The U.S. Securities and Exchange Commission (SEC) warns that, with the recent oil and gas boom and news reports of big discoveries in Texas and North Dakota, securities fraud cases are on the rise, The Dallas Morning News reports. Whereas eight years ago the SEC may have reported a few cases a year, the agency's total annual oil and gas related fraud lawsuits now amount to more than 20. Moreover, preventing this type of fraud has proved difficult, as court rulings have questioned the SEC's jurisdiction over investment offerings presented as joint ventures, finding investors in such deals to be partners who essentially stake money at their own risk.
I have written in previous articles about investment fraud, their red flags, and what auditors can do to help detect and prevent it. Oil and gas fraud appears to be on the rise. And regardless of surrounding legal arguments about issues such as the SEC's powers with respect to joint ventures versus investments, we have an opportunity to go a little deeper and learn from one fundamental issue that seems to underlie it — the inherently high-risk nature of the oil and gas business, contrasted with a seemingly widespread lack of due diligence being demanded by the apparent victims of fraud. Here are some additional concrete steps that can be taken to avoid this kind of fraud.
1. Ask for a "due diligence report" and any related objective evidence in support of the promoter's claims. When organizations work with a registered broker that recommends a private oil and gas offering, the broker must independently review the investment. Brokers should not just rely on the oil and gas promoter for information. Instead, they must check the statements and claims about the investment. Their due diligence report should outline how the venture's prospects and claims were evaluated.
2. Find out what the invested funds will be used for. Even if estimated, ask how much of the money will be used for each need, such as drilling operations, administrative overhead, and broker sales fees. If sales fees will be paid, how are those fees calculated? It is reasonable to expect the company raising the money to have plans for it, particularly if the persons involved have prior industry experience. Otherwise, why are they raising that specific offering amount? If broker sales fees are being paid, you should know that registered brokers are subject to rules and regulations, including the amount of sales fees they can charge. Misrepresentations and/or omissions can include paying large sales fees to brokers, significant compensation to the promoter and employees of the venture, payment of operating and other expenses for unrelated businesses, and using investment funds to pay for personal items.
3. Do the research necessary to answer the fundamental questions/concerns. Analysis of highly technical matters such as an oil and gas investment can be daunting, involving research on issues such as geological findings and new drilling technologies. Also, the only source of information may be the promoter. But there is a process and logic that can be used to cut through much of this complexity — much the same as an auditor would apply to a financial or management audit topic. The promoter may have a third-party engineering report for the site — ask to see it. Some operators may employ the expertise of independent third-party engineers and geologists to decide whether it makes sense to drill in an area. If the promoter says there is a report, but doesn't want to provide access to it, consider it a red flag. Other factors to consider include:
Related parties. Is there any relationship between companies subcontracted to do work and the promoters and principals in the venture? The promoters can do quite well for themselves when investment funds are used to pay themselves, for example, or to hire a company they own to do the drilling — they get paid even if the well is dry.
Well history. Investigate whether there is a prior history of drilling where the promoter now plans to do so, as this will give an indication of future prospects. Although there are new and improved ways of drilling, such as hydraulic fracturing (i.e., fracking) and horizontal drilling, these often require specialized and costly expertise.
Reserves. If the venture materials discuss reserves, who determined these estimates and how? There is a big difference between proven and possible reserves in terms of likely results from drilling activity. Although not required, some oil and gas ventures have their reserve estimates audited.