EXHIBIT 3.3
CONFIDENTIAL MEMORANDUM COPY NO.____________________
DATED: February 1, 2006 NAME OF OFFEREE ____________
RIDGEWOOD ENERGY S FUND, LLC
Gulf of Mexico Oil and Natural Gas Fund
1000 Shares of Beneficial Interest
Offered at $150,000 Per Share
Minimum Offering of $1,500,000
Maximum Offering of $150,000,000
Ridgewood Energy S Fund, LLC, a Delaware limited liability company (the "Fund"),
has been organized to acquire interests primarily in natural gas and oil
projects located in the deep or shallow U.S. waters of the Gulf of Mexico. The
Manager of the Fund (the "Manager") is Ridgewood Energy Corporation, a Delaware
corporation. The Fund is offering up to an aggregate of 1000 Shares of
beneficial interest ("Shares") at a purchase price of $150,000 per Share. See
Terms of the Offering.
- ------------------------------ ------------------------ ---------------------------- -----------------------------------
Funds Available for
Organizational and Gas Investments and
Shares Price to Investors Offering Expenses** Fund Operations
- ------------------------------ ------------------------ ---------------------------- -----------------------------------
Minimum 10 $1,500,000 $255,000 $1,245,000
Maximum 1000* $150,000,000 $25,500,000 $124,500,000
- ------------------------------ ------------------------ ---------------------------- -----------------------------------
*The Fund in its discretion may expand the maximum offering up to 1,335 Shares
or more.
**Expenses incurred in the offer and sale of the Shares, including commissions,
placement, legal, accounting, printing and filing fees, and a one-time
investment fee to the Manager.
THIS INVESTMENT IS SPECULATIVE AND NON-LIQUID AND INVOLVES A HIGH DEGREE OF
RISK, INCLUDING:
o Severe restrictions on transferability of the Shares.
o Drilling to establish productive natural gas or oil wells is highly risky
and the investment in wells could be completely lost.
o The Manager may have material conflicts of interest and has total control
of the Fund.
o The significant federal and state income tax benefits of investing in the
Fund and the applicable laws may be changed at any time.
There are many other risks as explained at Risk Considerations. Purchases will
be accepted only from persons meeting the requirements set forth under Investor
Suitability Standards.
THESE SHARES HAVE NOT BEEN REGISTERED WITH THE SECURITIES AND EXCHANGE
COMMISSION OR ANY OTHER FEDERAL OR STATE AGENCY. NO REGULATORY AUTHORITY HAS
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS CONFIDENTIAL MEMORANDUM OR THE
OFFER AND SALE OF THESE SHARES. ANY REPRESENTATION TO THE CONTRARY IS UNLAWFUL.
RIDGEWOOD SECURITIES CORPORATION
947 Linwood Avenue
Ridgewood, New Jersey 07450
(201) 447-9000
SHORT SUMMARY
RIDGEWOOD ENERGY S FUND, LLC
Gulf of Mexico Natural Gas and Oil Fund
Securities Offered: 1000 Shares ($150,000 per Share)
Amount Offered: Maximum: $150,000,000 Minimum: $1,500,000
The S Fund Continues a The S Fund is a continuation of the series of
Series of Gulf of Mexico Ridgewood Energy "Alphabet Funds" which have
Funds: invested in natural gas and oil properties in the
Gulf of Mexico, which began with the B Fund in
1992. After the B Fund, Ridgewood Energy offered
successive Alphabet Funds through, most recently,
the R Fund, which began offering shares on January
2, 2006. The Alphabet Funds have invested in major
natural gas and oil projects in the Gulf of Mexico
in partnership with major oil and gas companies
Natural Gas and Oil Prices The average price of natural gas for the past year
Increase: is more than double the average price in the
decade of the 1990s. In addition, oil prices have
increased significantly over the last several
years and both natural gas and oil prices are
predicted to remain at high levels for the
foreseeable future
Long Term Shortages: The demand for natural gas and oil is expected to
continue to exceed supply for the foreseeable
future, sustaining high prices.
Gulf of Mexico Discoveries: Major oil and gas companies focus their domestic
drilling activities in the United States waters of
the Gulf of Mexico as the primary North American
region with (i) potentially significant quantities
of natural gas and oil, combined with, (ii) an
existing pipeline infrastructure in some areas of
the region enabling a fast track to rapid
production and early cash flow.
Only Ridgewood Energy: Ridgewood Energy was founded in 1982. Ridgewood
Energy Funds have been investing in the Gulf of
Mexico since 1986. Ridgewood Energy is the only
program sponsor in the United States consistently
offering high net worth individuals direct,
institutional quality offshore natural gas and oil
investments in partnership with experienced
independent and major energy companies.
i
Track Record of Date First December* Distributions Cumulative
"Alphabet Funds": Closed Distribution Monthly For Distributions
------ ------------ Distribution 12 Months through
------------ Ended December 2005*
December* ---------------
2005
----
B Fund 3/92 2/93 .8% 9.6% 262.1%
C Fund 10/92 2/93 .8% 9.6% 262.1%
D Fund 7/98 9/99 - - 101.2%
E Fund 6/99 9/99 10.7% 117.2% 526.7%
F Fund 6/00 12/00 4.8% 33.0% 150.5%
G Fund 7/01 2/02 6.6% 78.1% 243.7%
H Fund 9/03 4/04 4.0% 37.1% 46.9%
I Fund 12/03 1/05 1.1% 6.5% 6.5%
J Fund 3/04 6/05 .5% 3.3% 3.3%
K Fund 8/04 6/05 .2% 1.7% 1.7%
L Fund 9/04 11/05 .8% 1.4% 1.4%
M Fund 11/04 - - N/A N/A
N Fund 2/05 11/05 1.8% 3.1% 3.1%
O Fund 8/05 - - N/A N/A
P Fund 9/05 - - N/A N/A
Q Fund 12/05 - - N/A N/A
R Fund - - - N/A N/A
* Except for the L Fund and the N Fund, which made
distributions of 3% and 7% respectively in the
month of January, the other Ridgewood Energy
Alphabet Funds did not make a distribution in the
month of January 2006. Generally, revenue earned
in October of 2005 would have been used for such
distribution; however, due to damage to pipeline
infrastructure equipment owned by non-Ridgewood
entities as a result of Hurricane Rita, the
Ridgewood Energy Funds were unable to market their
natural gas and oil in sufficient quantities to
justify a January 2006 distribution. The damage to
these facilities has largely been repaired and all
of the Ridgewood funds are operating under normal
conditions.
THE PERFORMANCE AND THE RESULTS OF PRIOR RIDGEWOOD
ENERGY ALPHABET FUNDS DOES NOT PREDICT SUCCESS OF
OR GUARANTEE SIMILAR RESULTS FOR THE S FUND. (See
Risk Considerations and Exhibit B Track Record.)
Early Investment Incentive The Manager at any time during this Offering may
have opportunities to invest in economically
promising transactions for the Fund. The Manager
is currently investigating such a transaction that
would require an investment by the Fund
potentially as early as mid-February 2006. Early
Investors who provide capital to the Fund to
acquire such Projects, which ultimately provide
benefits to all Fund Investors, will receive an
incremental benefit. The Fund is offering to such
Early Investors an Early Investment Incentive upon
the following terms and conditions:
o Investors who subscribe to the
Fund between February 1, 2006
and February 28, 2006 and have
fully paid their Capital
Contribution shall be entitled
to receive an Early Investment
Incentive equal to $12,000 per
$150,000 Share.
o Investors who subscribe to the
Fund between March 1, 2006 and
March 31, 2006 and have fully
paid their Capital
Contribution shall be entitled
to receive an Early Investment
Incentive equal to $8,000 per
$150,000 Share.
ii
o Investors who subscribe to the
Fund on or after April 1, 2006
shall not be entitled to, nor
shall they receive, an Early
Investment Incentive.
o The Manager anticipates that
the Early Investment
Incentive, as described
herein, shall be paid either
monthly or quarterly and begin
when the Manager determines
that the Fund has sufficient
cash flow. The Manager will
continue such payments, as
described herein until the
Early Investment Incentive to
Investors entitled to such
incentive has been paid in
full. Thereafter, all
Investors share in
distributions of the Fund in
accordance with their
individual ownership
percentage.
o Other than any right to
receive an Early Investment
Incentive, all other rights,
privileges and obligations of
Investors of the Fund shall
remain as described herein and
as set forth in the LLC
Agreement. Except for an Early
Investment Incentive, as
described herein, all
Investors have equal rights as
described in this Memorandum
and set forth in the LLC
Agreement.
Proposed Activities Gulf The investment objective of the Fund is to
of Mexico Natural Gas generate current cash flow for distribution to
and Oil Projects: Investors from acquiring, drilling, completing and
developing natural gas and/or oil projects in
shallow or deep waters of the Gulf of Mexico. The
Fund will attempt to build a balanced portfolio of
natural gas and oil projects ("Projects") which
are described in the Memorandum and may include,
without limitation, the following:
o Higher risk exploratory Projects which
may include deep drilling below 15,000
feet in shallow waters, perhaps near
pipeline infrastructure and which
projects have high economic potential.
The higher risk Projects would, if
successful, generally include a
substantial amount of development
capital which would have lower risk, but
at the same time, greater economic
potential.
o Higher risk exploratory Projects located
in the deepwaters of the Gulf of Mexico,
which Projects, although potentially
more costly to develop and longer to
complete, may potentially have
significantly greater potential for
reservoirs than in the shallower waters
of the Gulf of Mexico.
o Lower risk developmental Projects which
are already connected to pipelines, or
which are near the pipeline
infrastructure and can be connected
quickly.
Tax Benefits: The Fund's interests in the Projects may generate
significant drilling deductions, depreciation
deductions and depletion allowances.
iii
Summary: I. A long term supply of natural gas and/or
oil are the commodities to own due to
long-term supply shortages which have
resulted in high prices.
II. The United States waters of the Gulf of
Mexico is the place to own natural gas
or oil wells.
III. Ridgewood Energy offers institutional
quality Gulf of Mexico natural gas and
oil investments to high net worth
individuals.
Sharing of Income and Gain: Investors: 85%
Manager: 15%
Use of Proceeds: Acquisition, Drilling and 83%
Completion and Fund Operations
Syndication Fees and Closing Costs: 17%
THE INFORMATION CONTAINED IN THIS SHORT SUMMARY IS EXTREMELY GENERAL IN NATURE,
IS BASED ON, AMONG OTHER THINGS, PAST PERFORMANCE, FORECASTS OF NATURAL GAS AND
OIL PRICES AND CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS ABOUT DEVELOPMENT
PLANS, FUTURE RESULTS OF EXISTING RIDGEWOOD ENERGY PROGRAMS, EXPECTED PRODUCTION
RATES, CAPITAL EXPENDITURES AND NATURAL GAS AND OIL RESOURCE POTENTIAL. THESE
STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE. THE ACTUAL RESULTS ACHIEVED
BY THE S FUND, OR ANY OTHER RIDGEWOOD ENERGY FUND, WILL VARY, PERHAPS
SUBSTANTIALLY, FROM THE FORWARD-LOOKING STATEMENTS CONTAINED IN THIS SHORT
SUMMARY AND COULD BE MATERIALLY WORSE. POTENTIAL INVESTORS MUST REVIEW FULLY THE
ENTIRE CONFIDENTIAL OFFERING MEMORANDUM, INCLUDING RISK CONSIDERATIONS AND TRACK
RECORD, TO UNDERSTAND THE MANY RISKS ASSOCIATED WITH AN INVESTMENT IN THE S
FUND.
iv
TABLE OF CONTENTS
PAGE
SUMMARY OF PROGRAM.............................................................i
GENERAL........................................................................1
INVESTOR SUITABILITY STANDARDS.................................................3
MANAGER........................................................................4
PROPOSED ACTIVITIES............................................................4
USE OF PROCEEDS...............................................................16
RISK CONSIDERATIONS...........................................................16
General Risks Related to Natural Gas or Oil Exploration,
Drilling, Pipelines and Operations...................................17
Particular Risks Related to the Shares...............................22
TERMS OF THE OFFERING.........................................................28
PLAN OF DISTRIBUTION..........................................................29
PARTICIPATION IN COSTS AND REVENUES...........................................30
COMPENSATION..................................................................33
FIDUCIARY RESPONSIBILITIES OF MANAGER.........................................35
CONFLICTS OF INTEREST.........................................................38
MANAGEMENT....................................................................41
TAX ASPECTS...................................................................44
ADDITIONAL ASPECTS OF LLC AGREEMENT...........................................76
LIABILITY.....................................................................81
OTHER INFORMATION.............................................................82
General..............................................................82
Authorized Sales Material............................................83
LEGAL MATTERS.................................................................83
LITIGATION AND OTHER PROCEEDINGS..............................................84
DEFINITIONS...................................................................87
LIST OF TABLES
USE OF PROCEEDS...............................................................16
COMPENSATION..................................................................33
LIST OF EXHIBITS
FORM OF LLC AGREEMENT..................................................EXHIBIT A
RIDGEWOOD ENERGY CORPORATION TRACK RECORD..............................EXHIBIT B
FINANCIAL STATEMENTS OF RIDGEWOOD ENERGY CORPORATION...................EXHIBIT C
INVESTOR SUBSCRIPTION BOOKLET (BOUND SEPARATELY).......................EXHIBIT D
2006126
GENERAL
Certain provisions of the Fund's Limited Liability Company Agreement ("LLC
Agreement") and Subscription Agreement are summarized in several places
throughout this Memorandum. Although certain important provisions of these legal
documents are properly described in this Memorandum, provisions that may be
important to you may not be described in this Memorandum or described to your
satisfaction. Therefore, potential investors must review these legal documents,
as well as the Memorandum, in order to fully understand the terms of this
Offering. If the legal document differs from its description in this Memorandum
or if there is a conflict between the provisions of this Memorandum and a legal
document, the provisions of the legal document will control.
The DEFINITIONS section begins on page 87.
You should rely only on the information contained in this Memorandum and
its exhibits. The Fund has not authorized anyone to provide you with any other
information. However, the Fund understands that you may need additional
information before making a decision to buy Shares. The Fund will provide you
with any relevant additional information that the Fund has, can obtain or can
prepare without unreasonable effort or expense. However, you should only rely on
that additional information if it is given to you in writing and is signed on
behalf of the Fund. Because the Shares are being offered in a private offering,
if you receive this Memorandum or other offering materials and do not buy
Shares, you agree to return the Memorandum and other materials to us.
IN MAKING AN INVESTMENT DECISION INVESTORS MUST RELY ON THEIR OWN
EXAMINATION OF THE FUND AND THE TERMS OF THE OFFERING, INCLUDING THE MERITS AND
RISKS INVOLVED. THE SHARES OF THE FUND HAVE NOT BEEN RECOMMENDED BY ANY FEDERAL
OR STATE SECURITIES COMMISSION OR REGULATORY AUTHORITY. FURTHERMORE, THE
FOREGOING AUTHORITIES HAVE NOT CONFIRMED THE ACCURACY OR DETERMINED THE ADEQUACY
OF THIS DOCUMENT. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
THE SHARES OF THE FUND ARE SUBJECT TO RESTRICTIONS ON TRANSFERABILITY AND
RESALE AND MAY NOT BE TRANSFERRED OR RESOLD EXCEPT AS PERMITTED UNDER THE LLC
AGREEMENT AND UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND APPLICABLE STATE
SECURITIES LAWS, PURSUANT TO REGISTRATION OR EXEMPTION THEREFROM. INVESTORS
SHOULD BE AWARE THAT THEY WILL HAVE TO BEAR THE FINANCIAL RISKS OF THIS
INVESTMENT FOR AN INDEFINITE PERIOD OF TIME.
1
THE SHARES OF THE FUND ARE BEING OFFERED PURSUANT TO RULE 506 OF REGULATION
D PROMULGATED UNDER THE FEDERAL SECURITIES ACT OF 1933, AS AMENDED, AND THE
RELEVANT SECURITIES LAWS AND REGULATIONS OF CERTAIN STATES.
Forward-Looking Statement
Except for historical information, the Fund has made statements in this
Memorandum and its exhibits that constitute forward-looking statements, as
defined by the federal securities laws. These statements are subject to risks
and uncertainties. Forward-looking statements include statements made regarding
events, financial trends, future operating results, financial position, cash
flows and other general information concerning possible or assumed future
results of operations of the Fund or any prior Ridgewood Energy Program.
Investors are cautioned that such statements are only predictions, forecasts or
estimates of what may occur and are not guarantees of future performance or of
the occurrence of events or other factors used to make such predictions,
forecasts or estimates. Actual results may differ materially from those results
expressed, implied or inferred from these forward-looking statements and may be
worse due to a variety of factors including, without limitation, change in law,
fluctuations in natural gas and oil commodity prices, adverse weather, and
general delays in drilling, exploration or production. Finally, such statements
reflect the Fund's current views. The Fund undertakes no obligation to publicly
release the results of any revisions to the forward-looking statements made
herein to reflect events or circumstances that occur after today or to reflect
the occurrence of unanticipated events, provided however, that the Fund will
undertake to update this Memorandum to reflect events which materially change
the nature of this Offering that occur prior to the termination of the Offering.
2
INVESTOR SUITABILITY STANDARDS
AN INVESTMENT IN THE SHARES OF THE FUND IS ILLIQUID AND INVOLVES SIGNIFICANT
RISKS AND IS NOT A SUITABLE INVESTMENT FOR ALL PROSPECTIVE INVESTORS. See Risk
Considerations.
Investor Qualifications
- -----------------------
The Fund and the offering of Investor Shares are primarily structured to
comply with the private offering exemption under the federal Securities Act of
1933, as amended (the "Act"). In addition, the Fund is also structured to comply
with an exemption from certain restrictions on compensation under the Investment
Advisers Act of 1940 ("Advisers Act") as well as the rules and regulations
promulgated under the Act and Advisers Act by the Securities and Exchange
Commission (the "Commission"), as well as certain state laws and regulations
which impose limitations on the persons who may invest in Shares of the Fund and
from whom subscriptions may be accepted. Accordingly, the Fund is offering and
selling Investor Shares only to "accredited investors" as defined in Regulation
D under the Act who are also "qualified clients" as defined by Rule 205-3 of the
Adviser's Act, which investors will include without limitation:
o a natural person who has a net worth (including assets jointly owned
with his or her spouse) of more than $1,500,000 at the time of
purchase; or
o a company, trust, employee benefit plan, or other entity (an "Entity")
that has $1,500,000 in net worth and $5,000,000 in assets, in which
case such Entity is also an accredited investor, provided however, if
the Entity is (a) a private investment company excepted from
registration by Section 3(c)(1) of the Investment Company Act of 1940
("the "1940 Act"); (b) an investment company registered under the 1940
Act; (c) a business development company (as defined in Section
202(a)(22) of the Advisers Act); or (d) does not have $5,000,000 in
assets, then such Entity can not invest in the Fund unless, in
addition to the Entity having $1,500,000 or more in net worth, each
equity owner of the Entity satisfies the $1,500,000 net worth
requirement as well, which would then permit the Entity to invest in
the Fund.
For purpose of meeting the $1,500,000 net worth requirement, an investor's
equity in residences, furnishings and automobiles can be included.
3
For purposes of "accreditation" generally, a natural person will be an
"Accredited Investor" if he or she (or if spouses jointly) have in excess of
$1,500,000 in net worth. However, for an Entity, in addition to the $1,500,000
net worth requirement, it must have total assets in excess of $5,000,000 in
order to be accredited or, failing that, all equity owners of such entity must
meet the $1,500,000 net worth requirement.
IF YOU DO NOT MEET THE REQUIREMENTS DESCRIBED ABOVE, DO NOT READ FURTHER
AND RETURN THIS MEMORANDUM TO RIDGEWOOD SECURITIES CORPORATION. IF YOU DO NOT
MEET SUCH REQUIREMENTS, THIS MEMORANDUM DOES NOT CONSTITUTE AN OFFER TO SELL
SHARES OF THE FUND TO YOU.
Except in certain limited circumstances, United States federal law
prohibits the holding of interests in federal oil and gas leases by persons or
an Entity who are not citizens, nationals or permanent resident of the United
States. Each prospective Investor must represent whether he or she is a citizen
or national of the United States. The Fund shall have absolute discretion to
refuse to accept a subscription from such non-U.S. citizens or entities.
MANAGER
The Manager of the Fund is Ridgewood Energy Corporation, a Delaware
corporation that is wholly owned by Robert E. Swanson. See, Management and
Fiduciary Obligations of the Manager for more information.
PROPOSED ACTIVITIES
The primary investment objective of the Fund is to generate current cash
flow for distribution to Investors from acquiring, drilling, developing and
completing natural gas and oil projects in the offshore shallow or deep waters
of the Gulf of Mexico ("Projects" or "the Fund's Projects"). The Fund cannot at
this time identify specifically the Projects in which it will invest or the
drilling and other activities in which the Fund will engage for a variety of
reasons. Among these reasons are that the Fund has yet to acquire Working
Interests in any Project lease or well and will do so only after this Offering
is completed or when sufficient capital is available to the Fund to make any
such acquisition. The Manager will make decisions as to the management,
business, and affairs of the Fund in its sole discretion and judgment as to what
is in the best interest of the Fund. The Manager intends to cause the Fund to
4
acquire interests in as many Projects as is possible, given the funds raised,
the size of the interest acquired, and risk considerations. The Manager
anticipates that all of the Fund's Projects will be located in the offshore
shallow or deep waters of the Gulf of Mexico. However, at the present time the
Fund has not conclusively committed to any specific sites, leases or regions of
the Gulf of Mexico. No geological, engineering or other information about any
specific area is included in this Memorandum and the Fund is not committing to
provide any such information to an Investor. The decision of the Fund to acquire
a Project, the size and nature of the interest acquired, the location of the
Project, and the terms of such acquisition will be based upon evaluations of the
various properties conducted by the Manager after consultation with independent
geologists or engineers. See Risk Considerations.
With that background, the Manager of the Fund, in its sole discretion,
intends to invest in one or more of the following types of Projects:
o Lower risk developmental Projects which are already connected to
pipelines, or which are near the pipeline infrastructure and can be
connected quickly.
o Higher risk exploratory Projects in the shallow waters of the Gulf of
Mexico which may include deep drilling below 15,000 feet. Such
Projects may have high economic potential and may be near pipeline
infrastructure. These higher risk Projects would, if successful,
generally require a substantial amount of development capital, which
would have lower risk, but at the same time, greater economic
potential.
o Higher risk exploratory Projects located in the deepwaters (generally
greater than 1,000 feet water depth) of the Gulf of Mexico, which
Projects, although potentially more costly and risky to develop and
take longer to complete, may potentially have significantly greater
potential for productive reservoirs than in the shallower waters of
the Gulf of Mexico.
o Non-Consent Interests, which may include interests acquired from prior
Ridgewood Energy Programs.
o Ownership, development, construction, installation, acquisition,
and/or operation of infrastructure assets, including pipelines,
equipment and other assets, located or to be located in the offshore
waters of the Gulf of Mexico, that are used to gather, process,
transport and market natural gas or oil.
5
In addition, the Fund's activities may result in certain tax benefits,
consisting principally of deductions for intangible drilling costs, depletion,
and depreciation. See Tax Aspects. In considering Projects, the Manager
investigates each such Project against a list of factors that it believes will
result in the selection of those Projects that have the highest probability of
success. These factors, in no particular order, include, but are not limited to,
the following (i) targeting Projects that have or are expected to have operators
with significant resources and experience in oil and gas exploration; (ii)
targeting Projects that have or are expected to have partners that also have
significant resources and experience in oil and gas exploration; (iii) technical
quality of the Project including its geology, seismic profile, locational
trends, and whether the Project has potential for multiple prospects; (iv) oil
or gas reserve potential; (v) whether and the extent to which the operator
participates as a Working Interest owner in the Project; (vi) economic factors,
such as potential revenues from the Project, the rate of return, and estimated
time to first production; (vii) risk factors; (viii) existence of drilling rigs,
platforms and other infrastructure, at or nearby the Project; (ix) proposed
drilling schedule; (x) terms of the proposed transaction, including contractual
restrictions and obligations and lease term; and (xi) overall cost of the
Project.
Working Interest in Leases
The Projects that may be acquired by the Fund are expected to be located in the
waters (either shallow or deepwaters) of the Gulf of Mexico offshore on the
Outer Continental Shelf ("OCS"). The Fund anticipates that its operations and
activities would then be governed by, among other things, the Outer Continental
Shelf Lands Act ("OCSLA"), which was enacted in 1953.
Under OCSLA, as amended, the federal government has jurisdiction over oil
and natural gas development on the OCS. Pursuant to the OCSLA, the Secretary of
the Interior is empowered to sell exploration, development and production leases
of a defined submerged area of the OCS - a "Block" - through a competitive
bidding process. Such activity is conducted by the Minerals Management Services
("MMS"), an agency of the United States Department of Interior. As part of the
leasing activity and as required by the OCSLA, the leases auctioned include
certain lease terms such as the length of the lease, the amount of royalty to be
paid, lease cancellation and suspension, and, to a degree, the "planned
activities" of exploration and production to be conducted by the lessee. In
addition, the OCSLA grants the Secretary of the Interior continuing oversight
and approval authority over exploration plans throughout the term of the lease.
6
The winning bidder(s) at the lease sale - or Lessee(s) - are given a lease
by the MMS that grants such lessee the exclusive right to conduct oil and
natural gas exploration and production activities within a specific lease Block.
The Lessee's rights to conduct such activities are called "Working Interests"
and such Lessee obtains "title" to its particular ownership share of the Working
Interest. Leases in the OCS are generally issued for a primary lease term of 5,
8 or 10 years depending on the water depth of the lease Block. During this
"primary lease term", except in limited circumstances, Lessees are not subject
to any particular requirements to conduct exploratory or development activities
but in order to retain the lease rights beyond the initial term, the lessees
must proceed with "due diligence" to begin exploration activities. However, once
a Lessee begins exploration, the lease term generally is extended for so long as
the well continues in commercial production.
The Lessee of a particular Block, for the term of the lease, has the right
to drill and develop exploratory wells and conduct other activities throughout
the Block - i.e. Working Interests. If the initial well on the Block is
successful, a Lessee (or the Operator) may conduct additional geological studies
and may determine to drill additional developmental wells. If a developmental
well is to be drilled in the Block, each Lessee owning Working Interests in the
Block must be offered the opportunity to participate in, and cover the costs of,
such developmental well up to that particular Lessee's Working Interest
ownership percentage. Generally, if the Lessee elects to not participate in the
additional well, it will lose its rights to such additional well. The rights of
such non-participating Lessee to participate in such additional well in the
Block will then either be acquired by the remaining Lessees or sold to third
parties. Such rights are called Non-Consent Interests because they arise as a
result of an existing Working Interest owner's failure to "consent" to supply
additional capital for drilling new wells or other activities. Unlike a "Working
Interest" owner, a "Non-Consent Interest" owner does not obtain title and
ultimately the Non-Consent Interest reverts back to the original Working
Interest owner when the participating parties in the well have received a
penalty amount from the production attributable to the Non-Consent Interest.
While the Manager intends to focus primarily on Working Interests, any
Non-Consent Interest that the Fund will investigate or invest in will have
significant potential for economic returns to Investors.
Generally, the Working Interests in an offshore lease under the OCSLA are
burdened by a 16.67% royalty payable to the federal government. Therefore, the
net revenue interest of the holders of 100% of the Working Interest in the
Projects in which the Fund will invest is approximately 83.33% of the total
7
revenue of the Project and further reduced by any other royalties that apply to
a lease block. However, as described below, the MMS has adopted royalty relief
both for existing OCS leases for those who drill deep wells in shallow waters
and for drilling in deepwater. See, MMS Deep Gas royalty Incentive: Royalty
Relief and Deepwater Royalty Relief.
MMS Deep Gas Royalty Incentive: Royalty Relief
On January 26, 2004, the MMS promulgated new rules providing for incentives
for companies to increase deep natural gas production in the shallow waters of
the Gulf of Mexico ("Royalty Relief Rule"). Under the Royalty Relief Rule, the
MMS will suspend royalties otherwise applicable for a certain amount of natural
gas production when companies take the risk of exploring and developing deep-gas
wells in shallow water areas that they have already leased. The purpose of the
Royalty Relief Rule is to provide incentives for the development of such wells
in which natural gas or oil production can come online quickly because the
infrastructure (i.e., platforms and pipelines) to some degree is already in
place. Under the Royalty Relief Rule, lessees will be eligible for royalty
relief on their existing leases if they drill for new and deeper reserves at
depths greater than 15,000 feet below sea level. In addition, an even larger
royalty relief would be available for wells deeper than 18,000 feet.
Public Policy for MMS Royalty Relief
The Royalty Relief Rule illustrates a number of extremely important points.
The motivation of the government, or the public policy behind the Royalty Relief
Rule, is to stimulate exploration for major new gas fields in the shallow waters
of the Gulf of Mexico where:
o government geologists and industry geologists generally agree
represents the highest short term potential for discovering major new
gas fields in the lower 48 states; and
o these new gas fields are located near existing pipeline
infrastructure, thus enabling wells in such areas to quickly be
brought on production.
It should be noted that the Royalty Relief Rule does not extend to deep
waters of the Gulf of Mexico off the continental shelf. See, Deepwater Royalty
Relief. The Royalty Relief Rule is limited to leases in a water depth less than
600 feet. The U.S. Government has leased massive areas of the Gulf in deep
waters, and in ultra deep waters, which basically are areas with water depth of
1,000 feet to 10,000 feet. The government did not extend the Royalty Relief Rule
to the deep waters and ultra deep waters because there is comparatively less
pipeline infrastructure in place to quickly bring those discoveries to market.
The Royalty Relief Rule applies to areas of the Gulf of Mexico where gas, if
found, can quickly benefit the U.S. economy by coming to market. See, Deepwater
Royalty Relief
8
Deepwater Exploration Activities
The Fund will investigate, consider and possibly invest in Projects
proposed to be located in the "deepwater" of the Gulf of Mexico. Generally,
deepwater is defined as water depths in excess of 1,000 ft, although for certain
purposes (e.g., deepwater royalty relief) water depths may be less.
Exploration and production activities in the deepwater of the Gulf of
Mexico have accelerated during the past several years and it is the view of many
in the industry that such activity will significantly increase in the near
future. There are a variety of reasons for this increased activity including,
but not limited to, improvements to and new technologies for deepwater drilling,
development and production; the discovery of major natural gas and oil fields in
deepwater that have yielded wells with significant flow rates; deepwater royalty
relief; improved seismic technologies; and the declining production from
resources in the shallow waters of the Gulf of Mexico. While most deepwater
exploration activities seem to be targeted more towards oil reservoirs as
opposed natural gas, there have been some large and significant natural gas
discoveries in the deepwater of the Gulf of Mexico and more development of
deepwater natural gas prospects is expected in the future.
Generally, exploration and production activities in deepwater follow the
same principals as in shallower waters and with the same associated risks,
although deepwater exploration drilling presents additional challenges beyond
those faced in shallower waters. Given the water depths, drilling, development
and production activities tend to be more complicated and expensive. For
example, for both drilling and production, platforms fixed to the seafloor may
be both impractical and cost prohibitive depending on the water depths. In such
cases, drilling and production activities would be undertaken by floating
drilling rigs and production systems. These floating systems may be more
susceptible to adverse weather conditions, such as hurricanes, and may be more
costly and, in light of increased activity in deepwater, may be in short supply
and thus more difficult to obtain and schedule. In addition, transportation and
gathering systems are more prevalent and less costly in the shallow waters of
the Gulf of Mexico. In many deepwater areas of the Gulf of Mexico,
transportation infrastructure is either inadequate or non-existent, pressures
are greater, the water colder, and ocean currents stronger, all of which may
make exploration and production in deepwater more costly and time consuming than
in shallow waters.
9
Deepwater Royalty Relief
The Deep Water Royalty Relief Act of 1995 (the "Deepwater Relief Act") was
enacted to promote exploration and production of natural gas and oil in the
deepwater of the Gulf of Mexico and relieves eligible leases from paying
royalties to the U.S. Government on certain defined amounts of deepwater
production. The Deepwater Relief Act expired in the year 2000 but the relief was
extended by the MMS to promote continued interest in deepwater. For purposes of
royalty relief, the MMS defines deepwater as depths in excess of 656 feet (200
meters).
Currently, for leases entered into after November 2000, the MMS assigns a
lease specific volume of royalty suspension based on how the suspension amount
would affect the economics of the lease's development. The lease is given an
automatic royalty suspension by the MMS and such lease is referred to as a
"royalty suspension lease." Any such royalty suspension applicable to a
particular lease is generally set forth in the lease auction materials prepared
by the MMS. The amount of the suspension, if any, is not determined by water
depth levels (as it had in the past) but rather based upon the MMS' view of the
characteristics and economics of the project. For example, projects deemed
relatively secure and safe such as those near existing transportation
infrastructure may receive no royalty relief while a similar project far away
from any such infrastructure or in an area deemed more risky may receive
significant royalty relief. In addition, all post 2000 leases can apply to the
MS for discretionary royalty relief.
As a result, unlike the royalty relief associated with deep drilling in
shallow waters, there is no formulaic or predictable means of determining in
advance whether and to what extent royalty relief would be available for a
potential deepwater project.
Improved Seismic Data Reduces Risk for Deeper Drilling in Shallow Water and
Deepwater
Seismic surveys are performed to gather information on various formations
including subsurface geological formations as well as information used to
identify, among other things, potential geological hazards and environmentally
sensitive areas. Developing and improved three-dimensional seismic technologies
can provide a more accurate assessment of potential natural gas or oil
reservoirs so that exploration and development wells can be optimally located
and thereby reduce the potential number of wells needs to develop a field.
As a result of improved seismic technology, drilling wells in shallow
waters deeper than 15,000 feet below the sea bottom and wells in deepwater is
now technologically feasible and less problematic, but may add some additional
expense.
10
Pipeline and Gathering Infrastructure
It has been estimated by the U.S Department of Energy that investment in
pipeline and distribution infrastructure, both to maintain existing
infrastructure and expand it, may average $8 billion per year during the next 5
to 10 years. Therefore, as demand for natural gas and oil further outstrips
supply more pipelines and other gathering infrastructure will be needed.
Although the Manager intends to focus primarily on obtaining interests in
natural gas or oil wells, opportunities in the area of pipeline and gathering
infrastructure may arise, either independently or in conjunction with or as part
of a Working Interest. The Manager, in its discretion, may conclude that an
investment by the Fund in such infrastructure and activities is in the best
interests of the Fund.
Pipeline "gathering systems" are designed to collect the natural gas or oil
from the producing fields for transportation to the appropriate processing
facilities. Gathering systems normally consist of one or more small diameter
pipelines that are connected to and deliver natural gas or oil from the field,
where it is extracted from the earth, to a central processing point. Once
gathered through these pipelines from individual wells the natural gas or oil is
transported to a processing facility, such as an oil refinery.
The Fund will be focused primarily on natural gas or oil Projects but may
consider investments in pipeline and other infrastructure on a stand-alone basis
or as may be required as part of a larger Project.
Commodity Purchase and Sale Agreement
As of the date of this Offering, no definitive arrangements have been made
for the sale or transportation of either the natural gas or oil that may be
produced from the Projects or transported in any pipelines that the Fund may
own. The Fund believes, however, that it is likely that natural gas or oil from
the Projects described herein will have access to pipeline or other economic
transportation alternatives and can be marketed. See Risk Considerations.
Early Investment Incentive
The Manager at any time during this Offering may have opportunities to
invest in economically promising transactions for the Fund. The Manager is
currently investigating such a transaction that may require an investment by the
Fund potentially as early as mid-February of 2006. Early Investors who provide
capital to the Fund to acquire such Projects, which ultimately provide benefits
11
to all Fund Investors, will receive an incremental benefit. The Fund is offering
to such Early Investors an Early Investment Incentive upon the following terms
and conditions:
o For Investors who subscribe to the Fund between February 1, 2006
and February 28, 2006 and have fully paid their Capital
Contribution shall be entitled to receive an Early Investment
Incentive equal to $12,000 per $150,000 Share.
o For Investors who subscribe to the Fund between March 1, 2006 and
March 31, 2006 and have fully paid their Capital Contribution
shall be entitled to receive an Early Investment Incentive equal
to $8,000 per $150,000 Share
o Investors who subscribe to the Fund on or after April 1, 2006
shall not be entitled to, nor shall they receive, an Early
Investment Incentive.
o The Manager anticipates that the Early Investment Incentive, as
described herein, shall be paid either monthly or quarterly and
begin when the Manager determines that the Fund has sufficient
cash flow. The Manager will continue such payments, as described
herein until the Early Investment Incentive to Investors entitled
to such incentive have been paid in full. Thereafter, all
Investors share in distributions of the Fund in accordance with
their individual ownership percentage.
o Other than any right to receive an Early Investment Incentive,
all other rights, privileges and obligations of Investors of the
Fund shall remain as described herein. Except for an Early
Investment Incentive, as described herein, all Investors have
equal rights as described in this Memorandum and set forth in the
LLC Agreement.
Voluntary Additional Capital Contributions and Supplemental Offering of Shares
The LLC Agreement does not provide for any mandatory assessments of capital
from Investors. This means that the Fund cannot require any Investor to
contribute more money after such Investor completes his subscription and pays
his initial Capital Contributions. The Fund anticipates that the net funds to be
raised by this Offering will be adequate to pay and provide sufficient reserves
for the Fund's share of all costs of acquiring, drilling and completing the
Projects. However, if the Fund should require additional cash in the future for
certain purposes such as drilling, completing and developing additional wells or
if the Manager determines that the Fund should participate in drilling,
completing, equipping, re-working or re-entering any such additional well
12
("Additional Well Activities"), the Manager may determine, in its discretion, to
fund these Additional Well Activities through the use of Fund cash flow or by
borrowing. (Although the Manager has authority to borrow money, no Alphabet Fund
has ever borrowed money, and the Manager does not intend to borrow in the
future.) Alternatively, the Fund may, but is not obligated to, ask Investors, if
they desire, to participate in these Additional Well Activities by making
voluntary "Additional Capital Contributions". If voluntary Additional Capital
Contributions are requested by the Fund to fund Additional Well Activities, the
Manager will do so through a supplemental offering of a separate class or series
of shares. The LLC Agreement provides for the creation and offering of any such
class or series and provides the Manager with discretion in determining the
nature, scope, amount and terms of such supplemental offering of a class or
series of shares. Such discretion is necessary in order to provide the Manager
with sufficient flexibility to fashion such supplemental offering in a way that
best responds to the proposed project, as well as market conditions that exist
at that time. In any event, the opportunity to participate in such supplemental
offering of shares and make Additional Capital Contributions will be apportioned
among all Investors in proportion to their initial Capital Contributions. If
Investors who elect to make Additional Capital Contributions do not supply all
of the necessary Additional Capital Contributions requested, the Manager in its
discretion may request the Investors or any group thereof or other persons to
fund the shortfall with Additional Capital Contributions or, in certain
circumstances, loans. An Investor who elects not to participate in any
supplemental offering of shares and does not provide Additional Capital
Contributions for such Additional Well Activities will have no interest in such
Additional Well Activities, but will retain his interest in the Projects in
which the Fund has already invested.
Insurance
The Fund or Manager will seek to obtain hazard, property, general liability
and other insurance in commercially reasonable amounts to cover the Projects, as
well as general liability and similar coverage for the Fund's business
operations. The Manager has obtained what it believes to be adequate insurance
for prior Ridgewood Energy Programs, which insurance will apply to the Fund's
Projects. There can be no assurance, however, that insurance on the Projects or
the Fund will be adequate in scope or amount to protect the Fund from material
losses related to the Projects. In addition, the Manager's past practice has
been to obtain insurance as a package that is intended to cover most, if not
all, of the Ridgewood Energy Programs. While the Manager believes that it has
procured insurance sufficient to insure against most risks, the possibility does
exist that depending on the occurrence, insurance may not be adequate to cover
the entire loss sustained, if any, by the Fund. See Risk Considerations.
13
Operator
Currently, the Fund anticipates that any Project in which it may invest
will be operated and controlled by an unaffiliated third-party entity acting as
Operator for the Projects. The Operator is responsible for drilling,
administration and production activities for leases jointly owned by Working
Interest owners and acts for the account of all Working Interest owners under
the terms of the applicable Operating Agreements. Typically, Operating
Agreements limit the Operator's liability and provide for circumstances under
which the Working Interest owners may remove an Operator, although the Operator
typically may resign at any time. In certain circumstances, Operators will enter
into agreements with independent third-party subcontractors and suppliers to
provide the various services required for operating leases. The Fund has not
discussed or negotiated with any party to act as Operator of any of the Fund's
Projects.
Salvage Fund
As to Projects in which the Fund owns a Working Interest, the Fund will
(and may be required by the Operating Agreement to) reserve and set aside each
month in a separate interest-bearing account ("Salvage Fund"), a portion of the
Fund's share of net revenue, if any, that the Fund may receive from the
production and sale of natural gas or oil from each such Project. The purpose of
the Salvage Fund, which is in the nature of a sinking fund, is to provide for
the Fund's proportionate share of the anticipated gross cost net of anticipated
salvage value ("Anticipated Salvage Cost") of dismantling production platforms
and facilities, plugging and abandoning the wells, and removing the platforms,
facilities and wells in respect of each of such Projects after the end of their
useful life, in accordance with applicable federal and state laws and
regulations. There is no assurance that the Salvage Funds will have sufficient
assets to meet these requirements, and any unfunded expenses will be a liability
of the Fund. Any portion of a Salvage Fund that remains after the Fund pays its
share of the actual salvage cost will be distributed to the Shareholders.
Payments to each Salvage Fund will reduce the amount of cash distributions that
may be made to Shareholders by the Fund.
Competition
Strong competition exists in the acquisition of oil and gas leases and in
all sectors of the oil and gas exploration and production industry. Although the
14
Fund does not compete for the acquisition of working interests from the MMS, it
does compete with other companies for the acquisition of percentage ownership
interests in oil and gas working interests in the secondary market. Many
companies with whom the Fund competes for these working interests tend to be
larger companies that have financial and other resources substantially larger
than those of the Fund.
Regulation
Oil and gas exploration and development activities are subject to federal,
state and local laws and regulations.
Regulations governing exploration and development activities require the
Fund's operators to obtain permits to drill wells and to meet bonding and
insurance requirements in order to drill, own or operate wells. In addition, the
location of wells, the method of drilling and casing wells, the restoration of
properties upon which wells are drilled and the plugging and abandoning of wells
are also subject to regulations.
As mentioned earlier, federal offshore leases are administered by the MMS
pursuant to regulations promulgated under the Outer Continental Shelf Lands Act.
Lessees must obtain MMS approval for exploration, development and production
plans prior to the commencement of offshore operations. In addition, approvals
and permits are required from other agencies such as the U.S. Coast Guard, the
Army Corps of Engineers and the Environmental Protection Agency. The MMS has
promulgated regulations requiring offshore production facilities and pipelines
located on the outer continental shelf to meet stringent engineering and
construction specifications, and has proposed and/or promulgated additional
safety-related regulations concerning the design and operating procedures of
these facilities and pipelines. MMS regulations also restrict the flaring or
venting of oil and gas, and proposed regulations would prohibit the flaring of
liquid hydrocarbons and oil without prior authorization. The MMS has promulgated
regulations governing the plugging and abandonment of wells located offshore and
the installation and removal of all production facilities.
Moreover, the operator's activities are also subject to numerous laws
relating to environmental protection including, but not limited to, the Federal
Resource Conservation and Recovery Act, the Comprehensive Environmental
Response, Compensation, and Liability Act, the Clean Air Act, and comparable
state and local requirements and the Outer Continental Shelf Lands Act.
15
USE OF PROCEEDS
Maximum Proceeds* Minimum Proceeds
Investment Fee to Manager $ 6,750,000 (4.5%) $ 67,500 (4.5%)
Selling Commissions 12,000,000 (8%) 120,000 (8%)
Placement Agent Fee 1,500,000 (1%) 15,000 (1%)
Organizational, Distribution and Offering Fee (including 5,250,000 (3.5%) 52,500 (3.5%)
legal, accounting, engineering and geologic consulting
fees, printing, filing fees, etc.)
Acquisition of or Participation in Projects and Fund
Operations 124,500,00 (83%) 1,245,000 (83%)
Total Proceeds from Offering ** $150,000,000 (100%) $1,500,000 (100%)
* The Manager, on behalf of the Fund, may in its sole discretion expand the
offering up to $200,250,000 or more.
** Regardless of the gross proceeds of the Offering, the percentages associated
with the Investment Fee (4.5%), Selling Commissions (8%), Placement Agent Fee
(1%) and Organizational, Distribution and Offering Fee (3.5%) will remain the
same. The annual Management Fee (2.5%) will be included as a part of Fund
Operations.
Under the LLC Agreement, the Fund may commence operations with minimum
gross proceeds of $1,500,000 and a maximum of $150,000,000 (or $200,250,000 or
more if the Fund is expanded in the Manager's discretion). After payment of the
Investment Fee, selling commissions, Placement Agent Fee, Organizational,
Distribution and Offering Fee, the Fund will have net funds of a minimum of
$1,245,000 and a maximum of $124,500,000 (or more if the Fund is expanded by the
Manager) available for investment in the Fund's Projects and operations.
RISK CONSIDERATIONS
Investment in natural gas and oil exploration and drilling or in
infrastructure equipment or activities involves substantial risks and potential
conflicts of interest and is suitable only for those persons who meet the
Investor Suitability Standards, have a substantial net worth, have no need for
liquidity from such investment, understand and are prepared to assume the
substantial risks discussed below, and are able to bear the potential loss of
the entire investment. Each prospective Investor should consider carefully the
risk factors attendant to the purchase of Shares, including without limitation,
those discussed below, and each should review the investment with his own legal,
tax and financial advisors.
16
GENERAL RISKS RELATED TO NATURAL GAS AND OIL
EXPLORATION, DRILLING, PIPELINES AND OPERATIONS
The Fund's Drilling Activities May Not Be Productive
Drilling for natural gas or oil in either shallow water or deepwater
involves numerous risks, including the risk that the well will not have
commercially productive reservoirs. The costs of drilling, completing and
operating wells are often uncertain and drilling operations may be curtailed,
delayed or canceled as a result of a variety of factors, including:
o Unexpected drilling conditions;
o Pressure or irregularities in formations;
o Equipment failures or accidents;
o Fires, explosions, blow-outs and surface cratering;
o Marine risks such as capsizing, collisions and hurricanes;
o Adverse weather conditions; and
o Shortages or delays in the delivery of equipment.
Therefore, drilling activities may not be successful and, if unsuccessful,
could have an adverse effect on future results of the operations and financial
conditions of the Fund. Drilling exploratory natural gas or oil wells is
speculative, may be unprofitable, and may result in the total loss of your
investment. While all drilling, whether developmental or exploratory, involves
these risks, exploratory drilling involves greater risks of dry-holes or failure
to find commercial quantities of natural gas or oil. Therefore, drilling
activities may be unprofitable, not only from non-productive wells, but also
from wells that do not produce natural gas or oil in sufficient quantities or
quality to return a profit on the capital dollars invested.
Reserve Data, Prices and Future Net Revenue Estimates are Uncertain and May be
Wrong
Estimates of reserves by necessity are projections based on engineering and
geological data, including but not limited to, volumetrics, reservoir size and
characteristics, the projection of future rates of production, and the timing of
future expenditures. The process of estimating reserves requires substantial
evaluation on the part of the petroleum engineers and geologists, resulting in
17
determinations that are not always precise, particularly with respect to new
discoveries. The Fund will review the reserve analysis provided by the
Operators. However, engineers who are not retained by Operators may make
different estimates of reserve quantities and revenues attributable to those
reserves based on the same data. The Manager employs individuals in its Texas
office that can provide significant analysis of the Operator's information.
However, if necessary, Fund may retain such independent engineers to review the
Operator's reserve analysis and/or conduct an independent review. In any event,
future performance that deviates significantly from reserve reports could have a
material adverse effect on the Fund's operations, business and prospects, as
well as on the amounts and carrying values of such reserves.
In addition, the Fund's revenues, profitability, and cash flow are highly
dependent on the price of either or both natural gas and oil, which is affected
by numerous factors beyond the Fund's control. These prices historically have
been very volatile. There can be no guarantee that prices in the future will be
sufficient to make a profit on the sale of the Fund's natural gas or oil.
Geological information and studies may not be available or fully developed when
the Fund is considering investments nor is the Fund required to provide such
information, when available, to Investors
The Fund expects to utilize the net proceeds from this Offering for the
acquisition, exploration and development of as yet unidentified Projects. As a
result, prospective Investors may not have an opportunity to evaluate any such
Projects before investing, nor will they participate in the selection of such
Projects after investment in the Fund. In addition, when such geological and
other technical information regarding a Project does become available to the
Fund, neither the Manager nor the Fund is required to (but in its discretion
may) provide such information to Investors. Consequently, prospective Investors
will be relying upon the judgment of the Manager for such investment decisions.
The Success of an Investment in an Infrastructure Project is subject to Risks
Beyond the Fund's Control
The business of transporting, gathering and processing natural gas or oil
for third parties is subject to substantial risks. The volume of natural gas or
oil involved in these activities depends on the actions of third parties, and is
beyond the Fund's control. Further, the following factors, most of which are
18
beyond the Fund's control, may adversely impact the Fund's ability to maintain
or increase its services and, thereby, its revenues, negotiate or renegotiate
contracts, or to remarket unsubscribed pipeline capacity:
o price competition;
o drilling activity and supply availability;
o changes in regulation and actions of regulatory bodies;
o credit risk of customer base;
o increased costs of capital; and
o natural gas and oil prices.
Operating Risks may cause substantial losses and insurance may not protect the
Fund against all these risks
Ridgewood Energy carries insurance on all projects owned by Ridgewood
Energy Prior Programs. Ridgewood carries certain deductibles on many policies
that must first be paid before collecting under the policy. In addition, the
Operating Agreement normally requires the Operator to carry insurance to cover
its activities under the Operating Agreement. Nevertheless, risks include:
fires; explosions; blow-outs; uncontrollable flows of gas, formation water or
drilling fluids; natural disasters; pipe or cement failures; casing collapses;
abnormally pressured formations; acts of terrorism; and environmental hazards
such as leaks and pipeline ruptures. Insurance to cover some of these risks may
be prohibitively expensive or unavailable, particularly as to acts of terrorism.
Offshore operations are subject to a variety of operating risks peculiar to
the marine environment, such as capsizing, collisions and damage or loss from
hurricanes or other adverse weather conditions. These conditions can cause
substantial damage to facilities and interrupt production. As a result, the Fund
could incur substantial liabilities that may not be covered entirely by
insurance that could reduce or eliminate the funds available for exploration and
development programs and acquisitions, or result in loss of its interest in the
Projects.
Additional Government Regulation May Affect the Fund's Operations or the Price
of the Fund's Oil and Gas
The energy exploration, drilling and development business could be subject
to government regulation under which, among other things, rates of production
from wells may be regulated. Government regulations may also impact the market
for the Fund's natural gas or oil, which could adversely affect the price at
which such gas is sold. Government regulations affecting environmental matters
or offshore drilling and exploration activities could adversely impact the
Fund's activities. Finally, while the gathering and processing activities are
19
generally not subject to rate regulation, under certain circumstances, the FERC
may attempt nevertheless to exercise such jurisdiction. There is no way for the
Fund to predict the nature and extent to which such regulations or other
political activity may affect the Fund's operations.
The Fund Must Rely on Third Parties Over Which it has Minimal or No Control to
Operate its Projects.
The Fund does not own any drilling equipment nor does it maintain a staff
for on-site operations. Accordingly, it must rely completely upon the Operators
and other third parties over whom the Fund and Manager have little or no control
for drilling and other operations with respect to the Projects in which it
invests. Moreover, the Manager is under no duty to share with Investors
technical information regarding operations and drilling from the Operator. As a
result, Investors are relying exclusively on the Manager to adequately manage
any such relationship with a third party.
The Working Interests in Which the Fund Will Invest are Jointly Owned with Other
Participants, including the Operator, and Decisions about the Project may be
Controlled or Influenced by these Participants
It is anticipated that the Fund will own Working Interests in the Projects
to be developed with persons unrelated to the Fund and the Manager. The Fund may
own a minority or majority interest in such Working Interest with others.
Regardless of the Fund's percentage ownership in a Working Interest or Project,
the Fund will have the right to make decisions affecting the development of
those Projects. However, important decisions with respect to development
activities, which may be detrimental to the Fund, may be controlled or affected
by the other owners of Working Interests in such Projects. Finally, the Fund
could be held liable for the joint activity obligations or the tort actions of
such other Working Interest owners, and this liability could in turn result in
liability for the Manager.
If the Fund's co-participants fail to pay their portion of the lease
acquisition, drilling, testing and, if appropriate, completion costs for any
lease, there may be insufficient funds to perform such work. If the Fund as a
joint venturer or as a Working Interest owner does not contribute funds for
additional wells proposed by other participants, the Fund will lose all of its
rights to production from those additional wells. Moreover, while the Fund will
monitor and participate in decisions affecting exploration and development of
the leases or wells in which the Fund acquires a Working Interest or Non-Consent
20
Interest, decisions with respect to lease exploration and development activities
may be controlled by the other participants since the Fund in many cases, but
not all, is expected to own less than a 50% interest in each of such leases or
wells.
Further, the Fund will not originate and does not expect to operate any of
the leases in which it acquires an interest. For that reason, Investors must not
only bear the risk that the Fund will be able to select suitable Projects, but
also that, once acquired, such Projects will be managed prudently, efficiently
and fairly by their Operators. Furthermore, certain Working Interests in
Projects that may be acquired by the Fund may be subject in some cases to
expenses credited in favor of the persons from whom such leases and Projects
were acquired, which interests and expenses will be in addition to the Manager's
fees and interests described herein.
The Salvage Fund may be Insufficient to Cover Salvage Costs and the Fund may be
Liable for the excess
As indicated above, the Fund may be required to create a Salvage Fund to
cover certain Anticipated Salvage Costs. There is no assurance that the Salvage
Funds will have sufficient assets to satisfy all such costs and the Fund maybe
liable for its percentage share of unfunded expenses.
Ownership of Federal Leases
Federal law prohibits, with certain limited exceptions, the holding of
interests in federal oil and natural gas leases by persons who are not citizens,
nationals or permanent residents of the United States or corporate entities that
are not a citizen of any state. Since the Fund intends to acquire interests in
federal leases, each Investor must disclose in the Investor Subscription Booklet
his nationality or, in the case of an entity, the place of incorporation.
Prospective Investors who are not United States citizens or nationals or which
are foreign corporations formed outside the United States must so inform the
Fund when completing their Subscription Documents. The Fund will not accept a
subscription from a non-United States citizen, national, permanent resident or
foreign corporation if by accepting such subscription, as determined by the
Manager in its sole discretion, a risk exists that a federal lease will be
canceled or forfeited or that the Fund will be unable to acquire an interest in
a federal lease or that the Fund will be in violation of federal law.
21
PARTICULAR RISKS RELATED TO THE SHARES
The Ability to Transfer Shares is Extremely Limited and Investors Will be
Required to Own the Shares Indefinitely
Shares in the Fund will be an illiquid investment. There is no market for
the Shares, and, because there will be a limited number of persons who purchase
Shares and significant restrictions on the transferability of such Shares, it is
expected that no public market will develop. Moreover, neither the Manager nor
the Fund will provide any market for the Shares. Investors will generally be
prohibited from selling or transferring their Shares except in the circumstances
permitted under Article 13 of the LLC Agreement, and all such sales or transfers
require the consent of the Fund, which may withhold such consent in its sole
discretion. Accordingly, an Investor will have no assurance that he can
liquidate his investment in the Fund and must be prepared to bear the economic
risk of the investment until the Fund is terminated and dissolved.
The illiquidity of and other significant risks associated with an
investment in the Fund make the purchase of Shares suitable only for an Investor
who has substantial net worth, who has no need for liquidity with respect to
this investment, who understands the risks involved, who has reviewed this
Memorandum and the Exhibits hereto and the risks involved with his tax, legal
and investment advisors, who can sustain the complete loss of the investment,
and who has adequate means of providing for his current and foreseeable needs
and contingencies.
Investors Will not be able to Participate in the Management of the Fund and Must
Rely Exclusively on the Manager
Investors will not have the right, power or authority to participate in the
ordinary and routine management of the Fund or the Projects or to exercise
control over the decisions of the Fund. Under the LLC Agreement, the Manager is
granted the exclusive right to manage, control and operate the affairs and
business of the Fund and to make all decisions relating thereto and will have
full, complete and exclusive discretion with respect to all such matters.
Accordingly, no prospective Investor should purchase any Shares unless the
prospective Investor is willing to entrust all aspects of management of the Fund
to the Manager.
22
There will be Limited Ability to Sell or Transfer Fund Assets such that the Fund
will be Required to Own Under Performing Assets Indefinitely
The Fund's interests in the Projects will be illiquid. The Fund does not
anticipate selling its interests, or any part thereof, in the Projects. However,
if the Fund were to attempt to sell any such interest, a successful sale would
depend upon, among other things, the operating history and prospects for the
well or interest therein being sold, proven natural gas or oil reserves, the
number of potential purchasers and the economics of any bids made by them and
the current economics of the natural gas or oil market. In addition, any such
sale may result in adverse tax consequences to the Fund and Investors.
The Manager will have full discretion to determine whether any Project, or
any interest therein, should be sold and the Fund will have no obligation to
sell all or a portion of it, or retain it, for the benefit of Investors.
Investors may be required to remain in the Fund until it is terminated and
dissolved.
The Manager's Liability to the Fund May be Limited
The LLC Agreement, which is controlled by Delaware law, provides that the
Fund's officers and agents, the Manager, the affiliates of the Manager, and
their respective directors, officers and agents when acting for the Manager or
their affiliates on behalf of the Fund, (collectively, "Ridgewood Managing
Persons") will be indemnified and held harmless by the Fund from any and all
claims arising out of their management of the Fund, except for claims arising
out of the bad faith, gross negligence or willful misconduct of such persons.
Therefore, an Investor may have difficulty sustaining an action against any of
the Ridgewood Managing Persons based on breach of its or his fiduciary
responsibility or other obligations to the Fund. See Fiduciary Responsibilities
of Manager - Indemnification and LLC Agreement - Exhibit A.
There May Be Limited Ability to Spread Risk
Because the Escrow Amount is $1,500,000, the Fund could be formed and
conduct operations upon receipt of $1,500,000 in Capital Contributions from
Investors. To the extent that the Fund does not receive substantial capital
contributions once it begins operations, its ability to spread risks over a
larger number of investments in Projects will be reduced.
23
The Manager Will Receive an Annual Management Fee Regardless of Profitability
The Manager and its Affiliates will receive fees and compensation
throughout the life of the Fund. Inherent in the fee and compensation
arrangements are the possibility of conflicts between the best interests of the
Investors and the best interests of the Manager. The Manager may have incentives
to act in its best interests rather than in the best interest of the Investors.
See Compensation; Conflicts of Interest.
Expansion of the Fund may be Dilutive
The Manager, on behalf of the Fund, in its discretion, may increase the
maximum proceeds of this Offering from $150,000,000 to $200,250,000 or more. If
the Fund were so increased, it could dilute the investment made by Investors
prior to such expansion. However, such expansion would result in increased
capital, enabling the Fund to invest in additional Projects and add
diversification to the Fund's portfolio of Projects.
Compensation of Manager and Affiliates Not Linked to Profitability
Pursuant to the LLC Agreement, the Manager will receive certain fees and
reimbursement of expenses. The fees payable under the LLC Agreement may be
substantial and are payable whether or not the Fund operates at a profit. None
of the compensation to be received by the Manager was derived as a result of
arm's length negotiations.
Modification of Delaware Law
The LLC Agreement contains certain provisions that modify what would
otherwise be the applicable Delaware law relating to the fiduciary standards of
the Manager to the Investors. The fiduciary standards in the LLC Agreement could
be less advantageous to the Investors and more advantageous to the Manager than
the corresponding fiduciary standards otherwise applicable under Delaware law.
In accordance with Delaware Law, the LLC Agreement Limits Investor Access to
Certain Information
Delaware law permits Delaware limited liability companies to restrict
access to certain information provided that such restricted access is set forth
in the limited liability agreement. The Fund's LLC Agreement contains provisions
that do limit Investors' access to certain sensitive or confidential
information. Therefore, Investors may not have the ability to obtain certain
information from the Fund. See, Limitations on Investor's Information Rights;
LLC Agreement.
24
Limited Liability of Investors
The Fund will be governed by the LLC Act under which, as a general rule, an
Investor's liability for the obligations of the Fund is limited to such
Investor's Capital Contribution and such Investor's share of the Fund's assets.
An Investor of the Fund will not otherwise be liable for the obligations of the
Fund. Should an Investor participate in the management of the business of the
Fund, in such case, the Investor may be liable to the Fund or other Investors
for conduct that constitutes bad faith, gross negligence or willful misconduct.
In addition, Investors should be aware that they potentially could be liable to
return distributions made by the Fund if within a certain period of time after
such distributions were made the Fund becomes insolvent.
The Fund has not yet Finally and Conclusively Selected or Identified Projects
The Fund expects to utilize the net proceeds from this Offering for the
acquisition, exploration and development of as yet unidentified Projects. As a
result, prospective Investors may not have an opportunity to evaluate any such
Projects before investing, nor will they have a voice in the selection of such
Projects after investment in the Fund. Consequently, prospective Investors will
be relying upon the judgment of the Manager for such decisions.
The Amount and Frequency of Cash Distributions Depends on the Fund's Operations
and Need for Cash Reserves and is Uncertain
No distributions will be made from the Fund to the Investors of the Fund
until the Fund has funds that the Manager determines are not needed for the
operation of the Fund. Accordingly, there is no assurance that any distributions
from the Fund will be made to its Investors. Distributions will depend primarily
on the Fund's net cash receipts from its operations. Moreover, distributions
could be delayed to repay the principal and interest of Fund borrowings, if any,
or to fund Fund costs. Fund income will be taxable to the Investors in the year
earned, even if cash is not distributed.
The Manager will not be Making a Capital Contribution but Will Receive
Distributions
While the Manager (in its capacity as such) generally will receive 15% of
distributions of the Fund, it will not contribute any cash to the Fund with
25
respect to its interests as Manager (except to the extent that Fund
Organizational, Distribution and Offering Expenses might exceed the
Organizational, Distribution and Offering Fee). Accordingly, the Investors are
expected to contribute substantially all of the funds actually utilized for Fund
activities. If the entire venture is unsuccessful, the Investors will bear 100%
of the loss (except to the extent that the Manager purchases Shares for its own
account). See Terms of Offering.
Risks of Potential Conflicts of Interest
There are potential conflicts of interest involved in the operation of the
Fund. Some examples of these potential conflicts include without limitation:
o competing demands for management resources of the Manager among the
prior Ridgewood Energy Programs;
o conflicts between the interests of the Manager and its Affiliates in
receiving compensation from the Fund for investment activities,
operating activities, and divestitures, as well as reimbursement for
expenses, and the interests of the Investors;
o conflicts relating to the allocation of costs and expenses among the
Fund and prior Ridgewood Energy Programs;
o conflicts arising from the fact that the Manager will not make a
capital contribution in respect of its interest as such in the Fund,
and that the Investors will supply all of the capital of the Fund;
o conflicts as to who will supply additional capital in the event the
Fund were to require additional contributions; and
o the lack of independent representation of Investors in structuring
this offering and in determining compensation.
See Conflicts of Interest
TAX RISKS
The Fund is organized as a Delaware limited liability company and the
Manager intends to operate the Fund such that it will qualify as a partnership
for federal tax purposes. The principal tax risks to the Investors are that: (A)
the Fund may recognize income taxable to the Investors but may not distribute
enough cash to cover the Investors' income tax on their shares of the Fund's
taxable income; (B) the allocation of Fund items of income, gain, loss, and
deduction in the LLC Agreement may not be respected for federal income tax
purposes; (C) all or a portion of the Fund's expenses could be considered either
investment expenses (which would be deductible by an Investor only to the extent
the aggregate of such expenses exceeded 2% of such Investor's adjusted gross
income) or as nondeductible items that must be capitalized; (D) all or a
26
substantial portion of the Fund's income will be deemed to constitute unrelated
business taxable income, consequently tax-exempt Investors will be subject to
tax on their respective portions of such income; (E) a charitable remainder
trust that is an Investor could have all of its income from any source deemed to
be taxable; (F) all or a portion of the losses, if any, allocated to the
Investors will be "passive losses" and thus deductible by the Investor only to
the extent of passive income; and (G) the Investors could have capital losses in
excess of the amount that is allowable as a deduction in a particular year.
Although the Fund has obtained an opinion of counsel regarding the matters
described in the preceding paragraph, the Fund will not obtain a ruling from the
Internal Revenue Service (the "Service") as to any aspect of its tax status. See
Tax Aspects. The tax consequences of investing in the Fund could be altered at
any time by legislative, judicial, or administrative action. Prospective
Investors are urged to consult their own tax advisors prior to investing in the
Fund.
The Service may audit the Fund's tax returns. Any audit issues will be
determined at the Fund level. If adjustments are made by the Service,
corresponding adjustments will be required to be made to the federal income tax
returns of the Investors, which may require payment of additional taxes,
interest, and penalties. Audit of a Fund return may result in examination and
audit of an Investor's return that otherwise might not have occurred, and such
audit may result in adjustments to items in the Investor's return that are
unrelated to the Fund. Each Investor must bear the expenses associated with an
audit of that Investor's return.
In the event that an audit of the Fund by the Service results in
adjustments to the tax liability of an Investor, such Investor will be subject
to interest on the underpayment and may be subject to substantial penalties. The
statutory rate of interest on deficiencies is presently 7% per annum compounded
daily. In addition, a number of substantial penalties could potentially be
asserted by the Service on any such deficiencies.
Significant and fundamental changes in the nation's federal income tax laws
have been made in recent years and additional changes are likely. Any such
change may affect the Fund and the Investors. Moreover, judicial decisions,
regulations or administrative pronouncements could unfavorably affect the tax
consequences of an investment in the Fund. See Tax Aspects for a more in depth
explanation of the tax implications of investing in the Fund.
27
TERMS OF THE OFFERING
General Offering Terms
The Offering consists of a minimum of 10 Investor Shares (representing
Capital Contributions of $1,500,000) and a maximum of 1,000 Investor Shares
(representing Capital Contributions of $150,000,000) of beneficial interest in
the Fund that are offered at $150,000 per Share. Fractional Investor Shares are
available for purchase. The Fund may in its sole discretion expand the maximum
offering to 1,335 Investor Shares or more (representing Capital Contributions of
$200,250,000 or more) prior to the Termination Date in the event that it
determines that additional capital is required. The price for each Investor
Share is payable all in cash at the time the prospective Investor delivers a
completed and executed Subscription Agreement to the Fund, unless the Fund
decides otherwise in its sole discretion.
All proceeds from the sale of Investor Shares must be deposited in a
separate segregated interest-bearing escrow account at North Fork Bank until the
Escrow Date, which is the date on which the Fund accepts Investor subscriptions
of at least $1,500,000 in the aggregate. The account will be held in the name of
"Ridgewood Energy S Fund LLC - Share Escrow Account" and until the escrow
conditions are fulfilled the Fund will not invest any funds, no fees applicable
to those subscriptions will be paid from the escrow account and interest on the
escrowed funds will be held in the escrow account. If 10 Investor Shares are not
subscribed and paid for in collected funds by the close of business on July 31,
2006, the Fund will terminate and the Investors' Capital Contributions, together
with any interest thereon, will be returned by the escrow agent promptly to the
Investors. If the escrow conditions are fulfilled no later than July 31, 2006,
the Fund's proceeds, net of fees described below, will be maintained thereafter
in the name of the Fund, in one or more separate, segregated accounts at
commercial banks chosen by the Manager.
Funds released from the escrow account will be used to pay the Investment
Fee, Organizational, Distribution and Offering Fee, selling commissions and
Placement Agent Fee due at that time. Subsequent receipts from this offering
will be applied in the same manner when deposited. After payment of these fees,
the remaining funds will be used to develop the Fund's Projects.
The termination date of this Offering of Investor Shares will be July 31,
2006 (the "Termination Date"). The Fund may in its sole discretion terminate the
initial offering of Investor Shares at any time before the Termination Date or
extend the scheduled Termination Date to any date or from date to date but in no
event beyond 90 days after the Termination Date.
28
The Offering may be withdrawn by the Fund in its discretion and for any
reason at any time prior to the Termination Date as set by it. If the Offering
is withdrawn prior to satisfaction of the escrow conditions, then all cash
received from subscriptions will be returned promptly to the respective
subscribers, together with any interest earned on such amount. If the Offering
is withdrawn after the escrow conditions have been satisfied but prior to the
Termination Date, then all cash received from subscriptions, net of third party
fees, will be returned promptly to the respective subscribers, together with any
interest earned on such amount. For purposes of this provision, third party fees
shall not include those fees paid to the Manager or its affiliates.
Prospective qualified Investors may subscribe for the purchase of Investor
Shares in the Fund by completing and executing in full all of the appropriate
documents contained in the Investor Subscription Booklet (separately bound as
Exhibit D) and delivering such documents, together with the purchase price, to
the Fund, which includes the Investor Subscription Agreement. The Investor
Subscription Agreement contains representations to be made by prospective
Investors, the violation of which may entitle the Fund, the Manager and others
to indemnification for any losses resulting therefrom.
PLAN OF DISTRIBUTION
The Investor Shares will be offered on a "best-efforts" basis through
Ridgewood Securities Corporation (the "Placement Agent"), which is a registered
broker-dealer and a member of the National Association of Securities Dealers,
Inc. ("NASD"), and by other registered broker-dealers who may also serve as
purchaser representatives in connection with this offering. Robert E. Swanson,
the President and controlling member of the Manager and the President of the
Fund, is the President, registered principal and sole stockholder of the
Placement Agent. Selling commissions equal to 8% of the gross proceeds from the
sale of Investor Shares will be paid to the Placement Agent and to other
participating broker-dealers, as the case may be, and the Placement Agent will
be paid an amount equal to 1% of the aggregate Capital Contributions for serving
as placement agent (the "Placement Agent Fee"). See LLC Agreement - Exhibit A.
Payment of the selling commission and Placement Agent Fee will be due and
payable promptly after the latest to occur of (1) acceptance by the Fund of an
Investor's subscription, (2) the Escrow Date or (3) the receipt and collection
by the Fund of the gross purchase price for the Investor Shares in question. A
29
similar selling commission and Placement Agent Fee will be paid with respect to
any sales of additional Investor Shares. By executing and delivering the
Subscription Agreement to the Fund, each Investor will be deemed to have
consented to the arrangements between the Fund and the Placement Agent as
described in this Memorandum.
The Manager will coordinate the offering of the Investor Shares, will
prepare promotional materials and will provide support to cooperating
broker-dealers who participate in the offering. The Manager is also responsible
for review of Investor subscriptions, approval of subscriptions and Investor
relations during the offering.
The Fund reserves the right to waive the payment of all or a portion of a
selling commission or the Placement Agent Fee by any Investor, in which case the
cost of the Fund interest to any such Investor will be less than the cost of an
equivalent Fund interest to an Investor paying a full commission and Placement
Agent Fee. The Fund contemplates that it will exercise these rights, without
limitation, in respect of Investors who make Capital Contributions of $1,050,000
(7 Investor Shares) or more by waiving payment of all or a portion of the
selling commission and Placement Agent Fee and by modifying the Managing
Shareholder's compensation as described below.
To the extent permitted by law, the Placement Agent is to be indemnified by
the Fund against any liability based upon the assertion that it has no
obligation to the Fund or Shareholders to monitor Fund operations or to report
to Investors.
PARTICIPATION IN COSTS AND REVENUES
The Fund's investment objective is primarily to generate current cash flow
for distribution to Investors from the operation of the Fund Projects to the
extent that such distributions are consistent with the reserve requirements and
operational needs of those Projects. If the Fund does make distributions, this
section describes how the Fund will:
o determine what cash flow will be available for distributions
to Investors,
o distribute available cash flow,
o give the Manager a share of cash flow, if available,
o handle returns of Capital Contributions,
o allocate income and deductions for tax purposes, and
o maintain capital accounts for Investors.
30
"Available Cash" determines what amounts in cash the Fund will be able to
distribute in cash to Investors.
There are three types of Available Cash:
"Available Cash From Capital Transactions" is total cash received by the
Fund from the proceeds of the sale or other disposition of the Fund's Property
(including items such as insurance proceeds, refinancing proceeds, condemnation
proceeds and other amounts received out of the ordinary course of business), but
excluding dispositions of temporary investments of the Fund.
"Available Cash From Temporary Investments" is cash from Temporary
Investments, as defined in the LLC Agreement.
"Available Cash From Operations" is all other Available Cash.
The terms "Available Cash from Capital Transactions", "Available Cash from
Operations", Available Cash from Temporary Investments", "Capital Transactions,
and "Temporary Investments" are defined in the LLC Agreement and are not defined
by and are not the same as similar concepts under generally accepted accounting
principles.
There is no fixed requirement to distribute Available Cash; instead, it
will be distributed to Shareholders to the extent and at such times as the Fund
believes is advisable. Once the amount and timing of a distribution is
determined, it shall be made to Investors as described below.
Distributions From Operations
At various times during a calendar year, the Fund will determine whether
there is enough Available Cash From Operations for a distribution to
Shareholders. The amount of Available Cash From Operations determined to be
available, if any, excluding any amounts distributable as an Early Investment
Incentive, will be distributed to the Shareholders. At all times, the Manager
will be entitled to 15% and Investors will be entitled to 85% of the Available
Cash from Operations distributed (other than distributions attributable to the
Early Investment Incentive).
Distributions of Available Cash From Capital Transactions
Available Cash From Capital Transactions that the Fund decides to
distribute will be paid as follows:
31
o Before Investors have received total distributions
(including distributions from Available Cash From Operations
and Available Cash From Capital Transactions, but excluding
distributions attributable to the Early Investment Incentive
and distributions of Available Cash from Temporary
Investments) equal to their Capital Contributions, 99% of
Available Cash From Capital Transactions will be distributed
to Investors and 1% to the Manager.
o After Investors have received total distributions (including
Available Cash From Operations and Available Cash From
Capital transactions, but excluding distributions
attributable to the Early Investment Incentive and
distributions of Available Cash from Temporary Investments)
equal to their Capital Contributions, 85% of Available Cash
From Capital Transactions will be distributed to Investors
and 15% to the Manager.
General Distribution Provisions
After payment of the Early Investment Incentive, distributions to Investors
under the foregoing provisions will be apportioned among them in proportion to
their ownership of Investor Shares. The Manager has the sole discretion to
determine the amount and frequency of any distributions; provided, however, that
a distribution may not be made selectively to one Shareholder or group of
Shareholders but must be made ratably to all Shareholders entitled to that type
of distribution at that time. The Manager in its discretion nevertheless may
credit select persons with a portion of its compensation from the Fund or
distributions otherwise payable to the Manager.
Because distributions, if any, will be dependent upon the earnings and
financial condition of the Fund, its anticipated obligations, the Manager's
discretion and other factors, there can be no assurance as to the frequency or
amounts of any distributions that the Fund may make.
Return of Capital Contributions
If the Fund for any reason at any time does not find it necessary or
appropriate to retain or expend all Capital Contributions, in its sole
discretion it may return any or all of such excess Capital Contributions ratably
to Investors. A return of Capital Contributions is not treated as a
distribution. The Fund and the Manager will not be required to return any fees
deducted from the original Capital Contribution or any costs and expenses
incurred and paid by the Fund. The Investors will be notified of the source of
the payment. Any such return of capital will decrease the Investors' Capital
Contributions.
32
Capital Accounts and Allocations
The tax consequences of an investment in the Fund to a Shareholder in the
event of dissolution depend on the Shareholder's capital account and on the
allocations of profits and losses to that account. The Fund's taxable profits or
losses are allocated among the Shareholders as described below and profits or
losses are added to or subtracted from the Shareholders' capital accounts. The
amounts allocated to each Shareholder will generally not be equal to the
distributions the Shareholder receives until final liquidating distributions are
made to Shareholders.
Each Shareholder will have a capital account, which will have an initial
balance equal to the Shareholder's Capital Contribution. Capital accounts will
be adjusted in accordance with Regulations under Code Section 704. The capital
account balance will be increased by any additional Capital Contributions by the
Shareholder and by profits allocated to the Shareholder; it will be decreased by
the amount of distributions to the Shareholder, returns of capital and by losses
allocated to the Shareholder. Contributions of property by a Shareholder, if
any, or distributions of property to a Shareholder, if any, are valued at fair
market value, net of liabilities. The Fund does not currently anticipate that
any contributions or distributions of property will be made. Certain additional
adjustments to capital accounts will be made if necessary to account for the
effects of non-recourse debt incurred by the Fund, if any, or contributions of
property, if any, to the Fund. See Tax Aspects - Allocations.
For any year, profits and losses are allocated in accordance with Articles
4 and 7 of the LLC Agreement. In general, profits and losses in any year are
allocated 85% to Investors and 15% to the Manager. The primary exception to this
treatment is that all items of expense, loss, deduction and credit attributable
to Capital Transactions (notably intangible drilling expense) are allocated 99%
to Investors and 1% to the Manager.
COMPENSATION
The following table sets forth the types of fees the Manager, Affiliates
and certain consultants or independent third parties may receive in connection
with the Offering and operation of the Fund. These fees were not determined
through arms-length negotiations.
33
- ----------------------------------------------------------------------------------------------------------------------
OFFERING STAGE
======================================================================================================================
======================================================================================================================
Selling Commissions Ridgewood Securities, an $12,000 per full Investor Share (8%), which will be
affiliate of the Manager or reallowed to participating broker-dealers.
participating broker-dealers
======================================================================================================================
Placement Agent Fee Ridgewood Securities, an $1,500 per full Investor Share (1%).
affiliate of the Manager
======================================================================================================================
Investment Fee Manager $6,750 per full Investor Share (4.5%), which is
for the Manager's services in investigating and
evaluating the Projects for investing the capital
contributed to the Fund.
======================================================================================================================
Organizational, Manager $5,250 per full Investor Share (3.5%), which is
Distribution and Offering intended to pay legal, organizational and other
Fee expenses of offering the Fund.
- ----------------------------------------------------------------------------------------------------------------------
OPERATING STAGE
======================================================================================================================
Management Fee Manager The annual management fee is 2.5% of the total
Capital Contributions ($3,750 per full Investor
Share).
======================================================================================================================
Distributive Share Manager See Participation in Costs and Revenues.
Generally 15% of distributions.
- ----------------------------------------------------------------------------------------------------------------------
With respect to selling commissions, Ridgewood Securities, an affiliate of
the Manager, may pay additional compensation out of its own funds to certain
registered broker-dealers that undertake to perform additional due diligence and
other services, including a portion of its net revenues attributable to its
interests in the Fund or fees payable to it by the Fund. The Manager reserves
the right to pay similar additional compensation from its own funds to
broker-dealers that provide services and otherwise assist in the sale of
Investor Shares. In addition, Ridgewood Energy, in its sole discretion, may pay
over to certain Investors a portion of distributions or fees from the Fund
otherwise payable to Ridgewood Energy.
In addition to the Management Fee set forth above, the Manager will be
entitled to reimbursement from the Fund for all actual and necessary direct
expenses paid or incurred in connection with the operation of the Fund to the
extent that those expenses were incurred by the Manager in carrying out the
responsibilities assigned to it by the LLC Agreement, do not constitute
organizational, distribution and offering expenses and do not constitute
expenses defrayed from the Management Fee. Finally, the Manager may be entitled
to reimbursement from the Fund for direct expenses actually incurred for
operational or project development services it provides to a Project to the
extent that such charges do not exceed amounts that would be charged by
unrelated third parties and the Project itself does not reimburse such direct
expenses.
34
FIDUCIARY RESPONSIBILITIES OF THE MANAGER
The Manager is not liable to persons other than the Fund or the Investors
for any obligation of the Fund. The Investors and the Fund may have a number of
legal remedies against the Manager in the event it was to breach its duties.
Under the laws of Delaware, the Manager is accountable as a fiduciary and must
exercise good faith in handling Fund affairs. In managing the Fund, it is likely
that the Manager would be entitled to the benefits of the "business judgment
rule" of Delaware law that provides that the courts will not hold the Manager
liable for its negligence or mistaken decisions in the absence of bad faith or
willful misconduct
Limitations on Investors' Information Rights. Under Delaware law, Delaware
limited liability companies such as the Fund are permitted to restrict
Investors' rights to demand certain information from the Fund. The restrictions
need not be reasonable if they are either included in the limited liability
company's original organizing agreement or are unanimously adopted by all
members of the company thereafter. The Fund has included the restrictions
described below in the LLC Agreement. By subscribing to purchase Investor
Shares, each Investor agrees to all provisions of the LLC Agreement, including
without limitation the following:
o No Investor or other person acting in the right of or for the benefit
of an Investor is entitled to receive from the Fund or its management
any information concerning any other Investor or offeree of the Fund's
securities, without the prior written consent of the other Investor or
offeree.
o The Fund may withhold, redact ("white-out" or obliterate) or summarize
other types of information so as to prevent Investor information from
being disclosed in violation of the paragraph immediately above. For
example, the Fund's tax returns may be redacted to eliminate the names
and addresses of other Investors and information concerning them.
o Each Investor is entitled to obtain the following information from the
Fund upon reasonable written demand stating the purpose of the demand
(which must be reasonably related to the Investor's interest in the
Fund):
35
o true and full information regarding the Fund's business and
financial condition and the contributions (but not the
contributors) to the Fund;
o copies of the Fund's tax returns redacted to eliminate Investor
information, the LLC Agreement and material agreements between
the Fund and the Manager or other relevant Ridgewood Programs;
and
o other reasonable information regarding the Fund.
o Investors are not entitled to agreements, technical information, trade
secrets and other confidential information relating to the Fund's
investments.
o The LLC Agreement sets out all rights that Investors have to demand or
receive information from the Fund, except as provided by the federal
securities laws or other laws that are not superseded by the LLC
Agreement.
o The Fund may establish reasonable standards and limitations on
disclosures of information and costs of providing that information
will be borne by the requesting Investor.
o Providing information to one Investor or to persons outside a Fund
does not act as a waiver of the Fund's rights to withhold information
to another Investor.
Indemnification. The LLC Agreement provides that neither the Manager nor
any of its Affiliates will be liable, responsible, or accountable in damages or
otherwise to the Fund or any Investor for any loss or damage incurred by reason
of any act performed by or omission of the Manager or such Affiliates in the
furtherance of the interests of the Fund and within the scope of the authority
granted to the indemnified person by the LLC Agreement or by the Investors,
provided that such acts of the indemnified person did not constitute willful
misconduct, bad faith, gross negligence or any other material breach of
fiduciary duty with respect to such acts or omissions. The Fund, out of its
assets and not out of the assets of the Manager or other persons, will, to the
full extent permitted by law, indemnify and hold harmless the Manager and any of
its Affiliates who were or are parties or are threatened to be made parties to
any threatened, pending, or completed action, suit, or proceeding by reason of
any acts, omissions, or alleged acts or omissions arising out of such person's
activities as a Manager, or as an Affiliate of such Manager, if such activities
were performed in good faith in furtherance of the interests of the Fund and
were within the scope of the authority conferred to such person by the LLC
Agreement or by the Investors against losses, damages, or expenses for which
36
such person has not otherwise been reimbursed, provided that the acts of such
person did not constitute willful misconduct, recklessness, bad faith, gross
negligence or any other material breach of fiduciary duty with respect to such
acts or omissions.
Expenses of defense or settlement may be advanced to a person who may be
entitled to indemnification in advance of a determination that indemnification
will be provided, if that person undertakes to repay the advance if it is
ultimately determined that such person was not entitled to indemnification and
if, in the Manager's discretion, it is reasonable to do so. A successful claim
for indemnification would reduce the assets of the Fund. Provisions reducing the
liability or providing for indemnification of the Manager and its Affiliates may
have the effect of encouraging less prudent decisions because of the decreased
likelihood of being held accountable and may serve to deter derivative actions
against them even though such actions if successful might benefit the Fund.
The Investor Subscription Booklet contains representations that will be
made by prospective Investors as to their financial condition, the suitability
of their investments in the Fund, their receipt and understanding of the
Offering materials and compliance with applicable securities laws. If these
representations are untrue, the Investor making them will be obligated to
indemnify the Fund, the Manager and others involved in the Offering of Investor
Shares for any losses resulting therefrom.
The Manager has obtained limited directors' and officers' liability
insurance and other liability insurance on behalf of the Manager, its
principals, and the Fund. Substantially all of the premiums for this insurance
will be paid by the Fund and the other programs sponsored by the Manager or its
Affiliates.
Other Matters. The Manager is not required to take action on behalf of a
Fund unless such Fund has sufficient funds to meet obligations that might arise
from that action. The Manager is not required to advance or expend its own funds
for ordinary Fund business but is entitled to reimbursement from the Fund if the
Manager does so consistent with the LLC Agreement. The Manager is not required
to devote its time exclusively to the Fund and may engage in any other venture.
The Fund and its Affiliates are permitted to vote any Investor Shares they
own on matters on which the Investors may vote. In cases where the Manager or
its Affiliates or employees have an interest in the matter being voted on, the
effect of their voting Investor Shares owned by them will be determined by
37
principles of Delaware law applicable to directors, officers and stockholders of
Delaware corporations. In general, this law would permit and recognize the
voting of those Shares. In a court proceeding challenging the validity of the
action taken under that vote, the burden of proof would vary depending on the
vote of "uninterested stockholders." If a majority of the Shares voted by
persons having no special interest in the transaction are voted in favor of the
action, the burden of providing that the action was unfair to a Fund would be
borne by the persons challenging the action. If, in contrast, the persons having
no special interest in the action do not vote a majority of the Shares in favor,
the interested Manager or other persons would have the burden of convincing the
court that the action was fair to the Fund.
CONFLICTS OF INTEREST
The Investors will not be involved in the day-to-day operations of the
Fund. Accordingly, the Investors must rely on the Manager's judgment in such
matters. Inherent with the exercise of its judgment, the Manager will be faced
with conflicts of interest which are described in the LLC Agreement, but include
without limitation:
o The participation by the Manager and its Affiliates in natural gas and
oil exploration and production activities on behalf of the prior
Ridgewood Energy Programs ("Prior Programs"), the effect of which is
that the Manager owes a duty of good faith to the programs which it
manages and actions taken with regard such Prior Programs may not be
advantageous to the Fund.
o The Manager or its Affiliates may provide services to the Fund. The
Manager and such affiliates will be compensated for such services at
rates competitive with the rates charged by unaffiliated persons for
similar services.
o If additional wells are proposed in Projects in which the Fund has
acquired either Working Interests or Non-Consent Interests, a conflict
of interest could result between the Fund and a subsequent program as
to whether the Fund or that program should be entitled to participate
in the additional wells. The Manager, in its discretion, may first
allocate the opportunity to the Fund, if it has uninvested proceeds of
this Offering, and then will consider whether to solicit voluntary
additional capital contributions from the investors in a prior
Ridgewood Energy Program, in the Fund, or both. If the Manager does
not solicit voluntary additional capital contributions, it may
organize another investment program to acquire the resulting Working
Interests or Non-Consent Interests. All these entities would have
38
conflicting interests. Moreover, should the Manager elect to solicit
voluntary additional capital contributions from existing Investors,
the rights of Investors who participate and the terms upon which they
participate could conflict with the terms of this Offering and with
Investors of the Fund who elect to not participate in any subsequent
offering.
o Any ownership interests in the Fund by the Manager or its Affiliates
may have the effect of diluting the voting power of the other
Investors in the Fund.
o The Manager and its Affiliates are currently and may in the future act
as managers, sponsors or participants in other investment ventures
similar to the Fund or with similar objectives, or in differing
industries. These may create conflicting demands on the time and
resources of the Manager and its Affiliates or create conflicting
duties to the other ventures and the Fund.
o The rights to wells on locations in which the Fund may invest may be
on locations adjacent to wells and leases owned by the prior Ridgewood
Energy Programs. While the proposed wells are not to be drilled for
the purpose of proving or disproving the existence of gas on any
adjacent acreage, such drilling activities may incidentally develop
information valuable to one or more prior Ridgewood Energy Programs,
the Manager or its Affiliates in evaluating their nearby acreage at no
cost to them. In addition, the Fund could make an investment in a well
or infrastructure that could potentially enhance the value of an
investment made by a prior Ridgewood Energy Program. Accordingly, a
conflict of interest will exist between the interest of the Fund and
the interest of a prior Ridgewood Energy Program, the Manager or its
Affiliates in selecting the location and type of operations in which
the Fund will participate. There can be no assurance that transactions
between the Fund and its Affiliates, if any, will be on terms as
favorable as could have been negotiated with unaffiliated third
parties.
o Other interests of Operators or participants in leases or their
Affiliates may also be in conflict with those of the Fund. The Fund
will enter into Operating Agreements with participants in respect of
the Projects in which the Fund invests. Participants in those leases
may engage in oil and natural gas lease acquisition, exploration, and
production activities that may compete with the Fund.
o The Manager is authorized under the LLC Agreement to make subjective
determinations of the value of the Fund's assets. Such valuation could
impact or influence the performance record of the Fund.
39
o The Fund has provided no independent representation of prospective
Investors in connection with this Offering, and each prospective
Investor should seek independent advice and counsel before making an
investment in the Fund.
o The Fund may acquire a "Non-Consent Interest" in a particular well
from certain Working Interest owners, including possibly, those owned
by Affiliates. Ultimately, Non-Consent Interests revert back to the
original Working Interest owner upon the recoupment by the
participating parties of a penalty amount from the production
attributable to the non-consent interest. As a result, the Manager
could possibly devote more management time to Working Interests of the
Fund or other Ridgewood Energy Programs that do not revert to a
third-party.
o In addition to any government royalties, the Fund may invest in a well
that may also require payment of royalties to certain other entities,
including, possibly, affiliates of the Fund, who posses an "overriding
interest" in such well. Payment of royalties to owners of any such
overriding interest may reduce the gross revenue to the Fund from such
well.
o The Manager has complete discretion with respect to whether and when
to make distributions and the amount thereof. No distributions will be
made from the Fund to the Investors of the Fund until the Fund has
funds that the Manager determines are not needed for the operation of
the Fund. Accordingly, there is no assurance that any distributions
from the Fund will be made to its Investors. Distributions will depend
primarily on the Fund's net cash receipts from its operations.
Moreover, distributions could be delayed to repay the principal and
interest of Fund borrowings, if any, or to fund Fund costs. Fund
income will be taxable to the Investors in the year earned, even if
cash is not distributed. The timing and amount of distributions, if
any, will also impact upon the Manager's entitlement to distributions.
o Finally, pursuant to the LLC Agreement, the Manager acts as the "tax
matters partner" and, accordingly will be making determinations for
the Fund regarding taxes that may impact the Manager differently than
the Investors.
40
One factor that reduces conflicts of interest is that the Manager receives
the same fees from every Fund. Therefore, there is no financial incentive to
favor one Fund over another. The Manager and its Affiliates will attempt, in
good faith, to resolve all conflicts of interest in a fair and equitable manner
with respect to all persons affected by those conflicts of interest. Prospective
investors should be aware that the Manager and its Affiliates have not formally
adopted procedures or criteria to avoid or to resolve all conflicts of interest
that may arise between the Manager, its Affiliates, prior Ridgewood Energy
Programs, and the Fund. Under the LLC Agreement, in resolving any conflict of
interest that may arise, the Manager is not liable to Investors for such
resolution unless it has acted in bad faith, engaged in gross negligence or
willful misconduct.
MANAGEMENT
The Ridgewood Companies, founded by Robert Swanson, began in 1982 with
Ridgewood Energy Corporation. In 1991, Ridgewood Renewable Power was formed to
manage a series of investment programs focusing on the independent electric
power generation industry. Ridgewood Renewable Power has sponsored twelve funds
that have invested primarily in environmentally friendly power plants such as
landfill gas-fired, biomass-fired, and hydroelectric generating facilities. In
1998, Ridgewood Capital was formed to take advantage of the dramatic growth in
the technology sector. Since then Ridgewood Capital has sponsored six investment
funds which have invested in private technology companies.
The Manager
As the Manager of the Fund, Ridgewood Energy Corporation ("Ridgewood
Energy") will have direct and exclusive discretion in management and control of
the affairs of the Fund. Robert Swanson formed Ridgewood Energy, which has
sponsored oil, natural gas and other related natural resource investment
programs. The programs have acquired lease interests, financed them and
participated in making exploration, development, production, and marketing
decisions.
Ridgewood Energy began by organizing investment programs in the oil and gas
industry for high net-worth individuals. From the outset, Ridgewood's programs
focused on returning high-yielding cash dividends to investors over an extended
period of time combined with certain tax benefits. Later programs de-emphasized
the tax benefits and have focused on revenues and profitability. Capital raised
from investors has been used to purchase interests in operations designed to
extract oil or natural gas from underwater deposits, mainly in the Gulf of
Mexico.
41
THE PERFORMANCE OF PREVIOUS RIDGEWOOD PROGRAMS IN OTHER GULF OF MEXICO PROSPECTS
OR OF OTHER OPERATIONS IN SIMILAR OR CONTIGUOUS PROPERTIES SHOULD NOT BE
CONSIDERED TO PROVIDE ANY ASSURANCE THAT THIS FUND WILL BE SUCCESSFUL OR
GENERATE A PROFIT. SEE EXHIBIT B FOR RIDGEWOOD ENERGY'S TRACK RECORD.
Ridgewood's executive team includes:
Robert E. Swanson, age 58, is the Chairman and President, manager and
controlling shareholder of Ridgewood Energy. Mr. Swanson is the Chief Executive
Officer and controlling member of Ridgewood Renewable Power, Ridgewood Capital
Management and other affiliates. Mr. Swanson was a tax partner at the former New
York and Los Angeles law firm of Fulop & Hardee and an officer in the Investment
Division of Morgan Guaranty Trust Company. His specialty was in personal tax and
financial planning, including income, estate and gift tax. Mr. Swanson is a
member of the New York State and New Jersey bars. He is a graduate of Amherst
College and Fordham University Law School. Mr. Swanson and his wife, Barbara
Mardinly Swanson are the authors of "Tax Shelters, A Guide for Investors and
Their Advisors," published by Dow Jones-Irwin in 1982 and published in revised
editions in 1984 and 1985.
Greg Tabor, age 42 is Executive Vice President and Director of Business
Development for Ridgewood Energy. Mr. Tabor heads the Houston office of
Ridgewood Energy. Mr. Tabor has 20 years experience in petroleum business
development and as a land man responsible for negotiating leases, acquiring
properties, and divesting properties, with the largest part of his work devoted
to the Gulf of Mexico. Mr. Tabor came to Ridgewood in January 2004 from El Paso
Natural Gas Corp. where he was a senior business development officer. Mr. Tabor
worked for a decade primarily in the Gulf of Mexico on gas projects for Sante Fe
Corp. and its affiliates. Mr. Tabor is a graduate of the University of Houston.
Robert L. Gold, age 46, is Executive Vice President of Ridgewood Energy which he
joined in 1987. Mr. Gold is also the President of Ridgewood Capital since its
inception in 1998. As such, he has directed the investment programs of the prior
venture capital programs. For the two years prior to joining the Ridgewood
Companies, Mr. Gold was a corporate attorney in the law firm of Cleary,
Gottlieb, Steen & Hamilton in New York City. Mr. Gold is a member of the New
York bar. He is a graduate of Colgate University and New York University School
of Law.
42
Kathleen McSherry, age 40 is Senior Vice President and Chief Financial Officer
of Ridgewood Energy. She joined Ridgewood Energy in 1987 as Assistant Controller
and was promoted in 1994 to Controller. In addition, Ms. McSherry serves as Vice
President of Systems and Administration of Ridgewood Renewable Power. Prior to
her employment at Ridgewood Energy, Ms. McSherry worked in the Trust department
for Midlantic National Bank. Ms. McSherry holds a Bachelor of Science degree in
Accounting
Daniel V. Gulino, age 45, is Senior Vice President and General Counsel of
Ridgewood Energy. He began his legal career as an associate for Pitney Hardin, a
large New Jersey law firm, where his experience included corporate acquisitions
and transactions. Prior to joining Ridgewood, Mr. Gulino was in-house counsel
for several large electric utilities, including GPU, Inc., Constellation Power
Source, Inc. and PPL Resources, Inc., where he specialized in non-utility
generation projects, independent power and power marketing transactions. Mr.
Gulino also has experience with the electric and natural gas purchasing of
industrial organizations, having worked as in-house counsel for Alumax, Inc.
(now part of Alcoa) where he was responsible for, among other things, Alumax's
electric and natural gas purchasing program. Mr. Gulino is a member of the New
Jersey State Bar and Pennsylvania State Bar. He is a graduate of Fairleigh
Dickinson University and Rutgers University School of Law - Newark.
Kenneth D. Webb, age 53, is Ridgewood Energy's Geoscience Manager and joined
Ridgewood Energy in April of 2004 in the Houston office. Mr. Webb has over 30
years of experience in the U.S. oil and gas industry, mainly in the onshore and
offshore Gulf of Mexico area. His responsibilities include the geoscience
evaluation of exploration and development opportunities presented to the
company, and maximizing the potential of Ridgewood properties. Prior to joining
Ridgewood, Mr. Webb worked for several large independent exploration and
development companies, including Enserch, Transco, CNG, and Seagull Energy, and
has held positions ranging from Staff Geologist to Vice President of
Exploration. In addition, Mr. Webb held the position of Geoscience Manager for
an independent acquisition and divestment company immediately before joining
Ridgewood.
Randy A. Bennett, age 48, is Land Manager and joined Ridgewood Energy in July
2004. He is located in Ridgewood Energy's Houston, Texas office. Mr. Bennett has
more than 20 years of experience in the domestic U.S. oil and gas exploration
and production business. Prior to joining Ridgewood Energy, Mr. Bennett was
43
employed by both independent and major oil and gas exploration and production
companies including Sabine Corporation, Conoco, and most recently, 6 years with
Unocal. He is responsible for offshore Gulf of Mexico shelf and deepwater
exploration activities, production operations, business development, and
regulatory affairs. Mr. Bennett received a Bachelor of Science degree in
Petroleum Land Management from the University of Houston, is a Registered
Professional Landman (RPL), and is an active member of the American Association
of Professional Landmen, Houston association of Professional Landmen and the
Professional Landman's Association of New Orleans.
Mary Lou Olin, age 50, is Vice President and Secretary of the Manager, Ridgewood
Capital, Ridgewood Renewable Power and the Fund. Her primary areas of
responsibility are investor relations, communications and administration. Prior
to her employment at Ridgewood Energy in 1984, Ms. Olin was a Regional
Administrator at McGraw-Hill Training Systems where she was employed for two
years. Prior to that, she was employed by RCA Corporation. Ms. Olin has a
Bachelor of Arts degree from Queens College.
Mirna Valdes, age 43 is Ridgewood Energy's Vice President of Investor Relations.
She joined Ridgewood Energy in 1987 as Marketing Coordinator and was promoted in
1995 to Assistant Vice President. Prior to her employment at Ridgewood Energy,
Ms. Valdes worked at WABC-TV, New York. Ms. Valdes graduated from Taylor
Business Institute.
Please see Exhibit B for a Track Record of Ridgewood Energy's prior investments.
TAX ASPECTS
The following is a summary of material federal tax considerations for
persons considering an investment in the Fund. The discussion, among other
things, summarizes certain provisions of the Internal Revenue Code of 1986, as
amended (the "Code"), the applicable Treasury Regulations promulgated or
proposed thereunder (the "Regulations"), current published positions of the
Internal Revenue Service (the "Service") and existing judicial decisions, all of
which are subject to change at any time.
There can be no assurance that any deductions, credits or other tax
consequences which are described herein, or which a prospective Investor in the
Fund may contemplate, will be available. In addition, no assurance can be given
44
that legislative or administrative changes or court decisions may not occur
which would significantly modify the statements expressed herein. In some
instances, these changes could have a substantial effect on the tax aspects of
the Fund. Any future legislative changes may or may not be retroactive with
respect to transactions prior to the effective date of such changes.
Moreover, although the Fund has retained professional tax advisors, there
are risks and uncertainties concerning certain of the tax aspects associated
with an investment in the Fund and there can be no assurance that some or all of
the deductions or credits claimed by the Fund may not be challenged by the
Service. Disallowance of such deduction or credits could adversely affect the
Fund and the Investors. EACH PROSPECTIVE INVESTOR IS THEREFORE URGED TO CONSULT
HIS TAX ADVISOR WITH RESPECT TO THE TAX CONSEQUENCES ARISING FROM AN INVESTMENT
IN THE FUND.
NO RULING FROM THE SERVICE REGARDING EITHER THE TAX ASPECTS OR THE STATUS
OF THE FUND AS A PARTNERSHIP FOR TAX PURPOSES HAS BEEN OR WILL BE REQUESTED.
The description of the tax aspects discussed herein is supported by a tax
opinion of counsel to the Fund, Black & Associates. A copy of the tax opinion is
available upon request of any Investor. The tax opinion is, of course, not
binding on the Service or the courts.
The legal discussion below is based upon (a) the facts set forth in this
Memorandum and the Exhibits hereto and (b) the following representations by the
Manager:
o No election has been filed by the Fund under the Regulations to be
treated as an association taxable as a corporation and no such
election shall be filed in the future, without the consent of a
majority of the Investors;
o No interests in entities treated as partnerships or business trusts in
which the Manager or any Affiliate has acted as the manager or the
managing shareholder have ever been traded on a secondary market or
the substantial equivalent thereof;
o The Manager will not allow any transfer of Shares which, in the
opinion of its counsel, will cause the Fund's Shares to be treated as
readily tradable on a secondary market or the substantial equivalent
thereof without the consent of a majority of the Investors;
45
o The Manager does not expect to be in a significantly lower federal
income tax bracket than the Fund's Investors; and
o The Manager expects that at least 90% of the Fund's gross income for
each year of its existence will consist of interest or income from the
exploration, development, production, processing, refining,
transportation or marketing of natural gas or oil and gains from the
sale of assets used to generate that income.
1. Limitations
The federal income tax consequences described below are, to a significant
extent, available only to taxpayers who invest in the Fund with the bona fide
intent of deriving an economic profit without regard to any income tax
advantages. The determination of whether an Investor is participating in the
Fund for profit is subjective and based upon the motives of the particular
Investor. It is difficult to assess this subjective intent or anticipate the
future activities of any Investor, and thus it is assumed for purposes of this
discussion that the Investors shall have the requisite profit motive. A
determination that such is not the case would have a substantially adverse
effect upon the tax consequences of an investment in the Fund. No prospective
Investor should invest in the Fund unless the prospective Investor does so with
an intent to realize an economic profit without regard to tax consequences.
Virtually all of the income tax consequences described herein are dependent
upon the fair market value of the property to be acquired by and the services
rendered to the Fund being not less than the price paid therefore. While the
Manager believes that the values of such property and services will be not less
than the prices paid, there can be no assurance that the Service or the courts
will concur with such valuations.
2. Classification as a Partnership
A. In General. Under the Regulations, a business entity other than a
corporation (or a "publicly traded partnership" which is treated as a
corporation) with more than one member which is formed after January 1, 1997,
will be treated as a partnership for federal income tax purposes unless the
business entity elects to be treated as an association taxable as a corporation.
The Manager has represented that no such election has been filed by the Fund nor
will any such election be filed in the future, without the consent of a majority
of the Investors.
B. Publicly Traded Partnerships. Certain publicly traded partnerships are
treated as corporations for federal income tax purposes. Since the Fund will be
46
treated as a partnership for federal income tax purposes, this provision is
applicable to the Fund. A "publicly traded partnership" is defined as "any
partnership if...(1) interests in such partnership are traded on an established
securities market, or (2) interests in such partnership are readily tradable on
a secondary market (or the substantial equivalent thereof)." The Shares do not
and are not intended to trade on an established securities market.
Under the Regulations, interests in a partnership are considered to be
readily tradable on a secondary market or the substantial equivalent thereof if:
"(i) Interests in the partnership are regularly quoted by any person, such
as a broker or dealer, making a market in the interests;
(ii) Any person regularly makes available to the public (including
customers or subscribers) bid or offer quotes with respect to interests in the
partnership and stands ready to effect buy or sell transactions at the quoted
prices for itself or on behalf of others;
(iii) The holder of an interest in the partnership has a readily available,
regular, and ongoing opportunity to sell or exchange the interests through a
public means of obtaining or providing information of offers to buy, sell, or
exchange interests in the partnership; or
(iv) Prospective buyers and sellers otherwise have the opportunity to buy,
sell or exchange interests in the partnership in a time frame and with the
regularity and continuity that is comparable to that described in the other
provisions of this paragraph . . . ."
No interests in partnerships, business trusts or limited liability
companies in which the Manager or any of its Affiliates has acted or is acting
as the Manager or the managing shareholder have ever been traded on a secondary
market or the substantial equivalent thereof, as defined in such Regulations.
The Manager also will not allow any transfer of Shares which, in the opinion of
its counsel, will cause the Fund's Shares to be treated as readily tradable on
such market without the consent of a majority of the Investors.
In addition, no partnership will be treated as a corporation for federal
income tax purposes for any year if at least 90% of the partnership's gross
income for such year and all preceding years consists of, among other things,
interest or income from the exploration, development, production, processing,
refining, transportation or marketing of oil and gas and gains from the sale of
assets used to generate that income. The Manager has represented that the Fund
is expected to meet the foregoing 90% gross income test during each year of its
existence.
47
If (i) the Shares were in the future to become readily tradable as defined
above, or in subsequent Regulations, rulings or other relevant authority and
(ii) if the Fund would fail to satisfy the above 90% gross income test, the Fund
could for this reason become taxable as a corporation for federal income tax
purposes.
C. Summary. Assuming the Fund does not file an election under the
Regulations to be treated as an association taxable as a corporation and does
not become a "publicly traded partnership" as defined above, in the opinion of
Black & Associates, the Fund shall be treated as a partnership for federal
income tax purposes. Black & Associates' opinions are based upon the existing
provisions of the Code, the Regulations and interpretations thereof by the
Service and the courts. As mentioned, no assurance can be given that such laws
and Regulations will not be changed or that such changes will not be
retroactive.
3. Fund Taxation
Subject to the foregoing, it is the opinion of Black & Associates that the
Fund will not be subject to federal income tax. The Fund will, however, be
required each year to file Partnership information tax returns.
The Investors will be required to take into account, in computing their
federal income tax liabilities, their respective distributive shares of all
items of Fund income, gain, expense, loss, deduction, credit and tax preference
for any taxable year of the Fund ending within or with the taxable year of the
respective Investor, without regard to whether such Investors have received or
will receive any cash distributions from the Fund. An Investor therefore may be
subject to tax if the Fund has income even though no cash distribution is made.
If the cash distributed by the Fund for any year to an Investor, including
his share of the reduction of any Fund liabilities, exceeds his share of the
Fund's undistributed taxable income, the excess will constitute a return of
capital. A return of capital is applied first to reduce the tax basis of the
Investor's interest in the Fund, and any amounts in excess of such tax basis
will generally be treated as gain from a sale of such Investor's interest in the
Fund.
48
The Social Security Act and the Code exclude from the definition of "net
earnings from self-employment" a limited partner's distributive share of any
item of income or loss from a partnership other than a guaranteed payment for
personal services actually rendered. In the opinion of Black & Associates, this
provision would apply to the Investors. Among other things, the effect of this
provision is that (a) no quarters of coverage of increased benefits under the
Social Security Act will be earned by Investors by virtue of their shares of the
Fund's income and (b) if any Investors are currently receiving Social Security
benefits, their respective distributive shares of taxable income from the Fund
will not have be taken into account in determining any reduction in benefits
because of "excess earnings".
4. Leasehold Acquisition Costs
The cost of acquiring leases, or other similar property interests, is a
capital expenditure and may not be deducted in the year paid or incurred but
must be recovered through depletion. If, however, a lease is proved to be
worthless by drilling or abandonment, the cost of such lease (less any recovery
thereof through the depletion deduction) constitutes a loss to the taxpayer in
the year in which the lease becomes worthless.
5. Deduction of Intangible Drilling and Development Costs
Section 263(c) authorizes an election by the Fund to deduct as expenses
intangible drilling and development costs incurred in connection with natural
gas or oil wells at the time such costs are incurred in accordance with the
Fund's method of accounting, provided that the costs are not more than would be
incurred in an arm's length transaction with an unrelated drilling contractor.
Such costs include, for example, amounts paid for labor, fuel, wages, repairs,
supplies and hauling necessary to the drilling of the well and preparation of
the well for production. Generally, this election applies to items that in
themselves do not have salvage value. Alternatively, each Investor may elect to
capitalize his or her share of the intangible drilling and development costs and
amortize them ratably over a 60-month period.
The Fund may enter into "Carried Interest" arrangements whereby the Fund
would purchase interests in certain leases and agree to pay a disproportionate
part of the costs of drilling the first well thereon. In such situations, the
party who is paying more than his share of costs of drilling may not deduct all
of such costs as intangible drilling and development costs unless his percentage
of ownership of the lease is not reduced before he has recovered from the first
production of the well an amount equal to the cost he incurred in drilling,
49
completing, equipping and operating the well. The Fund may not have this right
in certain of the transactions of this type in which it may engage. If
circumstances permit, however, the Fund will adopt the position that all of the
intangible drilling and development costs incurred are deductible (even though
such costs may be disproportionate to its ownership of the lease) on the basis
that such arrangements constitute partnerships for federal income tax purposes
and that the excess intangible drilling and development costs are specifically
allocable to the Fund. There can be no assurance that this position would
prevail against attack by the Service.
In the case of an Investor which constitutes an "integrated oil company,"
30% of the amount otherwise allowable as a deduction for intangible drilling
costs under Section 263(c) must be capitalized and deducted ratably over a
60-month period beginning with the month the costs are paid or incurred. This
provision does not apply to nonproductive wells. For this purpose, an
"integrated oil company" is generally defined as an individual or entity with
retail sales of oil and gas aggregating more than $5 million and refining more
than 50,000 barrels per day for the taxable year.
To the extent that drilling and development services are performed for the
Fund in 2006, amounts incurred pursuant to bona fide arm's-length drilling
contracts and constituting intangible drilling and development costs should be
deductible by the Fund in 2006. To the extent that such services are performed
in 2007, however, the Fund will only be allowed to deduct in 2006 amounts that
are:
o incurred pursuant to bona fide arm's-length drilling contracts which
provide for absolute noncontingent liability for payment, and
o attributable to wells spudded within 90 days after December 31, 2006.
Sections 461(h)(1) and 461(i)(2) provide, in relevant part:
...in determining whether an amount has been incurred with respect to
any item during any taxable year, the all events tests shall not be
treated as met any earlier than when economic performance with respect
to such item occurs.
* * *
...economic performance with respect to the act of drilling an oil or
gas well shall be treated as having occurred within a taxable year if
drilling of the well commences before the close of the 90th day after
the close of a taxable year.
50
The clear implication of these provisions is that an amount incurred during
a taxable year for drilling or completion services which could otherwise be
accrued for tax purposes will not be disqualified as a deduction merely because
the services are performed during the subsequent taxable year (provided that the
services commence within the first 90 days of such subsequent year).
Consequently, in the opinion of Black & Associates, intangible drilling and
development costs meeting the above criteria should be deductible by the Fund in
2006 even though a portion of such costs are attributable to services performed
during 2007.
Each Investor, however, may deduct his share of amounts paid in 2006 for
services performed in 2007 only to the extent of his "cash basis" in the Fund as
of the end of 2006. For this purpose, a taxpayer's "cash basis" in a tax shelter
which is taxable as a partnership (such as the Fund) is the taxpayer's basis in
the Fund determined without regard to any amount borrowed by the taxpayer with
respect to the Fund which (a) is arranged by the Fund or by any person who
participated in the organization, sale or management of the Fund (or any person
related to such person within the meaning of Section 461(b)(3)(c)), or (b) is
secured by any asset of the Fund. Inasmuch as "cash basis" excludes borrowing
arranged by an extremely broad group of persons who could be "related" to a
person who "participated" in the organization, sale or management of the Fund,
it is not possible for counsel to the Fund to express an opinion as to whether
each Investor will be allowed to deduct his allocable share of any prepaid
drilling expenses to the extent that they exceed his actual cash investment in
the Fund. Amounts borrowed by an Investor from the Manager or any of its
Affiliates and borrowing arranged by such persons will not be considered part of
such Investor's "cash basis" for these purposes.
6. Depletion
Subject to the limitations discussed hereafter, the Investors will be
entitled to deduct, as allowances for depletion under Section 611, their share
of percentage or cost depletion, whichever is greater, for each oil and gas
producing property owned by the Fund.
Cost depletion is computed by dividing the basis of the property by the
estimated recoverable reserves to obtain a unit cost, then multiplying the unit
cost by the number of units sold in the current year. Cost depletion cannot
51
exceed the adjusted basis of the property to which it relates. Thus, cost
depletion deductions are limited to the capitalized cost of the property, while
percentage depletion may be taken as long as the property is producing income.
The depletion allowance for oil and gas production will be computed separately
by each Investor and not by the Fund. The Fund will allocate to each Investor
his proportionate share of production and the adjusted basis of each Fund
property. Each Investor must keep records of his share of the adjusted basis and
any depletion taken on the property and use his adjusted basis in the
computation of gain or loss on the disposition of the property by the Fund.
Percentage depletion with respect to production of oil and gas is available
only to those qualifying for the independent producer's exemption, and is
limited to an average of 1,000 barrels per day of domestic oil production or
6,000,000 cubic feet per day of domestic gas production. The applicable rate of
percentage depletion on production under the independent producer exemption is
15% of gross income from oil and gas sales. The depletion deduction under the
independent producer exemption may not exceed 65% of the taxpayer's taxable
income for the year, computed without regard to certain deductions. Any
percentage depletion not allowed as a deduction due to the 65% of adjusted
taxable income limitation may be carried over to subsequent years subject to the
same annual limitation. For an Investor that is a trust, the 65% limitation
shall be computed without deduction for distributions to beneficiaries during
the taxable year.
The determination of whether an Investor will qualify for the independent
producer exemption will be made at the Investor level. An Investor who qualifies
for the exemption, but whose average daily production exceeds the maximum number
of barrels on which percentage depletion can be computed for that year, will
have to allocate his exemption proportionately among all of the properties in
which he has an interest, including those owned by the Fund. In the event
percentage depletion is not available, the Investor would be entitled to utilize
cost depletion as discussed above.
The independent producer exemption is not available to a taxpayer who
refines more than 50,000 barrels of oil on any one day in a taxable year or who
directly or through a related person sells oil or gas or any product derived
therefrom (i) through a retail outlet operated by him or a related person or
(ii) to any person who occupies a retail outlet which is owned and controlled by
the taxpayer or a related person. In general, a related person is defined by
Section 613A of the Code as a corporation, partnership, estate, or trust in
which the taxpayer has a 5% or greater interest. For the purpose of applying
this provision: (i) bulk sales of oil or natural gas to commercial or industrial
52
users are excluded from the definition of retail sales; (ii) if the taxpayer or
a related person does not export any domestic oil or natural gas production
during the taxable year or the immediately preceding year, retail sales outside
the U.S. are not deemed to be disqualifying sales; and (iii) if the taxpayer's
combined receipts from disqualifying sales do not exceed $5,000,000 for the
taxable year of all retail outlets taken into account for the purpose of
applying this restriction, such taxpayer will not be deemed a "retailer."
The technical provisions and limitations relating to the availability of
depletion are complex and will vary among taxpayers. Many uncertainties exist
and each prospective Investor should review his individual circumstances with
his personal tax advisor.
7. Depreciation
Costs of equipment, such as casing, tubing, tanks, pumping units,
pipelines, production platforms and other types of tangible property and
equipment generally cannot be deducted currently, but may be eligible for
accelerated cost recovery. All or part of the depreciation claimed may be
subsequently recaptured upon disposition of the property by the Fund or of a
Share by any Investor.
In addition, the Code provides for certain uniform capitalization rules
which could result in the capitalization rather than deduction of Fund overhead
and administration costs.
8. Farm-outs and Back In Interests
The Fund may acquire leaseholds through Farm-out Agreements. Some Farm-outs
may be characterized for tax purposes as partnerships entered into by the Fund
and an Operator. The manner in which the parties to these Farm-outs agree to
allocate income, gain, loss, deductions, and credits (or any item thereof) may
be disallowed under Section 704 of the Code. If the Farm-out creates a
co-ownership arrangement, the Fund may be required to capitalize a portion of
the intangible drilling and development costs paid in excess of its fractional
share of the Working Interest acquired pursuant to the agreement. One type of
Farm-out in which the Fund might participate is a transaction in which, in
exchange for the drilling of a well on a particular drill site, an Operator
becomes entitled to an assignment of 100% of the leasehold interest in the drill
site acreage (until such time as the Operator's drilling, completion and
production costs are recovered out of production therefrom, with a lesser
percentage thereafter) and a lesser fractional interest in the portion of the
tract exclusive of the drill site acreage. The Service has ruled, in Revenue
53
Ruling 77-176, 1977-1 Cum. Bul. 77, that any transfer of rights in property
other than the drill site acreage in this type of transaction would be deemed a
sale of such other property by the party transferring the property on which gain
or loss is realized. The Service further ruled that, while the party receiving
the acreage and incurring the cost of drilling the well on the drill site may
elect to deduct such costs as intangible drilling and development costs, such
party would realize ordinary income equal to the value of the acreage earned
exclusive of the drill site acreage.
The Fund will attempt to structure any Farm-out or similar transaction in a
way that either eliminates or minimizes to the fullest extent possible the tax
consequences described above. Nevertheless, the ruling may have adverse tax
implications for the Fund if and when the Fund enters into such Farm-outs, since
the Fund may recognize gain or loss upon the transfer of an interest in the
property.
9. Allocations
In the opinion of Black & Associates, the allocations of each Investor's
share of income, gain, expense, loss, deduction or credit as set forth in the
LLC Agreement will more likely than not be sustained for federal income tax
purposes.
Under Section 704, a partner's distributive share of the income, gain,
expense, loss, or credit of a partnership is determined in accordance with the
partnership agreement, unless the allocation set forth therein is without
"substantial economic effect." An allocation will have substantial economic
effect only if it may actually affect the dollar amount of the partners' shares
of the total partnership revenue or costs independently of tax consequences.
Allocations which do not affect the amounts to be distributed from a partnership
generally do not have substantial economic effect. It is essential that the
allocations be reflected in the partners' capital accounts and that such capital
accounts be the basis upon which distributions are made upon liquidation.
Several relevant factors that are considered in making a determination as to
whether an allocation will be recognized for federal income tax purposes are
outlined in the Regulations. These factors include, among others, (1) the
presence of a business purpose for the allocation, (2) whether related items of
income, gain, expense, loss, deduction or credit from the same source are
subject to the same allocation, (3) whether the allocation was made without
recognition of normal business factors, (4) whether it was made only after the
amount of the specially allocated item could reasonably be estimated, (5) the
duration of the allocation and (6) the overall tax consequences of the
allocation. These factors and perhaps others may be relevant in determining
whether an allocation has substantial economic effect.
54
The Regulations relating to special allocations of partnership costs and
revenues under Section 704(b) provide that partnership allocations have economic
effect (and thus would be valid under the Code provided such effect is
substantial) only if they are consistent with the underlying economic
arrangements of the partners. Under the Regulations, an allocation of income,
gain, expense, loss, deduction or credit (or item thereof) to a partner is
considered to have economic effect if, throughout the full term of the
partnership, the partnership agreement provides:
o For the determination and maintenance of the partners' capital
accounts in accordance with the Regulations;
o Upon liquidation of the partnership (or any partner's interest in the
partnership), for liquidating distributions in all cases to be made in
accordance with the positive capital account balances of the partners,
as determined after taking into account all capital account
adjustments for the partnership taxable year during which such
liquidation occurs (other than those made pursuant to this requirement
and the third requirement below), by the end of such taxable year (or,
if later, within 90 days after the date of such liquidation); and
o For a "qualified income offset" provision as defined in Regulation
Section 1.704-1(b)(2)(ii)(d) and a "minimum gain charge-back"
provision as defined in Regulation Section 1.704-2(f).
No allocation to a partner will be given effect, however, which would cause
or increase a negative capital account balance for such partner in excess of
that partner's share of the partnership minimum gain. In general, a partnership
has minimum gain to the extent that nonrecourse liabilities encumbering
partnership property exceed the adjusted tax basis of such property.
Under the LLC Agreement, a capital account is to be maintained for each
Investor to which will be charged each item of Fund income, gain, expense, loss,
deduction and credit in accordance with the rules set forth in the Regulations.
Upon dissolution of the Fund, after satisfying all Fund liabilities, each
Investor will receive a distribution in accordance with the Investor's positive
capital account balance. In addition, the LLC Agreement contains a "qualified
income offset" provision as defined in Regulation Section 1.704-1(b)(2)(ii)(d)
and a "minimum gain charge-back" provision as defined in Regulation section
1.704-2(f).
55
Regulation Section 1.704-1(b)(2)(iii)(a) presently provides that the
economic effect of an allocation is not substantial if, at the time the
allocation becomes part of the partnership agreement, (1) the after-tax economic
consequences of at least one partner may, in present value terms, be enhanced
compared to such consequences if the allocation were not contained in the
partnership agreement, and (2) there is a strong likelihood that the after-tax
economic consequences of no partner will, in present value terms, be
substantially diminished compared to such consequences if the allocation were
not contained in the partnership agreement. In determining the after-tax
economic benefit or detriment to a partner, tax consequences that result from
the interaction of the allocation with such partner's tax attributes that are
unrelated to the partnership will be taken into account.
Under the LLC Agreement, 99 percent of all items of Fund expense, loss,
deduction and credit attributable to the acquisition, drilling and completion of
the Fund's Projects will generally be allocated to the Investors. This
allocation appears to satisfy the first test of Regulation Section
1.704-1(b)(2)(iii)(a) inasmuch as it will presumably enhance the after-tax
consequences to an Investor. The second test is not expected to be met, since
the Manager has represented that it does not expect to be in a significantly
lower income tax bracket than the Investors. In any case, there appears to be no
statutory authority for the position taken by the Treasury Department in
Regulation Section 1.704-1(b)(2)(iii)(a), inasmuch as it would appear to
disallow any special allocation which would enhance the after-tax economic
consequences to any partner, whether or not the allocation has substantial
economic effect.
Accordingly, it is Black & Associates opinion that the allocations set
forth in the LLC Agreement will more likely than not have the requisite
substantial economic effect.
If the allocations are not recognized, Section 704(b) requires that each
Investor's distributive share be determined in accordance with his interest in
the Fund, as determined from all the facts and circumstances. The most likely
consequences of an adverse determination in this regard would be the
disallowance of approximately 14% of the deductions taken by the Investors with
respect to the acquisition, drilling and completion of the Fund's wells.
Section 706 and the Regulations thereunder provide generally that a partner
may be allocated items of partnership income and deductions only for that
portion of the Fund's taxable year that the partner is a partner. Accordingly,
the partnership shall allocate such items only to those Investors who are
already admitted to the Fund at the time such expenses were incurred.
56
10. Organization, Start-up and Syndication Expenses
Section 709(a) prohibits any Investor from deducting any amounts paid or
incurred to organize the Fund or to promote the sale of (or to sell) an interest
in the Fund. Amounts paid to organize the Fund, however, may, at the election of
the Fund, be treated as deferred expenses of which the first $5,000, when
combined with all "startup" expenses (see below), may be deducted when incurred
and the remainder deducted ratably over a period of not less than 180 months.
Organization expenditures that may be amortized are those (i) incurred incident
to the creation of the Fund, (ii) chargeable to the capital account, and (iii)
of a character which, if expended incident to the creation of a partnership
having an ascertainable life, would be amortized over such life. The Fund
presently intends to amortize qualifying organization expenditures over a
60-month period.
Expenses connected with the promotion or sale of interests in a
partnership, known as syndication fees, are not deductible by the Fund or the
Investors and are not eligible for the 180-month amortization as is the case for
organizational expenses. Syndication fees include such expenditures connected
with the issuing and marketing of interests in a partnership such as sales
commissions, certain professional fees, selling expenses and printing costs.
Regulation Sections 1.709-1 and 1.709-2 make it clear that the definition of
syndication costs includes counsel fees related to securities law advice,
certain accountants' fees, brokerage fees and registration fees. The allocation
of certain expenses between organization costs and syndication costs is a
question of fact and the Manager will use reasonable judgment in claiming
amortization deductions for a portion of the Organizational, Distribution and
Offering Fee and other expenses. The Service may on audit contest such
deductions.
Section 195 provides that no deduction is allowed for "start-up
expenditures." However, taxpayers may elect under that section to deduct the
first $5,000 of the combined organizational expenses and "start-up expenditures"
when incurred, and the remainder of the "startup expenditures" over a period of
not less than 180 months. "Start-up expenditures" include amounts paid or
incurred in connection with investigating the creation or acquisition of an
active trade or business or paid or incurred in connection with any activity
engaged in for profit and for the production of income prior to the day on which
the active trade or business begins, in anticipation of the activity becoming an
active business.
57
A significant portion of the Fund's expenses may be characterized as
"start-up expenditures" for federal income tax purposes. Consequently, the Fund
intends to elect to amortize such expenses over a 60-month period.
While the Manager will use its best judgment in the allocation of expenses
among start-up, organization, syndication and other costs, no assurance can be
given that such allocation will not be challenged by the Service. In particular,
the Service may claim that various fees paid to the Manager constitute
syndication expenses.
11. Distributions
Cash distributions by the Fund to an Investor will not result in taxable
gain to such Investor unless they exceed the Investor's adjusted basis in his
Shares, in which case the Investor will recognize gain in the amount of such
excess. Non-liquidating distributions of property other than cash to an Investor
will reduce the Investor's basis in the Fund by an amount equal to the Fund's
basis in such property; provided, however, that the adjusted basis of the
Investor may not be reduced below zero. An Investor's tax basis in any property
distributed to the Investor will be an amount equal to the amount of reduction
in the Investor's basis in the Investor's Shares, occurring by reason of such
distribution, regardless of the value of the property distributed. A reduction
in an Investor's share of Fund indebtedness will be treated as a cash
distribution to the Investor to the extent of such reduction. Under some
circumstances, distributions from the Fund to an Investor may cause the amount
the Investor has at risk with respect to the Fund activity to fall below zero,
which could result in recapture of previously deducted losses.
12. Trade or Business Requirement
The Service may seek to disallow certain deductions claimed by the Fund on
the ground that these expenditures are not expenditures incurred in carrying on
a trade or business because the Fund will not have established and commenced its
business at the time the expenditures are made.
Neither the Code nor the Regulations provide any explicit definitions of
"carrying on a trade or business." Although various subjective criteria have
been recommended for consideration in this regard, no single factor has been
found to be controlling. Further, determining the point in time when a
58
particular venture begins carrying on a trade or business is essentially a
question of fact, the resolution of which is not to be determined solely from
the intention of the taxpayer. The Service might contend that the Fund is not
engaged in carrying on any trade or business within the meaning of Section
162(a) until such time as the business has begun to function as a going concern,
performs those activities for which it was organized and starts to generate
receipts. In addition, the Service may contend that certain expenses are in the
nature of "start-up" expenses rather than currently deductible trade or business
expenses.
In the event that the Service were to disallow Fund expenses based upon the
failure of the Fund to have been carrying on a trade or business, the Fund
expects to take the position that its expenses may be deducted in any case under
Section 212 which provides for deductions ("Miscellaneous Deductions") for
amounts incurred for the production of income, for the management, conservation,
or maintenance of property held for the production of income and in connection
with the determination, collection or refund of any tax.
Under Code Section 67, however, expenses of an individual taxpayer which
are otherwise deductible under Section 212 are disallowed to the extent that
they, when combined with the taxpayer's other Miscellaneous Deductions, do not
exceed 2% of his adjusted gross income. If, for any period, the Fund is found
not to be engaged in a trade or business, the Service could thus disallow an
Investor's share of various expenses of the Fund to the extent that such share,
when combined with the Investor's otherwise allowable Miscellaneous Deductions,
does not exceed such 2% threshold.
13. Alternative Minimum Tax
The Code imposes an alternative minimum tax in order to assure that
taxpayers may not reduce their tax below a minimum level through certain "tax
preference items." In general, the alternative minimum tax liability of a
noncorporate taxpayer is calculated by (1) adding together the taxpayer's
adjusted gross income and the taxpayer's tax preference items, (2) adding and
subtracting certain other specified items, and (3) then subtracting the
applicable exemption of $40,250 for single taxpayers, $58,000 for married
taxpayers filing joint returns, $29,000 for married taxpayers filing separate
returns, or $22,500 for estates and trusts. Married taxpayers filing separate
returns must also add to that total an amount equal to the lesser of (a) 25% of
the sum determined under clauses (1) and (2) above, in excess of $191,000, or
(b) $29,000. The total amount determined in the preceding two sentences (the
59
"Taxable Excess") is then taxed at the following rates: all taxpayers other than
married individuals filing separate returns are taxed at 26% of the first
$175,000 of the Taxable Excess and at 28% of any additional Taxable Excess,
reduced by any applicable foreign tax credit; while married individuals filing
separate returns are taxed at 26% of the first $87,500 of the Taxable Excess and
at 28% of any additional Taxable Excess, reduced by any applicable foreign tax
credit. These rates are subject, however, to the 15% maximum tax rate on
long-term capital gains (and qualified dividends). The taxpayer must then pay
the greater of the alternative minimum tax or the regular income tax. Generally,
no tax credits (other than the foreign tax credit) are allowable against the
alternative minimum tax. Under the Code, the exemptions listed in clause (3)
above are phased out where alternative minimum taxable income exceeds $150,000
($112,500 for single persons and $75,000 for estates, trusts and married persons
filing separately).
Alternative minimum tax preference items and adjustments which only result
in a deferral of tax rather than a permanent reduction may give rise to a credit
against regular tax payable by Investors in future years.
Although an investment in the fund is unlikely to cause an individual
Investor to report preference items, the intangible drilling deductions ("IDC")
allocated to such Investor by the Fund may increase his or her alternative
minimum taxable income ("AMTI"). A taxpayer who is not an integrated oil company
may not reduce AMTI by more than 40 percent of the AMTI that would otherwise be
reportable had the taxpayer been subject to the "excess IDC" tax preference.
That tax preference is generally the amount by which (a) the excess of the
actual IDC deduction over the deduction which would have been allowable if the
costs were capitalized and taken ratably over 10 years (or in accordance with
cost depletion) is greater than (b) 65 percent of the taxpayers income from oil,
gas and geothermal properties. Any portion of the IDC taken under the 60-month
amortization election may be excluded from the foregoing calculation.
An adjustment that may increase or decrease alternative minimum taxable
income is depreciation attributable to personal property placed in service after
1986 that differs from the amount available under the 150 percent declining
balance method.
The applicability of the alternative minimum tax must be determined by each
individual Investor based upon the operations of the Fund and his personal tax
situation. In many circumstances, the federal (and state) minimum tax provisions
will substantially eliminate the value of intangible drilling deductions for
60
individual taxpayers. Accordingly, any potential investor in the Fund should
consult his own tax advisor to determine the tax consequences to him personally
of the alternative minimum tax.
14. Termination of the Fund
The actual or constructive termination of the Fund may have important tax
consequences to the Investors. All Investors would recognize their distributive
shares of Fund income, gain, expense, loss, deduction or credit accrued during
the Fund's taxable year up until the date of termination whether or not any such
items are distributed. Similarly, the Investors must account for their
distributive shares of gains or losses realized from the sale or other
disposition of Fund assets in liquidation of the Fund. The Code provides that if
50% or more of the capital and profit interests in a Fund are sold or exchanged
within a single twelve-month period, the Fund will terminate for tax purposes.
If such a termination occurs, the assets of the Fund will be deemed
constructively distributed pro rata to the Shareholders and then recontributed
by them to a new (for tax purposes) partnership.
Upon the distribution of Fund assets incident to the termination of the
Fund, an Investor will recognize gain to the extent that money distributed to
the Investor plus the pro rata amount, if any, of liabilities discharged exceeds
the adjusted basis of his or her Shares immediately before the distribution.
Assuming that an Investor's interest in the Fund is a capital asset, such gain
will be capital gain unless Section 751 applies. Section 751 provides generally
that a partner's gain on liquidation of a Fund will be treated as ordinary
income to the extent that the partner receives or is deemed to receive less than
the partner's pro rata share of certain ordinary income assets, including
unrealized receivables and potential recapture of depreciation, depletion and
intangible drilling costs. No loss will be recognized by an Investor on the
distribution to the Investor of Fund property upon the termination of the Fund
unless the only such property distributed is money, unrealized receivables and
inventory. For these purposes, "money" includes marketable securities.
15. Activities Engaged in for Profit
Section 183 provides limitations for deductions attributable to an
"activity not engaged in for profit." The term "activity not engaged in for
profit" means an activity other than one which constitutes a trade or business,
or one that is engaged in for the production or collection of income or for the
management, conservation or maintenance of property held for the production of
61
income. The determination of whether an activity is not engaged in for profit is
based on all the facts and circumstances and no one factor is determinative.
Section 183 creates a presumption that an activity is engaged in for profit
if in any three years out of five consecutive taxable years the gross income
derived from the activity exceeds the deductions attributable thereto. Thus, if
the Fund fails to produce a profit in at least three of five consecutive years,
the presumption will not be available and the possibility of successful
challenge by the Service substantially increases. If Section 183 is successfully
asserted by the Service, no deductions will be allowed in excess of Fund income.
Since the test of whether an activity is deemed to be engaged in for profit
is based on the facts and circumstances existing from time to time, no assurance
can be given that Section 183 may not be applied in the future to disallow
deductions taken by the Investors with respect to their interest in the Fund.
It should be noted that, if the Service were to challenge an Investor's
deduction of Fund losses for lack of profit motive, such Investor would have the
burden of proving that the Fund did in fact enter into the transaction with a
reasonable expectation of profit and that the Investor's own investment in the
Fund was made with the requisite profit motive.
16. Material Distortion of Income
Section 446(a) provides that taxable income shall be computed under the
method of accounting on the basis of which the taxpayer regularly computes the
taxpayer's income in keeping the taxpayer's books. Section 446(b) provides,
however, that if the method used does not clearly reflect income, the
computation shall be made under such method as does clearly reflect income in
the opinion of the Service. If the method of accounting used by the taxpayer
does not clearly reflect income, Section 446(b) grants the Service discretion to
compute the taxpayer's taxable income "under such method" as the Service
determines does clearly reflect income.
It has been established that the Service's authority to change a method of
accounting may be used to correct not only the overall method of accounting of
the taxpayer but also the accounting treatment of any item. See, e.g., Burck v.
Commissioner, 533 F.2d 768 (2d Cir. 1976).
62
The Service claims a very broad authority under Section 446(b) to disallow
any deduction where the deduction results in what it determines to be "a
material distortion of income." An example of the Service's position is Revenue
Ruling 79-229, 1979-2 Cum. Bull. 210, which sets forth some of the factors it
can consider in determining whether a deduction results in a material distortion
of income, such as the customary practice of the taxpayer, the amount of the
expense in relation to such expenses in the past, and the materiality of the
expenditure in relation to the taxpayer's income for the year.
The broad authority claimed by the Service in Revenue Ruling 79-229 is
similar to a position taken by it in the past. However, on at least one
occasion, the United States Supreme Court specifically rejected the reasoning
that the Service has the authority to make exceptions to the general rule of
accounting by annual periods if it determines that it would be unjust or unfair
not to isolate a particular transaction and treat it on the basis of the
long-term result. Despite this authority, the Service may analyze deductions
taken by the Fund and attempt to reallocate such deductions to another taxable
year to the extent the Service determines that such deductions materially
distort income. Since the material distortion of income test is based upon the
facts and circumstances of a specific transaction, counsel cannot express an
opinion as to the likely outcome of an attempted reallocation of Fund deductions
by the Service.
17. Fund Borrowing
Any Fund income applied to the repayment of Fund borrowing will remain
taxable as income to the Investors although no distribution is made to them. A
foreclosure or other sale of any Fund property securing any such indebtedness
may also result in an Investor's realization of income for income tax purposes
even if no proceeds are distributed to the Investor. In determining for federal
income tax purposes the amount received on the sale or disposition of an
interest in the Fund an Investor must take into account, among other things, the
Investor's share of Fund indebtedness. An Investor may, therefore, realize an
amount of taxable gain in excess of the actual proceeds of a sale or disposition
of Fund property or of the Investor's interest in the Fund.
All Investors should be aware of the restrictions, contained in the Code,
on the deductibility of interest paid by an Investor.
18. Reportable Transactions
A taxpayer who participates in a "reportable transaction" is required to
attach a statement to his, her or its federal income tax return for the year in
63
which the taxpayer participates in the transaction, disclosing the nature of
such reportable transaction. "Reportable Transactions" are certain transactions
defined in the Regulations and Service rulings. The Fund may enter into
transactions which fall within the definition of "Reportable Transactions".
Possible examples include losses in excess of two million dollars in one taxable
year and transactions where the amount reported for tax purposes differs by more
than ten million dollars from the amount utilized for non-tax purposes. The
filing of a disclosure statement by the Fund could result in an audit of the
Fund's partnership information return by the Service, which in turn could result
in audits of the tax returns of Investors.
19. Audits, Interest and Penalties
Under the Code, the Service is permitted to audit a partnership's tax
return instead of having to audit the individual tax returns of the partners, so
that a partner would be subject to determinations made by the Service or the
courts at the partnership level. A partner is entitled to participate in such an
audit, or in litigation resulting therefrom, only in limited circumstances. In
the event that any audit results in a change in the Fund's return and an
increase in the tax liability of an Investor, there may also be imposed
substantial amounts of nondeductible interest and penalties. In addition to the
interest imposed on deficiencies (presently 7% per year compounded daily), the
Code now provides a penalty equal to 20% of any underpayment of tax attributable
to (1) negligence, any careless, reckless or intentional disregard of rules or
regulations, or any failure to make a reasonable attempt to comply with the
Code, (2) a substantial underpayment of tax (i.e., one which exceeds the greater
of $5,000 or 10% of the correct tax liability) which was neither based upon
substantial authority nor adequately disclosed or (3) any substantial valuation
misstatement (i.e., a valuation which exceeds 200% or is less than 50% of the
correct value) which, when combined with any other substantial valuation
misstatements for the taxable year, resulted in an underpayment of tax exceeding
$5,000. If a substantial valuation misstatement exceeds 400% or is less than 25%
of the correct value, the penalty is increased to 40% of any underpayment
attributable to such misstatement.
Investors must generally treat partnership items on their federal income
tax returns consistently with the treatment of such items on the partnership
information return filed by the Fund, unless the Investor files a statement with
the Service identifying the inconsistency or otherwise satisfies the conditions
for waiver of the consistency requirement. Failure to satisfy this requirement
will result in an adjustment to conform the Investor's treatment of the item
with the treatment of the item on the partnership information return filed by
the Fund. Intentional or negligent disregard of the consistency requirement may
subject an Investor to substantial penalties.
64
Because of the potentially substantial effect of all the foregoing
provisions, each prospective Investor should consult with his tax advisor about
these provisions before acquiring Shares.
20. Sales of Fund Property
The sale or disposition of Fund property used in the Fund's business will
generate a gain or loss equal to the difference between the amount realized on
such sale or other disposition and the Fund's adjusted basis in the property. In
general, gain realized from the sale or disposition of such property which is
depreciable property or land and was held for more than one year should qualify
as gain from the sale of a Section 1231 asset, except to the extent that any
such gain is attributable to property subject to recapture. Each Investor is
generally entitled to treat the Investor's share of Section 1231 gains and
losses as long-term capital gains and losses if the Investor's Section 1231
gains exceed the Investor's Section 1231 losses for the year. However, net
Section 1231 gains will be treated as ordinary income to the extent of
unrecaptured net Section 1231 losses of the Investor for the five most recent
prior years. If the Investor's share of Section 1231 losses, when added to his
or her other Section 1231 losses, exceeds the Investor's Section 1231 gains for
the taxable year, such losses will be treated as ordinary losses.
Section 1254 provides that upon disposition of any oil and gas property by
the Fund, a portion of any gain may be taxed as ordinary income from the
recapture of intangible drilling and development costs and depletion. The amount
that will be taxable as ordinary income will be equal to the lesser of: (1) the
amount of intangible drilling and development costs and depletion previously
deducted with respect to the property or interest sold (only insofar as they
reduced the adjusted basis thereof); or (2) the excess of the amount realized on
disposition of the property over the adjusted basis of the property.
Any gain on the sale or other disposition of equipment by the Fund will be
taxed as ordinary income to the extent of all depreciation deductions previously
claimed with respect to such equipment, with any excess being treated as Section
1231 gain. Similarly, gain on the sale of any building owned by the Fund will be
treated as ordinary income to the extent of any depreciation taken with respect
to such building in excess of straight-line depreciation. If, however, such
building has been held for one year or less, all depreciation will be recaptured
as ordinary income. In the case of a disposition of property in an installment
sale, any ordinary income under these recapture provisions is to be recognized
in the year of the disposition.
65
Under Section 751, a similar recapture rule applies upon the disposition of
Shares by an Investor such that an Investor will be required to treat as
ordinary income the portion of any gain realized upon the disposition of the
Investor's Shares that is attributable to property subject to recapture of
depreciation, intangible drilling and development costs and depletion or certain
other property which, if sold by the Fund, would give rise to ordinary income.
There are exceptions to the recapture rules for gifts, transfers at death,
transfers in certain tax-free reorganizations, like-kind exchanges and
involuntary conversions in certain circumstances.
Net capital gains of individual taxpayers currently are taxed at a
statutory rate (generally 15% for capital assets held for more than 12 months)
which is significantly less than the maximum statutory rate applicable to other
income (35%). Net capital gains means the excess of net long-term capital gain
over net short-term capital loss.
21. Limitations on Interest Deductions
In general, Section 163(d) limits the amount of investment interest which
an individual Investor may deduct to the Investor's "net investment income."
Interest expense (and income) from activities subject to the passive loss rules
is not treated as investment interest (or investment income). Investment
interest includes interest attributable to indebtedness that is incurred to
acquire an interest in an activity involving the conduct of a trade or business
which is not a passive activity and in which the taxpayer does not materially
participate. Interest attributable to borrowing incurred to purchase Shares will
be taken into account in computing the Investor's income or loss from passive
activities to the extent that the Fund's income is treated as derived from a
passive activity. Consequently, most of the interest expense attributable to
such borrowing should not constitute investment interest expense. Investment
interest, the deduction of which is disallowed in any year, may be carried over
to subsequent years. Each Investor should consult with the Investor's own tax
advisor as to the application, if any, to the Investor of the limitations
contained in Section 163(d).
In addition, under the Code, no deduction is allowed for personal interest
(such as interest on car loans or credit card balances for personal
expenditures). Interest on underpayments of tax (other than certain deferred
estate taxes) is treated as personal interest under the Code.
66
Interest on debt secured by the principal residence or second residence of
a taxpayer is, however, deductible if paid with respect to "acquisition
indebtedness" up to a maximum debt of $1,000,000 ($500,000 for a married person
filing a separate return) and "home equity indebtedness" up to a maximum debt of
$100,000 ($50,000 for a married person filing a separate return). For this
purpose, "acquisition indebtedness" means debt that is incurred in acquiring,
constructing or substantially improving the principal or a second residence of
the taxpayer and "home equity indebtedness" means debt secured by the taxpayer's
principal or second residence to the extent that the aggregate amount of such
debt does not exceed the difference between the "acquisition indebtedness" with
respect to the residence and the fair market value of the residence. Under the
Code, interest on certain pre-October 13, 1987 indebtedness of the taxpayer is
deductible regardless of the $1,000,000 and $100,000 limitations.
In addition to the foregoing, Section 265(a)(2) provides that interest on
indebtedness incurred or continued to "purchase or carry" tax-exempt securities
is not deductible. Investors who currently own or anticipate acquiring
tax-exempt securities and who contemplate purchasing Shares with borrowed funds
are urged to consult with their tax advisors with respect to the application of
Section 265.
22. Fund Elections
Pursuant to Sections 734, 743 and 754, a partnership may elect to have the
cost basis of its assets adjusted in the event of a sale by a partner of the
partner's interest in the partnership, the death of a partner, or the
distribution of property to a partner. The general effect of such an election is
that the transferees of an interest in the partnership are treated as though
they had acquired a direct interest in the partnership assets and, upon certain
distributions to partners, the partnership is treated as though it has newly
acquired an interest in the partnership assets and therefore acquired a new cost
basis for such assets. Any such election, once made, is irrevocable without the
consent of the Service.
In cases where the Fund owns property with substantially higher cost basis
than its value, it may be required to make the basis adjustments as if a Section
754 election were in effect. Otherwise, as a result of the complexities and the
substantial expense inherent in making the election, the Manager does not
presently intend to make such an election on behalf of the Fund. The absence of
any such election may result in a reduction in value of an Investor's Shares to
any potential transferee. Thus, the absence of the power to compel the making of
such an election should be considered an additional impediment to the
transferability of Shares.
67
Various other elections affecting the computation of federal income tax
deductions and taxable income derived from the Fund must be made by the Fund and
not by the individual Investors. For purposes of reporting each Investor's share
of Fund income, gains and losses, the Fund's elections are binding upon the
Investors.
23. At Risk Rules: Limitation on Deduction of Losses
Section 465 limits an Investor's deduction for losses allocated to the
Investor by the Fund to the amount that he has at risk with respect to the Fund.
The term "loss" is defined as the excess of the deductions allowable for the
taxable year over the income received or accrued by the taxpayer during the
taxable year from such activity.
Section 465 and the proposed Regulations thereunder generally provide that
an Investor will be considered to have at risk in the Fund the sum of (i) the
amount of money contributed to the Fund, (ii) the adjusted basis of other
property contributed to the Fund, (iii) income generated by the Fund, and (iv)
amounts borrowed by the Investor or the Fund for use in the Fund's activities,
where the Investor is personally liable for the repayment of the loan or where
the Investor has pledged property, other than property used in the activity, as
security for the borrowed amount, but only to the extent of the net fair market
value of the Investor's interest in the property; provided, however, that
borrowed amounts will not be considered at risk if borrowed from any person or
entity who (a) has an interest, other than as a creditor, in the Fund's
activities or (b) is related to someone who has such an interest. Thus, for
example, an Investor will not be considered to have at risk in the Fund amounts
borrowed from the Manager or its Affiliates. An Investor will not be considered
at risk with respect to amounts protected against loss through nonrecourse
financing, guarantees, stop loss agreements or other similar arrangements.
Distributions to an Investor will generally reduce the amount which the
Investor has at risk in the activity. The "at risk" rules provide that the
amount of any distribution received by an Investor or any other reduction in the
Investor's at risk basis, after his or her amount at risk is reduced to zero,
will be treated as ordinary income, but only to the extent of losses previously
claimed by the Investor from the Fund. Thus, if the Fund makes distributions to
an Investor which do not exceed his adjusted basis in the Fund, but do exceed
the Investor's amount at risk, he may have ordinary income.
68
Generally, the at risk limitation applies on an activity-by-activity basis
and, in the case of oil or gas properties, each property is treated as a
separate activity so that losses or deductions arising from one property are
limited to the at risk amount for that property and not the aggregate at risk
amount for all the taxpayer's oil or gas properties. The Service has announced
that, until further guidance is issued, it will permit the aggregation of oil or
gas properties owned by a partnership in computing a partner's at risk
limitation with respect to the partnership. The Service has also announced that
any rules that would impose restrictions on the ability of partners to aggregate
will be effective only for taxable years ending after the rules are issued. If
an Investor must compute his at risk amount separately with respect to each Fund
Property, the consequences of the at risk limitations to him are unpredictable,
but he may not be allowed to utilize his share of losses or deductions
attributable to a particular Property even though he has a positive at risk
amount with respect to the Fund as a whole.
If in any year an Investor has a loss from the Fund, the effect of Section
465(a) is to permit deduction of such loss up to the aggregate amount at risk on
the last day of the taxable year. If the amount at risk exceeds the loss, the
amount deemed at risk in subsequent years is reduced under Section 465(b)(5) by
the amount of losses claimed in previous years and increased by additional at
risk amounts contributed to the activity. If the amount of loss exceeds the at
risk amount, the excess loss is held in a suspense account and treated as a
deduction in the first succeeding taxable year that the taxpayer is at risk. The
carryover loss is then added to the deductions allowable for such year but is
limited at the end of such year by the amount then at risk. Under proposed
Regulation Section 1.465-2(b), there is no limitation on the number of years to
which such deductions may be carried.
In addition to the "at risk" rules discussed above, Section 704(d) provides
that a partner's distributive share of partnership loss is allowed as a
deduction only to the extent of the positive adjusted basis of his partnership
interest at the end of the partnership year in which the loss is incurred. If a
partner's distributive share of loss items exceeds his basis, as adjusted for
capital contributions, distributions, the partner's share of any partnership
income items and changes in his share of partnership liabilities, then only a
portion of each loss item is allowed, based upon the portion that each bears to
the total of all loss items. Excess losses which are not currently allowed may
be carried forward indefinitely until such partner has sufficient basis to
permit the deduction.
69
24. Passive Activities
Under the Code, deductions from passive activities, to the extent that they
exceed income from all such activities (exclusive of portfolio income),
generally will not be deductible against other income of the taxpayer. Thus, the
taxpayer cannot use passive losses to offset personal earnings, active business
income, or investment or portfolio income (such as interest, dividends,
royalties, or gains from the sale of assets that generate investment or
portfolio income). Similarly, credits from passive activities generally are
limited to the tax allocable to the passive activities. Suspended losses and
credits are carried forward and treated as deductions and credits from passive
activities in the next taxable year. When the taxpayer disposes of his entire
interest in an activity in a fully taxable transaction, any remaining suspended
loss incurred in connection with that activity is allowed in full.
Passive activities are defined to include trade or business activities in
which the taxpayer does not materially participate and rental activities.
Interest attributable to passive activities is not treated as investment
interest.
The passive loss provision generally applies to individuals, estates,
partnerships, and personal service corporations (as defined for purposes of the
provision). Certain closely held corporations are subject to a more limited rule
under which passive losses and credits may not be applied to offset portfolio
income.
Ownership of Shares will be a passive activity and an Investor will be
subject to the passive activity loss limitations with respect to his share of
the Fund's losses and deductions. Consequently, an Investor's share of the
Fund's losses and deductions may be deducted only to the extent of his share of
the Fund's income and any income from other passive activities.
A special provision of the passive activity rules applies to publicly
traded partnerships. If this special provision were to apply to the Fund,
certain additional limitations would apply, the most significant of which is
that an Investor could only deduct his share of Fund losses and deductions
against his share of passive activity income from the Fund. The definition of
"publicly traded partnership" for purposes of this special provision is the same
as the definition of "publicly traded partnership" discussed under
Classification as a Partnership above, except that this special provision does
not include the 90% of gross income exception.
70
25. Investment by Qualified Plans and Other Tax Exempt Entities
In General. The following entities are generally exempt from federal income
taxation:
o trusts forming part of a stock bonus, pension, or profit sharing plan
(including a Keogh plan) meeting the requirements of Section 401(a);
o trusts meeting the requirements for an Individual Retirement Account
("IRA") under Section 408(a) (referred to herein, along with trusts
described in (A), as "Qualified Plans"); and
o organizations described in Sections 501(c) and 501(d) (collectively
with Qualified Plans "Tax Exempt Entities").
This exemption does not apply to the extent that taxable income is derived
by the above entities from the conduct of any trade or business which is not
substantially related to the exempt function of the entity ("unrelated business
taxable income"). If an entity is subject to tax on its "unrelated business
taxable income," it may also be subject to the alternative minimum tax on
related tax preference items.
In the case of a charitable remainder trust, the receipt of any "unrelated
business taxable income" during any taxable year will cause all income of the
trust for that year to be subject to federal income tax. Therefore, an
investment in the Fund by a charitable remainder trust would not ordinarily be
appropriate. In some circumstances, however, taxability under the ordinary trust
rules may not be disadvantageous to a charitable remainder trust.
"Unrelated business taxable income" is generally taxable only to the extent
that the Tax Exempt Entity's "unrelated business taxable income" from all
sources exceeds $1,000 in any year. The receipt of "unrelated business taxable
income" by a Tax Exempt Entity in an amount less than $1,000 per year will,
however, require the Tax Exempt Entity (except an IRA) to file a federal income
tax return to claim the benefit of the $1,000 per year exemption. Fiduciaries of
Tax Exempt Entities considering investing in Shares are urged to consult their
own tax advisors concerning the rules governing "unrelated business taxable
income."
Gains or losses from the sale, exchange or other disposition of property,
interest income and royalty income are generally excluded from the computation
of "unrelated business taxable income." "Unrelated business taxable income"
includes, however, gain or loss from the sale, exchange or other disposition in
the ordinary course of the seller's business and "debt-financed property."
71
Although some of the Fund's income may be treated as royalty income, a
significant portion of the Fund's income will be considered to be derived from
sales in the ordinary course of business. Thus, Tax Exempt Entities should
expect a significant portion of the income derived from their investment in the
Fund to constitute "unrelated business taxable income."
B. Debt-Financed Property. Even though certain types of income, such as
interest and royalties, generally may be considered passive and excluded from
unrelated business income tax, such income when derived from an investment in
property which is "debt-financed" can still result in income subject to
taxation. "Debt-financed property" is defined in the Code as any property which
is held to produce income and with respect to which there is "acquisition
indebtedness." "Acquisition indebtedness" includes indebtedness incurred by a
Tax Exempt Entity to acquire Shares and indebtedness incurred by the Fund. Each
Tax Exempt Entity should consult with its own counsel regarding whether it may
have incurred "acquisition indebtedness" to acquire Shares.
In the event the Fund invests in and owns property on which there is
"acquisition indebtedness," a portion of each Tax Exempt Entity's distributive
share of the Fund's taxable income (including capital gain) may constitute
"unrelated business taxable income." This portion would be determined in
accordance with the provisions of Section 514 and is the portion of the Tax
Exempt Entity's distributive share of Fund income which is approximately
equivalent to the ratio of the Fund's debt to the basis of the Fund's property.
Therefore, a Tax Exempt Entity that purchases Shares may be required to report
such portion of its pro rata share of the Fund's taxable income as "unrelated
business taxable income." It should be noted that in computing the "unrelated
business taxable income" of a Tax Exempt Entity for this purpose, the deduction
for depreciation is limited to the amount computed under the straight-line
method.
The Fund is likely to incur "acquisition indebtedness" in its operations
which is allocable to any Tax Exempt Entity, thus resulting in "unrelated
business taxable income" to such entity.
C. ERISA Considerations. In considering an investment in Shares,
fiduciaries of Qualified Plans should consider (i) whether the investment is in
accordance with the documents and instruments governing such Qualified Plan,
(ii) whether the investment satisfies the diversification requirements of
72
Section 404(a)(1)(C) of the Employee Retirement Income Security Act of 1974
("ERISA"), if applicable; (iii) the fact that the investment may result in
"unrelated business taxable income" to the Qualified Plan (including IRAs and
Keogh plans); (iv) whether the investment provides sufficient liquidity; (v)
their need to value the assets of the Qualified Plan annually; and (vi) whether
the investment is prudent.
ERISA generally requires that the assets of employee benefit plans be held
in trust and that the Manager, or a duly authorized investment manager (within
the meaning of Section 3(38) of ERISA), have exclusive authority and discretion
to manage and control the assets of the plan. ERISA also imposes certain duties
on persons who are fiduciaries of employee benefit plans subject to ERISA and
prohibits certain transactions between an employee benefit plan and the parties
in interest with respect to such plan (including fiduciaries). Under the Code,
similar prohibitions apply to all Qualified Plans, including IRAs and Keogh
plans covering only self-employed individuals which are not subject to ERISA.
Under ERISA and the Code, any person who exercises any authority or control
respecting the management or disposition of the assets of a Qualified Plan is
considered to be a fiduciary of such Qualified Plan.
Furthermore, ERISA and the Code prohibit "parties in interest" (including
fiduciaries) of a Qualified Plan from engaging in various acts of self-dealing
such as dealing with the assets of a Qualified Plan for his own account or his
own interest. To prevent a possible violation of these self-dealing rules,
neither the Manager nor their Affiliates will purchase Shares with assets of any
Qualified Plan (including a Keogh plan or IRA) if they (i) have investment
discretion with respect to such assets or (ii) regularly give individualized
investment advice which serves as the primary basis for the investment decisions
with respect to such assets.
If the assets of the Fund were deemed to be "plan assets" under ERISA, (i)
the prudence standards and other provisions of Title 1 of ERISA applicable to
investments by Qualified Plans and their fiduciaries would extend (as to all
plan fiduciaries) to investments made by the Fund and (ii) certain transactions
that the Fund might seek to enter into might constitute "prohibited
transactions" under ERISA and the Code.
The Department of Labor has published a final regulation concerning the
definition of what constitutes the assets of a Qualified Plan with respect to
its investment in another entity (the "ERISA Regulation"). Section
2510.3-101(a)(2) of the ERISA Regulation provides as follows:
73
"Generally, when a plan invests in another entity, the plan's assets
include its investment, but do not, solely by reason of such investment,
include any of the underlying assets of the entity. However, in the case of
a plan's investment in an equity interest of an entity that is neither a
publicly-offered security nor a security issued by an investment company
registered under the Investment Company Act of 1940 its assets include both
the equity interest and an undivided interest in each of the underlying
assets of the entity, unless it is established that (i) The entity is an
operating company, or (ii) Equity participation in the entity by benefit
plan investors is not significant."
Under Section 2510.3-101(f)(1) of the ERISA Regulation, equity
participation in an entity by Qualified Plans is "significant" on any date if,
immediately after the most recent acquisition of any equity interest in an
entity, 25% or more of the value of any class of equity interests in the entity
is held by Qualified Plans.
Unless another exemption under the Regulation is available, the Manager
will not admit any Qualified Plan as an Investor or consent to an assignment of
Shares if such admission or assignment will cause 25% or more of the value of
any class of Fund Shares to be held by Qualified Plans. Accordingly, the assets
of a Qualified Plan investing in the Fund should not, solely by reason of such
investment, include any of the underlying assets of the Fund.
Each fiduciary of a Qualified Plan (and any other person subject to ERISA)
should consult his tax advisor and counsel regarding the effect of the plan
asset rules on an investment in the Fund by a Qualified Plan.
26. Partnership Anti-Abuse Regulations
Treasury Regulation section 1.701-2(b) provides, inter alia, that: "...if a
partnership is formed or availed of in connection with a transaction a principal
purpose of which is to reduce substantially the present value of the partners'
aggregate federal tax liability in a manner that is inconsistent with the intent
of subchapter K, the Commissioner can recast the transaction for federal tax
purposes, as appropriate to achieve tax results that are consistent with the
intent of subchapter K, in light of the applicable statutory and regulatory
provisions and the pertinent facts and circumstances." Subchapter K is the
section of the Code which deals with partnership taxation. The Fund does not
intend to enter into any transactions which it believes will be subject to
recasting by the Service under the authority of this Regulation. Due to the
74
extremely broad language of the Regulation, however, and varying interpretations
of the intent of subchapter K, no assurance can be given that the Service will
not attempt to apply the Regulation to one or more transactions engaged in by
the Fund.
27. Possible Changes in Tax Laws
The statues, regulations and rules with respect to all of the foregoing tax
matters are constantly subject to change by Congress or by the Department of the
Treasury, and the interpretations of such statutes, regulations and rules may be
modified or affected by judicial decision or by the Department of the Treasury.
Because significant amendments have been made to the Code in recent years and
few final regulations have been promulgated pursuant to such amendments and very
few rulings have been issued thereunder, and because of the continual changes
made by Congress, the Department of the Treasury and the courts with respect to
the administration and interpretation of the tax laws, no assurance can be given
that the foregoing opinions and interpretations will be sustained or that tax
aspects summarized herein will prevail and be available to the Investors.
28. State and Local Taxes
In addition to the federal income tax consequences described above,
prospective Investors should consider potential state and local tax consequences
of an investment in the Fund. In general, an Investor's distributive share of
the taxable income or loss of the Fund will be required to be included in
determining the Investor's reportable income for state or local tax purposes in
the jurisdiction in which he is a resident. In addition, some states in which
the Fund may do business or own properties impose taxes on non-resident
Investors determined with reference to their pro rata share of Fund income
derived from such state. Any tax losses derived through the Fund from operations
in such state may be available to offset only income from other sources within
the same state. To the extent that a non-resident Investor pays tax to a state
by virtue of Fund operations within that state, the Investor may be entitled to
a deduction or credit against tax owed to his state of residence with respect to
the same income. In addition, estate or inheritance taxes might be payable in
such jurisdictions upon the death of an Investor. Thus, an Investor might be
subject to income, estate or inheritance taxes and may be required to file tax
returns in states and localities where the Fund operates, as well as in the
state or locality of his residence.
75
Investors are urged to consult their own tax advisors in regard to the
state and local income tax consequences of an investment in the Fund.
29. Need for Independent Advice
The tax matters relating to the Fund and its proposed transactions are
complex and subject to various interpretations. The foregoing analysis is merely
a summary and is not intended as a complete discussion of all tax aspects of the
Fund's activities or as a substitute for careful tax planning. Each prospective
investor must consult with and rely upon his own tax counsel with respect to the
possible tax results of his investment in the Fund.
Neither the Fund, the Manager, counsel nor professional advisors engaged by
or associated with any of them guarantee that the tax consequences contemplated
to be offered to the Investors as a result of the proposed investment will in
fact be available in whole or in part. Investors must look solely to and rely
upon their own advisors with respect to the tax consequences of their
investment.
30. Conclusion
Subject to the preceding discussion, it is Black & Associates' opinion that
the material federal income tax benefits, in the aggregate, anticipated from the
operation of the Fund more likely than not will be realized in substantial part
by Investors who are individual United States citizens and who acquire their
Interest for profit subject to the passive activity loss limitations of Section
469 of the Code. It should be noted that Black & Associates' opinion is not
binding upon the Service or the courts.
ADDITIONAL ASPECTS OF THE LLC AGREEMENT
THE RIGHTS AND OBLIGATIONS OF THE MANAGER AND THE INVESTORS ARE GOVERNED BY
THE LLC AGREEMENT, A COPY OF WHICH IS ATTACHED HERETO AS EXHIBIT A. NO
PROSPECTIVE INVESTOR SHOULD SUBSCRIBE TO THE FUND WITHOUT FIRST THOROUGHLY
REVIEWING SUCH AGREEMENT. THE FOLLOWING IS ONLY A BRIEF SUMMARY OF CERTAIN
SIGNIFICANT PROVISIONS OF THE LLC AGREEMENT AND SHOULD NOT BE CONSIDERED AS A
COMPLETE DISCUSSION OF ALL OF THE PROVISIONS OF THE LLC AGREEMENT. SEE LLC
AGREEMENT - EXHIBIT A.
76
Accounting. The accounting period of the Fund will end on December 31 of
each year. The Fund will utilize the accrual method of accounting for the Fund's
operations on the basis used in preparing the Fund's federal income tax returns
with such adjustments as may be in the Fund's best interest.
Books and Records; Reports. The Fund will keep appropriate records relating
to its activity. All books, records and files of the Fund will be kept at the
Manager's office at Great Neck, New York or at another site chosen by the
Manager which will either be its office in Ridgewood, New Jersey or the Fund's
principal office at 1314 King Street, Wilmington, Delaware. An independent
certified public accounting firm will prepare the Fund's federal income tax
returns as soon as practicable after the conclusion of each year. The Fund will
use its reasonable best efforts to obtain the information for those returns as
soon as possible and to cause the resulting accounting and tax information to be
transmitted to the Shareholders as soon as possible after receipt from the
accounting firm.
Investors may receive periodic reports from the Manager as to the Fund's
activities and will receive as soon as practicable after the end of each year
the necessary federal and state income tax information.
Governing Law. All provisions of the LLC Agreement will be construed
according to the laws of the State of Delaware except as may otherwise be
required by law in any other state. In addition, the LLC Agreement requires that
for any lawsuit or other action, except for arbitration, Shareholders consent to
personal jurisdiction of and venue in the Delaware courts.
Mandatory Binding Arbitration. The LLC Agreement contains a provision that
requires all disputes arising under or with respect to the LLC Agreement, either
brought by the Manager or a Shareholder, to be submitted to binding arbitration
in New York, New York. Such arbitration shall be governed and conducted in
accordance with the rules of the American Arbitration Association; to the extent
such rules do not conflict with the express terms of the LLC Agreement's
arbitration provision. As a result, a Shareholder shall not be entitled to bring
an action in a court of law against the Manager or the Fund but shall be limited
only to submitting such claim to arbitration. The determination of the
arbitration panel is binding on both parties and cannot be appealed to a court
of law. In addition, the arbitration provision contains a "no class action"
clause, pursuant to which Shareholders will be prohibited from bringing or
certifying a class action, or consolidating such Shareholder's claim with those
of other similarly situated Shareholders. Thus, Shareholders are limited to
77
submitting their own individual claims to arbitration. Shareholders should be
aware that notwithstanding this provision of the LLC Agreement, certain rights
under the federal Securities Law may be subject to waiver and, under such
circumstances, this provision may not apply.
Control of LLC Operations. The powers vested in the Manager under the LLC
Agreement are broad. The Manager has full, exclusive and complete discretion in
the management and control of the affairs of the Fund and Investors have no
power to take part in the management of, or to bind, the Fund.
The Fund's officers are appointed by the Manager and may be removed by it
at any time. Additionally, the Manager may authorize any sale, lease, pledge or
other transfer of substantially all of a Fund's assets without a vote of the
Investors.
Amendments and Voting Rights. The Manager may amend the LLC Agreement
without notice to or approval of the holders of Investor Shares for the
following purposes: to cure ambiguities or errors; to conform the LLC Agreement
to the description in this Memorandum; to equitably resolve issues arising under
the LLC Agreement so long as similarly situated Investors are not treated
materially differently; to comply with law; to make other changes that will not
materially and adversely affect any Investor's interest; to maintain the federal
income tax status of the Fund or any Shareholder, as long as no Investor's
liability is materially increased; or to make modifications to the computation
of items affecting the Investors' capital accounts to comply with the Code or to
reflect the creation of an additional class or series of Shares and the terms
thereof.
Other amendments to a Fund's LLC Agreement may be proposed either by the
Manager or by Fund Investors either by calling a meeting of the Shareholders or
by soliciting written consents. The procedure for such meetings or solicitations
is found at Section 15.2 of the Fund's LLC Agreement. Such proposed amendments
require the approval of Investors who hold of record at least a majority of the
total Investor Shares on the record date for the action, given at a meeting of
Shareholders or by written consents. Any amendment requiring Investor action
(other than an amendment to allow the Fund to be taxed other than as a
partnership) may not increase any Shareholder's liability, change the Capital
Contributions required of him or her or his or her rights in interest in the
Fund's Profits, Losses, deductions, credits, revenues or distributions in more
than a de minimis matter, or change his or her rights on dissolution or any
voting rights without the Shareholder's consent. Any amendment which changes the
78
Manager's management rights requires its consent. Generally, Investors have no
right to vote on matters not involving an amendment to the LLC Agreement or the
removal of the Manager. However, if any other matter does require a vote of
Investors, it must be approved by Investors who own of record at least a
majority of the total Investor Shares, or if a different vote is required by
law, each Investor will have voting rights equal to his or her total Investor
Shares for purposes of determining the number of votes cast or not cast.
For all purposes, a majority of the Investor Shares is a majority of the
issued and outstanding shares, including those owned, if any, by the Manager or
its Affiliates. A majority of the shares voted is insufficient if it is less
than a majority of the outstanding shares.
The consent of all holders of Investor Shares is required for dissolving or
terminating a Fund, other than as provided by the LLC Agreement; or adding a new
Manager except as described below.
Removal of Manager. Investors may propose the removal of the Manager,
either by calling a meeting or soliciting consents in accordance with the terms
of the LLC Agreement. Removal of the Manager requires the affirmative vote of
Investors who are holders of record of at least a majority of the total Investor
Shares. See "Fiduciary Responsibilities of Manager" for information on the
effect of votes cast by interested Shareholders. Removal of a Manager causes a
dissolution of the Fund unless a majority of the Investor Shares elects to
continue the Fund. The Investors may replace the removed Manager or fill a
vacancy by vote of Investors who hold of record a majority of the total Investor
Shares.
If the Manager is removed, resigns (other than voluntarily without cause)
or is unable to serve, it may elect to exchange its management rights and rights
to distributions, if any, for a series of cash payments from the Fund in amounts
equal to the amounts of distributions to which the Manager would otherwise have
been entitled under the LLC Agreement in respect of investments made by the Fund
prior to the date of any such removal, resignation or other incapacity. The
removed Manager would continue to receive its pro rata share of all allocations
to Investors as provided in the LLC Agreement which are attributable to any
Investor Shares owned by it.
Alternatively, the removed Manager may elect to engage a qualified
independent appraiser and cause the Fund to engage another qualified independent
appraiser (at the Fund's expense in each case) to value the Fund Property as of
the date of such removal, resignation or other incapacity as if the property had
79
been sold at its fair market value so as to include all unrealized gains and
losses. If the two appraisers cannot agree on a value, they would appoint a
third independent appraiser (whose cost would be borne by the Fund) whose
determination, made on the same basis, would be final and binding.
Based on the appraisal, the Fund would make allocations to the removed
Manager's capital account of Profits, Losses and other items resulting from the
appraisal as of the date of such removal, resignation or other incapacity as if
the Fund's fiscal year had ended, solely for the purpose of determining the
Manager's capital account. If the removed Manager has a positive capital account
after such allocation, the Fund would deliver a promissory note of the Fund to
the Manager, the principal amount of which would be equal to the Manager's
capital account and which would bear interest at a rate per annum equal to the
prime rate in effect at Chase Manhattan Bank, N.A. on the date of removal,
resignation or other incapacity, with interest payable annually and unpaid
principal payable only from 25% of any available cash before any distributions
thereof are made to the Investors under the LLC Agreement.
If the capital account of the removed Manager has a negative balance after
such allocation, it would be obligated to contribute to the capital of the Fund
in its sole discretion either cash in an amount equal to the negative balance in
its capital account or a promissory note to the Fund in such principal amount
maturing five years after the date of such removal, resignation or other
incapacity, bearing interest at the rate specified above. If the removed Manager
chose to elect the appraisal alternative, its entire interest in the Fund would
be terminated other than the right to receive the promissory note and payments
thereunder as provided above.
Dissolution of Fund. The Fund will dissolve on the earliest to occur of (a)
December 31, 2045, (b) the sale of substantially all of the Fund's Property, (c)
the removal, dissolution, resignation, insolvency, bankruptcy, death or other
legal incapacity or disqualification of the Manager, (d) the vote of either all
Investors or of the Manager and Investors who own at least a majority of the
Investor Shares of record or (e) any other event requiring dissolution by law.
The Fund will wind up its business after dissolution unless (i) the Manager and
Investors who own at least a majority of the Investor Shares of record or (ii)
if there is no Manager, Investors who own at least a majority of the Investor
Shares of record, elect to continue the Fund. The Manager (or in the absence
thereof, a liquidating trustee chosen by the Investors) will liquidate the
Fund's assets if it is not continued.
80
Transferability of Interests. No Investor may assign or transfer all or any
part of his or her interest in the Fund and no transferee will be deemed a
substituted Investor or be entitled to exercise or receive any of the rights,
powers or benefits of an Investor other than the right to receive distributions
attributable to the transferred interest unless (i) such transferee has been
approved and accepted by a Fund, in its sole and absolute discretion, as a
substituted Investor, and (ii) certain other requirements set forth in the
Fund's LLC Agreement have been satisfied. The Fund and Manager retain the right
to deny or place conditions on any such transfer if the Fund or Manager believe
that such transfer would be in violation of applicable federal or state
securities laws or impose reporting obligations upon the Fund.
The Manager may not resign except for cause (which cause does not include
the fact or determination that continued service would be unprofitable to it)
and may not transfer its interest in a Fund except to pledge it as security for
a loan to the Manager if the pledge does not reduce cash flow distributable to
other Shareholders, or to waive compensation and fees payable to it under the
LLC Agreement.
The Manager's Capital Account. The Manager is obligated under the LLC
Agreement to restore any deficit in its capital account prior to any liquidating
distribution by a Fund. The Manager reserves the right, however, to offset this
obligation by waiving all or a portion of its rights to a distribution of any
fees or other compensation due it under the Fund's LLC Agreement.
LIABILITY
Assuming compliance with the LLC Agreement and applicable formative and
qualifying requirements in Delaware and any other jurisdiction in which a Fund
conducts its business, an Investor generally will not be personally liable under
Delaware law for any obligations of the Fund, except to the extent of any unpaid
Capital Contributions, except for the amount of any wrongful distributions that
render the Fund insolvent and except for indemnification liabilities arising
from any misrepresentation made by him or her in the Investor Subscription
Booklet (separately bound as Exhibit D to this Memorandum) submitted to the
Fund.
The law governing whether a jurisdiction other than Delaware will honor the
limitation of liability extended under Delaware law to the Investors is
uncertain. All states have adopted specific legislation permitting limited
liability companies to limit the liability of their members and it is likely
that those states would similarly honor a Fund's limitations on liability of
81
Investors. In many states, there has been no authoritative judicial
determination as to whether the limitation of liability would be honored.
However, regardless of the local treatment of LLC's, the Fund believes, although
it can not guarantee, that the Investors will not be subject to personal
liability and that with regard to the operation of a Fund itself, the limitation
of Investors' liability under Delaware law will govern. Investors should be
aware, however, that notwithstanding anything contained herein regarding
Investor liability, Investors maybe required to return distributions made to
them by the Fund if, within a certain period of time after such distribution the
Fund becomes insolvent.
BY SIGNING THE SUBSCRIPTION AGREEMENT (EITHER IN PERSON OR BY THEIR
REPRESENTATIVES) AND ENGAGING TO PAY THE PRICE OF SHARES, AN INVESTOR BECOMES
BOUND BY THE PROVISIONS OF HIS OR HER FUND'S LLC AGREEMENT AT THE TIME HIS OR
HER SUBSCRIPTION IS ACCEPTED BY THE FUND, EVEN THOUGH HE OR SHE DOES NOT SIGN
THE LLC AGREEMENT.
OTHER INFORMATION
General
The Fund undertakes to make available to each prospective Investor or his
purchaser representative, or both, during the course of the transaction and
prior to sale, the opportunity to ask questions of and receive answers from the
Fund or any person acting on its behalf relating to the terms and conditions of
the offering and to obtain any additional information necessary to verify the
accuracy of information made available to such purchaser. Prospective Investors
may only rely on information provided to them in writing and signed by the Fund.
Prior to making an investment decision respecting the securities described
herein, a prospective Investor should carefully review and consider this entire
Memorandum and the exhibits thereto including without limitation the LLC
Agreement. Prospective Investors are urged to make arrangements with the Fund to
inspect any books, records, contracts, or instruments referred to in this
Memorandum and other data relating thereto. The Fund is available to discuss
with prospective Investors any matter set forth in this Memorandum or any other
matter relating to the securities described herein, so that Investors and their
advisors, if any, may have available to them all information, financial and
otherwise, necessary to formulate a well-informed investment decision.
82
Authorized Sales Material
Sales material may be used in connection with the Offering of the Shares
only when accompanied or preceded by the delivery of this Memorandum. Only sales
material that indicates that it is distributed or approved by the Fund or the
Placement Agent may be distributed to prospective Investors. In addition, the
Fund or the Placement Agent may distribute a summary of the Offering containing
highlights or other summary information concerning the Offering, information
regarding the Manager, a particular project, the Fund or other investment
programs sponsored by the Manager or one of its Affiliates. All such additional
sales material will be signed by or otherwise identified as authorized by the
Fund. Any other sales material or information has not been authorized for use by
the Fund or the Placement Agent and must be disregarded by Investors.
All authorized sales material will be consistent with this Memorandum, as
supplemented. Nevertheless, sales material by its nature does not purport to be
a complete description of this Offering and Investors must review this
Memorandum and supplements carefully for a complete description of the Offering.
Authorized sales material should not be considered to be the basis for the
Offering of Shares or an Investor's decision to purchase Shares. Sales material
is not a part of this Memorandum and is not incorporated by reference into this
Memorandum unless expressly stated in this Memorandum or supplements hereto.
INVESTORS MAY NOT RELY ON ORAL STATEMENTS MADE BY BROKER-DEALERS,
REGISTERED REPRESENTATIVES, OR OFFICERS OR EMPLOYEES OF THE MANAGER OR THE FUND.
LEGAL MATTERS
The validity of the issuance of the Shares offered hereby is being passed
upon for the Manager by Black & Associates, 350 Fifth Avenue, Suite 6710, New
York, New York 10118. Such firm has acted as special counsel to the Manager and
will not represent or advise the Fund or any prospective Investor in connection
with this Offering. THEREFORE, EACH PROSPECTIVE INVESTOR SHOULD CONSULT THE
INVESTOR'S OWN LEGAL, TAX AND INVESTMENT COUNSEL.
Copies of Black & Associates' opinion as to the validity of the issuance of
the Shares and its opinion regarding the tax aspects of an investment in the
Fund may be obtained by writing to the Fund.
83
Black & Associates' representation of the Manager has been limited to
matters specifically addressed to it. No Investor should assume that Black &
Associates has in any manner investigated the merits of an investment in the
Shares, or undertaken any role other than reviewing items specifically referred
to it with regard to the preparation of this Memorandum and the issuance of the
opinions.
LITIGATION AND OTHER PROCEEDINGS
The Fund is not a party to any pending legal proceeding. Prior proceedings
affecting the Manager or its Affiliates follow.
In April 2002 Ridgewood Securities Corporation received notice from the
NASD of a proposed disciplinary action citing the failures by Mr. Swanson and
its other principal to complete a continuing education requirement on time. On
June 10, 2002, Ridgewood Securities Corporation accepted and paid the proposed
penalty of $7,500. The omissions had no effect on any Ridgewood investment
program or investors.
There have been no legal proceedings commenced against Ridgewood Energy,
Robert E. Swanson or any of their affiliates as to any Ridgewood Energy program
offered in 1990 or in subsequent years. However, there were several lawsuits
filed with respect to Ridgewood Energy Funds formed from 1986 through 1989. As
described below, those suits were settled (in one case) or dismissed by the
court (in all other cases). There is no pending litigation as to Funds offered
in the 1980s. There has been no litigation on any Ridgewood Energy Fund offered
after 1990.
In 1995, another plaintiff's attorney commenced an action against Ridgewood
Energy, Mr. Swanson and others in the U.S. District Court for the District of
New Jersey alleging a variety of the claims described above, named Gunter, et
al. v. Ridgewood Energy Corp., et al. (the "Gunter Case"). The complaint in the
Gunter Case alleged claims arising out of the 1994 sale of the assets of certain
Ridgewood Energy oil and gas programs to Apache Corporation. On December 4, 1995
the judge hearing the case entered an order which certified the Gunter Case as a
"class action," thereby permitting plaintiffs to represent a "class"' consisting
of the investors in the 1986 through 1989 Ridgewood Energy oil and gas programs
which participated in the sale of assets to Apache Corporation. After extensive
pre-trial discovery and motion practice, the parties agreed in June 1999 to a
settlement of the action in which, inclusive of attorneys' fees, Ridgewood
Energy Corporation and Mr. Swanson paid the class a total of $5 million in five
annual installments beginning in June 1999. All such installments have been
paid. The court considered and approved the fairness of the settlement in
September 1999.
84
On April 24, 1996, a group of 31 investors in various Ridgewood Energy oil
and gas programs commenced an action in the New Jersey Superior Court against
Ridgewood Energy Corporation, Ridgewood Securities Corporation and Robert E.
Swanson alleging common law fraud, negligent misrepresentation and breach of
fiduciary duty in connection with the sale of securities in those programs
between 1986 and 1990. No specific damages were claimed. Most of the plaintiffs
in this lawsuit were plaintiffs in the lawsuit described above and it
essentially restated the allegations of that 1991 lawsuit. The lawsuit was
dormant from June 1996 to September 1997, when the court dismissed it without
prejudice because the plaintiffs had not pursued the lawsuit.
Described below are proceedings which do not involve Ridgewood Energy, but
involve Ridgewood Renewable Power, or Ridgewood Capital, both of which were also
founded by, and controlled by Robert E. Swanson. Ridgewood Renewable Power plus
Ridgewood Capital have invested in dozens of different businesses, and lawsuits,
many of them frivolous, are a part of doing business in this litigious age.
In addition to routine litigation occurring in the ordinary course of the
management of the Ridgewood Renewable Power Programs ("Power Programs"),
Ridgewood Renewable Power and two of the Power Programs were sued by seven
individuals alleging that a registered representative of a broker-dealer not
affiliated with Ridgewood Renewable Power had made false statements to them and
to Ridgewood Power on their behalf in connection with the sale of interests in
the Power Programs, but that Ridgewood Renewable Power nonetheless benefited
from and is responsible for the representative's actions. Plaintiffs also sued
the registered representative's employer and seven issuers, none of whom are
affiliated with Ridgewood Power, whose securities were also sold by the
registered representative to plaintiffs. During 2001 and in January 2002, the
United States District Court for the District of Maryland and the Maryland trial
courts gave summary judgment in favor of Ridgewood Renewable Power and the two
Power Programs in all of these cases except for the last case, which was
dismissed voluntarily by the plaintiff. All appeals periods have expired and the
judgments in favor of Ridgewood Renewable Power are final.
On August 4, 2001, NetHorsepower, Inc., a Portfolio Company owned by the
two Ridgewood Capital Venture Partners II programs, brought suit against
Ridgewood Capital Management LLC and Ridgewood Horsepower, LLC (the holding
85
company for the investment made by the Venture Partners II programs) alleging
breach of a contract and breach of fiduciary obligations. The claimed damages
are in excess of $5 million. The lawsuit was brought in the Superior Court of
California, Visalia County, but the defendants removed the case to the United
States District Court for the Eastern District of California and it was then
transferred to the United States District Court for the Northern District of
California on Ridgewood Capital's motion. On January 28, 2002, that court
dismissed Ridgewood Capital and all defendants with prejudice except for
Ridgewood Horsepower, LLC. Subsequently, the federal action was dismissed as to
Ridgewood Horsepower, LLC without prejudice, and a second action, naming
Ridgewood Capital, Ridgewood Horsepower, LLC and two individual Ridgewood
Capital associates was filed in Tulare County, California Superior Court, based
on the same set of operative facts. By stipulation, it was transferred to the
San Francisco County Superior Court. An amended compliant was filed, in which
after demurrers, the claims of certain individual plaintiffs' were dismissed and
the only remaining claim against Ridgewood Horsepower LLC alleges breach of
contract. There are also claims against the two Ridgewood Capital associates,
who are being defended by Ridgewood Capital, asserting breach of duty and
constructive fraud. A summary judgment motion is anticipated. Ridgewood
Horsepower has no assets other than its investment in NetHorsepower and thus
Ridgewood Capital believes that in its current form the lawsuit is not likely to
have a material impact on the Venture Partners II programs or Ridgewood Capital.
Recently, the case against Ridgewood Capital, as well as other Ridgewood
defendants, was dismissed. Plaintiffs are planning an appeal.
On December 11, 2001, Ms. Jeanette Granat, the holder of five shares in
Ridgewood Venture Partners II LLC (one of the Venture Partners II programs),
brought a lawsuit in the United States District Court for the Southern District
of Florida against that program, Ridgewood Capital and the Placement Agent. Ms.
Granat had failed to make capital call payments and owed approximately 65% of
the amount due for the five shares she had purchased. She requested declaratory
and injunctive relief compelling that program to recognize her as the owner of
five full shares and to overrule forfeiture provisions of that program that have
deprived her of certain distributions and rights to proceeds because of her
capital call defaults. In addition, she complains of alleged breaches of
fiduciary duty and the program's limited liability company agreement by
Ridgewood Capital. Ridgewood Capital believes that the lawsuit is without merit
and is an attempt by Ms. Granat to avoid the consequences of her defaults.
Recently, Ridgewood Capital settled this case with Ms. Granat paying her
approximately $100,000 and agreeing to transfer a small percentage of Ridgewood
Capital's "back-end" participation rights with respect to Ridgewood Venture
Partners II LLC investment in SavaJe Technologies.
86
On July 23, 2002, Ridgewood Capital received notice that ACO Partners, LLC,
who had invested approximately $1 million in shares of GroupFire, Inc., a
portfolio company owned by the two Ridgewood Capital Venture Partners II
programs, had brought suit against Ridgewood Capital, the two funds, a former
consultant to the funds and Ridgewood GroupFire, LLC (the holding company for
the investment made by the Venture Partners II programs). The lawsuit alleged
breach of contract, fraud, breach of fiduciary duty and securities law
violations based on defendant's failure to provide additional capital to
GroupFire, Inc. and an alleged plan to prevent any other person from obtaining
control of the company. The Santa Clara County, California Superior Court
sustained two demurrers to the complaint, and on June 4, 2003, judgment was
entered in favor of the Ridgewood defendants and against plaintiff. All appeal
periods have expired and the judgment is final.
Financial Statements
Since the Fund is newly formed and has acquired no assets and incurred no
liabilities, no financial statements are included for the Fund. A copy of the
unaudited financial statements of Ridgewood Energy Corporation as of December
31, 2004 and December 31, 2005 are attached hereto as Exhibit C.
DEFINITIONS
Whenever used in this Memorandum, the following terms shall have the
meanings set forth below, unless the context otherwise indicates. The singular
shall include the plural and the masculine gender shall include the feminine and
vice versa, as the context requires. In addition, the term "person" as used in
this Memorandum shall include natural persons and entities, including without
limitation, corporations, unless the context otherwise indicates.
ACT - The Securities Act of 1933, as amended, and any rules and regulations
promulgated thereunder.
ADDITIONAL CAPITAL CONTRIBUTIONS - Any capital contributions to the Fund made by
a Shareholder pursuant to Section 9.8 of the LLC Agreement.
87
ADDITIONAL WELL ACTIVITIES - The drilling, developing, completing, equipping,
reworking or re-entering wells after the expenditure of the initial Capital
Contributions.
ADMINISTRATIVE AND OVERHEAD EXPENSES - The customary, routine and necessary
costs and expenses incurred by the Manager which are associated with or
attributable to administration of the business of the Fund, including, but not
limited to, an allocable portion of telephone, postage, computer service,
accounting and legal fees, regulatory reporting, and an allocable portion of
salaries and expenses of employees and officers of the Manager. Such expenses do
not include the direct expenses of the Fund such as legal, accounting and
consulting expenses.
AFFILIATE - An "affiliate" of, or person "affiliated" with, a specified person
is a person that directly, or indirectly through one or more intermediaries,
controls, or is controlled by, or is under common control with, the person
specified.
BLOCK - A numbered area of acreage, either on land or submerged in the Gulf of
Mexico, on an official diagram of leasing map which is auctioned off and leased
by the MMS for exploratory drilling and development.
CAPITAL CONTRIBUTIONS - The contributions of the Investors to the Fund. For all
purposes of this Memorandum, the Capital Contribution of each Investor shall be
$150,000 per Share (prorated for fractional or multiple Shares).
CARRIED INTEREST - Typically, a fractional Working Interest retained by the
seller of a Working Interest on the condition that the purchasers ratably pay
the portion of drilling costs for the first well otherwise attributable to the
Carried Interest.
CODE - The Internal Revenue Code of 1986, as amended from time to time.
DELAWARE ACT - The Delaware Limited Liability Company Act, as amended.
DRY-HOLE COSTS - The cost of drilling the well. Completion costs are in addition
to Dry-Hole costs but only come due if the well locates producible oil or gas.
88
ESCROW DATE - The date on which the Fund has collected full payment for at least
10 Shares and has deposited those funds in the escrow account for this Offering.
FARMEE - The person who is assigned a Working Interest or portion thereof under
a Farm-out Agreement.
FARM-IN - Earning acreage in potential oil and natural gas properties under a
Farm-out Agreement.
FARMOR - Owner of a Working Interest already under lease who assigns all or a
portion of such interest under a Farm-out Agreement.
FARM-OUT - Assigning all or a portion of a Farmor's Working Interest in a lease
pursuant to a Farm-out Agreement.
FARM-OUT AGREEMENT - An agreement whereby the owner of the Working Interest
agrees to assign all or a portion of such interest in certain specific acreage,
subject to the drilling of one or more specific wells or other performance as a
condition of the assignment, and retains some interest such as an Overriding
Royalty Interest, an oil and natural gas payment, offset acreage or other type
of interest which may convert to a Working Interest after the drilling of an
initial well, the recoupment of costs of the assignee or some other event.
FUND - Ridgewood Energy S Fund, LLC, c/o Ridgewood Energy Corporation, 1010
Northern Boulevard, Suite 208, Great Neck, New York 11021.
FUND PROPERTY - All property owned or acquired by the Fund or on its behalf.
INTANGIBLE DRILLING COSTS - All expenditures made with respect to any well,
prior the establishment of production in commercial quantities, for wages, fuel,
repairs, hauling, supplies and other costs and expenses incident to an necessary
for the drilling of such well, which costs and expenses may be currently
deducted for federal income tax purposes pursuant to Section 263(c) of the Code
and Treasury Regulation Section 1.612-4(a).
INVESTOR - A purchaser of whole or fractional Shares.
LLC ACT - The Delaware Limited Liability Company Act, as amended.
89
LIMITED LIABILITY COMPANY AGREEMENT or LLC AGREEMENT - The Limited Liability
Company Agreement, dated as of February 1,, 2006, by the Manager that
establishes the Fund and the rights and obligations of the Manager and the
Shareholders. A copy is annexed to this Memorandum as Exhibit A.
LOSSES - See "PROFITS or LOSSES," below.
MANAGING PERSONS - All of the following persons: the Manager, the Affiliates of
the Manager, and the directors, officers and agents of any of the foregoing when
acting on behalf of the Fund.
MANAGER - Ridgewood Energy Corporation or such substitute or different Manager
as may subsequently be admitted to the Fund pursuant to the terms of the LLC
Agreement.
MEMORANDUM - This Confidential Memorandum, dated January 2, 2006 may be amended
or supplemented from time to time.
MMS - The Minerals Management Service, an agent of the United State Department
of the Interior, that conducts the auctions of lease Blocks and provides general
oversight of the Interior Department's offshore programs.
NON-CONSENT INTEREST - Contractual ownership interests created out of existing
Working Interests under operating agreements, rather than an interest in the
entire lease on which the wells are to be located. They are called "non-consent"
because they are triggered when a Working Interest owner declines to supply
additional capital for the drilling of new wells or for other purposes. The
person who does supply that capital is granted a Non-Consent Interest in the new
well or other facility. Those Non-Consent interests will revert back to the
original Working Interest owners upon the recoupment by the owner of the
Non-Consent Interest of a penalty amount from the production attributable to the
non-consent interest. After such reversion, the Non-Consent Interest owner will
have no more ownership rights with respect to the reverted interest.
OCS - Outer Continental Shelf.
OCSLA - The Outer Continental Shelf Lands Act.
OPERATING AGREEMENT - The operating agreement among Working Interest owners,
including without limitation the Fund (or a joint venture in which such person
participates), and the Operator of wells which provides the terms and conditions
pursuant to which the Operator will conduct operations on jointly owned oil and
gas properties.
90
OPERATING COSTS - The customary expenses incurred in connection with the
operation and maintenance of a well in which the Fund owns an interest and the
production and marketing of oil and natural gas therefrom, including delay
rentals, storage rental, or shut-in gas royalties paid with respect to the
leases, the costs of reworking or plugging and abandoning commercial wells, all
costs of gathering, treating, compressing and transporting oil and natural gas
and all severance, windfall profits, ad valorem and other taxes (other than
income taxes).
OPERATOR - Any person, Fund, corporation or other entity responsible for
conducting operations on jointly owned oil and gas operations for the account of
all Working Interest owners, usually pursuant to the terms of an Operating
Agreement.
ORGANIZATIONAL, DISTRIBUTION AND OFFERING EXPENSES - Expenses incurred by the
Manager for organizing the Fund and closing the offering, including without
limitation legal, accounting, engineering and geologic consulting fees, filing
and other expenses of organizing the Fund, distribution and selling costs, and
closing costs for the offering.
OVERRIDING ROYALTY INTEREST - A royalty interest carved out of the Working
Interest net of the landowner's royalty.
PLACEMENT AGENT - Ridgewood Securities Corporation, a Delaware corporation with
its principal office at 947 Linwood Avenue, Ridgewood, New Jersey.
PRODUCTIVE WELL - A producing well or a well capable of production whether or
not completed or currently shut in.
PROFITS or LOSSES - For a given period, the Fund's taxable income or loss,
respectively, as determined under the Code, adjusted as follows:
any income of the Fund exempt from federal income tax and not
otherwise taken into account in computing Profits or Losses and any
income and gain described in Treasure Regulations Section
1.704-1(b)(2)(iv)(g)(1) is added to taxable income or loss;
any expenditures of the Fund described in Code Section 705(a)(2)(B) or
treated as such under Treasure Regulations Section
1.704-1(b)(2)(iv)(i) and not otherwise taken into account in computing
Profits or Losses are subtracted from taxable income or loss;
91
unrealized gain or loss on distributions in kind deemed to have been
realized on the distributed property is added or subtracted,
respectively, from taxable income or loss; and
items specially allocated under Sections 4.4 and 7.4 of the LLC
Agreement are not taken into account.
PROJECT - An area designated by the Manager in which the Fund owns or expects to
own one or more oil and natural gas interests and which the Manager reasonably
believe contains at least one reservoir of oil, natural gas or other
hydrocarbons.
REGULATIONS - The applicable Treasury Regulations promulgated under the Code.
RIDGEWOOD - Ridgewood Energy Corporation, a Delaware corporation wholly owned by
Robert E. Swanson that is the Manager of the Fund.
RIDGEWOOD ENERGY PROGRAM or PRIOR PROGRAM - One of the prior drilling and
completion limited partnerships or business trusts, or funds within those
limited partnerships, or one of the five Leasebank programs, or any other
program sponsored by Ridgewood and that have invested in the oil and gas
industry.
RIDGEWOOD SECURITIES - a Delaware corporation wholly owned by Robert E. Swanson
that will act as the Placement Agent for this offering.
ROYALTY - An interest in oil, natural gas or other minerals that entitles the
owner of the underlying real property to a specified fraction of production, in
kind or in value, free of the expense of development and operation, and which is
payable out of the leasehold interest after deduction of the cost of processing,
transporting and marketing such production.
SALVAGE FUND - A fund in the nature of a sinking fund established to provide for
funding anticipated salvage costs and other expenses incident to the shutdown of
wells, the removal of facilities and environmental rehabilitation, if required.
SERVICE - The Internal Revenue Service.
92
SHAREHOLDER - A member of the Fund, including each Investor and Ridgewood.
SHUT-IN - To temporarily cease production from and operation of a well by
shutting the valves at the wellhead or nearby.
SUBSCRIPTION AGREEMENT - The form of agreement (contained in Exhibit D hereto,
which is separately bound) which each prospective Investor must execute in order
to subscribe for Shares in the Fund.
TERMINATION DATE - July 31, 2006 or such later date determined by the Manager as
permitted by and pursuant to the LLC Agreement.
SHARES - Beneficial interests in the Fund representing a Capital Contribution of
$150,000.
WORKING INTEREST - A Working Interest is an interest under an oil and natural
gas lease, which carries with it the obligation to pay the costs of such
operation. The holders of the entire Working Interest bear 100% of the costs of
exploring, drilling, developing and operating the lease and are entitled to
receive revenues derived from oil and natural gas production on such lease which
remain after deduction of the cost of processing, transporting and marketing
such oil and natural gas, Royalty payments, Overriding Royalty Interest payments
and other burdens on production.