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June 03, 2013 Articles

The Applicability of the Securities Laws to Energy-Related Investments

Investment fraud is on the rise.

By David S. Siegel

Several factors have led to a steadily increasing amount of financial and investment-related fraud in recent years. Chief among these have been the aging of the population and the shift from traditional pension plans to individually managed retirement accounts. As the population of elderly people swells with the arrival of baby boomers increasingly responsible for the management of their own retirement accounts, the conditions improve for financial fraudsters. Studies show a link between advancing age and a diminishing ability to make appropriate financial decisions. For example, one study found that older people exhibit less investment skill than younger investors. George M. Kornitoes and Alok Kumar, 2011, Do Older Investors Make Better Investment Decisions?, Review of Economics and Statistics 93: 244–65. Another study found that suboptimal credit behavior increases past the age of 53. Sumit Agarwal, John C. Driscoll, Xavier Mabaix, and David Larbson, The Age of Reason: Financial Decisions Over the Life Cycle and Implications for Regulation, Brookings Papers on Economic Activity 2: 51–117 (2009). Yet another study found that financial literacy declines with advancing age and tied this decreasing financial literacy to poor investment decisions. Michael S. Finke, John Howe, and Landra J. Huston, Old Age and the Decline in Financial Literacy (2009). It appears settled that as the population ages, more and more people are likely to make unwise financial decisions, leaving them vulnerable to scammers and hucksters.

This development is borne out in the statistics showing a general increase in financial fraud concurrent with the graying of the population. According to the Federal Trade Commission, fraud complaints have increased by a factor of five in the last decade, rising to one million by 2010. The Securities and Exchange Commission (SEC) filed a record number of enforcement actions against investment advisors and companies in 2011. Kimberly Blanton,The Rise of Financial Fraud: Scams Never Change but Disguises Do, Center for Retirement Research Working Paper (2012). A study of financial exploitation of seniors found widespread abuse of the elderly, noting that 56 percent of certified financial planners reported having a client who had been financially exploited, with the average estimated loss per victim at $50,000. 2012 Senior Financial Exploitation Study. It appears clear that as the population ages and as, simultaneously, more and more people are shifted from traditional retirement savings plans such as company pensions to accounts they have to manage for themselves, the incidence of financial fraud will continue to increase.

Energy-Investment Fraud Is Alive and Well

The types of frauds perpetrated on the investing public are virtually limitless. Anyone casually following the media will have heard of scams such as the Bernard Madoff Ponzi scheme. Similar frauds on a smaller scale are prevalent nationwide, and the variety of fraudulent investment products is breathtaking. Hucksters peddle prepaid phone-calling cards, life-insurance settlements, sophisticated-seeming financial derivatives tied to everything from new commodities to vacation timeshares, and everything in between.

Energy-related investments are not immune to such fraudulent promotions. In fact, investments tied to the energy sector of the economy can be uniquely susceptible to wrongdoing. There are various reasons for this synergy between energy investments and opportunistic bad actors. First, the price of commodities such as oil and natural gas fluctuates periodically, and intervals of rising prices make it easier for fraudsters to sell investment opportunities. Second, the assets or exploration and production activities being sold are rarely located where the investor is convinced to part with his or her money. This makes it easier for the promoters to misrepresent the nature of purported activities at a drilling site, for example, or to misrepresent ownership of things such as leases or real estate. And, the publicity surrounding developments like the shale-gas drilling boom set the stage for promoters to promise unreasonably high or “guaranteed” levels of investment returns.

This fit between the nature of oil and gas operations, the wider economy, and opportunistic bad actors has in fact led to a rise in fraudulent energy-investment promotional activity. Various regulators have noted the troubling prevalence of energy-investment scams. For example, the North American Securities Administrators Association (NASAA) notes on its website that “state securities regulators around the country warn that oil and gas investment scams are alive and well. [H]igh oil prices have created a heightened interest in investments in energy-related business ventures.” When there is a highly publicized economic circumstance, which creates an opportunity for money to be made legitimately, scammers follow in the shadows to take advantage of the situation.

Cases from around the country validate these concerns. In Montana in 2012, the FBI shut down a scam in which promoters convinced investors to send them $673,000 to finance a drilling project on a Montana Indian reservation. The promoters, through email and high-pressure phone calls, promised investors that their initial investments would be repaid within six months and that they would receive regular monthly checks thereafter. As is so often the case, two of the promoters involved in the scheme had prior federal fraud convictions, and as the FBI agent working the case said in his affidavit, “neither company has ever made any meaningful effort to spend the money on development of oil and gas ventures at Fort Peck or anywhere else.”

In Dallas, in 2010, a defendant pleaded guilty to raising $7 million in investor funds through false pretenses and fraudulent misrepresentations. The defendant formed a company that purported to own and operate oil and gas leases in Texas, Oklahoma, Colorado, and Arkansas. The defendant promised investors that their royalty interests would yield annual returns greater than 25 percent. In fact, the defendant was running a Ponzi scheme and paying earlier investors with funds from later investors. Dallas FBI Press Release, Dallas Business Man Admits Running Oil and Gas Ponzi Scheme, Dec. 10, 2010.

As the NASAA noted, scammers follow in the wake of some favorable economic circumstances that can lend an air of legitimacy to the investments they promote. A much grayer area is occupied by legitimate corporations that would not normally be associated with scams or Ponzi schemes, but which may still come under suspicion for their statements of their future prospects. The recent boom in shale-gas drilling offers a good example of this phenomenon. Initially, the revelation that shale gas was in abundant supply in the United States and that it burned cleaner than other fossil fuels created great optimism that the United States could become largely energy independent and perhaps even a net energy exporter. Natural-gas companies placed enormous bets on their drilling operations, in many cases financed with money pouring in from investors seeking to profit from what appeared to be a sure thing. Then the recession hit and the price of natural gas plummeted, challenging the economics of the production model.

Now questions have been raised concerning whether the industry has deliberately overstated its future prospects to keep the pipeline of capital flowing. In June 2011, the New York Times ran an in-depth examination of the industry based in large part on numerous company emails and internal documents it obtained. The Times’s investigation revealed considerable internal skepticism about lofty earnings forecasts, stated reserves, and rates of production. One analyst wrote “the word in the world of independents is that the shale plays are just giant Ponzi schemes and the economics just do not work.” An official with one company wrote that the “herd mentality into the shale will eventually end, possibly like the sub-prime mortgage did.” A retired geologist from a major company wrote “these corporate giants are having an Enron moment . . . they want to bend light to hide the truth.” Another energy investment analyst asked in a 2009 email whether “there may be something suspicious going on with the public companies in regard to booking shale reserves.” And, production data obtained by the Times suggest that production from many wells declined steadily rather than leveling off, causing one retired geologist to opine that “this kind of data is making it harder and harder to deny that the shale gas revolution is being oversold.” Ian Urbina, Insiders Sound an Alarm Amid a Natural Gas Rush, N.Y. Times, June 25, 2011.

In response to concerns such as those aired in the New York Times investigation, regulators have begun asking their own questions. The attorney general of New York sent subpoenas to three large energy companies “as part of a broad investigation into whether they have accurately described to investors the prospects for their natural gas wells.” Ian Urbina, New York Subpoenas Energy Firms, N.Y. Times, Aug. 18, 2011. The investigation was at least partially prompted by the fact that the state of New York has more than $45 million of its pension money invested with the companies and, in the words of the Times reporter, “if a company improperly reported to investors how its wells were likely to perform or failed to disclose the true costs of drilling, there could be repercussions for the state’s financial portfolio.”

The Application of Securities Laws to Energy-Related Investments

As the foregoing discussion should make clear, energy-related investments provide numerous opportunities for the violation of securities laws. The growing aging population creates a larger pool of potentially vulnerable targets for unscrupulous promoters. Economic conditions make oil and gas plays “hot” and therefore attractive to investors seeking higher yields than are currently available from traditional stocks and bonds. And even in the realm of large publicly traded companies, which are presumably more reputable than fly-by-night promoters, both promoters and investors need to be vigilant about whether representations about future prospects are defensible.

Against this backdrop, practitioners on both sides of the bar should have some basic familiarity with the securities laws and whether they apply to certain investments. Claimants’ attorneys will want to know whether there are causes of action grounded in statute beyond remedies afforded by common law. Defense attorneys will want to know whether their clients have run afoul of these same statutes. This article does not purport to offer a field-wide survey of securities law. Similarly, there is no single case that addresses all the possible securities-law issues that could arise from the wide variety of energy-investment scenarios. What follows below is a brief survey of some recent case decisions that touch on selected securities-law questions in the energy-investment context.

Two recent cases from Colorado examined the central issue of whether certain energy-related investments constitute securities for purposes of the application of securities laws. In 2011, the SEC brought an action against Jeffrey Shields and his company, Geodynamics, Inc. The SEC alleged that Geodynamics was improperly selling unregistered joint-venture interests in oil and gas drilling programs. Whether the investments constituted a security was a threshold jurisdictional question because the SEC would lack jurisdiction to regulate the sales if they were deemed not to be securities. August 16, 2011 Order on Motion for Temporary Restraining Order, SEC v. Shields and Geodynamics, Inc., C.A. 11-CV-02121-REB (D. Colo.). The court applied a three-part test derived from the longstanding precedent in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The three criteria for a security set out inHowey are 1) an investment, 2) in a common enterprise, 3) with a reasonable expectation of profits to be delivered from the entrepreneurial or managerial efforts of others. Banghart v. Hollywood General Partnership, 902 F.2d 805, 807 (10th Cir. 1990).

The joint ventures at issue in Shields had been organized under Texas law. The SEC alleged that the defendants raised more than $5 million through boiler-room cold calling in which potential investors were promised returns as high as 548 percent. Rather than engage in actual drilling operations, the SEC alleged that Shields used the money to fund personal purchases of such things as a Learjet, homes, travel, and jewelry. The defendants sought to characterize their offerings as joint-venture interests, not securities, and thus as not being subject to the securities laws. The SEC argued that Shields and Geodynamics offered a “turnkey investment” that promised profits from oil and gas exploration actively conducted by Geodynamics in exchange for a set price. The joint-venture documents promised that the joint venture and its operations “shall be managed and controlled collectively by the Venturers.” The SEC argued that any control promised to the investors was illusory and that the investors were not in a position to exercise actual control because the true nature of the business was hidden from them through misrepresentations and omissions. The defendants supported their position with an affidavit from one of the investors stating that he had been given opportunities to exercise discretion over the affairs of the business, had access to financial information of the business, and that he had never considered his investment to be the purchase of a security. The court was persuaded by this testimony and held the investments not to be securities.

In another Colorado case, this one from state court, the court construed an investment in an oil and gas program similar to that in Shields. In Joseph v. HEI Resources, Inc., Case No. 09CV7181, the court analyzed the Fifth Circuit case of Williamson v. Tracker, 645 F.2d 404 (5th Cir. 1981). The Williamson opinion had created a presumption that partnership interests are not securities and the opinion set out factors that might overcome the presumption. The presumption could be overcome if the following elements were met: 1) The agreement gives so little power to the non-managing general partners that the arrangement is tantamount to a limited partnership; 2) the non-managing general partners were so dependent on some unique entrepreneurial or managerial skill that they could not realistically replace the promoter or general partner; or 3) a particular general partner is so inexperienced and unknowledgeable in business affairs that he or she is incapable of intelligently exercising partner powers. Joseph, slip. op. at 6. The Joseph court granted summary judgment to the defendants, finding that neither of the first two grounds for rebutting the presumption that general partnership interests are not securities was present. The court noted that the general partners had certain powers they could exercise on a simple majority vote and that the promoter and general partner were not irreplaceable. Joseph, slip. op. at 9–10.

These recent Colorado cases indicate that the particular facts regarding the management and control of the business at issue will determine whether an investment will be covered by the securities laws. There is no simple test that can be mechanically applied across the broad spectrum of types of oil and gas investments.

Another legal issue that may prove to be increasingly relevant in the energy-investment arena is how to distribute the limited assets of a fraudulent enterprise to large numbers of defrauded victims. This usually should not matter in the case of large publicly traded companies, but as the foregoing discussion noted, energy-related Ponzi schemes are often perpetrated by individual bad actors. In other cases, such as the one discussed immediately below, the defendant might be a broker-dealer who sold the bad investment to the public and is not nearly as well capitalized as a large oil and gas company would be.

In Stott v. Capital Financial Services, Inc., 277 F.R.D. 316 (N.D. Tex. 2011), the court was faced with sorting out the aftermath of a massive shale-gas Ponzi scheme. Provident Royalties, LLC purportedly ran an oil and gas development business. It sold preferred stock and partnership interests to investors for the apparent purpose of financing its operations. In fact, Provident was a Ponzi scheme and entered bankruptcy. The plaintiff investors sued various broker-dealers who had sold Provident securities to the public. The investors argued that the broker-dealers had violated the securities laws by failing to perform proper due diligence on Provident and by selling the securities through the use of private-placement memoranda containing material misrepresentations about the business. The plaintiffs and the broker-dealer sought court approval of a “limited fund” class-action settlement. Consummating a class settlement would require staying separate arbitration proceedings and the court had to also determine whether it could do so, in addition to determining whether the class-action-settlement requirements had been met. The brokers’ customers were required by their contracts to bring claims against it in Financial Industry Regulatory Authority (FINRA) proceedings and many did so, setting up a conflict between those who wished to have their claims heard in individual arbitration proceedings and those who wanted a class certified in the federal district court.

The court first considered whether the situation presented a true “limited fund.” The basic concept of a limited-fund settlement is that “numerous individual claims against an insufficient fund would impair the ability of all members of the class to protect their interests.”Stott, 277 F.Rd. at 326 (citations omitted). Relying on Ortiz v. Fibreboard Corp., 527 U.S. 815, 838–39 (1999), the court identified three necessary elements of a limited fund: 1) The totals of the aggregated liquidated claims and fund available for satisfying them, set definitely at their maximums, demonstrated the inadequacy of the fund to pay all claims; 2) the whole of the inadequate fund is to be devoted to the overwhelming claims; and 3) the claimants identified by a common theory of recovery are treated equitably among themselves. The court easily found that the proposed class settlement intended to use the entire fund available for payment of claims (less attorney fees) and that the claimants were to be treated equitably amongst themselves through a pro rata distribution scheme. Stott, at 327–28. The court took a closer look at the first requirement to determine whether the fund was truly inadequate to pay all claimants. The court noted that the claimants could readily ascertain their losses as these were simply the amounts invested but never returned. As for the amount proposed by the settling parties to be placed in the fund, it consisted almost exclusively of insurance coverage, coupled with a small cash contribution from the broker-dealer. The court found that there was no more money available, that the cash contribution was the absolute maximum the company could contribute while continuing operations, and that the insurance available was limited as the parties represented to the court, as opposed to a theoretically larger amount of insurance that would only be available if certain coverage issues were litigated in the insured’s favor. Finally, the court addressed whether a fund could be deemed truly limited if the settlement allowed the defendant to retain enough assets to continue operations. The court relied on the fact that FINRA had determined the maximum amount the broker-dealer could pay without being forced into regulatory violations for being inadequately capitalized. The court concluded that “total deprivation” of the broker-dealer’s assets was not required and that fairness to the class could be balanced with the defendants’ continuing solvency.

After determining that the proposed settlement met the requirements of a true limited fund, the court addressed whether it had the power to enjoin the pending arbitration claims. The court noted that limited-fund settlements typically entailed enjoining other legal proceedings to preserve the limited assets that would be available to all class members. The court concluded that under the All Writs Act, it had the power to permanently enjoin the competing arbitrations because the prosecution of those separate actions entailed the risk of adjudications that could be dispositive of the interests of all the class members who were not parties to the arbitrations. Simply put, if the arbitrations were allowed to proceed one by one, the defendant’s funds could be entirely depleted long before each injured class member received at least a pro rata settlement. Under the proposed settlement, no investor would get all of his or her money back, but at least all would share equitably in the recovery.

Finally, there is a recent U.S. Supreme Court case that is worth mentioning here even though it did not arise in an oil and gas context. In Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds, __ S. Ct.__, 2013 WL 691001 (U.S. Feb. 27, 2013), the Supreme Court just recently held that proof of the materiality of misrepresentations made in the sale of securities is not a prerequisite to class certification. The case concerned alleged misrepresentations by Amgen as to the safety, efficacy, and marketing of two of its flagship drugs. The class contended that these false statements artificially inflated Amgen’s stock price and that when the truth was disclosed, the stock price declined, thus harming the class. The Court had to determine whether Rule 23(b)(3)’s requirement that “questions of law or fact common to class members predominate over any questions affecting only individual members” meant that the question of materiality had to be resolved at the certification stage, or merely had to be a predominating question. Amgen had argued that the class could not be certified unless the plaintiffs could prove, at the certification stage, the materiality of alleged misrepresentations about its drugs. The Court agreed with Amgen that materiality of alleged misrepresentations is in fact crucial to the “fraud on the market” theory of liability because that theory presumes that efficient markets factor material information into stock prices, which are relied on by the public to make stock purchases. As Amgen framed the argument, if the representations were not material, there could be no presumption that the stock-buying public “relied” on them in purchasing their shares because an efficient market would not have allowed non-material representations to affect the stock price. The Court held that Rule 23(b)(3) only required common questions to predominate at the certification stage and that it was not necessary for the class to prove how those questions would ultimately be answered at a full trial on the merits. 2013 WL 691001 at *9. The Court also observed that the failure to prove that the misrepresentations were material would not lead to the need for individualized proof on that issue, thus making the case inappropriate for class-action treatment. Rather, a failure of proof on materiality would end the case for all the individuals alleged to compose the class. Id. at *11.

Amgen is a brand-new case and it remains to be seen what effect it may have on oil and gas litigation. Its holding that materiality of misrepresentations need not be proved at the certification stage could be relevant to efforts to certify class actions arising out of misrepresentations about, for example, stated reserves in oil and gas assets or rates of production from wells already in operation.


Investment fraud is generally on the rise for a variety of reasons, including the aging of the population and economic and societal trends that are forcing people to both manage their own retirement accounts and chase returns sufficient to sustain them in retirement. Oil, gas, and other energy-related investments are not immune to this general trend and, in fact, may be particularly suited to the needs of scammers and fraudsters because their claims about the assets underlying investments are difficult for the average, non-specialist to evaluate, let alone verify. Thus, practitioners need some basic familiarity with how, and in which situations, the securities laws may apply to energy investments. Because the variety of possible investment schemes is so wide, there is no single case that can answer all the questions that may arise. The cases cited above offer a basic introduction to the field and illustrate the types of issues that can arise when both legitimate and illegitimate promoters go to the public to raise money for their operations.


Keywords: energy litigation, investments, securities laws, oil, gas, fraud


David S. Siegel is senior counsel at Ajamie LLP in Houston, Texas.

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