Consolidated v. Department of Corporations

75 Cal.Rptr.3d 795

162 Cal.App.4th 598

CONSOLIDATED MANAGEMENT GROUP, LLC, et al., Plaintiffs and Appellants, v. DEPARTMENT OF CORPORATIONS, Defendant and Respondent.

No. A117513.

Court of Appeal, First District, Division 1.

April 28, 2008.

Baker & McKenzie, Laura J. O'Rourke, Joel Held, William R. Daugherty and Christopher Van Gundy, San Francisco, for Plaintiffs and Appellants.

Preston DuFauchard, California Corporations Commissioner and Edward Kelly Shinnick, California Corporations Counsel for Defendant and Respondent.

Rex A. Staples, General Counsel, Stephen W. Hall, Deputy General Counsel, Joseph Brady, Associate General Counsel, Lesley Walker, Associate Counsel and Joseph A. Hearst for Amicus Curiae.

MARCHIANO, P.J.

Consolidated Management Group, LLC (Consolidated), Consolidated Leasing Hugoton Joint Venture # 2 (Hugoton), and Consolidated Leasing Anadarko Joint Venture (Anadarko; Consolidated, Anadarko, and Hugoton are hereafter referred to collectively as petitioners) appeal from a judgment denying their petition for writ of administrative mandamus. The petition sought to overturn the decision of respondent California Department of Corporations (Department) rejecting petitioners' challenge to a Department desist and refrain order with respect to offers and sales of interests in Hugoton and Anadarko.

The issues on appeal are: (1) whether federal law preempts the Department's authority to issue the desist order; and (2) whether the interests in Hugoton and Anadarko are securities. Most of the cases that have addressed the first issue, including, a recent decision by another California Court of Appeal, have found no preemption and we agree with that majority view. Substantial evidence supported the Department's determination that the interests in question are securities. We affirm for the reasons that we explain below.

I. BACKGROUND

Consolidated, a Kansas limited liability company with its principal place of business in Hutchinson, Kansas, formed a number of Kansas general partnerships, including Hugoton and Anadarko, that purchase oil and gas exploration and drilling equipment and lease the equipment to oil and gas operators. This case concerns the sale of units of joint venture interests in Hugoton" and Anadarko, which have their principal places of business in Wichita, Kansas. The August 5, 2005 private placement memorandum for Hugoton provided for the sale of 116 units at $50,000 per unit; the October 1, 2005 memorandum for Anadarko provided for the sale of 100 units at $62,000 per unit.

In August and November 2005, Consolidated filed with the Department copies of the Form D notices of private placements of securities (Rule 506 of Regulation D; 17 C.F.R. § 230.506 (2007)) it had filed for Hugoton and Anadarko with the Securities Exchange Commission (SEC), along with consents to service of process and $300 notice filing fees.

Consolidated retained Guardian Capital Management (Guardian) to raise capital in Northern California for Hugoton and Anadarko, and the Department issued a desist and refrain order in January 2006 against Guardian, Guardian's president, Kenneth Keegan, and Guardian operatives Faber Johnston and Brandon Taylor, as well as Consolidated, Hugoton, and Anadarko. The order charged that these entities and individuals had engaged in general solicitation of the public for the offer and sale of Hugoton and Anadarko units, that the units were securities subject to qualification under California law, and that the securities had been offered and sold without being qualified in violation of Corporations Code section 25110.¹

Petitioners requested a hearing on the desist and refrain order, which was held in March 2006 before an administrative law judge (ALJ).

Department investigator Jon Wroten testified at the hearing that he was working undercover using an alias on December 1, 2005. He received a call from Faber Johnston. Johnston obtained Wroten's number from a third party Wroten was investigating. Wroten had told the third party that he owned a sheet rocking company and that he had $20,000 to $30,000 to invest. On December 1, the third party called Wroten and asked if he was interested in information about an investment unrelated to the one they had been discussing. Wroten said, "Yes," and then received the call from Johnston.

Johnston told Wroten that Guardian was under contract with Consolidated to market an oil and gas drilling project called Anadarko, and that the investment could potentially return 21 percent per annum. Johnston said that Consolidated personnel had been drilling for oil for 30 years, and that when they found natural gas instead of oil they had capped the wells. The price of natural gas was rising, Consolidated had drilling equipment and rights to the capped wells, and Anadarko's business would involve leasing the equipment to firms who would extract the natural gas from the wells.

Wroten had no relationship with Johnston prior to the phone call. During the call, Johnston asked Wroten what he did for a living and Wroten said that he had a dry walling company; he did not tell Johnston anything else about himself. Johnston asked if he could send information about the investment, Wroten said, "Yes," and Wroten received over 100 pages of documents from Johnston, including the Anadarko private placement memorandum, promotional materials, and an invitation to participate in a December 6, 2005 conference call with Consolidated's President. The promotional materials included a brochure stating that demand for natural gas was increasing, that Consolidated had "100+ years of industry knowledge" and "proven track record," and that "[w]e are uniquely situated in areas of vast oil and natural gas reserves." Johnston left phone messages for Wroten and sent him a second written solicitation, but Wroten did not communicate with Johnston after their December 1 conversation.

Guardian President Kenneth Keegan confirmed at the hearing that Johnston was authorized by Guardian to send out promotional materials. Keegan testified that shortly after he joined the Los Gatos Chamber of Commerce (Chamber) in July or August of 2005, he purchased mailing labels from the Chamber for its 430 members. The membership mailing list was not available to the general public. Keegan said that Guardian mailed invitations to over 200 Chamber members who "we thought were possibly accredited" investors inviting them to luncheon presentations that sought to generate interest in Hugoton and Anadarko. Keegan said that he knew "quite a few" of the people invited, but admitted that Guardian did not have a preexisting relationship with all of them.

Keegan wrote the Department a letter in October 2005 advising that "[Guardian] is compensated by [Consolidated] for its effort in providing capital received from accredited investors...." Keegan indicated at the hearing that Guardian did not receive "direct compensation" from Consolidated; Guardian was paid by Balboa Leasing, which was listed on Anadarko's Form D as an entity that would be compensated for the sale of investments. Keegan explained that the money flowed from Consolidated through Balboa Leasing to Guardian.

Keegan testified that he told potential investors they would be required to actively participate in the management of Hugoton and Anadarko. He conceded that some who attended the luncheons had no experience in the oil and gas industry. He acknowledged that he was promoting investments in equipment located "many states away" from where the investors resided, and that the wells where the equipment would be used were in Kansas and Oklahoma.

The ALJ issued a proposed decision denying petitioners' motion to dismiss the desist and refrain order on the ground of federal preemption, finding that the joint venture interests in Hugoton and Anadarko were securities, and concluding the securities were not exempt under Regulation D. The Department adopted the ALJ's proposed decision, and petitioners filed the administrative mandate action herein. In its order denying the petition, the trial court rejected petitioners' preemption argument and found that the joint venture interests were securities.

II. DISCUSSION

A. Preemption

Under section 25110, "[i]t is unlawful for any person to offer or sell in this state any security in an issuer transaction ... unless such sale has been qualified ... or unless such security or transaction is exempted...." Section 25102.1, subdivision (d) exempts from section 25110 "[a]ny offer or sale of a security with respect to a transaction that is exempt from registration under the Securities Act of 1933 pursuant to Section 18(b)(4)(D) [15 U.S.C. § 77r(b)(4)(D) ] of that act," provided that a copy of a completed Form D and a consent to service of process are filed, and a notice filing fee is paid, as was done by Hugoton and Anadarko in this case. Transactions are exempt from registration under the federal statute if they comply with the requirements of Rule 506 of Regulation D (17 C.F.R. § 230.506 (2007)) for limited private placements (15 U.S.C. § 77d(2)), which include a prohibition against any form of general solicitation (17 C.F.R. § 230.502(c) (2007)). Petitioners do not dispute the Department's finding, upheld by the trial court, that interests in Hugoton and Anadarko were offered through general solicitations in contravention of the federal rules for private offerings.

Petitioners nevertheless maintain that California is preempted by federal law from requiring that the sales of those interests be qualified as provided in section 25110. Their argument is based on the National Securities Markets Improvement Act of 1996 (NSMIA; 15 U.S.C. § 77r), which preempts state laws requiring the registration or qualification of a "covered security" (15 U.S.C. § 77r(a)(l)), including a security in "a transaction that is exempt from registration under this title pursuant to ... Commission rules or regulations issued under ...