A Slippery Mess: Are Oil, Gas Interests Regulated Securities?

A surprising number of businesspeople and lawyers, including securities lawyers, fail to recognize that interests in oil, gas and mineral rights could be considered securities under U.S. federal and state securities laws. Accordingly, if you participate in oil and gas-related investments, you should attempt to determine whether the investment constitutes a security.

As the price of oil climbs from its lows in 2020 and the U.S. Securities and Exchange Commission (SEC) adopts new rules that impose new reporting requirements and restrictions on certain activities of investment advisers to private funds, the question of whether investments in certain oil, gas and mineral rights constitute securities is becoming increasingly important.

The U.S. regulatory regime for private funds has grown considerably since the 1930s and 1940s when Congress adopted the main U.S. securities laws defining a “security” and the U.S. Supreme Court decided the landmark case SEC v. W.J. Howey Co., which provided the touchstone analysis for determining when an investable asset is a security. More than 75 years later, too many businesspeople and their lawyers overlook the fact that interests in oil, gas and mineral rights can be securities under U.S. federal and state securities laws.

And while the consequences of noncompliance with U.S. securities laws have become more acute during that intervening period, courts and the SEC have not provided enough clarity concerning this issue and, instead, have left us with a patchwork of opinions and interpretations that do not fit together precisely like a jigsaw puzzle. The inherent uncertainty of any ex ante analysis, when coupled with the increasingly severe consequences for an incorrect conclusion, begs for new analytical clarification by legislators or regulators, including the SEC.

What is a security?

The definition of a “security” under federal securities laws, as outlined in the Securities Act of 1933 (Securities Act), the Securities Exchange Act of 1934 (Exchange Act), the Investment Advisers Act of 1940 (IAA), and the Investment Company Act of 1940 (ICA) (together the IAA and the ICA are the 1940s Acts), and whose definitions are virtually identical, is broad and encompasses a wide range of financial instruments.

In addition to traditional instruments, such as stocks and stock options, the Securities Act and 1940s Acts expressly include a “fractional undivided interest in an oil, gas, or other mineral rights” in their definitions of a security, and the Exchange Act expressly includes a “certificate of interest in an oil, gas, or mining title or lease” in its definition of a security.

These definitions clearly contemplate encompassing certain rights in oil, gas, other minerals and mining as “securities”; however, these enumerated concepts are unhelpful in delineating which types of rights in oil, gas, other minerals and mining constitute securities and which do not. Accordingly, additional analysis is necessary, and most courts employ a functional approach by analyzing the “economic realities” of the instrument, investment, or other interest in question.

Thanks to the Howey decision and the line of decisions that followed it, the analysis of the economic realities is typically explored by determining whether the particular oil, gas, other mineral or mining interest in question constitutes another specifically listed type of security under the Securities Act, Exchange Act, and 1940s Acts: an “investment contract.”

An investment contract is identified by an investment of money in a common enterprise with profits expected to come primarily from the efforts of others, a principle known as the Howey test. Thanks to the Howey test, the definition of a “security” can be applied to various schemes designed by those seeking the use of others’ money on the expectation of profits.

Court tests

Courts have applied different approaches to divining whether rights concerning oil, gas, mineral interests or mining are securities. Some rely solely on whether the right in question is expressly enumerated in the definition of a security (a “Plain-Language Analysis”), whereas others are willing to find that such rights properly fall within another category of enumerated security, such as an “investment contract” or “any interest or instrument commonly known as a ‘security’” (an “Economic-Realities Analysis”). Further complicating the analysis, the SEC has recognized four principal types of oil, gas, and mineral interests owned by private parties: (1) the mineral rights, (2) the landowner’s royalty, (3) the overriding royalty and (4) the leasehold interest.

Many courts and regulators have taken the position that (A) each type of oil and gas interest, i.e., each of the four types listed, is to be considered in its entirety as a separate interest and (B) fractional undivided interests are involved only when they are created in one of those four particular types of interests.

If the entirety of a specific mineral interest, the entire landowner’s royalty, the entire override, or the entire lease is sold—as distinguished from a fractional interest in a specified mineral interest, the landowner’s royalty, the overriding royalty, or the lease—then no sale of a fractional undivided interest is involved.

Accordingly, if an entire mineral interest, an entire landowner’s royalty, the entire overriding royalty, or an entire leasehold interest is sold, then the sale would not constitute the sale of a “security” under the Plain-Language Analysis. Note, however, that this conclusion under the Plain-Language Analysis is arguably inconsistent with the actual plain language of the statutes because each “type” of oil and gas interest is not deemed to be an undivided portion of the interest. Instead, some courts and regulators have effectively redefined an “interest” in oil, gas, minerals and mining as a specific category of associated rights so as to avoid subdividing those newly separate rights into fractions, which would create a security.

Even so, the sale of an entire mineral interest, an entire landowner’s royalty, the entire overriding royalty or an entire leasehold interest might, nevertheless, constitute the sale of a “security” under the Economic-Realities Analysis if all of the elements of the Howey test are satisfied.

The problem, in a nutshell, is that sometimes an expressly identified security is interpreted to  constitute a security, yet other times an expressly identified security is interpreted definitionally in a manner so as to avoid finding a security, and sometimes an expressly identified item is interpreted to not constitute a security under the Economic-Realities Analysis. This produces precious little ex ante predictability. It would be helpful to oil and gas professionals, investors and financial intermediaries if the SEC would provide clarification through the rulemaking process.

Material ramifications

In the meantime, a securities regulator’s ex post determination that any particular oil, gas or mineral interest constitutes a security can have material ramifications. Federal and state securities regulators and courts have constructed complex regulatory and reporting frameworks that govern securities and the actions and duties of brokers, dealers, investment advisers and investment companies. A determination by any regulator or court of competent jurisdiction that applicable oil, gas or mineral interests are securities can subject individuals and companies to those regulatory and reporting requirements.

For example, disgruntled clients may turn to securities regulators for assistance when they believe they have been wronged. And individuals and companies who find themselves on the wrong side of a securities-related investigation may find their lives and livelihoods turned upside down. Consequences for failure to comply with securities laws range from recission rights to penalties, to professional suspensions and restrictions. Some civil violations of federal and state securities laws may also constitute criminal offenses, and, in extreme cases, the SEC may refer cases to the DOJ or the FBI for criminal investigation and prosecution.

Accordingly, it is prudent for people who engage in financial activities related to oil, gas and mineral investments to engage knowledgeable lawyers to conduct a careful, nuanced analysis of whether their investment-related activities involve “securities” that are subject to state and federal regulation. While such an analysis cannot provide certainty in today’s unsettled regulatory environment, anyone found on the wrong side of the law after conducting such an analysis in earnest will likely find themselves in a substantially better legal position.

Robert Long and Steven Bartz are shareholders, and Michael Besser is an associate in the Dallas office of Greenberg Traurig.