CONFIDENTIAL MEMORANDUM COPY NO._______________________
DATED: September 6, 2005 NAME OF OFFEREE________________
RIDGEWOOD ENERGY Q FUND, LLC
Gulf of Mexico Natural Gas Fund
800 Shares of Beneficial Interest
Offered at $150,000 Per Share
Minimum Offering of $1,500,000
Maximum Offering of $120,000,000
Ridgewood Energy Q Fund, LLC, a Delaware limited liability company (the "Fund"),
has been organized to acquire interests primarily in natural gas properties
located in the 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 an aggregate of 800 Shares of beneficial interest ("Shares") at a
purchase price of $150,000 per Share. See Terms of the Offering.
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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 800* $120,000,000 $20,400,000 $99,600,000
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*The Fund in its discretion may expand the maximum offering 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 ▇▇▇▇▇ is highly risky and the
investment in ▇▇▇▇▇ 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
▇▇▇ ▇▇▇▇▇▇▇ ▇▇▇▇▇▇
▇▇▇▇▇▇▇▇▇, ▇▇▇ ▇▇▇▇▇▇ ▇▇▇▇▇
(▇▇▇) ▇▇▇-▇▇▇▇
SHORT SUMMARY
RIDGEWOOD ENERGY Q FUND, LLC
Gulf of Mexico Natural Gas Fund
Securities Offered: 800 Shares ($150,000 per Share)
Amount Offered: Maximum: $120,000,000 Minimum: $1,500,000
The Q Fund The Q Fund is a continuation of the series of Ridgewood
Continues a Series Energy "Alphabet Funds" which have invested in natural gas
of Gulf of Mexico properties in the Gulf of Mexico, which began with the B
Natural Gas Funds: Fund in 1992. After the B Fund, Ridgewood Energy offered the
C Fund, the D Fund, the E Fund, the F Fund, the G Fund, the
H Fund, the I Fund, the J Fund, the K Fund, the L Fund, the
M Fund, the N Fund, the O Fund, and, most recently, the P
Fund, which began offering shares on May 16, 2005. The
Alphabet Funds have invested exclusively in major natural
gas projects in the Gulf of Mexico in partnership with major
oil and gas companies
Natural Gas Prices The average price of natural gas for the past year is more
Doubled: than double the average price in the decade of the 1990s.
Long Term Gas The demand for natural gas is expected to continue to exceed
Shortages: supply for the foreseeable future, sustaining high prices.
Gulf of Mexico Major oil and gas companies focus their domestic drilling
Discoveries: 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, combined with, (ii)
an existing pipeline infrastructure 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
investments in partnership with experienced independent and
major energy companies.
Track Record of Dividends For
"Alphabet Funds" August 12 Months Cumulative
Date First Monthly Ended August Dividends August
Close Dividend Dividend 2005 2005
----- -------- -------- ---- ----
B Fund 3/92 2/93 .74% 13.9% 259.9%
C Fund 10/92 2/93 .74% 13.9% 259.9%
D Fund 7/98 9/99 - 2% 101.2%
E Fund 6/99 9/99 9.9% 103% 481.0%
F Fund 6/00 12/00 2.6% 16.8% 134.2%
G Fund 7/01 2/02 7.0% 75.9% 213.3%
H Fund 9/03 4/04 2.4% 27.8% 32.7%
I Fund 12/03 1/05 .19% 2.7% 2.7%
J Fund 03/04 - .19% 1.0% 1.0%
K Fund 07/04 - .10% .57% .57%
L Fund 09/04 - - N/A N/A
M Fund 11/04 - - N/A N/A
N Fund 02/05 - - N/A N/A
O Fund - - - N/A N/A
P Fund - - - N/A N/A
i
The performance of prior Ridgewood Energy Alphabet Funds
does not predict success of or guarantee similar results for
the Q Fund. (See Risk Considerations and Exhibit B Track
Record.)
Early Investment The Manager at any time during this Offering may have
Incentive 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 September
2005. 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 For Investors who subscribe to the Fund between
September 6, 2005 and October 14, 2005 and have fully
paid their Capital Contribution shall be entitled to
receive an Early Investment Incentive equal to
$10,000 per $150,000 Share.
o Investors who subscribe to the Fund after October 14,
2005 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 early Investment 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. 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 The investment objective of the Fund is to generate current
Gulf of cash flow for distribution to Investors from acquiring,
Mexico Natural Gas drilling, completing and developing natural gas prospects in
Projects: the U.S. waters off Texas and Louisiana in the Gulf of
Mexico. The Fund will build a balanced portfolio of natural
gas projects ("Projects") which are described in the
Memorandum and may include, without limitation, the
following:
ii
o Higher risk exploratory projects which may include
deep drilling below 15,000 feet and which have very
high economic potential and which may be near the
pipeline infrastructure. 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 Lower risk developmental projects which are already
connected to natural gas 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. Tax benefits from the Q
Fund may shelter a large part or all of the income from the
Prior Ridgewood Energy Programs for existing Ridgewood
Shareholders.
Summary: I. Long term supplies of natural gas is the commodity 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 gas ▇▇▇▇▇.
III. Ridgewood Energy offers institutional quality Gulf of
Mexico natural gas investments to high net worth
individuals.
Sharing of Income Investors: 85%
and Gain: Manager: 15%
Use of Proceeds: Acquisition, Drilling and Completion and 83%
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
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 RESOURCE POTENTIAL. THESE STATEMENTS ARE
NOT GUARANTEES OF FUTURE PERFORMANCE. THE ACTUAL RESULTS ACHIEVED BY THE Q 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 Q FUND.
iii
TABLE OF CONTENTS
PAGE
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SUMMARY OF PROGRAM.....................................................................................................i
GENERAL................................................................................................................1
INVESTOR SUITABILITY STANDARDS.........................................................................................2
MANAGER................................................................................................................4
PROPOSED ACTIVITIES....................................................................................................4
USE OF PROCEEDS.......................................................................................................13
RISK CONSIDERATIONS...................................................................................................14
General Risks Related to Natural Gas Exploration, Drilling, Pipelines and
Operations...................................................................................................14
Particular Risks Related to the Shares.......................................................................19
TERMS OF THE OFFERING.................................................................................................25
PLAN OF DISTRIBUTION..................................................................................................26
PARTICIPATION IN COSTS AND REVENUES...................................................................................28
COMPENSATION..........................................................................................................30
FIDUCIARY RESPONSIBILITIES OF MANAGER.................................................................................32
CONFLICTS OF INTEREST.................................................................................................35
MANAGEMENT............................................................................................................38
TAX ASPECTS...........................................................................................................41
ADDITIONAL ASPECTS OF LLC AGREEMENT...................................................................................73
LIABILITY.............................................................................................................78
OTHER INFORMATION.....................................................................................................79
General......................................................................................................79
Authorized Sales Material....................................................................................79
LEGAL MATTERS.........................................................................................................80
LITIGATION AND OTHER PROCEEDINGS......................................................................................81
DEFINITIONS...........................................................................................................85
LIST OF TABLES
USE OF PROCEEDS.......................................................................................................13
COMPENSATION..........................................................................................................30
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
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 the Fund Manager believes that the most
important provisions of these legal documents are properly described in this
Memorandum, provisions that may be important to you may not be 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,
the provisions of the legal document will control.
The DEFINITIONS section begins on page 79.
You should rely only on the information contained in this document and
its exhibits. The Fund has not authorized anyone to provide you with information
that is different. 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
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.
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.
1
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 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.
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.
2
Investor Qualifications
-----------------------
The Fund and the offering of Investor Shares are structured to comply
with the private offering exemption under the federal Securities Act of 1933, as
amended (the "Act") and an exemption from restrictions on compensation under the
Investment Advisers Act of 1940 ("Advisers Act") the rules and regulations
promulgated thereunder by the Securities and Exchange Commission (the
"Commission") and certain state laws and regulations 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
"qualified clients" as defined by Rule 205-3 of the Adviser's Act including:
o a natural persons who also have a net worth (including assets jointly
owned with the spouse) of more than $1,500,000 at the time of purchase;
o separate accounts of pension or employee benefit plans if the accounts
or their owners meet the $1,500,000 net worth requirement set forth
above;
o a company or entity that has $1,500,000 in net worth, provided however,
that each equity owner of the company or entity must meet the
$1,500,000 net worth requirement is the company or 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; or a business
development company (as defined in Section 202(a)(22) of the Advisers
Act); or
o Qualified Purchasers, as defined in Section 2(a)(51)(A) of the 1940
Act.
For purpose of meeting the $1,500,000 net worth requirement, an investor's
equity in residences, furnishings and automobiles can be included.
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.
3
Except in certain limited circumstances, United States federal law
prohibits the holding of interests in federal oil and gas leases by persons who
are not citizens or nationals of the United States and by entities (including
U.S. entities), which are owned or controlled by non-U.S. nationals. Each
prospective Investor must represent whether he or she is a citizen or national
of the United States or, if the Investor is an entity, whether any controlling
interest in it is owned by a person who is not 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 ▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇. The Manager's principal
office is ▇▇▇▇ ▇▇▇▇▇▇▇▇ ▇▇▇▇▇▇▇▇▇, ▇▇▇▇▇ ▇▇▇, ▇▇▇▇▇ ▇▇▇▇, ▇▇▇ ▇▇▇▇ ▇▇▇▇▇.
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 prospects in the offshore waters of Texas and Louisiana
in the Gulf of Mexico ("Projects" or "the Fund's Projects"). It is impossible at
this time to identify specifically the Projects in which the Fund 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 natural gas lease 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 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 waters of the Gulf of
Mexico. However, at the present time the Fund has not 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, 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.
4
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 the
natural gas pipelines, or which are near the pipeline infrastructure
and can be connected quickly.
o Higher risk exploratory Projects which may include deep drilling below
15,000 feet and which have very high economic potential but which may
be near pipeline infrastructure. 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 Non-Consent Interests, which may include interests acquired from prior
Ridgewood Energy Programs.
o Ownership, development, construction, installation, acquisition, and/or
operation of natural gas 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 and natural gas liquids.
o Although the focus of the Fund will be on natural gas projects, the
Fund may, from time to time, consider oil projects in the Gulf of
Mexico that have the potential for returns similar to the natural gas
projects the Fund has considered or is considering.
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.
5
Working Interest in Natural Gas Leases
--------------------------------------
The Projects that may be acquired by the Fund are expected to be
located in the waters of the Gulf of Mexico offshore from Louisiana and Texas on
the Outer Continental Shelf ("OCS"). The Fund anticipates that its operations
and activities would then be governed by 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.
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. The 5-year lease
term is for Blocks in water depths generally less than 400 meters, 8 years for
depths between 400 meters to 800 meters, and 10 years for depths in excess of
800 meters. During this "primary lease term", except in limited circumstances,
Lessees are not subject to any particular requirements to conduct exploratory or
development activities. However, once a Lessee drills a well and begins
production, the lease term is extended for so long as the well continues in
commercial production.
6
The Lessee of a particular Block, for the term of the lease, has the
right to drill and develop exploratory ▇▇▇▇▇ 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 ▇▇▇▇▇. 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 ▇▇▇▇▇ 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 gas 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 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 for existing OCS leases for those who drill deep gas ▇▇▇▇▇.
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 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
▇▇▇▇▇ in shallow-water areas that they have already leased. The MMS believes
that by providing this royalty suspension incentive for such ▇▇▇▇▇, natural gas
7
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
▇▇▇▇▇ 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
that part of the U.S. where:
o Government geologists and industry geologists generally agree that the
Gulf of Mexico represents the highest short term potential for
discovering major new gas fields in the lower 48 states.
o These major new gas fields are located on the continental shelf of the
Gulf of Mexico where there exists an enormous pipeline infrastructure
enabling those gas ▇▇▇▇▇ 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. 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 no pipeline infrastructure in place to quickly
bring those discoveries to market. The government gave the royalty relief where
gas, if found, can quickly benefit the U.S. economy by coming to market.
The government wants to encourage significant amounts of new natural
gas to be developed and come to market. Basically, the government needs massive
amounts of gas to be discovered. Over the past 50 years, tens of thousands of
shallow ▇▇▇▇▇ have been drilled on the continental shelf of the Gulf of Mexico.
The government does not expect significant massive new discoveries to be found
at shallow depths.
Drilling of the Gulf of Mexico at horizons deeper than 15,000 feet is
basically virgin exploratory territory in the Gulf. Only a few percent of the
total ▇▇▇▇▇ drilled in the Gulf have been deeper than 15,000 feet, and less than
1% of all ▇▇▇▇▇ have been drilled deeper than 18,000 feet. See Risk
Considerations.
8
Improved Seismic Data Reduces Risk for Deeper Drilling
------------------------------------------------------
Drilling ▇▇▇▇▇ deeper than 15,000 feet is technologically feasible, but
it is more expensive. (Drilling below 25,000 feet gets technologically more
difficult due to extremes of heat and pressure, which challenge traditional
drilling techniques and materials). In addition to Royalty Relief for deep
▇▇▇▇▇, two primary reasons for the interest in deeper drilling are:
o Much higher natural gas prices make projects much more profitable.
o Vastly improved three dimensional seismic data provides more
information about geologic structures below 15,000 feet, thereby
reducing, but by no means eliminating, the risk involved.
Natural Gas 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, may average $8 billion per year during the next 5 to
10 years. Therefore, as demand for natural gas 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 ▇▇▇▇▇,
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.
Natural gas midstream activities are essentially the gathering and
processing of natural gas. Natural gas gathering systems normally consist of one
or more small diameter pipelines that are connected to and deliver raw natural
gas from the well head, where it is extracted from the earth, to a central
processing point. Once gathered through these pipelines from individual ▇▇▇▇▇ to
a processing facility, the natural gas is processed so that it can meet the
requirements and specifications of and be transported through "downstream"
interstate pipelines. Generally, processing facilities remove impurities from
the raw natural gas extracted from the ▇▇▇▇▇. Such impurities include certain
natural gas liquids (which can be sold separately), water, carbon dioxide or
sulfur, which might corrode a steel pipeline, or inert gases, such as helium,
that could reduce the energy value of the gas.
9
The production and gathering of natural gas are generally not subject
to significant government regulation and are exempt from the jurisdiction of the
Federal Energy Regulatory Commission ("FERC"), which, among other things, sets
the rates that a jurisdictional pipeline can charge for its capacity. Although
the Fund will focus primarily on Working Interests, if it does invest in
gathering and processing Projects, it will attempt to limit its investments and
activities to the natural gas gathering system, which generally is unregulated.
The Funds can not guarantee that part of its activities will not involve, even
if tangentially, pipelines that could be considered as an interstate pipeline
and thus subject to FERC regulation. See Risk Considerations.
Natural Gas Agreement
---------------------
As of the date of this Offering, no definitive arrangements have been
made for the sale or transportation of natural gas that may be produced from the
Projects or transported on any pipelines that the Fund may own. The Fund
believes, however, that it is likely that gas from the Projects described herein
will have access to pipeline transportation 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 would require an investment by
the Fund potentially as early as September of 2005. 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 For Investors who subscribe to the Fund between September 6,
2005 and October 14, 2005 and have fully paid their Capital
Contribution shall be entitled to receive an Early Investment
Incentive equal to $10,000 per $150,000 Share.
o Investors who subscribe to the Fund after October 14, 2005
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 early Investment Incentive has been
paid in full. Thereafter, all Investors share in distributions
of the Fund in accordance with their individual ownership
percentage.
10
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 described in this
Memorandum. However, if the Fund should require additional cash in the future
for certain purposes such as drilling, completing and developing additional
▇▇▇▇▇ or if the Manager determines that the Fund should participate in drilling,
completing, equipping, re-working or re-entering any such additional well
("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 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
11
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. In this case, 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.
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
12
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 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 ▇▇▇▇▇, and removing the platforms,
facilities and ▇▇▇▇▇ 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.
USE OF PROCEEDS
Maximum Proceeds* Minimum Proceeds
Investment Fee to Manager $5,400,000 (4.5%) $ 67,500 (4.5%)
Selling Commissions 9,600,000 (8%) 120,000 (8%)
Placement Agent Fee 1,200,000 (1%) 15,000 (1%)
Organizational, Distribution and 4,200,000 (3.5%) 52,500 (3.5%)
Offering Fee (including legal,
accounting, engineering and geologic
consulting fees, printing, filing fees, etc.)
Acquisition of or Participation in
Projects and Fund Operations 99,600,000 (83%) 1,245,000 (83%)
Total Proceeds from Offering ** $120,000,000 (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.
13
Under the LLC Agreement, the Fund may commence operations with minimum
gross proceeds of $1,500,000 and a maximum of $120,000,000 (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 $99,600,000 (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 exploration and drilling or in natural gas
infrastructure 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.
GENERAL RISKS RELATED TO NATURAL GAS EXPLORATION,
DRILLING, PIPELINES AND OPERATIONS
Drilling Activities May Not Be Productive
-----------------------------------------
Drilling for natural gas involves numerous risks, including the risk
that the well will not have commercially productive natural gas reservoirs. The
costs of drilling, completing and operating ▇▇▇▇▇ 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;
14
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 natural gas ▇▇▇▇▇ 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. Therefore, drilling activities may be
unprofitable, not only from non-productive ▇▇▇▇▇, but also from ▇▇▇▇▇ that do
not produce natural gas in sufficient quantities or quality to return a profit
on the capital dollars invested.
Gas Reserve Data, Gas Prices and Future Net Revenue Estimates are Uncertain
---------------------------------------------------------------------------
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 natural gas reserves
requires substantial evaluation on the part of the petroleum engineers and
geologists, resulting in 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 employ
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 natural gas, which is affected by numerous
factors beyond the Fund's control. Gas prices historically have been very
volatile. There can be no guarantee that natural gas prices in the future will
be sufficient to make a profit on the sale of the Fund's natural gas.
15
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 Natural Gas Infrastructure Projects is subject
------------------------------------------------------------------------------
to Risks Beyond the Fund's Control.
-----------------------------------
The business of transporting, gathering and processing natural gas for
third parties is subject to substantial risks. The volume of natural gas
involved in these activities depends on the actions of such third parties, and
is beyond the Fund's control. Further, the following factors, most of which are
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 liquids prices.
Operating Risks may cause substantial losses; Insurance may not protect the Fund
--------------------------------------------------------------------------------
against all these risks
-----------------------
Ridgewood Energy carries insurance on all of its properties. ▇▇▇▇▇▇▇▇▇
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;
16
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 natural gas
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. Having stated the above, in Ridgewood Energy's first 18 years in the
Gulf of Mexico such losses, including occasional storm damage, have been covered
by insurance, except for deductible amounts on the policies.
Risks of Government Regulation
------------------------------
The natural gas exploration, drilling and development business could be
subject to government regulation under which, among other things, rates of
production from gas ▇▇▇▇▇ may be regulated. Government regulations may also
impact the market for the Fund's natural gas, 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 of natural
gas is 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.
Reliance on Third Parties
-------------------------
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.
17
Joint Activities With Others
----------------------------
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 ▇▇▇▇▇ proposed by other participants, the Fund will lose all of its
rights to production from those additional ▇▇▇▇▇. Moreover, while the Fund will
monitor and participate in decisions affecting exploration and development of
the leases or ▇▇▇▇▇ in which the Fund acquires a Working Interest or Non-Consent
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
▇▇▇▇▇.
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.
Salvage Fund may be Insufficient
--------------------------------
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.
18
Ownership of Federal Leases
---------------------------
Federal law prohibits, with certain limited exceptions, the holding of
interests in federal oil and natural gas leases by (i) persons who are not
citizens or nationals of the United States and (ii) entities that are owned or
controlled by non-United States nationals. 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
nationality of its equity owners. Prospective Investors who are not United
States citizens or nationals or which are owned or controlled in whole or in
part by non-U.S. nationals must so inform the Fund when completing their
Subscription Documents. The Fund will not accept a subscription from non-United
States citizen or national 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.
PARTICULAR RISKS RELATED TO THE SHARES
Limited Transferability of Shares
---------------------------------
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.
19
Lack of Investor Participation in Management
--------------------------------------------
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.
Limited Transferability of Fund Assets
--------------------------------------
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 reserves, the
number of potential purchasers and the economics of any bids made by them and
the current economics of the natural gas 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.
Limitations on Liability of Managing Persons to Fund
----------------------------------------------------
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.
20
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.
Manager Will Receive Compensation
---------------------------------
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 $120,000,000 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
21
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.
Delaware Law Permits the Manager to Limit 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.
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.
Projects Not Yet Identified or Selected
---------------------------------------
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.
Uncertainty of Cash Distributions
---------------------------------
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 natural gas operations. Moreover,
distributions could be delayed to repay the principal and interest of Fund
22
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.
Disparity in Shareholder Contributions
--------------------------------------
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
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)
23
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
substantial portion of the Fund's income could be deemed to constitute unrelated
business taxable income, such that tax-exempt Investors could be subject to tax
on their respective portions of such income; (E) if any income of the Fund is
deemed to be unrelated business taxable income, 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 5% per annum compounded
24
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.
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 800 Investor Shares
(representing Capital Contributions of $120,000,000) 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 Q 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 March 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 March 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.
25
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 March
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.
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. The Investor Subscription Booklet includes: (i) a
Subscription Agreement, (ii) an Investor Questionnaire and (iii) a Purchaser
Representative Questionnaire. The Investor Subscription Booklet 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
26
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. ▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇,
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
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 co-operating
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.
27
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 anddeductions for tax purposes, and
o maintain capital accounts for Investors.
"Available Cash" determines what amounts in cash the Fund will be able
to distribute in cash to Investors.
There are two types of Available Cash:
"Available Cash From Dispositions" 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 Operations" is all other Available Cash.
Available Cash From Dispositions and Available Cash From Operations 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
28
Shareholders. The amount of Available Cash From Operations determined to be
available, if any, 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.
Distributions of Available Cash From Dispositions
Available Cash From Dispositions that the Fund decides to distribute
will be paid as follows:
o Before Investors have received total distributions (including
distributions from Available Cash From Operations and
Available Cash From Dispositions) equal to their Capital
Contributions, 99% of Available Cash From Dispositions 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
Dispositions) equal to their Capital Contributions, 85% of
Available Cash From Dispositions will be distributed to
Investors and 15% to the Manager.
General Distribution Provisions
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
29
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.
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 the expenditure of Investor's Capital Contributions 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
30
connection with the Offering and operation of the Fund. These fees were not
determined through arms-length negotiations.
----------------------------------------------------------------------------------------------------------------------
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 intended to pay legal, organizational and other
Offering 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
31
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.
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
32
Fund upon reasonable written demand stating the purpose of the demand
(which must be reasonably related to the Investor's interest in the
Fund):
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
such person has not otherwise been reimbursed, provided that the acts of such
33
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.
34
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
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
activities on behalf of the prior Ridgewood Energy 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 ▇▇▇▇▇ 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 ▇▇▇▇▇. 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
35
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 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 ▇▇▇▇▇ on locations in which the Fund may invest may be on
locations adjacent to ▇▇▇▇▇ and leases owned by the prior Ridgewood
Energy Programs. While the proposed ▇▇▇▇▇ 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 natural gas 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.
36
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.
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 natural gas 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.
37
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 differently upon the Manger than
on Shareholders.
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 ▇▇▇▇▇▇ ▇▇▇▇▇▇▇, 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. ▇▇▇▇▇▇ ▇▇▇▇▇▇▇ 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, ▇▇▇▇▇▇▇▇▇'s
38
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.
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:
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇, age 58, is the Chairman and President, manager and
controlling shareholder of Ridgewood Energy. ▇▇. ▇▇▇▇▇▇▇ is the Chief Executive
Officer and controlling member of Ridgewood Renewable Power, Ridgewood Capital
Management and other affiliates. ▇▇. ▇▇▇▇▇▇▇ was a tax partner at the former New
York and Los Angeles law firm of ▇▇▇▇▇ & ▇▇▇▇▇▇ and an officer in the Investment
Division of ▇▇▇▇▇▇ Guaranty Trust Company. His specialty was in personal tax and
financial planning, including income, estate and gift tax. ▇▇. ▇▇▇▇▇▇▇ is a
member of the New York State and New Jersey bars. He is a graduate of Amherst
College and Fordham University Law School. ▇▇. ▇▇▇▇▇▇▇ and his wife, ▇▇▇▇▇▇▇
▇▇▇▇▇▇▇▇ ▇▇▇▇▇▇▇ are the authors of "Tax Shelters, A Guide for Investors and
Their Advisors," published by ▇▇▇ ▇▇▇▇▇-▇▇▇▇▇ in 1982 and published in revised
editions in 1984 and 1985.
▇▇▇▇ ▇▇▇▇▇, age 42 is Executive Vice President and Director of Business
Development for Ridgewood Energy. ▇▇. ▇▇▇▇▇ heads the Houston office of
Ridgewood Energy. ▇▇. ▇▇▇▇▇ 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. ▇▇. ▇▇▇▇▇ came to Ridgewood in January 2004 from El Paso
Natural Gas Corp. where he was a senior business development officer. ▇▇. ▇▇▇▇▇
worked for a decade primarily in the Gulf of Mexico on gas projects for Sante Fe
Corp. and its affiliates. ▇▇. ▇▇▇▇▇ is a graduate of the University of Houston.
▇▇▇▇▇▇ ▇. ▇▇▇▇, age 46, is Executive Vice President of Ridgewood Energy which he
joined in 1987. Mr. ▇▇▇▇ 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
39
Companies, Mr. ▇▇▇▇ was a corporate attorney in the law firm of Cleary,
Gottlieb, ▇▇▇▇▇ & ▇▇▇▇▇▇▇▇ in New York City. Mr. ▇▇▇▇ is a member of the New
York bar. He is a graduate of Colgate University and New York University School
of Law.
▇▇▇▇▇▇▇▇ ▇▇▇▇▇▇▇▇, age 39 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, ▇▇. ▇▇▇▇▇▇▇▇ serves as Vice
President of Systems and Administration of Ridgewood Renewable Power. Prior to
her employment at Ridgewood Energy, ▇▇. ▇▇▇▇▇▇▇▇ worked in the Trust department
for Midlantic National Bank. ▇▇. ▇▇▇▇▇▇▇▇ holds a Bachelor of Science degree in
Accounting
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇, age 44, is Senior Vice President and General Counsel of
Ridgewood Energy. He began his legal career as an associate for Pitney, ▇▇▇▇▇▇,
▇▇▇▇ & ▇▇▇▇▇, a large New Jersey law firm, where his experience included
corporate acquisitions and transactions. Prior to joining Ridgewood, ▇▇. ▇▇▇▇▇▇
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. ▇▇. ▇▇▇▇▇▇ 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. ▇▇. ▇▇▇▇▇▇ is a
member of the New Jersey State Bar and Pennsylvania State Bar. He is a graduate
of Fairleigh ▇▇▇▇▇▇▇▇▇ University and Rutgers University School of Law - Newark.
▇▇▇▇▇▇▇ ▇. ▇▇▇▇, age 53, is Ridgewood Energy's Geoscience Manager and joined
Ridgewood Energy in April of 2004 in the Houston office. ▇▇. ▇▇▇▇ 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, ▇▇. ▇▇▇▇ 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, ▇▇. ▇▇▇▇ held the position of Geoscience Manager for
an independent acquisition and divestment company immediately before joining
Ridgewood.
40
▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇, age 48, is Land Manager and joined Ridgewood Energy in July
2004. He is located in Ridgewood Energy's Houston, Texas office. ▇▇. ▇▇▇▇▇▇▇ has
more than 20 years of experience in the domestic U.S. oil and gas exploration
and production business. Prior to joining Ridgewood Energy, ▇▇. ▇▇▇▇▇▇▇ was
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. ▇▇. ▇▇▇▇▇▇▇ received a Bachelor of Science degree in
Petroleum Land Management from the University of Houston, is a Registered
Professional ▇▇▇▇▇▇▇ (RPL), and is an active member of the American Association
of Professional Landmen, Houston association of Professional Landmen and the
Professional ▇▇▇▇▇▇▇'▇ Association of New Orleans.
▇▇▇▇ ▇▇▇ ▇▇▇▇, 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, ▇▇. ▇▇▇▇ was a Regional
Administrator at ▇▇▇▇▇▇-▇▇▇▇ Training Systems where she was employed for two
years. Prior to that, she was employed by RCA Corporation. ▇▇. ▇▇▇▇ has a
Bachelor of Arts degree from Queens College.
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
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
41
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;
o The Manager does not expect to be in a significantly lower federal
income tax bracket than the Fund's Investors; and
42
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 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 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
43
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.
44
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 ▇▇▇▇▇ & 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.
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,
45
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 natural gas 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 properties 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, 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
46
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 ▇▇▇▇▇. 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 2005, 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 2005. To the extent that such services are performed
in 2006, however, the Fund will only be allowed to deduct in 2005 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 ▇▇▇▇▇ spudded within 90 days after December 31, 2005.
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.
47
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 2005 even though a portion of such costs are attributable to services
performed during 2006.
Each Investor, however, may deduct his share of amounts paid in 2005
for services performed in 2006 only to the extent of his "cash basis" in the
Fund as of the end of 2005. 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
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
48
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
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
49
S
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 natural gas 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 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
50
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.
51
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 requirement (3)
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).
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
52
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 expenditure of Capital Contributions
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 ▇▇▇▇▇.
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.
53
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.
A significant portion of the Fund's expenses may be characterized as
54
"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
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
55
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
"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
56
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 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.
57
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
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.
58
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., ▇▇▇▇▇
v. Commissioner, 533 F.2d 768 (2d Cir. 1976).
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
59
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. See Limitations on
Interest Deductions.
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 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".
60
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 5% 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.
61
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.
62
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.
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
63
$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.
64
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.
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
65
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.
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
66
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.
25. Investment by Qualified Plans and Other Tax Exempt Entities
In General. The following entities are generally exempt from federal
income taxation:
67
o Trusts forming part of a stock bonus, pension, or profit sharing plan
(including a ▇▇▇▇▇ 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 of property held by a dealer and "debt-financed property."
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
68
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
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
▇▇▇▇▇ plans); (iv) whether the investment provides sufficient liquidity; (v)
69
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. ▇▇▇▇▇ 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
▇▇▇▇▇ 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 ▇▇▇▇▇ 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:
"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
70
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
all 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
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
71
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 generally 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.
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
72
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.
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
73
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 ▇▇▇▇ ▇▇▇▇ ▇▇▇▇▇▇, ▇▇▇▇▇▇▇▇▇▇, ▇▇▇▇▇▇▇▇. 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 submitting their own individual claims to arbitration.
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.
74
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 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
75
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
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
76
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.
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 (including receipt of an opinion of counsel that the
transfer does not have adverse effects under the securities laws and the
Investment Company Act of 1940) have been satisfied.
77
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
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.
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.
78
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.
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.
79
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, ▇▇▇ ▇▇▇▇▇ ▇▇▇▇▇▇, ▇▇▇▇▇ ▇▇▇▇,
▇▇▇ ▇▇▇▇, ▇▇▇ ▇▇▇▇ ▇▇▇▇▇. 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 may be obtained by writing to the Fund.
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
opinion referred to above. The opinion of Black & Associates is available to any
Investor upon request.
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 ▇▇. ▇▇▇▇▇▇▇ 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.
80
In 1994, the Manager sold all of the assets of 24 of the oil and gas
programs to Apache Corporation, and the proceeds of sale were distributed to
investors and the programs terminated. Another six oil and gas programs have
been terminated over time as their ▇▇▇▇▇ became depleted. Ridgewood Energy is
currently administering the remaining oil and gas programs.
There have been no legal proceedings commenced against Ridgewood
Energy, ▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇ 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). In addition, there was one suit brought by a
former employee (essentially a wrongful termination suit) that was litigated and
won by ▇▇▇▇▇▇▇▇▇, and one arbitration brought by a broker (essentially over
compensation) that was settled. There is no pending litigation as to Funds
offered in the 1980s. There has been no litigation on any Ridgewood Energy Fund
offered since 1990.
In 1991, a former employee commenced an action against Ridgewood Energy
and ▇▇. ▇▇▇▇▇▇▇ in the U.S. District Court for the Northern District of
California for breach of an implied employment contract. The complaint also
included securities allegations in connection with the purchase by such employee
of interests in various oil and gas programs sponsored by Ridgewood Energy and
▇▇. ▇▇▇▇▇▇▇. After discovery, the District Court granted summary judgment in
favor of Ridgewood Energy and ▇▇. ▇▇▇▇▇▇▇ on all the claims relating to the
purchase of securities in the oil and gas programs based on plaintiff's failure
to state a cause of action. Subsequently, the District Court also entered
summary judgment in favor of Ridgewood Energy and ▇▇. ▇▇▇▇▇▇▇ on plaintiff's
employment claim. Both these orders (which had the effect of completely
terminating plaintiff's lawsuit without any liability to Ridgewood Energy or ▇▇.
▇▇▇▇▇▇▇) were affirmed by the Ninth Circuit Court of Appeals.
Also in 1991, a well known plaintiff's attorney purporting to represent
a group of 30 investors in various Ridgewood Energy oil and gas programs
commenced an action against Ridgewood Energy, ▇▇. ▇▇▇▇▇▇▇ and others alleging a
variety of claims. Prior to discovery, the plaintiffs voluntarily dismissed
Ridgewood Energy and ▇▇. ▇▇▇▇▇▇▇ as defendants in the action. The action was
subsequently completely terminated without any liability of Ridgewood Energy or
▇▇. ▇▇▇▇▇▇▇.
81
In 1994, two independent brokers who both purchased for themselves, and
sold to their clients, securities offered in certain of the Ridgewood Energy oil
and gas programs commenced an arbitration proceeding before a National
Association of Securities Dealers ("NASD"') arbitration panel alleging claims
similar to those described above on behalf of themselves and their clients
against Ridgewood Energy, the Placement Agent, ▇▇. ▇▇▇▇▇▇▇ and others. In
addition, the brokers also asserted a claim for additional compensation from
Ridgewood Energy and affiliates for the sale of such securities. The NASD
arbitration panel dismissed all of the claims against Ridgewood Energy for lack
of jurisdiction. The arbitration against the Placement Agent and ▇▇. ▇▇▇▇▇▇▇ was
settled in February 1998 together with a threatened lawsuit for an amount
significantly less than $100,000.
In 1995, another plaintiff's attorney commenced an action against
Ridgewood Energy, ▇▇. ▇▇▇▇▇▇▇ and others in the U.S. District Court for the
District of New Jersey alleging a variety of the claims described above, named
▇▇▇▇▇▇, et al. v. Ridgewood Energy Corp., et al. (the "▇▇▇▇▇▇ Case"). The
complaint in the ▇▇▇▇▇▇ 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 ▇▇▇▇▇▇ 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 ▇▇. ▇▇▇▇▇▇▇ 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.
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
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇ 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.
82
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 ▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇. 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
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
83
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, ▇▇. ▇▇▇▇▇▇▇▇ ▇▇▇▇▇▇, 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. ▇▇.
▇▇▇▇▇▇ 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 ▇▇. ▇▇▇▇▇▇ to avoid the consequences of her defaults.
Recently, ▇▇▇▇▇▇▇▇▇ Capital settled this case with ▇▇. ▇▇▇▇▇▇ 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.
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 ▇▇▇▇▇ 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.
84
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, 2003 and December 31, 2004 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.
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.
85
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 Partnership 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.
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 ▇▇▇▇▇ 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.
86
FUND - Ridgewood Energy Q Fund, LLC c/o Ridgewood Energy Corporation, ▇▇▇▇
▇▇▇▇▇▇▇▇ ▇▇▇▇▇▇▇▇▇, ▇▇▇▇▇ ▇▇▇, ▇▇▇▇▇ ▇▇▇▇, ▇▇▇ ▇▇▇▇ ▇▇▇▇▇.
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.
LIMITED LIABILITY COMPANY AGREEMENT or LLC AGREEMENT - The Limited Liability
Company Agreement, dated as of September 6, 2005, 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 September 6, 2005 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.
87
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 ▇▇▇▇▇ 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 ▇▇▇▇▇ 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 ▇▇▇▇▇ which provides the terms and conditions
pursuant to which the Operator will conduct operations on jointly owned oil and
gas properties.
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 ▇▇▇▇▇, 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
88
and other expenses of organizing the Fund, distribution and selling costs, and
closing costs for the offering.
PLACEMENT AGENT - Ridgewood Securities Corporation, a Delaware corporation with
its principal office at ▇▇▇ ▇▇▇▇▇▇▇ ▇▇▇▇▇▇, ▇▇▇▇▇▇▇▇▇, ▇▇▇ ▇▇▇▇▇▇.
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;
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.
PROPERTY - 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
▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇ 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
89
program sponsored by Ridgewood and that have invested in the oil and gas
industry.
RIDGEWOOD SECURITIES - a Delaware corporation wholly owned by ▇▇▇▇▇▇ ▇. ▇▇▇▇▇▇▇
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
▇▇▇▇▇, the removal of facilities and environmental rehabilitation, if required.
SERVICE - The Internal Revenue Service.
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 - March 31, 2006 or as may extended 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.
90