Material Omission In Torchlight Resource's SEC Filings

Jun.25.14 | About: Torchlight Energy (TRCH)

Summary

Torchlight omitted relevant language, failing to disclose that it pays another company substantial fees.

Management has confirmed these payments in prior conversations, and another larger public company involved in the same arrangements discloses the payments.

Deloitte guide to preparation of financial statements shows company should disclose this type of arrangement.

I have written a few articles so far describing issues with Torchlight's assets, valuation, management team track record, and liquidity situation, all of which imply Torchlight may trade down by 75-100%. However, in the midst of further due diligence, I discovered something that may be even more concerning for current and prospective investors in Torchlight Resources (TRCH): Torchlight makes a material omission in its SEC filings. This could bring regulatory sanction to Torchlight and may expose the company to litigation risk by investors in offerings and in public market purchases. And this omission may risk Torchlight's ability to complete the financing that it has disclosed it needs to complete to remain in business.

Specifically, Torchlight is a participant in AMIs with Husky Ventures, an Oklahoma E&P. The AMIs are structured where Torchlight pays a 100% of the costs of land and wells drilled, and only receives 75% of the working interest in the wells. Husky, for originating the AMI, gets 25% of the working interest for "free". This is obviously a material fact, as it helps explain why Torchlight has spent so much money drilling wells and is receiving so little revenue from them, as discussed in this article.

However, there is no mention of these promote payments in Torchlight's recent 10-K. This is odd because it is a material fact. Beyond the obviousness of the necessity to disclose such a material deal on Torchlight's core asset, there is another way to tell that this arrangement needs to be disclosed. There is another publicly traded oil and gas company that participates in some of the same AMIs with Husky, Gastar Exploration (GST). Gastar is a much larger and much better financed company than Torchlight. It also has a much longer history as a publicly traded company. And the AMIs with Husky represent a much smaller portion of Gastar's business than they do Husky's business, as Gastar has substantial assets in Appalachia in the Marcellus and Utica shale.

In Gastar's recent 10-K, Gastar discloses the AMIs with Husky and explains the economics of the wells. Here is a link to Gastar's 10-K. On page 8, Gastar discloses that "For the first 12,500 gross acres acquired in the initial AMI prospect, we paid 62.5% of lease acquisition costs for a 50% leasehold interest and 50% of lease acquisition costs on additional acres in excess of 12,500 gross acres acquired for a 50% working interest. We will pay 54.25% of the lease acquisition costs in the two new prospect areas for a 50% working interest. In the initial prospect area, we pay 62.5% of the first four wells' gross drilling and completion costs and 56.25% of the next four wells' gross drilling and completion costs to earn a 50% working interest."

There is no such language in Torchlight's 10-K, nor is there any mention of economics or payments granted Husky. Obviously Gastar would not want to disclose this, as it shows unfavorable economics to them in their Hunton wells. The only reason Gastar would have disclosed this is because it is a material fact for Gastar that is required to be disclosed. All the more so for Torchlight, for which the Hunton AMIs with Husky represent the vast majority of asset value and production potential.

Furthermore, Torchlight management has confirmed in question and answer sessions and one on one meetings with investors that such a promote is paid on every well drilled with Husky and on all land bought through Husky. And Gastar Management previously confirmed that both Gastar and other AMI participants pay such a promote, and they confirmed that Gastar's deal is different from all other AMI participants. Because Gastar was the "anchor" investor in the Husky Hunton deal, Gastar got favorable terms where they only have to pay a promote on the first 8 wells. Torchlight was not an anchor investor and was thus required, like all other participants, to pay the 25% working interest to Husky on every net well drilled.

Deloitte provides a checklist for public companies to help them in their preparation of financial statements for submission to the SEC. This checklist with instructions can be found here. The appropriate place for a disclosure of the relationship between Husky and Torchlight is in the "Management Discussion And Analysis" section of the 10-K, which incidentally is where Gastar includes it. This section is covered starting on page 86 of the Deloitte document. There are several disclosure items this would fulfill, including items on page 89 and 90 of the report, such as "Describe any unusual or infrequent events or transactions or any significant economic changes that materially affected income from continuing operations. In each case, indicate the extent to which income was affected."

This failure of disclosure may be a nail in the coffin for Torchlight. This is not a minor oversight, it is a major economic aspect of Torchlight's largest asset.

Secondarily, it appears Torchlight's management team and affiliated entities have been making unusual purchases of Torchlight stock, at the end of the day and at a higher price than any other trade of the day. On a number of occasions recently, senior management and board members have filed a form 4 showing they purchased several thousand shares of stock. Only one affiliated person buys stock per day. What is in common is that the stock is purchased well above the volume weighted average price for the day, and in some cases is by far the highest price paid for the stock, and is purchased at the open or the close.

This activity by a senior executive officer of a company is a big deal, and is fortunately readily observable. On June 13th, Thomas Lapinski, CEO of Torchlight, bought 6,000 shares of Torchlight stock for $4.19 to $4.20 per share, as disclosed in an SEC form 4 filing which can be seen at this link (other similar insider purchases can be seen on the same website). The volume weighted average price paid for Torchlight stock on June 13 was approximately $4.05. And only 6,000 shares traded at $4.19 or above - obviously all of which were purchased by Mr. Lapinski, all of which were purchased in the last hour and 15 minutes of trading. There were two sets of purchases at that price, separated by other purchases below $4.19, making it clear that if Mr. Lapinski desired, he could have purchased shares at a lower price.

Here is a chart of the stock on that day and the daily volume, which tells the story described above.

Torchlight Stock Price June 13 2014Click to enlarge

Note the only purchases at $4.19 or above happened in the last hour and fifteen minutes of the day, and that there was an interlude between purchases at that price where stock could have been bought for a lower price around 3:30 pm. Instead, the remainder of the desired stock was purchased at the close, at the high price of the day, by the CEO, for almost 5% above the volume weighted average price.

Disclosure: This commentary is provided as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. The author(s) will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results. Statements in this communication are forward-looking statements of the author(s). The forward-looking statements and other views expressed herein are as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time due to numerous market and other factors. The author(s) disclaim any obligation to update publicly or revise any forward-looking statements or views expressed herein.

Disclosure: The author is short TRCH. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.