Energy Products Cases
Many stockbrokers recommend oil and gas investments to clients. When recommending such an investment, the financial advisor should endeavor to make the investor aware from the outset of the volatile nature of an oil and gas investment. Furthermore, the broker has a duty to determine if the investment itself is suitable in light of that investor’s profile and stated investment objectives.
If an investor’s account becomes over-concentrated in oil and gas investments, or a broker fails to disclose the degree of risk associated with a specific investment, the broker and his or her firm may well be liable for investment losses. A brokerage firm’s failure to do due diligence with respect to an oil and gas investment may also give rise to liability. If an investor suffers losses as a result of an unsuitable recommendation, these losses may be recovered through securities arbitration administered by the Financial Industry Regulatory Authority (“FINRA”), or in some circumstances, through a lawsuit.Some of the More Complex and Risky Oil and Gas Investments
The following list provides only a sampling of some of the more complex and risky oil and gas investments:
Master Limited Partnerships (“MLPs”): are structured as publicly traded partnerships. As such, a MLP involves a General Partner (“GP”) which controls the operations and interests of the entity, and Limited Partners (“LPs”) – the investors – who own common units and have a limited role in operations and management. Most MLPs operate in the ‘midstream’ of the oil and gas industry, meaning that sub-sector within the industry that involves transportation (by pipeline, rail, barge, tanker or trucking carrier) of crude and/or refined petroleum products.
Promoted Features and Fees:
- MLPs are not taxed, instead passing each type of income, expense, gain, or loss on, to be taxed with the investor’s income
- MLPs distribute most of their free cash each quarter
- As to fees, the GP often has incentive distribution rights, which allocate a percentage of distributions to the GP before the remainder of the distribution is allocated among all partners
- MLP investors (unitholders) have limited control and voting rights, as compared to stockholders in a corporation
- Significant conflicts of interest exist between the sponsor, GP and LPs
- Because most MLPs operate in the energy sector, and as most are tied to oil, these investments are susceptible to economic downturns, fluctuations in energy commodity prices, or any geo-political / legislative / regulatory changes which affect oil
Direct Participation Programs (“DPPs”): are business enterprises designed to allow investors to participate directly in the cash flow and tax benefits of an underlying investment. Generally passive investment vehicles, DPPs typically invest in real estate or the energy sector. Further, DPP investments are usually only available to “accredited investors” as defined by the SEC’s Rule 501 under Regulation D. Such investments may be referred to as “private placements” or “Reg. D offerings.”
Usually organized as a limited partnership, DPPs allow income, gains, losses and tax benefits to be passed through to the investors. DPPs are not publicly traded, and may or may not be registered with the Securities and Exchange Commission (“SEC”).
Promoted Features and Fees:
- DPPs are designed to pass the tax consequences of owning specific assets on to the investor
- Oil and gas DPPs promote the tax benefits that investors may achieve through write-offs of intangible drilling costs and depletion deductions
- Investors can choose to be a limited or general partner
- As to fees, sponsors charge high upfront fees and recurring annual fees
- Sponsors have significant conflicts of interest, including fact that sponsors receive a disproportionately large amount of net income, thus incentivizing risky behavior
- Typically very illiquid in nature; sold through a private placement offering
- While oil and gas DPPs promote tax benefits, investors can only apply write-off and depletion deductions to passive income if the investor is a limited partner
- Fees can be extremely high, in some instances up to 17%, including an investment fee to manager, selling commissions, placement agent fees, and certain organizational and offering fees
Drilling Funds: as the name implies, these funds focus on the search for potential underground or underwater crude oil or natural gas fields. These drilling funds operate in what is known as the ‘upstream’ of the oil and gas industry, meaning that sub-sector of the industry that involves drilling and operating wells.
Promoted Features and Fees:
- Drilling funds are structured as a limited partnership
- Sponsored by oil and gas exploration companies (e.g., Atlas Resources), or investment companies (e.g., Ridgewood)
- As to fees, the average up-front fee is 12.5% (can be as high as 15.5%)
- Drilling funds are illiquid in nature and cannot be easily sold in a secondary market
- Often, distributions may include both income and return of investment principal
- Exploration companies will often use sales proceeds to drill risky wells, then drill wells for their own account near high-producing wells, thus leaving investors in the drilling fund with the dry hole
- Extremely high fees
- Returns on drilling funds sponsored by various companies have been terrible –
Atlas Resources – sponsored 19 funds, 2000-2010 – all funds lost money for investors
Ridgewood – sponsored 14 funds, 2000-2010 – 13 of 14 funds lost money for investors
The Securities and Exchange Commission (“SEC”) has issued an Investor Alert in recognition of the rise of fraudulent misconduct with oil and gas investments, particularly as it concerns private offerings to investors.
As a suggested approach, the SEC recommends that an investor considering an oil and gas private offering take the following steps:
First consider whether the person recommending the investment is registered:
Most persons offering securities for sale must be registered to do so, and investors can locate information through FINRA’s BrokerCheck website for registered representatives, or the SEC’s Investment Adviser Public Disclosure (“IAPD”) website for registered investment advisers;
If the person is not registered, this may well be a red flag and the investor should proceed with the utmost caution in conducting further due diligence.
Ask for the “due diligence report”:
A registered broker who recommends an oil and gas investment has a duty to independently review the investment. The broker may not merely rely upon the statements and claims made by an oil and gas promoter marketing the investment;
Any due diligence report should outline how the broker evaluated the investment’s prospects and claims.
Consider whether the investment is appropriate for you:
Generally, private securities offerings are limited by law to certain institutional and high net worth, or accredited, investors;
The policy behind this general rule is that a private offering is typically a riskier investment than, for example, purchasing publicly traded stock, due to a host of factors including lack of readily available information, illiquidity, and the risk of losing the entire investment.
Investors should be very wary of any unsolicited phone calls hyping a too good to be true, can’t miss investment opportunity. Securities regulators caution investors to beware of any sales pitch involving any of the following red flags:
- By investing you will receive an interest in a well that cannot miss;
- The risks are minimal;
- The person making the pitch has personally invested in the venture;
- The promoter has “hit” on every well drilled so far;
- A large and reputable oil company is operating or plans to operate in the area;
- Only a few interests remain to be sold, so you should immediately send in your money;
- This is a special, private deal, and is only open to a limited number of lucky, pre-selected individuals.
The attorneys at Law Office of Christopher J. Gray, P.C. possess considerable experience in representing investors who have lost money due to fraud or other misconduct by a stockbroker or investment advisor. If you or a loved one has lost money in connection with an oil and gas investment, those losses may be recovered through FINRA arbitration, or in some instances, litigation. Investors may contact us via the contact form on this website, at (866) 966-9598 or email@example.com for a no-cost, confidential consultation.