SEC. & Exch. Comm'n v. Sethi , 910 F.3d 198 ( 2018 )

Case: 17-41022 Document: 00514747886 Page: 1 Date Filed: 12/04/2018
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
United States Court of Appeals
Fifth Circuit
No. 17-41022 FILED
December 4, 2018
Lyle W. Cayce
SECURITIES AND EXCHANGE COMMISSION, Clerk
Plaintiff - Appellee
v.
SAMEER P. SETHI,
Defendant - Appellant
Appeal from the United States District Court
for the Eastern District of Texas
Before STEWART, Chief Judge, and KING and OWEN, Circuit Judges.
CARL E. STEWART, Chief Judge:
Sameer P. Sethi sold interests in an oil and gas joint venture. He
promised investors partnerships with world-famous oil companies and large
returns. The SEC wasn’t buying it—not only did Sethi fail to register his
interests as securities, he materially misrepresented his relationships with
large oil companies. The SEC filed claims against Sethi under Section 10(b) of
the Securities Exchange Act, 15 U.S.C. § 78j(b), Rule 10b-5, 17 C.F.R.
§ 240.10b-5, and Section 17(a) of the Securities Act, 15 U.S.C. § 77q(a). Then
the SEC filed a motion for summary judgment. The district court granted the
motion, holding that Sethi offered securities and committed securities fraud.
Sethi appeals. We affirm.
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I.
Sethi sold interests in an oil and gas drilling joint venture. He sold these
interests through his company, Sethi Petroleum, which he founded in 2003 and
manages alone. Sethi sought out investors using a broad cold-calling
campaign. With the help of twenty salespersons, he purchased lead lists and
offered positions in his joint venture to potential investors. When a potential
investor expressed interest, Sethi would determine whether the investor was
“accredited.” If so, he would further promote the venture using two main
documents: a private placement memorandum (“PPM”) and a copy of the joint
venture agreement (“JVA”).
The PPM told investors that Sethi intended to raise $10 million by
selling fifty units at $200,000 apiece. Sethi would then use the investor funds
to purchase mineral interests in an oil and gas development in the Williston
Basin in North Dakota, South Dakota, and Montana. The PPM further
specified that Sethi would use the funds to purchase a 62.5% net working
interest in at least twenty wells, all of which would be operated “by publicly
traded and/or major oil and gas companies,” such as ExxonMobil, Hess
Corporation, and ConocoPhillips. The PPM also made clear that Sethi would
not commingle venture funds with funds from “Sethi Petroleum or any
Affiliate.”
The JVA laid out the rights, duties, and obligations for the investors and
the managing venturer—Sethi Petroleum. While the JVA purported to give
the investors control over the venture’s affairs, it delegated power over the day-
to-day operations to Sethi Petroleum. The JVA also gave Sethi Petroleum the
sole power to distribute profits, execute oil and gas agreements, hire
professionals, and take and hold property. The JVA required a majority vote
of the investors for larger actions, such as acquiring oil and gas interests.
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As a result of his sales efforts, Sethi ended up raising over $4 million
from ninety investors, which he used to purchase a fractional working interest
in eight wells from Irish Oil & Gas, with the interests ranging from 0.15% to
2.5%. Three different operators worked on the wells—Crescent Point Energy
U.S. Corp., Oxy USA Inc., and Slawson Exploration Co. Six of the wells
produced oil, and the operators voluntarily cancelled two other wells.
Over the course of the investments, no evidence shows that a vote or
investor meeting ever occurred.
II.
We review a district court’s grant of summary judgment de novo, using
the same legal standard as the district court. Turner v. Baylor Richardson
Med. Ctr., 476 F.3d 337, 343 (5th Cir. 2007). Summary judgment is
appropriate where there is no genuine issue of material fact and the parties
are entitled to judgment as a matter of law. Id. All reasonable inferences must
be drawn in favor of the nonmovant, but “a party cannot defeat summary
judgment with conclusory allegations, unsubstantiated assertions, or only a
scintilla of evidence.” Id. (internal quotation marks omitted).
III.
On appeal, Sethi challenges two of the district court’s decisions. First,
he argues that the district court erred when it held that interests in his drilling
projects qualified as securities. Second, he argues that the district court erred
in granting summary judgment on the SEC’s securities fraud claims.
A.
Under Section 5 of the Securities Act, it is “unlawful for any person,
directly or indirectly” to use interstate commerce to offer to sell “any security”
unless the person has filed a “registration statement” for the security. 15
U.S.C. § 77e(c). The Securities Act broadly defines the term security to include
a long list of financial instruments, including “investment contracts,” the type
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of security at issue here. See 15 U.S.C. § 77b. While Congress defined the term
“security,” it left it to the courts to define the term “investment contract.” In
Howey, the Supreme Court developed a “flexible” test for determining whether
an arrangement qualifies as an investment contract:
[A]n 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 the promoter or a third party.
SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946). Distilled to its elements,
an investment contract qualifies as a security if it meets three requirements:
“(1) an investment of money; (2) in a common enterprise; and (3) on an
expectation of profits to be derived solely from the efforts of individuals other
than the investor.” Williamson v. Tucker, 645 F.2d 404, 417-18 (5th Cir. 1981)
(citing SEC v. Koskot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974)). Here,
the parties dispute the third factor.
When determining whether investors expect to rely “solely on the efforts
of others,” courts construe the term “solely” “in a flexible manner, not in a
literal sense.” Youmans v. Simon, 791 F.2d 341, 345 (5th Cir. 1986). Courts
read this requirement flexibly “to ensure that the securities laws are not easily
circumvented by agreements requiring a ‘modicum of effort’ on the part of
investors.” Long v. Shultz Cattle Co., 881 F.2d 129, 133 (5th Cir. 1989). The
critical inquiry is whether “the efforts made by those other than the investor
are the undeniably significant ones, those essential managerial efforts which
affect the failure or success of the enterprise.” Williamson, 645 F.2d at 418
(internal citation omitted). Even though an investor might retain “substantial
theoretical control,” courts look beyond formalities and examine whether
investors, in fact, can and do utilize their powers. Affco Invs. 2001, LLC v.
Proskauer Rose, LLP, 625 F.3d 185, 190 (5th Cir. 2010).
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Here, the court must apply these general principles to a partnership. 1
While we employ a “strong presumption” that “a general partnership . . . is not
a security,” Nunez v. Robin, 415 F. App’x 586, 589 (5th Cir. 2011) (per curiam)
(unpublished) (quoting Youmans, 791 F.2d at 344), this court in Williamson
articulated three factors that, if proven, overcome this presumption. These
factors flesh out situations where investors depend on a third-party manager
for their investment’s success, and each factor is sufficient to satisfy the third
Howey factor. Under the Williamson factors, 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 or venturer that the arrangement in fact
distributes power as would a limited partnership; or (2) the
partner or venturer is so inexperienced and unknowledgeable in
business affairs that he is incapable of intelligently exercising his
partnership or venture powers; or (3) the partner or venturer is so
dependent on some unique entrepreneurial or managerial ability
of the promoter or manager that he cannot replace the manager of
the enterprise or otherwise exercise meaningful partnership or
venture powers.
Williamson, 645 F.2d at 422. 2 Courts, however, are not limited to these three
factors—other factors could “also give rise to such a dependence on the
promoter or manager that the exercise of partnership powers would be
1 This court applies the same analysis to partnerships and joint ventures. Youmans,
791 F.2d at 346 n.2 (“Our discussion of partnerships applies with equal force to joint ventures
since this kind of business investment device is the same for purposes of the federal securities
laws.”).
2 A number of other circuits have adopted the Williamson factors as a way to analyze
the third Howey factor. See, e.g., SEC v. Shields, 744 F.3d 633, 644 (10th Cir. 2014) (adopting
the Williamson factors); United States v. Leonard, 529 F.3d 83, 90-91 (2d Cir. 2008) (same);
SEC v. Merch. Capital, LLC, 483 F.3d 747, 755-66 (11th Cir. 2007) (same); Stone v. Kirk, 8
F.3d 1079, 1086 (6th Cir. 1993) (same); Koch v. Hankins, 928 F.2d 1471, 1477-81 (9th Cir.
1991) (same); Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d 236, 241
(4th Cir. 1988) (same).
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effectively precluded.” Id. But regardless of which factor is at issue, a party
can only prove one of the Williamson factors by looking to the unique facts of
the arrangement at issue. Differently put, a party faces a “factual burden”
when proving one of the Williamson factors. Id. at 425.
The first Williamson factor is whether the drilling projects left the
investors so little power “that the arrangement in fact distribute[d] power as
would a limited partnership.” Id. at 422. In determining whether an
arrangement deprives investors of power, courts look to two sources of
evidence. First, courts look to the legal documents setting up the arrangement
to see if investors were given formal powers. See, e.g., id. at 424 (looking to the
“partnership agreement” to see if partners were given power). Second, courts
examine how the arrangement functioned in practice. How the arrangement
functioned is typically the most important indication of whether investors had
power. 3 See, e.g., Nunez, 415 F. App’x at 590 (looking to the fact that an
investor exercised power over the partnership’s finances); Long, 881 F.2d at
134 (crediting the jury’s conclusion that investors, in practice, followed the
manager’s recommendations).
Here, the governing venture documents gave investors some theoretical
power to control the drilling projects. Importantly, they had the power to
remove Sethi as manager. See Youmans, 791 F.2d at 347 (holding that the
3 Post-investment conduct is relevant for determining the expectations of the parties
at the time they entered the drilling investment contracts, as other circuits have held.
Shields, 744 F.3d at 646; see also Merch. Capital, LLC, 483 F.3d at 760; Koch, 928 F.2d at
1478 (looking to the “practical possibility of the investors exercising the powers they
possessed pursuant to the partnership agreements.”). Although the Fifth Circuit has not
explicitly held that courts may look to post-investment activity, nearly every case has in fact
analyzed such activity. See, e.g., Nunez, 415 F. App’x at 590 (looking to the fact that the
investor exercised power over the partnership’s finances); Long, 881 F.2d at 134 (crediting
the jury’s conclusion that investors followed the manager’s recommendations); Youmans, 791
F.2d at 347 (directing the trial court on remand to further develop the “practical application”
of the relevant contract provisions).
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removal power is “an essential attribute of a general partner’s . . . authority.”).
They also could call meetings and propose amendments with a 20% vote,
develop rules for meetings with a 50% vote, and veto Sethi’s decisions.
These powers, however, were illusory in practice. Sethi blocked
investors from using their powers on numerous occasions. First, and most
tellingly, Sethi was responsible for calling meetings and soliciting votes. He
never did. The investors never held a meeting and did not vote on any matter.
A receiver appointed by the district court also found no evidence that Sethi
ever “organized a vote or solicited input of any kind from investors.” While
Sethi contends that the project was in its early stages, the SEC provided
evidence that Sethi took several actions without informing investors. When he
purchased well interests for the venture, he did not inform the investors or
solicit any investor approval, even though this approval was required by the
JVA. He did not notify investors when he sued to rescind this interest. Nor
did Sethi ask for any investor input when he drilled eight of twenty wells
promised in the PPM.
Second, Sethi gave the investors little to no information. The investors
did not have access to the project’s books. One investor, Michael Martin,
declared that Sethi’s employees stymied his efforts to gather information on
numerous occasions, denying him promised “up-to-date” reports and
repeatedly failing to return his calls and emails. Other investors corroborated
Martin’s story, declaring that Sethi “never consulted” them on “business
matters” and failed to provide “promised quarterly updates.” The district
court’s receiver further supported this evidence, concluding that Sethi “actively
sought to minimize transparency with investors and limit the information to
be made available to, and the involvement of, the investors.” Without
“sufficient information,” investors could not “make meaningful decisions”
about their investments. Merch. Capital, 483 F.3d at 759.
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Sethi does not provide any evidence to the contrary. He correctly states
the law in arguing that a voluntarily passive investor cannot transform an
investment into a security. See Rivanna Trawlers Unlimited, 840 F.2d at 240-
41. Sethi did not, however, support this argument with any evidence.
Meanwhile, the SEC provided summary judgment evidence that investors did
seek to use their powers but could not. Sethi also argues—again without
evidence—that investors might have been actively monitoring their
investments. But overcoming a motion for summary judgment requires Sethi
to do more than provide “unsubstantiated assertions.” Turner, 476 F.3d at 343.
In sum, the SEC provided unrebutted evidence showing that the
investors could not use their legal powers. As a result, the district court
correctly concluded that Sethi’s drilling projects distributed power as if they
were limited partnerships. Because we agree that the first Williamson factor
was met, we do not address the second and third factors.
B.
Sethi also argues that the district court erred when it granted the SEC’s
motion for summary judgment on its securities fraud claims under Section
10(b) of the Exchange Act, Rule 10b-5, and Section 17(a) of the Securities Act.
Section 10(b) of the Exchange Act makes it unlawful “[t]o use or employ,
in connection with the purchase or sale of any security . . . any manipulative
or deceptive device or contrivance in contravention of such rules and
regulations as the Commission may prescribe as necessary or appropriate in
the public interest or for the protection of investors.” 15 U.S.C. § 78j(b). Under
the power granted by this statute, the SEC created Rule 10b-5, which makes
it unlawful for any person, directly or indirectly:
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to
state a material fact necessary in order to make the statements
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made, in the light of the circumstances under which they were
made, not misleading, or
(c) To engage in any act, practice, or course of business which
operates or would operate as a fraud or deceit upon any person
17 C.F.R. § 240.10b-5.
To prove a violation of Rule 10b-5 4 for material representations or
misleading omissions, the SEC must prove three elements: “(1) material
misrepresentations or materially misleading omissions, (2) in connection with
the purchase or sale of securities, (3) made with scienter.” SEC v. Seghers, 298
F. App’x 319, 327 (5th Cir. 2008) (unpublished) (per curiam) (citing Aaron v.
SEC, 446 U.S. 680, 695 (1980)). To show that a defendant has violated
§ 17(a)(2) or (a)(3), the SEC must show the same elements as for Rule 10b-5,
except that it need only prove “the defendant acted with negligence.” Id.
Here, the parties dispute the first and third elements of this test,
material misrepresentation and scienter. Under Rule 10b-5, a defendant
makes a misrepresentation when “the information disclosed, understood as a
whole, would mislead a reasonable potential investor.” Laird v. Integrated
Recs., Inc., 897 F.2d 826, 832 (5th Cir. 1990). The scope of this standard is
determined by the relative status and sophistication of the parties. Id. The
defendant’s misrepresentation is material “if there is a substantial likelihood
that a reasonable investor would consider the information important in
making a decision to invest.” ABC Arbitrage Plaintiffs Grp. v. Tchuruk, 291
F.3d 336, 359 (5th Cir. 2002). To prove scienter, the SEC need only prove that
the defendant acted with severe recklessness. Broad v. Rockwell Int’l Corp.,
642 F.2d 929, 961 (5th Cir. 1981) (en banc). Severe recklessness is defined as
“those highly unreasonable omissions or misrepresentations that involve not
4The scope of liability under Section 10(b) and Rule 10b–5 is the same. See SEC v.
Zandford, 535 U.S. 813, 816 n.1 (2002).
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merely simple or even inexcusable negligence, but an extreme departure from
the standards of ordinary care, and that present a danger of misleading buyers
or sellers which is either known to the defendant or is so obvious that the
defendant must have been aware of it.” Id. at 961-62.
Sethi primarily argues that he did not make any misrepresentations at
all. He also suggests that he did not act with scienter. We are not persuaded.
Sethi’s brief cites no summary judgment evidence to support his conclusory
arguments. Meanwhile, the district court, relying on unrebutted evidence,
held that Sethi misstated his relationships with major oil companies when
offering interests in his drilling venture and, as a result, misled investors. The
record supports the district court’s findings.
In communications with prospective investors, Sethi and his employees
made several statements concerning his relationships with major oil
companies. His cold-call script emphasized the venture’s current relationship
with “HUGE, PUBLICLY traded companies, like Conoco Phillips, Continental,
GMXR just to name a few.” The script also claimed that the venture was
“working DIRECTLY with these major companies.” Affidavits confirm this
evidence. One investor declared that Sethi told him that “Sethi Petroleum was
partnering with Exxon Mobil and other major oil companies to drill and
operate.” A former cold-caller also declared that Sethi instructed him to
emphasize Sethi Petroleum’s relationships with “major oil and gas companies.”
Sethi did not stop these representations after the initial call—the
offering documents also portrayed Sethi Petroleum as having current
partnerships with several major oil and gas companies. The Executive
Summary represented that “all” of the venture’s wells would be drilled by
“Exxon Mobil (XOM), Conoco Phillips (COP), Continental Resources (CLR),
Hess Corp. (HES), and several others, all of whom have extensive drilling
experience in the Williston Basin.” The PPM told investors that “publicly
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traded and/or major oil and gas companies” would drill the venture’s wells.
The PPM also specifically mentioned the four companies listed above as
examples of the type of company that would drill the venture’s wells.
Taken together, Sethi’s statements suggest that Sethi Petroleum had
preexisting relationships with some of the largest oil companies in the world—
relationships that Sethi would leverage in the venture’s favor. In reality, these
relationships did not exist. No evidence in the record indicates that Sethi
Petroleum had any preexisting relationship with any of the listed companies
or ones that are similar. Nor does the record show that the venture ever
partnered with Exxon Mobil, Conoco Phillips, or a similar company. In fact,
Sethi acquired the venture’s only well interests from Irish Oil & Gas, Inc.—a
small, private oil company. Three other companies—Crescent Point Energy
U.S. Corp., Slawson Exploration Co., and Oxy USA Inc.—operated the wells.
Sethi does not point us to any contrary evidence. Sethi also offers no evidence
that either Crescent Point Energy or Slawson Exploration are of the same scale
and notoriety as the major oil companies touted in the offering documents. And
while Oxy USA is a subsidiary of Occidental Petroleum, a major oil company,
Sethi offers no evidence about whether and to what extent Occidental
Petroleum was involved in the well operation. Nor does he present any
evidence of a preexisting relationship with Oxy USA or Occidental Petroleum.
The district court correctly concluded that these facts constitute a
misstatement.
These facts also establish scienter. Sethi knew that he did not have
relationships with the listed companies, and Sethi does not dispute that the
venture never partnered with a major oil company. 5 Nevertheless, he
5Sethi contends that he relied on consultants when he made these statements and,
therefore, did not act with scienter. Again, however, he provides no evidence to support his
argument. Nowhere in the record do we find any sign that Sethi relied on statements by his
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repeatedly represented that he had relationships with several major oil
companies, and he used these representations as a tool to entice investors. By
touting his relationships with major oil companies, Sethi created a “danger of
misleading buyers” into believing that his venture would be well-managed and
their investments would be in the hands of the most successful drillers in the
world. Broad, 642 F.2d at 961.
In sum, the district court correctly found that Sethi made material
misstatements to investors when he knowingly misrepresented his
relationships with major oil companies.
IV.
For the foregoing reasons, the judgment of the district court is
AFFIRMED.
consultants, or that consultants ever made statements about Sethi Petroleum’s relationships
with major oil companies.
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