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.
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'
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