SECURITIES LAW CONSIDERATIONS FOR THE OIL & GAS INVESTMENT SPONSOR

INTERNET OIL & GAS PRIMERTM

SECURITIES LAW CONSIDERATIONS FOR THE OIL & GAS INVESTMENT SPONSOR

Author's Note: In the November andDecember, 1996 Issues, we discussed when the offer and sale of Oil and Gas Interests become securities transactions and the impact of this "Securities" characterization. We saw that oil and gas transactions can easily be classified as "securities" when one is dealing with someone outside the oil & gas industry. We also saw that the legal requirements applying to transactions in "securities" are broad and complicated.
But just how serious would it be to ignore these "technical" requirements? (Certainly, many members of the oil & gas industry do.) This month we'll answer that questions by looking at the effects of a failure to comply with the securities laws.*

PART THREE: INTRODUCTION TO OIL & GAS AND THE SECURITIES LAWS:EFFECT OF NON-COMPLIANCE WITH SECURITIES LAWS*

In the December, 1996 issue of this Newsletter, we overviewed the extensive legal requirements that apply at both the federal and state level to the sale of interests in oil & gas rights where those sales are considered "securities transactions." However, the majority of oil and gas operators simply ignore the very clear requirements of those securities laws: they do not register/qualify their offerings with federal and state authorities or comply with the requirements for claiming a securities registration exemption; they do not make "full disclosure" to prospective investors, as that concept is interpreted under the securities laws; they accept investors who may not be viewed as "suitable" participants in unregistered offerings; and they certainly do not register themselves as broker-dealers and agents. And -- most do not go to jail, or end up in the poor house as a result of investor rescission actions.

But, in the words of "Dirty Harry, "you've got to ask yourself – 'do you feel lucky?'" Harry's bank robber didn't -- but Harry was carrying a 44 Magnum, "which could blow your head clean off!" Your decision on whether or not to continue ignoring the securities laws may well turn, from a practical standpoint, on whether the securities laws permit an irate investor to confront you with a Magnum -- or only a popgun!

Both federal and state securities acts authorize criminal sanctions against securities law violators. In practice, however, criminal penalties are normally imposed only on the practitioners of "true" fraud, or after blatant, continued securities law violations of a "willful" nature.1

Federal and state acts also authorize the securities authorities to bring injunctive actions to enjoin continued violations of the securities laws. Again, with the limited personnel and resources of the securities agencies, these steps are usually taken only against the more "high profile" offenders-- or following investor complaints!2

The sponsor's greatest exposure under the securities laws, from a practical standpoint, is investor civil suits. The most common of these are for securities law violations which create an investor rescission right -- an automatic right to the return of all moneys contributed to the venture, plus interest.3

Not every violation of the conditions of the securities laws gives the investor an express right of rescission. However, in many instances, violation of a prohibition of the securities laws which is not coupled with an express right of investor rescission has been held to give the investor an implied right to sue for the return of his money. (Suits under SEC Rule 10b(5) under the Securities Exchange Act are a prime example.)

The sponsor's primary exposures, practically speaking, are: (i) a suit for rescission for an improper failure toregister/qualify his security;4 or (ii) a suit for failure to satisfy the full disclosure/anti-fraud requirements of the securities laws. While failure to register involves a shorter fuse statute of limitations -- one year on the federal level, and most commonly two years on the state level -- it still usually proves the greater threat: there are fewer subjective issues (failure to file a necessary "notice of claim," or to deliver a required offering document, is clear-cut; "material" fact isn't) and the statute of limitations may be "tolled" or otherwise extended.

If a violation of the securities laws occurs which creates investor rescission rights, officers, directors, principal shareholders, and "controlling persons" are directly and personally liable (there is no "corporate insulation"), frequently irrespective of any wrongdoing (or knowledge of wrongdoing) on their part. "Underwriters" are also liable; and other parties may be liable as "conspirators," "aiders and abettors," or inadvertent "co-issuers" or "underwriters."

The seriousness of the sponsor's practical exposure is increased by the ability of a "savvy" investor (or investor's attorney) to increase the size of the lawsuit through bringing a class action on behalf of himself "and all investors similarly situated," frequently "enhanced" through a similar combining as to a number of prior offerings which, the investor asserts, should be "Integrated."5

A new woe for sponsors is their possible liability under the Racketeer Influenced and Corrupt Organization Act, which permits the recovery of treble damages for injuries arising from a "pattern [two or more acts] of racketeering activity," including mail fraud and fraud in the sale of securities. Variations of this federal statute have been enacted by several states, frequently in an even more daunting form. While it is currently unsettled as to whether or not several instances of "garden variety" fraud could constitute the requisite "racketeering" pattern, much securities litigation now includes the assertion of a RICO claim.

Coming Next Month: Securities Registration Requirements: an Overview

*Didn't you say in the DecemberIssue that this month we'd be overviewing Securities Registration requirements? Yes, but I fib a lot: we'll be overviewing Securities Registration Requirements in the next part of this Primer.

1Even many of these blatant violators may never see the inside of a jail cell due to the woefully limited budgets provided for those charged with prosecuting those who have violated the criminal aspects of the securities laws.

2Once a formal complaint is filed with a securities agency, the administrator's hands are often tied - action must be taken, particularly at the state level. The fact that you voluntarily returned a sore loser's money doesn't prevent him from "blowing the whistle" with federal and state authorities. And embittered ex-employees are another risk.

3Where interests have been sold on a "well-by-well" basis, the Investor will have a right to "cherry pick," rescinding as to dry holes or marginal wells and retaining the prolific producers.

4Remember, if exemptions from the registration/qualification requirements were available, and the conditions of these exemptions were complied with, there would be nothing "improper" about the failure to register/qualify and no exposure to liability on this score. (These exemptions will be overviewed in the next article in this Primer series.)

5"Integration" will be discussed in a later article in this Primer.

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