and gas leases presented here constitute securities as defined
in Section 2(1) of the Securities Act of 1933 and in Section
3 of the Securities Exchange Act of 1934. 15 U.S.C. § 77b and
78c. For the reasons stated herein, defendants' motion for
summary judgment is granted.
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
speculative purposes." Id. (quoting from Mr. Justice Jackson's
discussion regarding the definition of fractional undivided
interests in mineral rights in S.E.C. v. C.M. Joiner Leasing
Corp., 320 U.S. at 352, 64 S.Ct. at 124).
Several courts have faced the problem of drawing the line
between an isolated sale or assignment of an oil and gas lease
to one individual and a scheme wherein one sells or assigns
fractional interests to many investors. Johnsen v. Rogers,
[1982-1983 Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶ 99,072
(C.D.Cal. 1982) (security); Robertson v. Humphries, [1979-1980
Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶ 97,283 (10th Cir. 1980)
(no security); Ballard & Cordell Corp. v. Zoller & Danneburg
Exploration, Ltd., 544 F.2d 1059 (10th Cir. 1976) (no
security); Parvin v. Davis Oil Co., 524 F.2d 112 (9th Cir.
1975) (security); Nor-Tex Agencies, Inc. v. Jones,
482 F.2d 1093 (5th Cir. 1973), cert. denied, 415 U.S. 977, 94 S.Ct.
1563, 39 L.Ed.2d 873 (1974) (security); Lynn v. Caraway,
252 F. Supp. 858 (W.D.La. 1966), aff'd per curiam, 379 F.2d 943 (5th
Cir. 1967), cert. denied, 393 U.S. 951, 89 S.Ct. 373, 21
L.Ed.2d 362 (1968) (no security); Graham v. Clark, 332 F.2d 155
(6th Cir. 1964) (no security); Woodward v. Wright,
266 F.2d 108 (10th Cir. 1959) (security); S.E.C. v. C.M. Joiner
Leasing Corp., 320 U.S. 344, 64 S.Ct. 120, 88 L.Ed. 88 (1943)
Of these cases, the Court finds Robertson v. Humphries,
supra, to be dispositive of the present case. In Robertson, the
plaintiffs conveyed their oil and gas leases for $100,000 to
defendant, who was their selling agent. In addition, the
plaintiffs retained a one-sixteenth (1/16) overriding royalty
interest in the leases. The Tenth Circuit Court of Appeals
identified the issue as whether the plaintiffs' retained
overriding royalty interest amounts to a fractional undivided
interest. The Robertson court emphasized that it looked at the
substance rather than the form of the transaction in making its
finding that the sale of the leases did not involve a security.
Robertson v. Humphries, [1979-1980 Transfer Binder]
Fed.Sec.L.Rep. (CCH) ¶ 97,283 at 96,999.
In explaining its finding, the Robertson court said:
Plaintiffs here in one transaction sold the whole
of their leasehold interest and retained an
override. . . . The plaintiff did not in fact
sell a "fractional interest" in the lease. The
override was taken out of the royalty, and was
not bought or sold. . . . As mentioned above, the
plaintiff Robertson did not create fractional
interests to be sold.
In the present case, the plaintiffs are the sellers of a
leasehold interest in the oil and gas rights in their own
land. In return for selling the entire leasehold interest in
their oil and gas rights, plaintiffs received a one-eighth
(1/8) royalty interest in any oil or natural gas produced on
the leased property. The Court notes that the plaintiffs did
not divide up the leasehold interest in oil and gas rights to
their land but sold the whole interest to defendants.
Therefore, the Court finds that the sale of the entire
leasehold interest in the oil and gas rights in plaintiffs'
land does not constitute the sale of a security within the
meaning of the 1933 and 1934 Acts, notwithstanding the fact
that the plaintiffs retained an overriding one-eighth (1/8)
The plaintiffs could also argue that the assignment of a
fractional interest in the oil and gas lease to Triple G,
which defendants concede is a security, transforms their sale
to defendants into a sale of a security. However, this
argument is not persuasive since plaintiffs allege defendants'
misrepresentations in connection with the sale of their
leasehold interest, but not in connection with the subsequent
assignment to Triple G.
2. Investment Contract
Plaintiffs may avoid summary judgment if they show that the
leasehold interest sale involves an investment contract. The
sale of an entire interest may involve an "investment
contract" constituting a "security." Ballard & Cordell Corp. v.
Zoller & Danneberg, 544 F.2d at 1065-66 (10th Cir. 1976); see
also Lynn v. Caraway, 379 F.2d at 944-45. In S.E.C. v. Howey
Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946), the
Supreme Court said that the test for determining whether a
particular transaction constitutes an investment contract is
"whether the scheme involves an investment of money in a common
enterprise with profits to come solely from the efforts of
others." 328 U.S. at 301, 66 S.Ct. at 1104. However, an
investment contract must transfer more than a "naked leasehold
right" and usually involves additional economic inducements.
Ballard & Cordell Corp. v. Zoller & Danneberg, 544 F.2d at
1065; Roe v. United States, 287 F.2d 435, 437 (5th Cir.),
cert. denied, 368 U.S. 824, 82 S.Ct. 43, 7 L.Ed.2d 29 (1961).
The case of Robertson v. Humphries, supra, is dispositive of
the investment contract issue in this case. In that case, as
discussed above, the plaintiffs sold their entire interest in
oil and gas leases and retained an overriding royalty interest.
In finding that no investment contract existed, the Tenth
Circuit Court of Appeals said:
It is apparent from the evidence that plaintiffs
sold the whole of their fractional interest in
the subject oil and gas leases, and provided
neither management nor risk capital to finance
the venture. The plaintiff, through his reserved
overriding royalty, retained no management
control in the development of the leases. . . .
The evidence presented below establishes nothing
more than the transfer of a leasehold right.
[1979-1980 Transfer Binder] Fed.Sec.L. Rep. (CCH) ¶ 97,283 at