Securities Regulators Issue Warnings Regarding Energy Stock Scams

By James Eccleston

hree securities regulators have issued alerts to investors relating to investments in energy stocks. The regulators - the SEC (Securities and Exchange Commission, NASAA (North American Securities Administrators Association) and FINRA (Financial Industry Regulatory Authority) all are concerned that scam artists may prey on unsuspecting investors. Let's examine the warnings, and the guidance offered to investors (and their legal counsel).

FINRA recognizes that a combination of factors (such as the price of oil) has excited investors about the prospects of energy and alternative energy stocks. Unfortunately, that excitement has "fueled a rash of energy-related stock scams", according to FINRA. In describing how these scams work, the regulator has observed that they "typically involve the touting of a small unknown company, using a combination of baseless price predictions, misrepresentations and hyperbole." Reminiscent of other stock scams, a "pump and dump" occurs, whereby false and misleading statements create artificial demand for the stock, pumping up its price. When the price is pumped up, the con artists sell their shares, leaving investors holding worthless stock.

To avoid being scammed, FINRA recommends several things. First, never rely on unsolicited emails or faxes, and always consider the source. FINRA warns that, "It's easy for companies or their promoters to make glorified, unsubstantiated claims about new products, lucrative contracts, or the company's revenue, profits, or future stock price." Second, FINRA wants investors to remember that, normally, strangers do not approach others to share purportedly great investment opportunities. Third, FINRA recommends exercising skepticism about "any pitch that suggests immediate pay-offs, especially if the investment involves a start-up company or a product or service that is still in development." That's because it can take "years or decades" before even promising technologies can enter the market.

FINRA also recommends that investors do their homework by reading the company's SEC EDGAR filings (if any), determining where the stock trades, and investigating the person touting the stock. Investors must be especially careful about investing in stocks that trade on the OTC Bulletin Board or in the Pink Sheets, as they do not have the same financial and reporting listing requirements as the Nasdaq Stock Market or the New York Stock Exchange. Likewise, in investigating the person touting the stock, note that a legitimate investment sales representative must be licensed, and his or her firm must be registered with FINRA, the SEC or a state securities regulator.

The second warning comes from NASAA, which is the association for state securities regulators. NASAA has focused its alert on oil and gas investment fraud, and provides helpful details as to how investors can conduct their due diligence.

First, while oil and gas investments can take many forms, limited partnership interests historically have been popular and continue to be popular. In a drilling limited partnership, investors buy units so that the oil and gas company can lease property and drill wells. For managing the project, NASAA reports that the company usually takes an upfront fee of 15-16% of one's investment and also shares in a percentage of revenue generated. If successful, investors receive quarterly cash distributions (until the well runs dry), in addition to a substantial first-year tax write-off. The problem, according to NASAA, is that "drilling partnerships have always been a gamble, but recently, they have proven somewhat riskier than usual." Investors need to understand that the investment "is very speculative, is a highly illiquid investment and can have a long holding period", NASAA warns. Worse, there exist fraudulent oil and gas deals. NASAA cautions investors that fraudsters often will structure the limited partnership (or other legal entity) in one state, yet operate from and select a well in another state, and solicit investors in still other states. Such a structure, NASAA observes, "makes it difficult for law enforcement officials and victims to identify and expose the fraud."

Second, if investors nonetheless wish to invest in an oil and gas deal, NASAA recommends that they consider oil exploration and oil producing companies that are well-established and listed on the New York Stock Exchange. If that investment option is not attractive, NASAA advises investors to seek the advice of a neutral expert (such as securities lawyers), and to ask several questions. They are:

Who will be responsible for the payment of taxes? Will they be paid out of the investor's share?

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

What is the name and address of the operator? What is his/her experience with ventures of this nature? What are the terms of the agreement with the operator, including the compensation terms?

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

The SEC also has weighed in with its investor alert, "Oil and Gas Scams: Common Red Flags and Steps You Can Take to Protect Yourself." The SEC's alert reiterates much of the guidance discussed above. Notably, though, the SEC recommends that investors contact the oil and gas regulatory agency in the state in which the company is drilling wells. Specifically, inquire about a company's drilling history to confirm claims of prior success. The SEC cautions investors that states do not have uniform names for their oil and gas agencies (in Texas, it is called the Railroad Commission of Texas, for example). But an Internet search (using the name of the state followed by "oil and gas") should suffice to identify the right agency. Alternatively, the SEC invites investors to call the SEC at 800-732-0330.

Investors, beware! "Lucrative" oil and gas deals may turn out to be lucrative only for one person - the fraudster! To avoid such scams, follow the advice of the regulators!

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About the Author:
James J. Eccleston is the president of Eccleston Law Offices, P.C. The Chicago-based firm represents investors and advisers nationwide in securities and employment matters. 312-332-0000 www.EcclestonLaw.com.