Everyone knows the oil and gas industry is big business in Texas. While that may be great news for our economy when the price of oil goes up, the not-so-great news is that oil and gas securities fraud is common, and can make scammers big money. Check out the Texas State Securities Board’s (TSSB) 2017 report on enforcement actions, which describes oil and gas as “a staple of investment fraud in Texas.” In fact, oil and gas scams seem to be on the rise in recent years, possibly due to a couple of factors: potential investors have more money available due to the stock market’s rise, while at the same time oil prices have stabilized, leading more companies to pursue drilling.
But wait – how can an investment in an oil or natural gas well be a security? Isn’t that more of a real property investment? In fact, while transfers of interests in real property do not typically constitute securities, the Texas Securities Act (TSA) specifically applies to oil, gas, and mining interests. Consequently, sales of oil and gas interests are securities subject to the requirements of the TSA and the jurisdiction of the TSSB. Many other states also define this kind of investment as a security. Depending on how the interest is structured, federal securities laws may apply as well. Oil and gas interests include, but are not limited to, joint ventures, general partnerships, limited partnership interests, stocks, bonds, and leases for fractional undivided interests.
Why Does it Matter Whether My Investment is a Security?
Because oil and gas investments are securities, the law requires anyone who sells such investments to be a registered securities broker or dealer. There are a few exceptions, particularly where the investor is also experienced in the oil and gas industry. But if you’re an individual or small investor who has purchased this kind of investment, the likelihood is that the seller is subject to the registration requirement. If you invested in an oil or gas well with the assistance of an unlicensed securities broker or dealer (also known as promoters), the sale may constitute the illegal sale of a security. In the circumstance of an illegal sale, you may be entitled to a return of your investment, interest, and recovery of your attorneys’ fees. In addition, both federal securities laws and the TSA forbid misrepresentation or omission of material facts in the sale of securities. If you’ve been victimized by an unscrupulous promoter, the securities laws offer you multiple avenues to potentially recover your investment and any subsequent losses.
In the past, brokers might have tried to sell you an interest in an oil and gas participation program (sometimes known as Direct Participation Programs, or DPPs), but this type of fraudulent investment vehicle earned particular scrutiny from regulators such as the Financial Industry Regulatory Authority (also known as FINRA), and many of these broker dealers have been put out of business. Now we are seeing an increase in fraud perpetrated by promoters who are not broker dealers attempting to structure different kinds of investments to avoid securities law requirements. One common method is to solicit investment in a so-called joint venture to pursue oil and gas exploration and drilling activities. Fraudsters hope that by changing the label of an investment vehicle, the courts will conclude that a transaction is really more of a business deal than an investment in a security. As we will explain, however, court decisions have mostly left them hoping in vain.
When is a Joint Venture Not Really a Joint Venture?
Courts will examine an oil and gas interest structured as a joint venture very carefully, to determine whether it is a true business enterprise or merely an investment contract masquerading as one. Both the TSA and the federal securities laws employ a flexible definition of “security,” precisely to protect the public from, as one court describes it, “the countless and variable schemes devised by those who seek to promote the use of others’ money on the promise of . . . profit.” (Ballard & Cordell Corp. v. Zoller & Dannenberg, 544 F.2d 1059, 1063 (10th Cir. 1976).) In Texas, a true joint venture has to have three elements:
On the other hand, in Texas as in the federal courts, an investment contract requires:
Courts have been more likely to find that an agreement is an investment contract instead of an actual joint venture when the investors can prove that they expected to rely solely on the expertise and efforts of the promoter (who is usually also designated the “managing venturer” in the agreement) to earn a profit. An agreement is more likely to be considered an investment contract when investment interests were widely offered and sold to a broad section of the public having little or no experience in the oil and gas industry, the investors did not know each other and were completely dependent on the managing venturer for information (even contact information for each other) and for any profits, and the promoter specifically emphasized its unique experience and ability in the industry. (E.g., SEC v. Shields, 774 F.3d 633 (10th Cir. 2014).)
What Constitutes Fraud in Oil and Gas Investments?
As we noted above, with certain exceptions it is considered securities fraud for an unregistered promoter to sell a security. Consequently, if you purchased oil and gas securities from a non-registered seller, you may be able to recover your investment, plus attorneys’ fees and damages. But even if your securities broker is licensed, or exempt from the registration requirement, you may still have been defrauded. Misrepresenting or omitting material facts in a sales pitch also constitutes fraud. A material fact is anything that a reasonable investor would believe important to consider in making an investment decision. Some examples:
Typically, in this last instance, a promoter will greatly inflate the estimated costs, and then use the investment funds for personal or other business uses. Even if the well fails, the promoter makes a profit – only the investors are left holding the bag.
How Can I Protect Myself From Bad Investments?
Both the North American Securities Administrators’ Association (NASAA) and the U.S. Securities and Exchange Commission (SEC) offer guidance to investors considering oil and gas investments. You can find the NASAA’s here, and the SEC’s here and here. A typical scam might include a business entity (like a joint venture or limited partnership) located in one state, a well operated in a second state, and offerings made to potential investors in still other states (the better to prevent anyone from dropping by to check out the location.) The basic rule of thumb is, as with any investment, if it seems too good to be true, it probably is. Be aware of high pressure sales tactics and common red flag phrases such as:
Do your research. Ask questions, and research the answers that you get. The alerts from the NASAA and the SEC suggest questions you should ask, and the kind of answers you should expect. If you are working with a broker, know your broker and ask for references. Look to see if your broker has any disciplinary infractions. Consult other brokers. Research the oil and gas company by contacting your state’s secretary of state agency. You can discover valuable information about public companies on the SEC’s website, including a company’s financial statements and mutual fund disclosures. If you encounter difficulty finding financial or other information about a particular company, the opportunity may not be legitimate. Failure to investigate could cost you a bundle.
What if It’s Already Too Late?
If you have fallen victim to an oil and gas security scam – what can you do? You can file a complaint with the SEC to alert them of the promoter or broker’s misconduct. You also can, and you should, contact an experienced securities fraud attorney to guide you through the process of recovering your losses. The promoter and those working with him are liable for any misconduct resulting in your economic loss, and criminal charges may even result from their fraudulent scheming.
If you invested in an oil or gas well and the transaction was not undertaken by a licensed securities broker or dealer, we’d like to hear from you. Call us at 512-306-8188 or contact us online.