Warning regarding sales of fractional oil and gas interests through phone banks and other re-sellers
From time to time, a client who has generated an oil and gas prospect will mention to us that it intends to sell—or has already sold–a fractional interest in that prospect to a “phone bank,” or to another type of re-seller. In this scenario, the client knows that the re-seller intends to re-sell the interest to another investor (often more than one). The ultimate purchaser typically allows the re-seller to retain a “promote”–a portion of the interest—as its compensation in connection with the resale transaction.
Over the years, a few of our clients have sold fractional interests in this way, only to later find themselves being investigated (or worse) by the federal Securities and Exchange Commission (the “SEC”) and/or state securities law administrators (“SSLAs”). The purpose of this short post is to explain why this might happen, and to caution you not to engage in these sales.
Fractional interests in oil and gas prospects are securities. Many people don’t know that the SEC and most, if not all, SSLAs consider fractional oil and gas interests to be securities.
A security must be registered with the SEC or be exempt from the registration requirements. Sales of securities are heavily regulated by a complex web of laws. One requirement of these laws is that each seller of a security must either (i) register the security with the SEC (generally not economically feasible) or (ii) obtain an exemption from this registration requirement for the security. Typically, obtaining such an exemption involves taking steps to ensure that the security is offered to investors in a “private” or “limited” offering. For the offering to qualify as private, the seller generally must (among other things) obtain a written representation from each investor that it is buying the security “for its own account and not for distribution or resale,” or words to that effect. The purpose of this representation is to ensure that the buyer is not acting as a conduit to a broader market (i.e., facilitating a “public” offering).
Why sales to re-sellers are not private offerings. Re-sellers of securities cannot honestly represent that they are buying for their own account and not for distribution or resale. And, in fact, re-sellers often cast a very wide net in attempting to find purchasers for the securities, sometimes contacting tens, hundreds, and even thousands of potential investors. In this situation, the SEC may take the position that the offering is an unregistered public offering.
Consequences of selling in an unregistered public offering. Companies who sell securities in an unregistered public offering are potentially subject to civil and criminal penalties. Some of these penalties can be severe, and may include prison time. The individuals who act on behalf of these companies may also be subject to these penalties. In addition, purchasers of the securities, including purchasers who bought securities directly from the original seller of the security (sometimes called the “issuer”) and who had no contact with the re-seller, may have the right to rescind the transaction and force the issuer to give them their money back. And because the issuer knows the representation the re-seller made wasn’t true, the issuer can’t successfully sue the re-seller for breaching it.
What if the re-seller is willing to indemnify me against claims and penalties? The SEC takes the position that indemnities for breaches of securities law violations are not enforceable. The SEC is not always able to get courts to agree with this position, but courts are more likely to agree with the SEC where the seller is aware of the violation in advance. And of course, indemnities are of no value when prison terms are being handed down.
Are there other ways to protect sellers in these situations? Some clients have asked us if they can avoid liability for an unregistered public offering by vetting the investors themselves prior to selling the interests, and/or by selling the interests directly to the investors. We advise our clients not to take this approach. The SEC’s position is that, for an offering to qualify as a private offering, (i) the offeror of the security has to have a preexisting relationship with each offeree (i.e., before the offering process begins), and (ii) the offeror must reasonably believe, based on the information it has gathered in the course of that relationship, that the investment is appropriate for the investor, both in terms of the investor’s sophistication and the investor’s ability to afford the loss of his or her entire investment.
Sales through re-sellers present other risks. Finally, in our experience, the chances of an investor suing or filing a complaint with the SEC and with SSLAs against an issuer of a security are far greater when the issuer doesn’t have a personal relationship with the investor than when it does have such a relationship.
Potential for both federal and state law violations. This is just a summary of the federal law on this issue. The individual states also regulate offerings of securities, and many impose penalties for violations relating to offers to persons residing in the state, even if the re-seller does not actually complete any sales there.
Conclusion. For all these reasons, we typically advise our clients not to use re-sellers, and to limit their offerings of securities to people with whom they have a preexisting relationship.
This is not an exhaustive discussion of the issues presented by sales of securities. If you have questions, please feel free to contact one of the lawyers in our Business or Oil, Gas & Energy sections for more information.