Special Report: For these oil and gas bets, the odds favor the house

NEW YORK (Reuters) - Atlas Energy LP has a deal for investors eager to get in on the U.S. energy boom: Contribute at least $25,000 in a partnership that will drill for oil and gas in Texas, Ohio, Oklahoma and Pennsylvania and then share any revenue from the wells’ output.

Retired engineer Bill Jenkins and his wife Carol look over documents concerning their investment in Reef's Income & Development Fund II at their home in Orlando, Florida, October 31, 2014. REUTERS/Steve Nesius

Atlas Resources LLC, a subsidiary of the Pittsburgh, Pennsylvania-based energy group, aims to raise as much as $300 million before the offer closes Dec. 31. The company says it will toss in up to $145 million of its own capital, too.

But not all investors are created equal in this undertaking. Atlas’s confidential offering memorandum, reviewed by Reuters, shows why.

Up to $45 million of the money raised will be paid to Atlas affiliate Anthem Securities to cover commissions to broker-dealers who market the deal, the memorandum says. As much as $39 million more will be used to buy drilling leases from another affiliate. Atlas-affiliated suppliers may also get some of the $53 million set aside for buying drilling and transport equipment.

An additional $8 million of Atlas’s investment is not an investment at all; it is a 15 percent markup on estimated equipment costs. As soon as drilling begins, Atlas will pay itself nearly $52 million in various other fees and markups.

In short, Atlas’s $145 million exposure is reduced by at least 40%, and possibly much more, after taking into account payments to group affiliates and markups. Further, if and when the venture starts generating revenue, Atlas is entitled to a 33 percent cut, reflecting the size of its stake before accounting for those payments and markups.

Atlas is raising money for the venture, called Atlas Resources Series 34-2014 LP, in what is known as a private placement - a sale of unregistered securities through broker-dealers to a limited number of investors. And as the offering details suggest, oil and gas private placements tend to be structured so that “the house always wins,” said Mitch Little, a Frisco, Texas-based lawyer who has represented investors in and issuers of private placements.


Private placements, a lightly regulated market comprising hundreds of billions of dollars a year in new issues, have a long history in the oil and gas sector. Small prospectors, known as “wildcatters,” have for years used them as a quick, easy way to fund the expensive and highly speculative process of drilling, drawing in investors keen to take advantage of generous federal tax breaks on energy exploration. In the new century, the U.S. “fracking” boom has prompted a new wave of prospecting, attracting tens of thousands of investors.

Reuters was able to review offering memoranda and other marketing material for six oil and gas private placements issued over the past 15 years by four companies: Atlas; Reef Oil & Gas Partners of Richardson, Texas; Discovery Resources & Development LLC of Frisco, Texas; and Black Diamond Energy Inc of Buffalo, Wyoming.

These documents contain details on multiple previous private placements by each company, and they show that the deal Atlas is now marketing adheres to a common template: The issuers typically charged between 15 percent and 20 percent in upfront fees from investors, while paying brokers – often affiliated with the issuer - an additional 10 percent of the total offering in sales commissions.

The upshot is that the issuer often starts out at an advantage relative to outside investors.

For slightly more than half of 43 private placements Atlas issued over the past three decades, outside investors lost money or just about broke even. In 29 of those deals, Atlas did better than those investors.

Of 34 deals Reef has issued since 1996, only 12 have paid out more cash to investors than they initially contributed, according to Reef’s latest publicly available financial statements. The statements show Reef sold an additional 31 smaller deals between 1996 and 2010 for which it collected a total of $146 million and paid out just $55 million.

Brian Begley, Atlas Energy’s vice president for investor relations, declined to comment.

Reef Chief Executive Officer Michael Mauceli said in a statement: “We have conducted our business with the utmost integrity, meeting and surpassing ethical, business and regulatory standards.”

Energy ventures are by their nature risky prospects, narrow bets on a single commodity. Wells can come up dry. Volatility in oil and gas prices can sink returns. As Atlas warns in the memorandum for its offering: “These securities are speculative and involve a high degree of risk. You should purchase these securities only if you can afford a complete loss of your investment.”


Beyond the inherent risks, though, these deals are often unfair to outside investors, said David Miller, a Houston-based lawyer who represents investors in lawsuits against issuers and brokers of private placements. “Investors are taking on huge risks, but simply are not getting paid for those risks,” he said.

Issuers say that criticism ignores the tax benefits of their deals. Investors can write off more than 90 percent of their initial outlay the year they make it.

But investors in oil and gas deals comprise not just the savvy, high-income individuals meant to use the tax break. Of the 28 people interviewed for this article who invested in deals from Reef, Atlas, Discovery Resources and Black Diamond over the past 10 years, 17 were retirees who had low tax burdens when they signed on.

Under U.S. law, brokers can market private placements only to institutions and accredited investors, the latter defined as American residents with either $1 million in assets, not including the investor’s primary residence, or $250,000 in annual income.

Those criteria were set in 1982. Since then, inflation has greatly expanded the number of people who qualify. Now, they include people like Arla Funk, a 79-year-old retiree who works part-time for the Salt Lake City, Utah, school system in a job that pays $10 an hour.

In 2006, Funk invested $100,000 in a private placement called Atlas American Series 27-2006. “We were looking for some long-term retirement kind of income,” Funk said. She said the broker who sold her on the deal told her she would receive “a paycheck that comes every month.”

As of Dec. 31, 2013 - seven years after she gave Atlas her money - she and other outside investors had earned back just 31 percent of their principal. For her and other unhappy investors in private placements, selling isn’t a realistic option: There is no active secondary market for the securities.

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“When I finally found out what a scam it was, I was upset because it was too late for me to do anything,” Funk said.

In addition to the Atlas and Reef deals reviewed for this article, thirteen from Black Diamond between 2001 and 2006 failed to generate enough revenue to return investors’ initial contribution.

Black Diamond filed for bankruptcy in 2011 after a major bank creditor called its loans. It never completed the bankruptcy process. Its principals, one of whom, Charles Koval, was a founder of Atlas Energy, are trying to sell Black Diamond’s leases and equipment. Koval declined to comment.

Discovery Resources, which issued four private placements between 2006 and 2009, filed for bankruptcy in 2010, as did its founder Richard Weyand. Federal prosecutors in March charged Weyand with filing a false tax return for 2008 to hide $101,000. He pleaded guilty in April and is currently awaiting sentencing.

Weyand’s lawyer, Jeff Boggess, said Discovery Resources’ deals provided tax breaks to investors and therefore could not be called unsuccessful.


All sorts of businesses – including banks, heavy industry and, especially, investment pools like hedge funds and private equity firms - use private placements to raise money for all sorts of purposes.

The market is vast: A Reuters analysis of nearly 100,000 filings with the Securities and Exchange Commission found that between 2008 and the second quarter of this year, issuers intended to raise as much as $5.5 trillion through private placements. And that sum excludes the 22,000 issues intended to raise “indefinite” sums. (The number of issuers does not include those who submitted paper, rather than electronic, filings before 2009.)

The market is also opaque. The required documents filed with the SEC typically state the name of the issuer, the maximum amount sought, and little more. There are no follow-up filing requirements.

The Financial Industry Regulatory Authority, the securities industry’s self-regulatory body, requires that brokers perform due diligence on each issue they sell to ensure its suitability for investors. But as Reuters reported in a previous article, many brokers rely on outside due-diligence firms that are in fact paid by the issuers - a setup under which some issuers have engaged in multimillion- and even multibillion-dollar frauds.

In the oil and gas sector, the SEC data show that since 2008, nearly 4,000 private placements have sought to raise as much as $122 billion.

Brad Bennett, head of enforcement at FINRA, said in a statement that brokers need to be “meticulous in their consideration of the types of customers for whom [oil and gas private placements] may be suitable.” He added that the deals should be “only recommended to clients whose financial goals are consistent with the products and who understand the risks inherent in them.”

State and federal regulators have little scope for oversight of private placements, and the scant reporting requirements give them little information to work with.

In a 2013 alert to the public, the SEC said investors needed to keep in mind that oil and gas private placements were especially risky, that they often carried hidden fees, and that issuers routinely made money even when drilling yielded no oil or gas.

A spokesman for the SEC declined to comment.

Issuers stay on the right side of securities laws through voluminous disclosures in their offering documents, which brokers are required to provide to investors. Fred Rosenberg, a former investment broker who analyzes oil and gas private placements for parties in legal disputes, reviewed the offering memorandum for Atlas’s latest deal at Reuters’s request. He said the 407-page document made the risks of the investment clear. “This looks, on my first reading, to be a legitimate offering,” he said.

Among other things, the document says investors might never get their money back, and it warned investors that there could be conflicts of interest between them and Atlas, and that the conflicts might not be resolved in their favor.

However, Rosenberg said: “If the investor expects a profitable return and income stream over his lifetime ... think otherwise.”


In the past decade, investors have been drawn to oil and gas placements as a way to profit from the revolution in drilling technologies that have opened up huge stores of oil and gas in previously inaccessible locations. One of them was Bill Jenkins.

In early 2007, the retired engineer, now 77 years old, attended the Money Show, a convention held in several locations every year that brings together investors and providers of money-making opportunities.

At Reef’s booth, he picked up a printed breakdown of some older Reef deals. Over six to eight years, the flier said, an initial outlay of $100,000 would have paid back, depending on the deal, between $176,160 and $231,310.

Jenkins then got a call from Richard Main, who worked for Reef’s affiliated securities broker. Jenkins said Main told him that Reef’s Income & Development Fund II required a minimum investment of $100,000 – more than Jenkins and his wife had available – but that he could get them in for just $25,000. Main told them they had to hurry, though, because the deal was just about to close, Jenkins said.

The couple went for it.

Main told them to expect some paperwork. “ ‘You’re not going to understand it, but don’t worry, I’ll walk you through it,’ ” Jenkins said the broker told him.

Jenkins received a 52-page offering memorandum, marketing materials and other documents, and a postage-paid return envelope. He said Main told him: “As soon as you get the package, call me because I need to get this thing back.”

On the phone, Jenkins followed along as Main guided him to pages where he had to sign. When they were done, Jenkins said, Main told him: “ ‘Now if you can’t get this in the mail today, give me a call and let me know so I can maybe work with my boss and get you into it.’ ” After the couple sent the package back to Main, “He called back and said, ‘Yeah, you guys did good, you made it,’ ” Jenkins said.

Soon, the couple began receiving monthly checks ranging from $150 to $300.

Though the offering documents fully disclosed the risks of the venture, Jenkins said he didn’t realize until much later that he and his wife had signed dozens of pages of paperwork attesting to their understanding of the deal and their willingness to accept the possibility of losing all of their investment.

If he had looked more closely at the time, Jenkins would have found that the offering memorandum clearly stated that the minimum investment was $25,000. It also contained a long section about the risks of the investment, such as conflicts of interest among Reef’s various entities.

Under the terms, investors would turn over $50 million to Reef, and right away Reef would keep $7.5 million for fees and broker commissions. After that, Reef would receive a monthly management fee of $41,667 from the fund. Reef would also charge drilling and operating, legal and other expenses to the fund.

The amounts of these expenses would be determined by other Reef entities hired to do work for the venture. No more than half of the money would be used to buy oil and gas properties in areas where there were proved reserves. Once the properties started producing revenue, Reef would determine how much would be available for distribution.

Main declined to comment. His lawyer, John R. Fahy, disputed much of Jenkins’s account. He said Main never told Jenkins the minimum investment was $100,000 and didn’t rush Jenkins through the process.


In November 2007, as the checks from the $25,000 investment were rolling in, Jenkins received another call from Main. He was now touting Reef Income & Development Fund III.

The couple put in another $25,000. This time, they got some relatives in on the deal. When checks from Fund II started to dwindle, they didn’t worry. Reef newsletters reassured them that volatility was normal.

But then the size of the checks from Fund III began to shrink. Soon they were arriving only every three months. Jenkins said a friend and fellow Reef investor noticed that separate monthly statements from the two funds were identical; money from both had gone into the same wells. “We called them and they said, ‘Oh, we forgot to plug in the numbers for III,’ ” Jenkins said.

Jenkins and his fellow investors asked for their money back in 2011, but Reef declined. Under terms of the deal, Reef is not required to buy back the shares.

In 2012, Jenkins, along with friends and relatives who had invested with him, filed an arbitration claim with FINRA against Reef Securities, claiming Reef had defrauded them by misrepresenting the two deals. The investor group sought nearly $2 million in compensatory and punitive damages.

FINRA arbitrators ruled on July 14 that Reef Securities was “liable on the claim of negligent failure to supervise” and that Reef should return $188,000, or slightly more than half of the investors’ money. It did not provide a public explanation for the basis of its decision.

Reef CEO Mauceli noted that the amount was far less than what the group of investors was seeking and that it did not include punitive damages.

The panel awarded the Jenkinses $32,500. The couple’s lawyer, Daxton White, will get 40 percent of the total award to investors. He said he doesn’t expect the decision will alter Reef’s way of doing business. “As long as they can sell it, they’ll keep doing it, because they make money regardless of the deal’s outcome,” he said.

Reef has gotten back 48 percent of the capital it put into Reef Income and Development Fund II and 61 percent of what it put into Reef Income and Development Fund III, while investors have gotten just 16 percent and 4 percent of their capital back on those deals, respectively.

Mauceli said the “disproportionate returns” reflect Reef’s “carried interest” as general partner in the deals, “which is a long-standing and well-respected standard in the oil and gas industry.” He stressed that the differences also did not take into account tax benefits investors may have enjoyed. “The investments we offer are highly speculative opportunities designed for sophisticated, accredited investors, such as Mr. Jenkins,” he said.

Main left Reef in 2008. FINRA suspended his broker’s license in 2010 after he failed to respond to the regulator’s request for information, records show. He is now one of two principals at an oil and gas investment business, FIG Tree Capital Ventures, his lawyer said.

Reef’s two most recent private placements are showing early promising results – mostly for Reef. The company has earned back 182 percent on a 2011 deal; outside investors are still in the hole, having earned just 21 percent of their outlay. And for a 2012 deal, the company has already recouped nearly 20 percent of its capital; other investors have gotten 3 percent of theirs.

Additional reporting by Selam Gebrekidan. Edited by John Blanton