SMU Law Review Volume 50 Issue 3 Article 2 1997 Coming of Age: Initiating the Oilfield into Performance Disclosure John Burritt McArthur Follow this and additional works at: https://scholar.smu.edu/smulr Recommended Citation John Burritt McArthur, Coming of Age: Initiating the Oilfield into Performance Disclosure, 50 SMU L. REV. 663 (1997) https://scholar.smu.edu/smulr/vol50/iss3/2 This Article is brought to you for free and open access by the Law Journals at SMU Scholar. It has been accepted for inclusion in SMU Law Review by an authorized administrator of SMU Scholar. For more information, please visit http://digitalrepository.smu.edu. Articles COMING OF AGE: INITIATING THE OILFIELD INTO PERFORMANCE DISCLOSURE John Burritt McArthur* TABLE OF CONTENTS I. INTRODUCTION ........................................ 665 II. SOLICITATION BY MISREPRESENTING PAST PERFORMANCE IS A SERIOUS PROBLEM IN THE OIL AND GAS BUSINESS .............................. 672 A. RESERVE AND PRODUCTION MISREPRESENTATIONS IN THE TRADITIONAL EQUITY INVESTMENT .............. 672 1. Some Operators Make False Analogies to Nearby A reas ............................................. 673 Copyright © 1997 by John Burritt McArthur. All rights reserved. * B.A., Brown University, 1975; M.A., University of Connecticut, 1978; J.D., Uni- versity of Texas, 1984; M.P.A., Harvard University, 1994. The author was one of the lawyers who litigated the A.E. Investments ("AEl") v. Davis Oil Co. case discussed in detail in Part II.A. AEI was a subsidiary of the Aetna Insurance companies. The Aetna case introduced the author to many of the issues discussed in this Article and made him decide that the industry needed substantial improvements to the operator-investor relationship. He discussed many of the Davis Oil issues with the late John Jolly, for many years the executive director of COPAS. Mr. Jolly was one of Aetna's experts. He also explored many of the same issues with Aetna's other experts: Joe Abel, Phil Doty, A.L. Lyth, Preston Moore, Donald Hockaday, Everett Holseth, Don Silberman, Victor Stabio, and Mike Zeeb. In addition, he discussed the pros and cons of various positions with Aetna's other lawyers, his partners Mark Wawro and Lee Godfrey, as well as with legal assistant Mike Stinson, and benefited greatly from talking over a variety of related matters with Aetna's in-house managing lawyer, its litigation vice president Peter Mear. Mr. McArthur also defended certain corporate officers in the Longhorn Oil and Gas litigation discussed in Part II.B. In addition, Mr. McArthur has handled litigation over the measurement of and obligation to pay royalties, the determination of proper well charges by an operator, and a number of take-or-pay cases. Mr. McArthur has discussed various issues in this Article with Gene Gallegos, Robert Green, Don Hockaday, Everett Holseth, Frank Leggio, A.L. Lyth, Preston Moore, Craig Shephard, Mike Stinson, Don Silberman, Mark Wawro, and Mike Zeeb. None of these, of course, is responsible for the views expressed in the Article, which are solely the author's. A number of people have provided information cited in these pages. Foremost among them are Gerald Bader, John Bohn, Howard Boigon, Thomas Coghill, Andrew Derman, Frank Douglass, Gene Gallegos, James Irish, Frank Leggio, Bob Minerich, Robert Pezold, Colette Poeppel, David Richman, Jan Riley, Don Silberman, Mike Stinson, Jon Wallis, Mark Wawro, and Mike Zeeb. SMU LAW REVIEW [Vol. 50 2. Some Operators Make False Analogies to Specific, ParticularlyImpressive, Wells ...................... 674 3. Some Operators Overemphasize Early Results and Completion Statistics .............................. 675 B. MISREPRESENTATIONS IN DRILLING FUND AND PARTNERSHIP PROGRAMS ............................. 683 1. Longhorn Oil and Gas: Fabricatinga Track Record, Concealing Losses, Inflating Reserves ..... 685 2. Home-Stake: Running the Ponzi Scheme .......... 689 3. Prudential: Converting the Ponzi Scheme into a H igh A rt Form .................................... 695 4. The John King Organization: Manipulating Cash Surrender Values .................................. 708 5. Petro-Lewis: Concealing FailureAfter Periods of Success ............................................ 709 III. THIS INDUSTRY NEEDS PERFORMANCE DISCLOSURES, PAST AND PRESENT ................. 712 A. INVESTORS NEED TO KNOW How WELL THE OPERATOR HAS PERFORMED FOR OTHER INVESTORS . 713 B. THE OIL BUSINESS IS SUFFICIENTLY PREDICTABLE TO USE PRIOR ECONOMIC PERFORMANCE ................ 715 C. REGULATION THROUGH FULLER INFORMATION IS CONSERVATIVE REGULATION ......................... 723 D. DECISION THEORY SUPPORTS THE ARGUMENT THAT INVESTORS NEED MORE FRONT-END INFORMATION... 730 E. THE LAWS OF FRAUD, FIDUCIARY DUTY, AND SECURITIES REGULATION Do NOT ADEQUATELY D ETER FRAUD ........................................ 732 F. DISCLOSURE Is NOT PERFECT, BUT IT IMPROVES INDUSTRY STANDARDS ................................ 740 IV. THE MECHANICS OF DISCLOSURE .................. 741 A. TODAY'S FORM CONTRACT, THE JOA, NEEDS TIGHTER CONTROLS ................................... 742 B. OPERATORS MUST DISCLOSE RETURN-BASED MEASURES OF PRIOR INVESTOR RESULTS ............. 750 C. OPERATORS MUST DISCLOSE THE PRIOR PERFORMANCE OF EACH "OPERATING" ENTITY ....... 756 D. INVESTORS NEED TIMELY ECONOMIC UPDATES ....... 757 E. COPAS SHOULD BE A CLEARINGHOUSE FOR OPERATOR PERFORMANCE ............................ 758 V. CONCLUDING POINTS: SCOPE, THE USE OF THE CASE M ETHOD ......................................... 761 A. DRILLING FUNDS AND INDUSTRY COMPANIES NEED PROTECTION Too ..................................... 761 B. THE CASE METHOD CAN DIAGNOSE STRUCTURAL PROBLEM S ............................................ 765 VI. PROTECTION IS LONG OVERDUE ................... 775 1997] PERFORMANCE DISCLOSURE IN THE OILFIELD 665 I. INTRODUCTION OST oil and gas is discovered by independent operators who sell shares in their projects to outside investors and then admin- ister the process of drilling and development.' Nonoperators, the investors in oil and gas programs, need more protection than they currently receive from industry customs and legal standards. Market dis- tortion occurs because oil and gas operators usually do not tell their in- vestors how past programs have done. By not distributing this information, operators deprive investors of the information they need to judge an operator's ability to perform its promises. This Article is a companion to an already published article on the places where the industry contract fails to give investors necessary ac- counting information. 2 Taken together, the two articles give a compre- hensive picture of why it remains too easy for operators to exaggerate the economic value of their proposals. Several common types of investors sign up in oil and gas programs. The traditional investor is a working interest owner who puts up cash in return for an equity interest.3 Other investors buy shares in drilling pro- grams, which may be incorporated as separate entities, or become limited partners in drilling partnerships. They receive partnership or stock inter- 1. In the broadest definition, an operator is "a person (natural or artificial (e.g., cor- porate)) engaged in the business of drilling wells for oil and gas." HOWARD R. WILLIAMS & CHARLES J. MEYERS, MANUAL OF OIL AND GAS TERMS 842 (8th ed. 1991) [hereinafter WILLIAMS & MEYERS MANUAL]. The operator's duties in drilling a well are defined in an operating agreement, which is "[ain agreement between or among interested parties for the testing and development of a tract of land. Typically, one of the parties is designated as the operator .... The authority of the operator, and restrictions thereon, are spelled out in detail in the typical agree- ment." Id. at 837. One of the surprising facts about the oil business is that even major oil companies, com- panies with years of industry leadership, impressive technical staffing, and hundreds of millions of dollars in annual investments, often do not drill their own wells. In many in- stances they leave the risk-taking to independent operators and wait until at least initial wells have been drilled before purchasing interests. The trade organization of independent producers, the Independent Petroleum Association of America (IPAA), estimates that in- dependent producers drill eighty-five percent of all new wells and produce as much as sixty-four percent of the natural gas in the United States. Natural Gas Gathering Services Performed by Interstate Pipelines and Interstate Pipeline Affiliates-Issues Related to Rates and Terms and Conditions of Service, Before the Federal Energy Regulatory Commission 5 (Docket No. RM94-4-000) (Jan. 14, 1994) (comments of the Independent Petroleum Asso- ciation of America). (This is not true in the most expensive ventures, which often only the majors can afford to finance.). 2. John B. McArthur, A Twelve-Step Program for COPAS to Strengthen Oil and Gas Accounting Protections, 49 SMU L. REV. 1447 (1996). 3. The "working interest" includes the operator's interest and is, in a somewhat over- lapping definition, the "operating interest under an oil and gas lease," the interest of those who have "the exclusive right to exploit the minerals on the land." WILLIAMS & MEYERS MANUAL, supra note 1, at 1377. Working interests in a well often are stated as a single interest, with the costs to be borne and revenues to be shared stated as a percentage of that interest. See id. at 1378. These interests include any equity interest