Oil and Gas Investment Frauds

State securities regulators around the country and the Council of Better Business Bureaus warn that oil and gas investment scams are alive and well, despite the recent industry downturn. Five states with significant amounts of oil and gas drilling and exploration operations reported a total of 850 investigations of unlawful oil and gas investment activity over the past two years. Illinois alone is investigating 17 major cases involving promoters who allegedly defrauded 1250 oil and gas securities investors of nearly $14 million.

Most oil and gas investment opportunities, while involving varying degrees of risks to the investor, are legitimate in their marketing and responsible in their operations. However, as in many other investment opportunities, it is not unusual for unscrupulous promoters to attempt to take advantage of investors by engaging in fraudulent practices.

Although some of the con artists have moved on to more lucrative fields since the oil boom ended in the early 1980’s, many linger on in the oilpatch. Kenneth Hooper, assistant director of the Texas State Securities Board, laments that “the incidence of oil fraud has hit the bottom and is starting back up.”

The Leviticus Project was established in 1978 as a federally funded multistate law enforcement project designed for the investigation and prosecution of a variety of crimes relating to the coal industry. Because of the high incidence of oil investment fraud discovered over the past few years, the member states of the Leviticus project have expanded their scope to include the investigation and prosecution of perpetrators of oil and gas investment fraud.

A recent survey by the North American Securities Administrators Association (NASAA) and the Council of Better Business Bureaus (CBBB) revealed a disturbing trend of increased oil and gas scams in the last two years. The survey uncovered these and numerous other examples of fraudulent oil and gas investment schemes in over 20 states:

• In November 1985, a federal grand jury indicted an Illinois couple on 722 counts of securities, mail and wire fraud, conspiracy and selling unregistered securities. 300 investors in 20 states and several foreign countries had allegedly been bilked out of nearly $6.5 million through the sale of investments in southern Illinois oil wells. The indictment charged that the couple exaggerated the value and productivity of about 72 wells, retained the best wells for themselves and diverted investor funds to buy themselves Rolls Royces, a jet plane, a helicopter and other luxury items.



• Several states took action in 1985 against an oil development company that offered an investment scheme involving oil and gas exploration in Israel. Promotional materials provided detailed explanation of how certain biblical interpretations pointed to the existence of oil in Israel. Information filed with the state securities agencies acknowledged that the company did not know of any gas or oil reserves in Israel and that it had no scientific basis to expect exploration to be fruitful. Promoters claimed to be guided by “religious and scriptural interpretation.”



• Texas officials recently obtained a life sentence against a Dallas man who, claiming to be a millionaire petroleum engineer, raised $500,000 from Texas investors. It turned out that the man was a high school dropout with five theft-related felony convictions. Only a third of the money he collected was ever spent on drilling operations. What investigators could trace of the rest of the money was spent on such things as the purchase of a beauty parlor and a furniture store for the man’s relatives.



• An investigation by the Alabama Securities Commission and the F.B.I. resulted in a July 1985 indictment of an Alabama promoter charged with defrauding 50 investors of over $6 million. The indictment charged that the promoter misrepresented certain facts about his experience, the nature of the drilling venture and the prospects for success. He was also charged with converting more than $1 million of investor funds to his own use.

Other investigations revealed a case in which investors’ funds were diverted from well drilling to pay for the promoter’s European and Bahamian vacations leaving no money to pay for drilling wells. In another case, promoters solicited over $1.4 million from investors in eight states for the purchase of interests in oil and gas wells which had been permanently plugged and abandoned. Prospective limited partners in another instance were told that “scientific equipment” designed and built by the promoter would improve the prospects of striking oil or gas by 400%. Actually, no such equipment existed. Investors were led to believe that the promoter had engineering and business degrees as well as extensive oil field experience, when in fact, his most relevant prior experience was pumping gas at a service station.

What Are Oil and Gas Partnerships?

Oil and gas investments take many forms, including limited partnership interests, ownership of fractional undivided interests in leases and general partnerships. Tax consequences and investor liability vary according to the type of program.

In a drilling limited partnership, an oil or gas company sells partnership units to investors and uses the money it raises to lease property and drill wells. In return for managing the project, the sponsor company usually takes an upfront fee that averages about 15-16% of one’s investment and share in a percentage of any revenue generated. In return, the promoter offers the prospect of a substantial first year tax write-off and quarterly cash distributions from the sale of any oil and gas the partnership finds until the wells run dry.

Drilling partnerships have always been a gamble, and recently they have proven somewhat riskier than usual. Historically, about one in three haven’t even returned the original investment. And, for partnerships formed since 1979 -- which have suffered from the dramatic and largely unexpected fall in oil and gas prices — that level of failure has increased to 42%, one study estimates.

Fraudulent Sales Techniques

Fraudulent oil and gas deals are normally structured with the limited partnership (or other legal entity) in one state, the operation and physical presence of the field in a second state, and the offerings made to prospective investors in states other than the initial two states. Thus, there is less chance of an investor dropping by a wellsite or a nonexistent company headquarters. Such a structure also makes it difficult for law enforcement officials and victims to identify and expose the fraud.

Boiler Rooms In order to attract the interest of potential investors, unprincipled promoters frequently use “boiler room” offices with banks of phone manned by salespersons with little or no background in energy exploration, but plenty of experience in high-pressure sales. These techniques include repeated unsolicited phone calls to members of the public, hyping the profitability of the deal and promising extravagant tax advantages.

State securities regulators and Better Business Bureaus caution potential investors to beware of the following claims in a typical high-pressure sales pitch in an unsolicited telephone call:

• you will have an interest in a well that cannot miss;



• the risks are minimal;



• a geologist has given the salesperson a tip;



• the salesperson has personally invested in the venture;



• the promoter has “hit” on every well drilled so far;



• there has been a tremendous “discovery” in an adjacent field;



• a large, reputable oil company is operating or planning to operate in the area;



• only a few interests remain to be sold and you should immediately send in your money in order to assure the purchase of an interest;



• this is a special private deal open only to a lucky chosen few investors.

How to Avoid Being Swindled

Most scam deals, say regulators, are devastatingly simple. “The game isn’t really high-level fraud,” says Royce Griffin, Colorado Securities Commissioner and president of NASAA. “It’s usually more a total misuse of proceeds. Take the investor’s money and buy yourself a Mercedes, things like that.”

You can minimize the risk of being swindled if you resist pressures to make hurried, uninformed investment decisions. There are several steps you should take before parting with your money.

State securities regulators and Better Business Bureaus advise potential investors not to be afraid to ask the hard questions when solicited for oil and gas investment opportunities. Based on their own experience, regulators have devised a checklist of questions you should ask before investing.

1. Registration Requirements. Ask if the offering is filed with the office of the state securities commission in your state or the state in which the promoters are located. If so, contact that agency for any information it may be able to provide. If the promoter claims that the offering is exempt from registration requirements in the particular state in which the offers and sales are made, find out which of the exemptions is claimed and the terms of the exemption. Contact the state securities agency to confirm that the offering is indeed exempt.



2. Salespersons -- Legitimate or con artist? If it is a legitimate deal, the salesperson will not be reluctant to answer questions or provide written explanations to questions. Ask the name of the person offering you the security, where he is calling from and his background, particularly in other oil or gas ventures. Contact your state securities agency to find out if the promoter or salesperson has been sanctioned for previous violations of securities laws.



3. The Company -- Be sure it is real. Ask the names of the principals of the company or the general partners offering the security, their backgrounds and experience in the oil and gas industry, and how long they have been associated with the company. Find out the history of the company, its capitalization, assets and retained earnings. What contingent liabilities does it have from other ventures? Does it have sufficient funds to cover unexpected costs? Find out the company’s or general partners’ history in drilling operations. In particular, ask how long it has been in the oil and gas business, the number of wells drilled, the number of strikes and depth of the wells, and whether the company retained its interest in the wells it drilled. Determine if conflicts of interest involving the promoter are disclosed. All the above information should be contained in a prospectus or “offering documents” that the promoter must furnish potential investors before they commit their funds.



4. The Investment -- Avoid having your money used for a European vacation. Make sure funds raised are kept in a separate escrow account until used and that they won’t be commingled with other funds. Also, be certain the funds will not be used for purposes other than those specified. Ask how much money is to be raised and the cost per fractional interest. Ask how much of the money will pay for advertising, salaries, drilling costs, legal fees, administrative expenses, sales commissions and any estimated profit to the company. Assuming the well is completed, ask what the completion costs will be for each investor, including additional commissions to be paid (the purpose and amount), and whether investors may be obligated to pay in more money in the future. Finally, evaluate the risk involved in making the investment. Is the well to be drilled a wildcat (drilled in territory not known to be productive) or is the drilling to be done in an area of proven oil reserves?



5. The Lease. Secure a legal description of the property on which the program is to be drilled. How and when was it acquired? Is the principal selling the lease to the venture at the acquisition cost, and if not, how much profit is being made? Ask for a description of surrounding property, including local well completions and a geologist’s report on the area. You will want to know if the lease is already in default and whether there is any overriding royalty or landowner’s royalty being paid. Ask for a disclosure of the person(s) selling the lease, the cost of the lease and any relationship between the lessor and the operator. Secure a statement of the depth of the well to be drilled and an indication of when drilling is to begin. Insist on seeing a copy of the driller’s contract with the promoter.



6. Additional questions to ask before investing.

• Is a general statement made of all taxes that must be paid out of the investors’ share of any production?



• What is the location of available pipelines, or what method will be used to sell any production?



• What is the name and address of the operator? What are the terms of the agreement with him, including the compensation to be received and experience?



• How will the decision be made for completing the well or abandoning it? Who will make the decision? What is to become of funds received from the salvage value of equipment on the lease?

The checklist of questions to ask and information to obtain is a long one. It will take some time and perhaps even money invested in outside consultation before you feel comfortable risking your money in the investment. It is always advisable to seek the advice of a neutral expert before committing your funds to any investment deal.

For more information

The securities administrator in your state, province or territory is responsible for protection of investors and ensuring that complete information is available for many types of investments. If you have questions about a possible oil and gas investment, contact your securities administrator. For the phone number or address of your securities regulator, telephone the North American Securities Administrators Association (NASAA) at (202) 737-0900. Contact information is also available on the association's web site at www.nasaa.org. Your prompt action could save you money.

The Council of Better Business Bureaus (CBBB) and the Better Business Bureaus of the U.S. and Canada answer inquiries on companies located in the areas they serve. Before putting money in an investment plan, it is a good idea to contact your local BBB for a reliability report on the company you intend to deal with.

The Investor Alert is a quarterly program jointly sponsored by the CBBB and NASAA, the organization representing all 65 state, provincial and territorial securities regulators in the U.S., Canada, Mexico and Puerto Rico. The quarterly Investor Alerts expose investment frauds to the public and provide useful information on how to avoid the often sophisticated and unlawful schemes that prey on investors.

Issued 1987

This publication was compiled by the North American Securities Administrators Association and the Better Business Bureau and is furnished to you by the Texas State Securities Board.