Fractional equity investments in oil and gas exploration and production projects generally are securities under U.S. and Texas Law. Federal securities law defines “security” to include fractional interests in mineral leases. Undivided leasehold interests do not fit within the definition, but may be found to be securities in the form of investment contracts per the U.S. Supreme Court’s 1943 decision SEC v. C.M. Joiner Leasing Corporation. In 1988, the Fifth Circuit, which covers Texas, held in Adena Exploration v. Sylvan that a 25 percent working interest purchased by a sophisticated oil and gas industry investor was a security. The Texas Securities Act also encompasses fractional interests in mineral leases. Those who sell these interests can be subject to the federal and state broker-dealer requirements. 

            Securities regulators will generally find that recipients of transaction-based compensation relating to the sale of securities are acting as securities broker and are required to be registered   The SEC’s Division of Trading and Markets states that whether a broker fits this definition depends on several factors, including:

1)      Does the person “participate in important parts of the securities transaction, including solicitation, negotiation, or execution of the transaction?”

2)      Does the compensation depend on the success or size of the transaction?

3)      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. There is no federal broker-dealer exemption for selling solely to institutional investors or oil and gas industry participants. Texas exempts persons who sell to wealthy institutions from mandatory broker-dealer registration, but not those who sell to wealthy individuals. Finally, federal law generally requires a broker to be “engaged in the business” so it may not encompass one-off events. Texas law has no such de minimis exemption from the registered broker requirements. 

Issuers who pay transaction-based compensation to non-exempt, unregistered broker-dealers incur several risks. The Texas Securities Commissioner has summary cease and desist authority, meaning she 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, cease and desist orders can be enforced in court. Third, the issuer may be prohibited from selling securities in Texas in the future. Finally, as to the brokers, Texas has criminal prohibitions against selling securities without a license and prohibits non-exempt unregistered brokers from enforcing their commission agreements. 

Issuers may also face risks from private litigants. Securities registration exemptions generally prohibit paying compensation to non-exempt unregistered broker-dealers. So paying transaction-based compensation to such brokers may provide cause for the investor to seek to rescind the investment. 

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