transaction actually qualifies for the federal exemption is implicitly reserved for the federal courts only, thus preempting California from making that determination and subsequently issuing the desist order. Id. at 5, 8.

The Petitioners supported their argument by relying on the minority federal court opinion set forth in Temple v. Gorman, 201 F. Supp. 1238 (SD Fla. 2002). In Temple, the plaintiffs alleged that the defendants had sold unregistered securities in violation of Florida law. Upon reviewing the legislative history of the NSMIA, the Temple court held that the plaintiff’s claim was preempted by NSMIA by virtue of defendant filing Form D, regardless of whether the securities actually complied with the requirements for an exemption. Temple, at 1244.

The Consolidated court flatly rejected the Temple analysis, saying that the NSMIA is unambiguous, thus obviating the need to look at the legislative history. The Consolidated court made it clear that simply filing a Form D and purporting to qualify as an exempt transaction is not enough to skirt proper state qualification. The court wrote: “Offerings must…’actually qualify for a valid federal securities registration exemption in order to enjoy NSMIA preemption.’” (Consolidated, slip op. pp. 7-8 (quoting Brown v. Earthboard Sports USA Inc., 481 F.3d 901, 910 (6th Cir. 2007).

The Consolidated court agreed with other courts voicing this majority analysis, summarizing the primary problem with the Temple holding: “[Other courts’] decisions… note how easily state registration requirements could be circumvented if simply claiming that a transaction is exempt produced preemption.” Consolidated, slip op. p. 8.

Because petitioners filed Form D merely purporting to be exempt under federal law, though their transactions did not actually qualify for federal exemptions, there was no preemption.

Petitioners’ offered joint venture interests were securities

The petitioners argued that, even if there was no preemption, their offers of units in a joint venture does not qualify as a “security” subject to qualification under California law.

Among the list of instruments that are defined as “securities” in California statute section 25019 is an “investment contract.” California courts use one or both of two tests to determine whether a transaction is an investment contract: 1) the “risk capital” test set forth in Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811 , 815 (1961) and 2) the “federal” test of SEC v. W. J. Howey Co., 328 US 293, 298-299 (1946).

The Consolidated court relied upon the federal test, defining an investment contract as “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 the promoter or a third party.” Howey, 329 U.S. at pp. 298-299. The difference between a joint venture interest that is a security versus one that is not is that last part of the Howey definition – the profits come primarily from the efforts of others, rather than from the joint efforts of all partners. Consolidated, slip op. p. 11.

The leading case defining when a general partnership interest constitutes a security under the Howey definition is Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981). The Williamson court offered three factors to consider in determining whether the investor was so dependent on the promoter or third party that he was unable to exercise meaningful partnership powers: 1) the agreement does not actually distribute much power to the investing partner or venturer; 2) the investor is so inexperienced or unknowledgeable in business affairs that he cannot intelligently exercise his partnership powers; or 3) the investor is so dependent upon the unique ability of the promoter or manager that he cannot replace the manager or exercise meaningful partnership powers. Williamson, 645 F.2d at 424. “The focus… is on investor expectations at the time of the original investment.” Consolidated, slip op. p. 12.

The court found that the first Williamson factor worked in petitioners’ favor, as the agreements did provide for collective management and control by all investors/ partners, properly distributing power like a standard general partnership. Id. at p. 12.

Proposed investors’ lack of industry-specific knowledge and experience were symptomatic of a security.

However, the court determined that the second Williamson factor – the lack of experience or knowledge of the proposed investors – weighed against petitioners. The Consolidated court noted a split in jurisdictions in interpreting this factor. The 9th Circuit, for example, looked only at whether the proposed investors had experience or knowledge in business affairs, generally, in any industry. (Holden v. Hagopian, 978 F.2d 1115, 1121 (9th Cir. 1992). The 5th Circuit, on the other hand, looks to see whether the proposed investors have experience or knowledge specifically relevant to the proposed venture – this reflects the analysis originally undertaken in Howey. (Long v. Schultz Cattle Co. Inc. 881 F.2d 129, 135 (5th Cir. 1989)).

The Consolidated court adopted the interpretation of the 5th Circuit, saying that inquiry “takes into account the reality that general business sophistication does not necessarily equip an investor to manage a specialized enterprise.” Consolidated, slip op. p. 13. Applying that standard to petitioners’s circumstance, the court determined that the evidence supported the lower court’s factual finding that the potential investors had no experience in the oil and gas industry and therefore “lack[ed] the knowledge to effectively exercise the managerial powers conferred by the joint venture agreements.” Id.

There was a paragraph in their investors’ questionnaire—which the investors had to initial – in which the investors warranted that they did have extensive experience and knowledge in business affairs such that they could intelligently exercise their management powers. But this provision did not impress the court. Throughout its opinion, the Consolidated court reiterated and applied previous court’s admonitions that substance matters far more than form in determining whether an instrument is an investment contract – regardless of what the offering documents state, the truth lies in how they operate in reality. Consolidated, slip op. pp. 11, 14, 15. The initialed paragraph was not a valid reflection of the actual knowledge and experience of targeted investors.

Proposed investors were essentially dependent on petitioners, also symptomatic of a security

The court found that the third Williamson factor – the investors’ dependence on the unique ability of a promoter or third party – also weighed against petitioners. Although, again, the court noted that petitioners had included provisions in their offering documents specifically stating that potential investors were “prohibited” from relying on the petitioners, the court looked beyond that form to find the substance. Consolidated, slip op. p. 15.

The Court listed the many ways in which targeted investors were essentially wholly dependent upon the expertise and ability of Consolidated: the ventures were purchasing lists of equipment from Consolidated affiliates at a price set by Consolidated. Consolidated, slip op. p. 15. They relied upon Consolidated’s knowledge of and rights to wells with natural gas. Id. Consolidated had already undertaken numerous decisive managerial activities to ensure the success of the ventures even before the offerings were made – significant pre-purchase managerial activities have been held sufficient to satisfy the third Williamson factor. Id. (citing S.E.C. v. Mutual Benefits Corp., 408 F.3d 737, 743-744 (11th Cir. 2005).

Because two of the three Williamson factors indicated that the petitioners’ joint venture interests were in fact securities, the court determined that they were securities, subject to California rules regarding qualification. Consolidated, slip op. p. 16.