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FEARNEYHOUGH v. MCELVAIN

December 5, 1984

RAYMOND FEARNEYHOUGH, LOIS FEARNEYHOUGH, HUSBAND AND WIFE; RUSSELL LIERLY, RUTH LIERLY, HUSBAND AND WIFE; AND TRIPLE G OIL CO. LTD., PLAINTIFFS,
v.
DELORIS MCELVAIN AND ROY R. HICKS, DEFENDANTS.



The opinion of the court was delivered by:  Bua, District Judge.[fn*] [fn*]The Honorable Nicholas J. Bua, District Judge for the Northern District of Illinois, is sitting by designation.

MEMORANDUM AND ORDER

I. FACTS

On October 7, 1981, plaintiffs Raymond and Lois Fearneyhough, landowners who reside in Adams County, Illinois, executed an Oil and Gas Lease with the defendants Deloris MeElvain and Roy R. Hicks. Under the lease, defendants were given the right to enter onto plaintiffs' land for the purpose of oil and gas exploration and drilling for a period of one year, or as long as there were wells producing on the land. In exchange for an exclusive leasehold for oil and gas exploration on their land, plaintiffs received one dollar in present consideration and a royalty of one eighth (1/8) of all oil or natural gas produced from the land.

Plaintiffs' interest is an "overriding" royalty interest since they were to receive it without any contribution toward the cost of drilling or deduction from the royalty reflecting the cost of drilling. Defendants received the right to explore and drill on the land without paying rent and also received a seven-eighths (7/8) interest in all oil or natural gas produced on the land. The lease also provided for its assignment in whole or in part.

On May 25, 1982, defendants executed an assignment agreement with a former plaintiff, Triple G Oil Company, Ltd. of Mundelein, Illinois. In the assignment, defendants conveyed its leasehold rights in a portion of the land subject to the original lease. While plaintiffs allege other assignments between defendants and unknown assignees, the record contains no evidence to support these allegations.

The plaintiffs Russell and Ruth Lierly, landowners who reside in Adams County, Illinois, allege essentially the same facts as plaintiffs Raymond and Lois Fearneyhough. Plaintiffs claim an action under § 10(b) of the Securities Exchange Act and Rule 10b-5 based on defendants' alleged misrepresentations regarding their intentions to commence drilling on plaintiffs' land.

II. DISCUSSION

A cause of action under § 10(b) of the 1934 Act, 15 U.S.C. § 78j(b), and Rule 10b-5 must allege fraud in connection with the purchase or sale of securities. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 731, 95 S.Ct. 1917, 1923, 44 L.Ed.2d 539 (1975); Maryville Academy v. Loeb Rhoades & Co., Inc., 530 F. Supp. 1061, 1065 (N.D.Ill. 1981). Therefore, a 10b-5 action requires both a purchaser and a seller of a security. In the present case, plaintiffs are the sellers of leasehold interests for the development of oil and gas on their land. They allege that the purchasers of the oil and gas interests, the defendants, defrauded them in the purchase of the leasehold interests, which plaintiffs claim are securities. The crucial issue is whether oil and gas leasehold interests are securities when sold in this type of transaction.

The term "security" is defined in section 2(1) of the 1933 Act to include any "investment contract" or any "fractional undivided interest in oil, gas, or other mineral rights," and any "certificate of interest or participation in any profit sharing agreement." 15 U.S.C. § 77b(1). The term "security" as defined under the 1934 Act includes any "certificate of interest or participation in any profit sharing agreement or . . . in any oil, gas, or other mineral royalty or lease" and any "investment contract." 15 U.S.C. § 78c(a)(10). The definition of "security" under the 1933 and 1934 Acts applies to Rule 10b-5 actions. See, e.g., Tcherepnin v. Knight, 389 U.S. 332, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967). While the definitions of sale and of security are to be liberally construed under the federal securities law, courts have refrained from laying down any hard and fast rules as to what constitutes a security, and instead look to the substance rather than the form of the transaction in making a case-by-case determination. Ballard & Cordell Corp. v. Zoller & Danneburg Exploration, Ltd., 544 F.2d 1059, 1063 (10th Cir. 1976).

1. Fractional Undivided Interests

Plaintiffs argue that any sale of oil and gas interests constitutes a sale of a "security" within the meaning of both 1933 and 1934 Acts. In addition, they contend that an assignment of an interest in an oil and gas lease is clearly a security. Therefore, plaintiffs conclude that the lease between themselves and defendants and the assignment of the leasehold interest between defendants and Triple G qualify as securities under the Acts.

Defendants argue that only the sale of fractional leasehold interests come within the definition of a security. They contend further that the transfer of a whole leasehold interest, though under the terms of the lease the holder may be entitled to only one eighth (1/8) or some other portion of the production, is not considered the transfer of a security. Therefore, defendants conclude that the sale by plaintiffs of the oil and gas rights to their land and the retention of a one-eighth (1/8) royalty interest does not constitute the sale of a security because the plaintiffs sold almost seven eighths (7/8) of the entire leasehold interest to the defendants.

It is well established that an assignment of a fractional undivided interest in oil and gas rights is a security within the definition of Section 2(1) of the 1933 Act. S.E.C. v. C.M. Joiner Leasing Corp., 320 U.S. 344, 64 S.Ct. 120, 88 L.Ed. 88 (1943). However, not every transaction involving the sale of a fractional undivided interest in oil, gas, and other mineral rights is ipso facto the sale of a "security" within the meaning of the Act. Woodward v. Wright, 266 F.2d 108, 112 (10th Cir. 1959). It was Congress' intent to exclude from the scope of the Act isolated sales or assignments of oil and gas leases or fractional parts thereof to specific persons, and to specifically include as securities "only that form of splitting up of mineral interests which had been most utilized for speculative ...


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