CHAPTER 6 OBTAINING EQUITY CAPITAL FOR DRILLING OPERATIONS: THE SECURITIES ASPECT
| Jurisdiction | United States |
(Nov 1982)
OBTAINING EQUITY CAPITAL FOR DRILLING OPERATIONS: THE SECURITIES ASPECT
Cotton, Bledsoe, Tighe & Dawson, P.C.
Midland, Texas
The purpose of this paper is to discuss the securities implications of obtaining equity capital for oil and gas operations. Obviously, general business and income tax implications are also an integral part of choosing the form of entity and the promotional aspects of the venture. The income tax implications of this subject will be dealt with in another paper and I will present an overview of certain of the business considerations that may be deemed important to both a promoter and an investor in the obtaining of equity capital. It should be noted that this paper is limited to equity participation, that is, an interest in which the investor obtains an ownership interest in the underlying entity (whether a partnership or corporation) or a direct interest in oil and gas leases. A portion of this presentation will cover the relatively new SEC Integrated Disclosure Rules, as they affect oil and gas financing and a discussion of the types of sharing arrangements permitted under, and practical problems involved in complying with, the North American Securities Administrators Association Guidelines for Oil and Gas Programs.1
ORGANIZING THE ENTITY
The choices available to a promoter interested in obtaining equity financing are either to organize a corporation, a general partnership, a limited partnership, or to allow investors to invest directly in oil and gas leases. Both the general partnership and direct ownership of leases are sometimes referred to as "joint venture arrangements," which arrangement will be discussed herein.
The Business Considerations
The logical starting point for the inquiry concerning choice of entity is the goal of the promoter. Most importantly, is the promoter trying to obtain "seed money" to begin a company which is expected to grow and expand, or is he merely trying to finance a specific project? If the former goal is being sought by the promoter, the likely choice will be to incorporate and to structure the transaction in such a fashion so that the investors
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purchase common stock in the enterprise. If, on the other hand, a specific project requires equity financing, a form of partnership or joint venture may be more appropriate. The same analysis generally holds true from the investor's standpoint. A corporation offers limited liability and free transferability of interests (subject to applicable securities laws), as well as being a convenient and familiar investment vehicle. These considerations would be expected to be of importance to promoters and investors who are seeking a long-range investment in which the value of the underlying assets are expected to increase. However, these same advantages will be of less significance to investors who were seeking an investment in a particular drilling project. Regardless of the economic merit (or lack thereof) in the project, a large part of the investor's motivation will be the income tax advantages that may be realized from oil and gas participation. As will be explained in another paper, the deductions available to an individual who invests in oil and gas exploration through a partnership generally are not available to a shareholder of a corporation, and earnings received through a corporation are subject to double taxation.
To the extent income tax considerations are important, the choices become a general partnership, limited partnership or some form of direct purchase. The chief distinction between a general and limited partnership is the preservation of limited liability to passive investors in a limited partnership as opposed to the joint and several liability present in a general partnership. While naming a managing general partner and documenting agreements and indemnities between the parties to a general partnership may insulate a participant in a general partnership to some degree, a limited partnership is still preferable to a passive investor who expects the success of his investment to be obtained by third parties. In addition, a limited partnership has the additional advantage of centralizing management in one or a small group of general partners. Also, the continuity of the enterprise is more assured in a limited partnership since, under typical limited partnership agreements, the death or dissolution of a limited partner does not terminate the limited partnership. A general partnership is appropriate in those instances where all the parties have some familiarity with the operations to be undertaken, wish to be involved in decisions with respect to partnership operations and can assume the liability burdens implicit in such an investment.
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Another possible form of equity investment in oil and gas operations is the purchase of a fractional undivided interest in oil and gas leases. The leases are then operated by an operator under an operating agreement and the operator is generally a co-owner in the leases. Under this arrangement, each participant owns a real property interest and has the right to sell his interest in the leases (subject, perhaps, to certain rights of first refusal specified in the operating agreement), as well as the general right to participate or decline participation in subsequent wells to be drilled on the leases. Professionals in the oil and gas business generally prefer this form of investment because of the fact that a real property interest is being acquired which can be easily dealt with by industry professionals. Another advantage of this type of direct investment is the ease with which individual working interests can be utilized as collateral. As contrasted to a pledge of a limited partnership interest in which operations are under the control of a third party, bankers generally prefer collateral consisting of an undivided interest in the leases. While a direct interest does provide the benefits alluded to herein, it generally is not a satisfactory means of participation for persons not routinely engaged in the oil and gas business due primarily to potential liability problems. While the law in this area varies from state to state, an investor may be subject to joint and several liability to creditors, landowners and other third parties for debts or liabilities created by the operator's actions (or failure to act) in connection with the lease premises. The traditional method to protect against this eventuality is through insurance coverage. However, insurance coverage obtained may be subject to certain exclusions and the insurance coverage may be inadequate to cover any damages which are assessed. Furthermore, direct ownership of oil and gas interests may involve time-consuming and expensive problems upon the death of the owner since such interests are real property. Upon an investor's death, the direct ownership of leases may subject the property to local probate administration and local death or inheritance taxes. In addition, when dealing with relatively unsophisticated investors, the use of fractional undivided interests can cause time-consuming problems for the promoter. Because of the nature of the interest being acquired, participants generally will have the right to take any oil discovered in kind and the operator is typically not given general authority to farmout, sell, exchange or otherwise dispose of the working
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interest. Thus, it is necessary to obtain individual approval for the execution of such agreements. This can be a time-consuming task when a large number of investors are involved and additional time can be spent in explaining technical industry documents to investors with very little, if any, background in the functioning of the oil and gas industry.
Most of you have heard of or participated in "joint ventures" formed for the purpose of oil and gas exploration. Joint ventures are very misunderstood and can generally be organized in different fashions which can have at least three meanings: (1) a description of a co-ownership arrangement in which the only documentation is the operating agreement between the parties; (2) an arrangement involving a form of operation documented by an agreement analogous to a general partnership agreement (often utilized in real estate syndications); or (3) a direct ownership arrangement wherein a master agreement is utilized in addition to an operating agreement. The third structure is often utilized in large oil and gas private placements where sophisticated investors seek the advantages of a direct ownership participation, but the investors and the promoter wish to delegate substantial control of the operation of the joint venture to the promoter as managing venturer, in addition to the rights the promoter would obtain from serving as operator of the leases. The law with respect to the legal nature of a joint venture is somewhat fuzzy, but generally speaking courts characterize these arrangements as having the same legal effect as general partnerships, including the joint and several liability feature. This is particularly true of Texas law.2 For tax purposes, of course, a joint venture is regarded as a partnership.
In summary, the general business considerations surrounding the type of entity to be selected are constricted by what investors will buy. Leaving aside the formation of the corporation to achieve long-term equity growth, investors with relatively small amounts of money to invest who are not familiar with the oil and gas business will typically prefer a limited partnership, while professional and/or sophisticated investors with large amounts of funds to spend will more often wish to participate in a general partnership, direct ownership or a form of joint venture whereby they maintained a measure of control over their investment.
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Practiced Differences in Forms of Agreements
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