LXL Energy Handbook - 2014 A Guide to the Energy Industry for the in-house Energy Lawyer, Focusing in 2014 on International Private Acquistions
Contents Message to the Reader
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1.0 G lobal Trends and Recent Developments in Acquisitions
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2.0 Preliminary Considerations
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2.1 International Auctions 2.2 Acquisition structures - share sale or asset sale? 2.3 A dvantages and disadvantages of asset purchase v share purchase 2.4 Farm-Out (or Farm-In)
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3.0 Preliminary stages
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3.1 Seller Due Diligence 3.2 Buyer Due Diligence 3.3 Conditions and Consents 3.4 P re-Emption, right of first refusal and right to negotiate
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4.0 Sale and Purchase Agreements
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4.1 Effective Date, Execution Date and Completion 4.2 Consideration / Purchase Price 4.3 Purchase Price Adjustments 4.4 Conditions precedent 4.5 Completion and the “interim period” 4.6 Termination provisions 4.7 Warranties and indemnities 4.8 Post-Completion Issues
44 45 46 50 51 52 53 57
5.0 Concluding Remarks
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2014 - A bird’s eye view
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Message to the Reader We are pleased to present our 2014 Energy Handbook. As with previous years this book has been written for the lawyers working in our clients’ companies and for other friends of the firm. It is presented in hard copy and in an interactive pdf version and we hope that you will find it a useful tool to aid your work. This year we have focused on acquisitions of oil and gas assets. As every corporate and commercial lawyer will know, assets can either be acquired directly or indirectly by purchase of the entity that owns them. In transactions that are governed by English law, as most international deals are today, the forms of agreement that deal with these are well developed. But there are always lessons to be learned and specific aspects relevant to the particular deal to be addressed and covered. This point is no more true than in relation to transactions involving oil and gas assets where the nature of the underlying product being acquired and the complex relationships between state, counter-parties and owners have to be carefully borne in mind when drafting the legal documentation. In 2012 we focused on the Gas and LNG sectors and the global Gas Supply Chain and in 2013 on Disputes and Arbitration in the energy sector. We sincerely hope that you will enjoy this latest contribution to the series. As ever and since the writers are also lawyers we must highlight that we are not in this book providing any legal advice and as such we must also exclude any liability for any damages that may arise upon reliance on any of its content.
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A personal thanks must go this year to our partner Giulia Carloni, who has worked hard to put this edition together ably assisted by our colleague Ali Lazem. As a boutique energy law firm, the partners of LXL LLP sincerely hope that the reader and user of this handbook will appreciate its contents and may think of using us if external legal assistance is ever needed. Once again we would like to dedicate this handbook to those lawyers who we have had the pleasure of working with over the years, and in particular to those lawyers who have become friends as well as colleagues.
Alan Jones LXL LLP 28th August 2014
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1.0 G lobal Trends and Recent Developments in Acquisitions
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Below we set out the key recent trends and developments in international acquisition transactions in the oil and gas sector: • 2013 saw the focus on the development of existing resources rather than acquisition of new ones – many producers focused on developing properties acquired in the previous years, that is in streamlining operations and maximising returns on assets.
• Globally, the industry saw a drop of 41% in deal values, from US$349
billion in 2012 to US$205 billion in 2013 and a completion of 119 fewer deals in 2013 than in the previous years. Notably in 2013 there was a reduced willingness to commit to larger transactions.
• However, with an average of almost four transactions every day, oil and gas has remained one of the most active and resilient global sectors for M&A.
• The US and Canada were the centre of deal activity in 2013, accounting for 64% of all transactions.
• Many of the largest deals were strategic and enabled companies to increase their exposure to unconventional plays1.
• One of the interesting features of 2013 is that outbound NOC invest-
ment has continued. The overall rise in prominence of NOCs and the continued growth in NOC to NOC partnerships and relationships will continue to drive the shape of the industry.
1 Source: Deloitte – Oil & Gas Mergers and Acquisitions Report Year-End 2013 – The Deal Market Quiets Down.
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• Global M&A in the energy, mining and utilities sector during Q1 2014 hit the lowest Q1 since 2006 (US$ 54.7bn) with only US$ 87.5 bn-worth of transactions, which represents an 18.9% slump from Q1 2013.
• The decline in deal values results in the energy, mining and utilities (EMU) sector accounting for just 14.3% of the total global M&A value (US$ 613.7bn) in Q1 2014.
• The largest EMU transaction in the first quarter of 2014 was the
nationalisation of YPF Sociedad Anonima by the Argentinian Government acquiring a 51% stake from the Spain-based Repsol. The settlement deal was valued at US$ 8.3bn and further emphasises the new overall EMU trend in lower valued deals which has failed to register any deals above the US$ 10bn since last April’s US$ 14.4bn acquisition by Russian Grids of a stake in the Federal Grid Company of Unified Energy System.
• All of the top deals during Q1 in 2014 involved cross-border activity – highlighting the continued needs in the global energy industry and the maturing of the North American shale oil and gas revolution. North America remained the most targeted region for EMU deals with US$ 29.3bn worth of transactions announced but the value shrank by 40% from Q1 2013.
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• Upstream energy producers find themselves under pressure to
operate more efficiently, leading to divestures such as those made by Royal Dutch Shell, BP, Newfield Exploration and Devon Energy.
• Sustained high oil prices, coupled with strong stock valuations for
independent oil companies is a reason for large companies feeling deterred from takeovers.
• Similarly, well-run operations are being rewarded for paying out dividends and developing assets with existing cashflow, rather than taking on additional leverage for new transactions or funding new growth.
• In terms of future trends, there could be a new cycle in the energy sector, particularly in the US fuelled by shale gas. We should witness increased demand driven by the availability of cheaper energy in that market. North America saw lower deal values in all sub-sectors2.
2 Source: MergerMarket.
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2.0 Preliminary Considerations
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“Success is a science; if you have the conditions, you get the result”
In preparing for a sale of upstream assets, one of the first considerations for a seller will be identifying exactly the assets that will be for sale.
Oscar Widle
• an undivided interest in and under any relevant joint operating
The assets will normally comprise the following:
• an undivided interest in the relevant licence/concession granted by the host government in respect of a specific geographic area (known as “contract area” or “licence area”); agreements;
• an interest in other ancillary agreements relating to the exploration,
development or production (such as unitisation, product sale and transportation agreements); and
• physical assets relating to the exploration, development or production of petroleum.
Both seller and buyer will need to consider at the very outset of a proposed transaction a number of key issues as they may affect the timeframe as well as the way the transaction will be structured. These are:
• any governmental and/or third party consents and conditions which will be required to complete the deal;
• any third party pre-emption rights; • any commercial “must haves” (for example, a seller may wish to
divest a package of assets and focus its operations in a different world region, or the buyer may wish to secure operatorship of one or more assets as part of the acquisition process);
• any funding requirements - a buyer will need to consider how it will
intend to finance the acquisition and provide comfort to seller as to its funding means at a very early stage;
• a ny shareholders’ approval required in order to enter into the transaction; • any tax implications – separate tax advice should be sought very early in the acquisition process since the structure ultimately adopted for the sale will have an impact on the tax position for both parties.
Another consideration for seller will be how it wishes to sell the assets, for example by way of a formal bidding/auction process; alternatively it may wish to simply engage in one-to-one negotiations with a particular buyer.
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2.1 International Auctions The most common method used by seller in the oil and gas industry to dispose of a company or its business is by way of international auction. This process will involve contacting an initial group of prospective bidders to gauge interest and seek to agree certain confidentiality terms with each of them. At this stage, no meaningful commercial or financial information is disclosed as sellers will wish to eliminate any non-genuine interest from companies who may be seeking to gain access to some information from a competing market player. Once this stage has been undertaken, the seller will ask each identified potential buyer to enter into a formal Confidentiality Agreement, in order to allow it to disclose further information. In light of the fact that several companies will be involved in the process there is a greater risk of information being leaked, therefore the confidentiality obligations will be placed not only on the bidders themselves and their affiliates, but also on their advisers and anyone else who may generally become involved in the sale process. The principal confidentiality terms will include an obligation to keep the proposed sale confidential and to use the information disclosed only for the purposes of the proposed transaction. They will also commonly include provisions to the effect that a bidder cannot make any approach to the target’s customers, management or employees. Prospective buyers will also be receiving an “Information Memorandum”, which will provide prospective bidders with a history of the business, a description of its main assets and general information about key commercial and legal agreements pertaining to the business being sold. The seller will wish to ensure that the Information Memorandum does not contain any misleading statements. However, any Information Memorandum will invariably contain a very detailed disclaimer and a seller will generally be very wary of giving any warranties in relation to the accuracy of its contents on the basis that ultimately it is intended to be a selling document only. At the same time as issuing the Information Memorandum, the seller will issue what is known as a “Process Letter”. Its purpose will be to ensure that all offers received are made on a basis which allows the seller to compare these with each other.
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It further aims to identify at an early stage whether there may be any regulatory issues, clearances or other conditions which may impact on the transaction and affect its successful completion. A restricted number of potential buyers will then be asked to submit written non-binding “indicative offers” – these will need to be carefully drafted and attention should be paid to the exact terms and conditions which the seller had requested in its process letter so to ensure that the offer will be compliant with all its terms. Generally, buyers will be asked to confirm any key assumptions which they may have made in arriving at a total consideration, to set out what plans they might have for the business, what circumstances there may be which might delay the transaction (e.g. any board or shareholder approval to be obtained) and, importantly, set out how they intend to finance the acquisition. Although this is a very short document and is not intended to be legally binding, it is very important to set out clearly what assumptions the buyer has made to value the business as well as to disclose any issues which it anticipates will impact the timeline for the deal, as this will ensure that both parties are aware of the steps which need to take place for the transaction to complete. Those prospective buyers who are then short-listed will be provided with more detailed insight into the target so that they can revise and firm-up their original offers. This is often done by way of providing the potential buyers with a “seller due diligence pack” which consists of a number of documents including e.g. an accountant’s report into the target company’s financial history as well as all the main legal and commercial agreements which will be placed in a data room (more often than not, this is a virtual/electronic data room as opposed to a physical one). In most cases, the data room will also contain a first draft of the sale and purchase agreement (“SPA”) – this draft will confirm whether the proposed sale is intended to be structured as a share or asset sale.
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2.2 Acquisition structures - share sale or asset sale? Most acquisitions are structured in two fundamentally different methods, a share sale or an asset sale. In a share sale the buyer effectively purchases the issued share capital of the target company owning the underlying energy assets. In this structure, only the ownership of the company would change whilst the target continues to trade as usual. Theoretically, a share sale is less complex than an asset sale, which typically involves the transfer of several individual assets and therefore requires careful consideration in identifying exactly what these are, as well as often having to obtain third parties’ consents and approvals. However, in a share sale, extensive due diligence is required as the buyer purchases the shares of the target company who owns the business together with all of its other assets and liabilities. Therefore a buyer will want to perform thorough due diligence to establish what liabilities it will be assuming. In oil and gas transactions, these could potentially be very significant, e.g. unknown environmental liabilities (with buyers having to assume the risk of potentially significant costs/claims for liabilities arising before it even owned the business) as well as high decommissioning costs for retired assets such as platforms or pipelines no longer utilised for oil and gas production or transportation. Conversely, in an asset sale the buyer purchases all individual assets that form the business, whereas the liabilities of the target company can be left behind with the seller. This provides for greater flexibility for the buyer who would want to avoid liabilities that are difficult to assess. Accordingly, in a share sale the buyer is purchasing the business as a going concern and thus benefits from continuity of the business with minimal disruption, whereas in an asset sale the buyer will be operating the business after the relevant assets and the goodwill of the target business have been transferred to it.
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Generally speaking, a buyer will seek to purchase the business via an asset sale free of all liabilities. On the other hand the seller would seek to free itself from all the liabilities that are linked to the target company. However, it is never usually as simple as this as, for example, the seller will want to pass all liabilities for the business it is selling to the buyer even if the deal is structured as an asset deal, and moreover in some jurisdictions liabilities pass to the buyer whether or not an asset structure is chosen. The choice of structure is ultimately determined by the objectives and intentions of the parties as well as a range of other factors – these include the attitudes of third parties (customers, contractors, suppliers); bargaining power of the parties; potential liabilities and commercial and tax considerations.
2.3 Advantages and disadvantages of asset purchase v share purchase Whether the deal will be structured as a share sale or an asset sale will also depend on various commercial considerations. We set out below some of the main advantages and disadvantages of both structures which will form any analysis made by either party in structuring the deal.
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1. Share Sale Advantages Seller
• sells the entire company, • careful consideration will need to be given to inclusive all liabilities and achieves a clean break – e.g. can be used where seller wishes to exit a specific country/region;
• a corporate seller could enjoy significant tax exemptions.
Advantages Buyer
what the parties will wish to do in respect of any assets or liabilities held within the target entity that the seller does not wish to sell or the buyer does not wish to assume as a result of the purchase. This will involve assessing whether it is possible (both in practical terms as well as under applicable laws) to transfer such assets and liabilities out of the target entity before completion of the sale.
Disadvantages
• purchases the entire company • possibly subject to change of control proviinclusive all of its assets, employees and contracts that are required to run the business;
• benefits from the business’s continuity as it continues to trade without any disruptions;
• most likely not affected by pre-emption rights as most joint operating agreements’ provisions relating to restriction on transfers do not apply in respect of share dispositions;
• m ay have access to the target company’s tax losses, which it might be able to use to offset taxable income within the buyer’s group;
• more straightforward than an asset sale as only shares are being transferred, although this is balanced by the level of due diligence that is required.
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sions in the JOAs and other applicable agreements, including the licence or concession agreement given by the relevant government – this needs to be considered at the very early stage of the legal due diligence to analyse what procedure and restrictions are in place (if any) which apply to the proposed sale (e.g. obtaining a letter of comfort from the relevant governments in the countries in which the oil/ gas interests are located);
• purchasing all the liabilities whether contingent or disclosed;
• requires extensive due diligence and negoti-
ation, therefore the process will be time-consuming and costly;
• careful consideration will need to be given to
any assets or liabilities held within the target entity that the seller does not wish to sell or the buyer does not wish to assume as a result of the purchase. As above this will involve assessing whether it is possible (both in practical terms as well as under applicable laws) to transfer such assets and liabilities out of the target entity before completion of the sale.
2. Asset Sale Advantages Seller
Disadvantages
• where the intention is to sell • if a seller intends to sell its entire business, it will only part of its business;
be left with unwanted assets and liabilities;
• can use the tax losses within • typically requires a large number of third party its group after the sale of the assets;
consents, approvals, novations and assignments, all of which may affect the timeline of the transaction and potentially even the deal;
• usually subject to double taxation; • likely to be subject to certain pre-emption rights set out in any applicable JOAs which may affect both the timeline of the sale as well as buyer’s overall evaluation of the deal;
• in international transactions (e.g. non-EU coun-
tries such as those based in the Pacific Rim), employees may not be able to be automatically transferred from seller to the buyer, in which event the seller will have to terminate the existing contracts and the buyer will need to issue offers of employments. A seller will therefore likely incur termination payment liabilities.
Buyer
• buyer can minimise the risk • typically requires a large number of third party by “cherry picking” the assets and liabilities;
• cherry picking could result in
simpler and quicker due diligence than in a share sale;
• can reflect the fair market value of the assets by allocating the purchase price among the assets;
• potential tax advantages for
consents, approvals, novations and assignments, all of which affect the timeline of the transaction and potentially even the deal;
• usually subject to double taxation; • likely to be subject to pre-emption rights proce-
dure set out in any applicable joint operating agreement(s), which may affect both the timeline of the sale as well as potentially the deal if pre-emption rights are exercised by existing JV partners.
a buyer;
• not subject to change of control provisions (but see pre-emption rights in disadvantages).
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2.4 Farm-Out (or Farm-In) An additional structure which an acquisition can take in the circumstances described below (which is typical to the oil and gas sector), is by way of “farming in” to a party’s upstream asset. Although there are many similarities between a farm-in and an asset sale, certain features are peculiar to the farm-out structure. These are as follows:
• in the farm-out, the seller (“farmor”) agrees to assign whole or
part of its upstream asset to a buyer (“farmee”) in return for the farmee agreeing to pay an agreed share of actual work programme costs (for example, 20% share of costs in return for 20% interest in the asset);
• in addition, the farmee may agree to pay a “carry” – that is, a
contribution to the farmor’s share of work programme costs and may include both an element of reimbursement for historical costs as well as an advance payment in respect of future budgeted costs;
• it is common for carry costs to be recoverable by the farmee and to be capped, often at the budgeted costs of the minimum work obligations under the relevant host government’s licence/agreement; and
• the farm-out structure is usually used for assets in the explo-
ration stage with outstanding minimum work commitments and in most cases the seller will retain some interest in the asset (and possibly the operatorship).
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A farm-out allows the seller to reduce its interest in an upstream asset by sharing the risks and costs and by bringing in new technical expertise or help with funding the work commitments. Conversely, buyers tend to prefer this structure where they are interested in high-value asset investment opportunities as farm-out arrangements have a lower upfront capital investment, since they are very unlikely to have any existing reserves before the farm-out, whilst also carrying a larger upside potential in the event of a discovery.
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3.0 Preliminary stages
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“Better three hours too soon than a minute too late” William Shakespeare
Pre-SPA preliminary stages are crucially important in identifying items that can make the deal (like an agreed purchase price) or break it (like discovering a pre-emption right which is likely to be exercised or a consent which is unlikely to be given). Legal due diligence is an essential step of any acquisition, as this process is intended to identify any potential hidden liabilities, which in turn will allow the parties to draft appropriate provisions in the SPA, in particular representations and warranties, covenants and indemnification provisions, as well as the necessary disclosures (all of these will be discussed separately in the context of the SPA – see section 4). This section 3 will set out the key seller due diligence due diligence considerations, a more expansive section on buyer’s due diligence, decommissioning matters, general corporate issues such as employment, and approvals/consents.
3.1 Seller Due Diligence 3.1.1 Why Seller Due Diligence? Although the primary focus of any due diligence exercise in a deal is often the buyer’s due diligence, seller’s due diligence is also important as the seller will need to establish the reasons for a buyer’s interests in the acquisition, the reputation of the buyer, and most importantly the financial legitimacy of the offer – i.e. does the buyer have the cash or credit rating to make good on the asking price and does the buyer have a reputation of pulling out of potential acquisitions? 3.1.2 Seller Due Diligence on Relevant Agreements The seller will conduct due diligence on agreements relevant to the target(s) to ascertain confidentiality obligations as well as assignment and pre-emption rights: (a) Confidentiality Confidentiality obligations under the relevant agreements must be considered as third/counter party consent may be required for disclosure of the existence of agreements and any of their content. If consent is required, then the seller would have to consult with the relevant parties, which of course gives the parties a heads up to the divestment about to take place – somewhat earlier than what would perhaps be commercially intended.
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The need for consent could give third/counter parties the ability to:
• prevent disclosure of the agreements; • prevent disclosure of information and data contained in the agreements or that can be established by reviewing the agreements.
(b) Assignment, Change of Control and Pre-Emption Rights The seller will have to review assignment, change of control and pre-emption provisions in the relevant agreements as these can all affect their transferability. Upon review of the relevant provisions, the seller might be persuaded to structure the sale as either an asset or a share sale. For example, if the seller planned on marketing the sale as a share sale, a due diligence review of assignment and change of control provisions might pose issues when selling the business as a whole, whereas an asset sale would allow cherry-picking of assets. 3.1.3 Other Seller Due Diligence Concerns In order to obtain consent from interested third/counter parties, the seller will have to ensure that a potential buyer is able to comply with responsibilities that come with the purchased interests as well as considering the following:
• sound financial standing to meet its obligations (including e.g. decommissioning);
• buyer’s environmental reputation; • competition laws/regulations; and • buyer’s technical and legal capabilities. It falls on the seller to satisfy the other parties that the buyer will be able to comply with the acquired responsibilities, failing which the remaining parties could reasonably withhold their consent to the transfer. For much the same reasons, the relevant minister or governmental department will also require the seller to find a suitable and credit-worthy buyer.
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3.2 Buyer Due Diligence The necessity of buyer’s due diligence can be found in one of the oldest contract law principles – caveat emptor (“buyer beware”), which comes from the typical information asymmetry of sellers knowing more about the interests being sold than the buyer, and the buyer needing to find and extract information from the seller. It is however common that even the seller may not know the information the buyer is seeking! In light of this principle, a buyer will need to make appropriate enquiries and thorough due diligence prior to acquiring the business. The starting point of this exercise – being crucial to buyer’s ability to gain legal ownership of the assets – is investigating seller’s title. 3.2.1 Investigation of title Investigating title is a question of: “does the seller have good title to what he is selling?” This stage of due diligence must not be overlooked, even though it might seem obvious on the face of it that the seller has good title. In all likelihood, title in energy interests will be ‘good’ because there are several checks and balances involved, including its rights being cemented by (and deriving directly from) government authorities, agreements being entered into with other companies in relation to the assets, and often the assets for sale having been already involved in several previous transactions, including being bought by the seller itself. Therefore, whilst it is most likely that the seller will have good title, investigating the seller’s claim of the same is the most essential of buyer’s due diligence tasks because of the legal principle nemo dat quod non habet – “no one can give what he does not have”, and caveat emptor dictates that the buyer needs to investigate this to avoid any complications and complex litigation in the future. Title is investigated by following the trail/chain of previous ownership and making sure that whenever the target assets were previously transferred (if at all), the transfers were completed properly and there are no irregularities with the chain of title.
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This involves checking for parties’ signatures on transfer documents, including inter alia deeds of novation and accession to the:
(i) licence(s)/concession(s);
(ii) operating agreement(s);
(iii) deeds of accession/novation/amendment to the above.
The buyer will trace the above agreements to ensure that the seller validly holds the percentage interests that it claims to own and wishes to sell. In the UK, a buyer will also check the Department of Energy and Climate Change (“DECC”) website which has records of parties’ interests and roles in specific licences and blocks, including percentage interests, whether they are operator and which group a company falls under. This resource proves to be a helpful guide to compare DECC’s record with the seller’s Information Memorandum, and with the more conclusive facts/information ascertained from the relevant agreements/deeds. It is also important to examine how secure the seller’s title is. In doing so, the buyer’s legal team must verify whether the upstream asset is in a joint development zone or is part of a unitised area or whether unitisation is possible/likely to occur in the future. 3.2.2 Encumbrances, charges, royalties and third-party rights A buyer will seek to ensure it acquires assets/companies free from encumbrances, charges and third party rights. In addition to raising relevant enquiries with the seller, the buyer will also have to conduct its own investigation into this. When a third party (most likely a bank) takes security against a specific asset or group of assets, company shares or anything else, it will register its interest in a public domain. In the UK, third parties register their charges at Companies House and their charges are listed in order of priority. Encumbrances more likely to affect an upstream asset include local participation rights, overriding royalties or charges on net profits, and bonus payments.
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3.2.3 Existence of agreements and main commercial terms: The legal due diligence report will highlight the following in relation to any relevant agreements:
• • • • • • • •
their existence; the parties; when they were entered into / came into force; their purpose; their term; change of control provisions and pre-emption provisions; governing law and dispute jurisdiction; and the basic terms, which include inter alia:
- material rights and obligations;
- financial commitments; and
- conditionality
• any onerous obligations – these could affect the value of the asset. The agreements which are likely to exist include:
• • • • • • • • •
licence/concession/production sharing agreements; JOAs; bidding agreements; SPAs; gas sale agreements (“GSAs”); unitisation agreements; transportation/lifting agreements; pipeline agreements; and marketing agreements.
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Joint Operating Agreement As JOAs are vital agreements in that they regulate the rights and obligations of the licensees/concessionaries, they will invariably form one of the most informative parts of any legal due diligence report. As such, here we set out its key features. No one JOA, like any other agreement, will be identical to another. However, there are key elements to look out for when conducting a review of the JOA and its amendments, including:
• percentage interests; • the operator; • rights and duties of the operator, such as:
- right to resign and notice period;
- p reparation of programmes, budgets and AFEs (Authority for Expenditure);
- seeking approval of AFEs by JOC;
- i mplementation of programmes and budgets (subject to AFE approval);
- reports to participants concerning joint operations;
- obtaining requisite services and materials;
- accountancy obligations;
- provision of technical and advisory services;
- p reparation of a Development Plan and its submission to the relevant authorities (e.g. in the UK, to DECC);
• the partners’ voting percentage rights and comparing these with the target’s percentage interests;
• assignment provisions; • pre-emption rights (see section 3.4 below); and • abandonment/decommissioning obligations.
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3.2.4 Abandonment/Decommissioning A very significant liability that the buyer must be aware of is that relating to decommissioning/abandonment – therefore it is essential that at a very early stage of its due diligence, the buyer is aware of its regime and how this will impact its valuation. This will be located in the applicable host government’s law, treaties (where the licence area straddles a location which falls between two different jurisdictions), and in the relevant asset agreements (particularly, the JOA). The buyer also needs to determine the sufficiency of the security given by the joint venture parties (including and most importantly by the seller) and what its financial and other obligations will be after completion. 3.2.5 General Corporate Issues Another aspect that the buyer must be comfortable with is the seller’s ability to properly dispose of the assets. This applies whether the sale is a share or asset sale as the seller’s internal corporate process is likely to be nearly the same for either type of sale, namely board and shareholder resolutions. With share sales, the buyer would also have to conduct a due diligence on the entire target company, including all rights and liabilities affecting the target.
3.3 Conditions and Consents Some agreements relevant to upstream assets could contain restrictions on transfers. Although the JOA and host government agreements are the most likely to impose conditions or require consent for asset transfers or change of control in the case of a share sale, other agreements that might need to be considered include:
• • • •
offtake agreements service contracts transportation/pipeline agreements financing agreements
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The identification of third-parties from whom consent is required in order to transfer an upstream asset in an asset sale or for change of control of the entity holding the asset will be carried out by both buyer and seller. The parties that need to be identified will include:
• JV participants; • contracting parties in other agreements, e.g. pipe-line agreements, transportation agreements, SPAs and GSAs;
• the host government; • the state oil company; and • lenders. 3.3.1 Third-Party Consent Consents (or waivers) will be required in relation to assignment provisions and pre-emption rights. It may be possible for a third-party to withhold consent and completely derail a deal at its sole discretion; however in practice this right is unlikely to be absolute. If third-party consent is required under an agreement, the clause can be drafted in a number of ways with different grounds for withholding consent. The grounds are likely to be any of or a combination of the following:
• reasonable grounds; and/or • lack of financial or technical capability of the prospective buyer to perform the obligations under the contract; and/or
• absolute right to withhold consent (except for study-and-bid
group agreements, this is highly unlikely to be included in any agreements).
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Absolute rights for JV participants to veto a potential buyer are unusual because a potential seller should not generally be forced to retain an interest in a project which it would like to dispose of, especially if it has objectively found an appropriate purchaser of that interest. Therefore, instead of giving JV participants absolute rights to veto a sale, JOAs usually contain pre-emption rights which give the non-selling JV participants the option to prevent a sale (for subjective reasons) by acquiring the sale interests themselves. In the event that a JV partner does not pre-empt for subjective reasons, it cannot withhold consent for subjective reasons. Generally speaking, consent can only be withheld for objectively reasonable grounds, such as financial/technical capabilities of the new entrant to the JOA.
English Law and Consent – some key principles Under English law, the position with respect to simple consent, i.e. where a contract stipulates that consent is required but does not expand further on whether the consent must be reasonable, is that a term is implied in the contract that the power to withhold approval must be exercised in good faith and approval will not be withheld arbitrarily (Lymington Marina Ltd v McNamara and Ors [2007])3. This position has not changed since the Lymington case, but has been expanded further. In a case where a contracting party had an absolute discretion to withhold consent, the court stated that a contractual discretion given to one party to take a decision that affects another contracting party is limited “by concepts of honesty, good faith, and genuineness, and the need for the absence of arbitrariness, capriciousness, perversity and irrationality.”4 This is the case whether the discretion is absolute or not. The aforementioned concepts must be borne in mind together with what is referred to as the Wednesbury standard of reasonableness (from “Wednesbury unreasonableness”), which states that withholding consent will not be valid if a reasonable person acting reasonably would have given consent.
3 Lymington Marina Ltd v McNamara and Ors [2007] EWCA Civ 151, per Lady Justice Arden at para 44. 4S ocimer International Bank Limited (in liquidation) v Standard Bank London Ltd [2008] EWCA Civ 116, per Lord Justice Rix at para 66.
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The drafting of the consent clause is important. For example, in a case where a party had to act in “a commercially reasonable manner” with respect to agreeing to terminate a financing arrangement, in which it demanded payment of five years’ fees the English High Court decided that: (i) the consent giver must make a commercially reasonable decision in an objective sense (showing good faith and rationality was not sufficient);
(ii) t he consent giver need not justify the decision to withhold consent but he must prove that another person in the same position in that company might have reached the same decision;
(iii) t he decision maker can take into account its own commercial interests and these take precedent over the consent-seeker’s interests;
(iv) i n determining what is commercially reasonable, the consent-giver can take into account the necessity to protect its fee income, unless the nature or amount of that income is so disproportionate to the consent seeker’s obligation to continue with the contractual arrangement that no commercially reasonable man in the consent giver’s position could refuse consent.5
The Court of Appeal upheld the High Court’s decision, deciding that the consent-giver is entitled to prioritise its own commercial interests as part of the manner in reaching its decision. Vitally, making a decision in a commercially reasonable manner did not mean the decision maker had to come to a mutual or mutually satisfactory outcome.6 Lessons can be learned from these cases even though they are not JOA focused. For example, in the context of a JOA, if this does not state that technical capabilities are ground for refusing consent, and consent must be refused only in a commercially reasonable manner, it could be commercially reasonable for a JV partner to refuse consent on the basis that the lack of technical know-how of the expected new entrant will cause it to assume a greater supervisory role, which could be said not be commercially reasonable. 5 Barclays Bank plc v (1) Unicredit Bank AG (formerly known as Bayerische Hypo-Und Vereinsbank Ag) and (2) Unicredit Bank Austria AG [2012] EWHC 3655 (Comm), per Popplewell J at para 69. 6 Barclays Bank plc v Unicredit Bank AG (formerly known as Bayerische Hypo-Und Vereinsbank Ag) & ANR [2014] EWCA Civ 302, per Longmore LJ at para 17.
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3.3.2 Host Government Consent Consent of the host government is almost always necessary pursuant to transferring the interests under a licence, concession agreement or other similar agreement. The host government approval will generally be from the relevant ministry or minister, such as DECC or the Secretary of State in the UK, and in many countries the ‘Minister/Ministry of Petroleum’. (i) UK Asset Sale In the UK, after entering into an SPA for an asset sale, the seller applies to the Secretary of State for consent to the licence assignment; the Secretary then transmits its consent to the deed (which could be the Master Deed or the traditional standard deed of assignment); the buyer, seller and remaining JV Partners (usually referred to as ‘Remaining Participants’ in deeds of assignment) execute the deed of assignment (traditional or Master Deed form) – this will normally state that “the Secretary of State has given his/her consent to this assignment” or similar drafting; the buyer and seller then inform the Secretary of execution and completion – this is now done online via DECC’s online energy portal; the Secretary then updates its records.7 (ii) UK Share Sale Parties to a share sale in the UK need to be aware of the “Model Clauses”. The Model Clauses are statutory regulations which are incorporated into onshore or offshore licences (as applicable). The Model Clauses which are relevant to offshore oil and gas exploration are currently contained in the Petroleum Licensing (Production) (Seaward Areas) Regulations 2008. Model Cl. 41(3) gives the Secretary the power to revoke the licence when the licensee is a company that has undergone a change of control. It is therefore common practice for companies undergoing a change of control to obtain a letter of comfort from the Secretary, even though this is not legally binding. Change of control is defined in Model Cl. 41(4) as having occurred when a “person has control of the Licensee who did not have control of the Licensee when the licence was granted (or, if there has been an assignment or assignation of rights conferred by the licence, when those rights were assigned to the Licensee)”. Model Cl. 24(2) should also be borne in mind – this gives the Secretary the power to revoke a licence from an operator when the Secretary considers the operator is “is no longer competent to exercise that function”. This determination could be made by the Secretary if an operator has undergone 7 Although not immediately available online following notification to the Secretary, parties and the general public can check licence information on DECC’s website: https://www.og.decc. gov.uk/information/licence_reports/offshorebylicence.html
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a change of control and, as above, a company that is an operator and is undergoing a change of control would obtain a reassurance in the comfort letter from the Secretary on this point also.
3.4 Pre-Emption, right of first refusal and right to negotiate 3.4.1 What are they? “Pre-emption” clauses, generally speaking, give non-selling JV participants the option to purchase the sale assets before they are sold to a third party. Such clauses are seldom uniform and each must be analysed carefully on its own merits on a case-by-case basis. However, generally speaking, they take three forms, each of which will be bespoke in a specific agreement, mainly JOAs: (i) a true right of pre-emption: the seller is obliged to offer the JV partners the sale interests on the same terms and conditions agreed with a third party buyer;
(ii) a right of first refusal: the seller offers the JV partners the sale interests before agreeing terms with a third party buyer (the seller usually cannot then sell the interests to a third party on lesser terms than those offered to a JV partner); and
(iii) a right to negotiate: the JV partners can negotiate with the seller to reach an agreement to purchase the interests for a specified period of time, after which the seller can freely assign to a third party buyer even at a lower price than any offered by a JV partner. In this section, we refer to (i) and (ii) above collectively as pre-emption rights. Pre-emption rights are seldom triggered by a proposed transfer of the assets to an affiliate of the seller. An affiliate would be a defined term in the JOA, e.g. “a legal entity that controls, is controlled by or is controlled by an entity that controls a party” (i.e. the seller)). In JOAs for UK upstream assets, affiliate is normally defined by reference to the Companies Act 2006 and for JOAs entered into before 2006, the Companies Act 1985. It is not uncommon for assignment and pre-emption clauses to
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be merged into one. An example of this can be demonstrated with the following chain of sub-clauses (in outline only). “Assignment and Pre-Emption
X.1 N o assignment or transfer (whether total or partial interest) unless in accordance with the clause.
X.2 A party can assign or transfer its interests to an affiliate company subject to notice being given to the JV parties and that the seller proves the financial (and possibly technical) capability of the affiliate to meet the obligations it shall assume under the JOA.
X.3 Or, other than as provided in X.2, a party can dispose of its interest (total or partial) (“disposing interests”) to a third party (i.e. not an affiliate or a JV partner). The proposed seller will give notice to its JV partners of the proposed assignment, the price (if not in cash terms, an equivalent in cash value), as well as details of the prospective transferee (if any). The JV partners then have a 30 day pre-emption right to purchase the disposing interests in accordance with their percentage interests under the JOA for the same price and terms and conditions as has been offered to a third party.
X.4 If none of the JV participants exercising their right under X.3 above, then subject to obtaining consent of the relevant authorities (such as, in UK, the Secretary of State), the seller can assign the disposing interests within 60 days after expiry of the 30 days at X.3 above. This assignment however is subject also to the seller proving the financial (and possibly technical) capability of the prospective transferee to meet the obligations it shall assume under the JOA.
X.5 I f a transfer/assignment is made pursuant to X.2, X.3 or X.4, the pre-emption rights under X.3 shall continue in relation to the transferred/assigned interests.8
X.6 I f the disposing interests are not assigned within the 60 day period in X.4, then this clause shall apply to any future proposals to dispose of the interests as though an offer to dispose had not been made in the first instance”.
8 This means that the clauses will have effect in the future if/when the transferee/assignee decides to dispose of the assets
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3.4.2 Why are pre-emption rights included in upstream oil and gas agreements? Some of the parties with interests in the upstream assets, including the JV participants, the national oil company (if any) of the state where the assets are, and the host government, might prefer to avoid having a new JV participant for a number of reasons, including:
• concerns over the potential JV participant not having the
financial and technical know-how required by the role it may assume with its acquisition (of course the seller could prove to the relevant parties with pre-emption rights that the potential participant has the necessary capabilities);
• avoiding a business relationship with a particular potential
buyer – reasons can be political or commercial, such as the reputation of the potential buyer (e.g. environmental record, reputation of being obstructive in decision-making, or not living up to its obligations);
• avoiding having more JV participants (if the seller does not
sell its entire interests in the assets) which can complicate decision-making procedures as well as potentially creating more financial risk; and
• wanting the sale assets for themselves if the project is advanc-
ing well or the JV participant wanting to exercise pre-emption rights has the opportunity to sell the interests at a premium after purchase (this is called making a “turn”) or swap the interests for assets elsewhere.
Pre-emption rights, although very common in the upstream oil and gas industry, are not as popular as they once were. In the UK, for example, with effect from 30 June 2002, JOAs entered into for UK North Sea projects can no longer contain “pre-emption arrangements” – pre-emption rights in effect before that date still have effect, except for JOAs which fall under arrangements of the Master Deed which have new arrangements for pre-existing pre-emption provisions (please see section 3.4.5 below for more on this and the reasons behind the ban on pre-emption rights in UK North Sea projects).
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3.4.3 When do they become relevant? Pre-emption rights become relevant as soon as the decision to sell is taken. This is especially so with respect to a right of first refusal and a right to negotiate whereby the seller must invite offers from the JV partners before agreeing terms with a third-party buyer. Whatever type of pre-emption clause applies to the proposed transaction, the seller and buyer will consider the pre-emption clauses at a very early stage to ascertain whether (and if so, how) they apply to the proposed deal. Pre-emption rights would be considered, although not be necessarily applicable, in the following situations:
• the ‘seller’ is transferring the interests as part of an intra-group transfer - however as stated above, they are unlikely to be triggered as transfers to affiliates are generally permitted;
• t he seller decides to farm-out its upstream oil and gas interests; • a proposed sale/transfer of the shares in the company/special purpose vehicle holding the upstream interests;
• a proposed sale/transfer of all or some shares in a company that indirectly holds the upstream interests;
• the granting of the option for a party to exercise any of the above situations; and
• the granting of security over the interests or the shares of the company that directly or indirectly holds the interests.
The seller and buyer will also have to consider at what stage JV partners should be approached, in both a legal and a commercial sense. Finally, the buyer, in considering pre-emption rights during the due diligence stage, may wish to consider the provisions as though it was already a JV partner and how they will affect it when selling the interests in the future and how it may be impacted by other JV partners selling their own interests. 3.4.4 How to avoid triggering pre-emption rights As a JV participant would have to match the quantitative value and terms and conditions agreed by the seller with a prospective third-party buyer, the seller and third-party buyer could use this to avoid pre-emption rights from being exercised by structuring the deal in legitimate ways that cannot (or are at least very likely not to) be matched by the JV participants.
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(a) Non-cash consideration Sometimes referred to as ‘the unmatchable deal’, the buyer can offer non-cash consideration which it knows the JV participants cannot match. This can include a swap/exchange where the buyer offers interests in other upstream assets that it holds, equity in the buying company or one of its affiliates, and even loan notes. One difficulty with non-cash consideration is that provisions may be found (normally contained in JOAs) which require the seller to allocate a cash value to the interests if non-cash consideration is expected from a buyer. A JV partner could then exercise its pre-emption rights by paying the equivalent sum in cash. If the JOA does not contain a cash-equivalent provision, the unmatchable deal may very well be within the remit of the seller and buyer to avoid triggering pre-emption rights. The rationale here is that cash-equivalent provisions have been within the know-how of JOA negotiators for many years and if they are not included in a JOA, the omission would have been a conscious decision by the drafters. (b) Indivisible package deal Another method of avoiding pre-emption rights is by making the assets for sale seemingly an indivisible package which cannot, under the terms of the SPA, be split between parties. Package deals can be effective in avoiding pre-emption rights on the basis that the seller will dispose of the set package of interests for a certain consideration which a JV partner cannot pre-empt because a cash value has not been assigned to specific interests which are pre-emptable (i.e. are subject to pre-emption rights). The effectiveness of such an approach, however, is far from guaranteed as JV partners could claim one of two things:
(i) that the right to pre-empt cannot be denied and a fair cash value should be assigned to the relevant asset; or
(ii) the right to pre-empt the entire package even if they have pre-emption rights in a JOA relating to only one of the sale assets.
Another method for avoiding pre-emption rights in a package deal is pricing assets that can be pre-empted with a high cash value and those that cannot with a lesser value which balance out in the end as consideration for the entire package (see further below).
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(c) Affiliate route A share sale is another acquisition method in which pre-emption rights are unlikely to be triggered, however that might not be effective if the JOA contains change of control provisions. There have been documented cases of sellers transferring particular assets to an affiliated shell company and the shares in the shell company then being sold to a third-party buyer. The legitimacy of this can be questionable, however, depending on the circumstances of the transfer to the affiliate and subsequent sale. Most importantly, JOAs can and often do have provisions to prevent such a deal structure by requiring the affiliate company to hold the assets for a minimum period of time (e.g. 2 years) before its shares can be sold. Such provisions would also give JV partners the right to require the transaction to be unwound so that they can pre-empt if the affiliate ceases to be an affiliate before the expiry of the 2 year period and/or to ensure the pre-emption provision applies on a direct or indirect sale i.e. by way of an affiliate. The transfer to an affiliate in order to bypass pre-emption rights is known as an ‘affiliate’ route or a ‘hive-up’ route (also in the US as the ‘Texas two-step’). If the transfer of assets to an affiliate is notified to JV partners when it is known that arrangements are already in place to sell the shares in the affiliate, the co-venturers could try to pre-empt on the basis that the affiliate is not a true affiliate. The strength of the argument by JV partners would largely depend on the state of the deal to sell the shares – this is a beneficial vs legal ownership debate. It must be emphasised that should an affiliate route be utilised (where there are no change of control provisions and/or no clauses providing that the affiliate holds the assets for a minimum period of time before its shares are sold), aggrieved JV participants may have a claim that the pre-emption clauses were breached. Under English law the courts would likely look to the true intent underlying the transfer to the affiliate and there might be a liability if it is found that the transfer took place to avoid contractual obligations. Where there are pre-emption rights the buyer would be prudent to request the seller to provide an indemnity that it has complied with the pre-emption rights procedure.
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Meaning of “Affiliate” under English Law The Court of Appeal and Supreme Court decisions in Farstad Supply AS v Enviroco Ltd (No. 2) affirmed that on a true construction of the meaning of subsidiary under the Companies Act, the holding company must (i) be a subscriber of the subsidiary’s memorandum of association, (ii) be a member on the subsidiary’s registration, and (iii) be entered as such in the subsidiary’s register of members (however where there is a chain of ownership, which is often the case, the definition will still be satisfied – i.e. a company will still be a subsidiary of the ultimate parent when the subscriber to its shares is a subsidiary of the ultimate parent – this definition will be satisfied up and down the chain of ownership). The issue in Farstad was the pledge by a ‘parent’ company of shares in its supposed subsidiary (Enviroco) to a bank as security. As part of the pledge, the ‘parent’ company’s secured shares were registered in Enviroco’s register of members in the name of the bank’s nominee. For that reason, the Court decided that Enviroco was not a subsidiary of the parent company under the Companies Act. On the basis of this Court decision, a JOA that defines affiliate with reference to the Companies Act should either be avoided or, if unavoidable, a clarification should be included to exclude the decision in Farstad and/or emphasise that a company is still an affiliate even if its shares have been pledged as security and/or are registered in the name of a nominee by way of security.
3.4.5 Pre-Emption rights in UKCS JOAs In the UK, in respect of licences granted after 1 July 2002, i.e. since the 20th Licencing Round, the Secretary of State will not approve new JOAs with pre-emption provisions, except in special circumstances where the applicant makes a convincing case for inclusion of pre-emption provisions before the licence is awarded. DECC makes it plain that it may count against an application where there is a choice between competing bids for a licence. For this reason, most JOAs for interests in the UK since July 2002 do not contain preferential rights. In the event that DECC does approve the inclusion of pre-emption rights due to special needs, the provision must be in a form prescribed by DECC.
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Most energy companies in the UK are parties to the UKCS Master Deed which aims to create pro-forma transfer arrangements, reduce complexities around signature, allow greater certainty around the timing of completions, and with respect to pre-July 2002 JOAs it standardises pre-emption provisions (if any).9 So, parties to the Master Deed who are also parties to UKCS JOAs that contain pre-emption rights are subject to the ‘New Pre-emption Arrangements’ of the Master Deed. These pre-emption arrangements provide as follows:
• a disposing participant that decides to transfer all or some of its interests under a JOA will serve notice to the JV partners of its decision to sell/transfer together with further information which might be required by the JOA’s pre-existing pre-emption arrangements (disposal notice). This is to enable the JV partners to assess the nature and extent of the disposal and to give them the option to consider exercising their rights under the pre-existing pre-emption provisions;
• the next steps involve the time periods in which JV partners can reserve or waive their rights to pre-empt. There are two time periods – an optional 7 day period to respond and a mandatory 30 day period to pre-empt or not. These time periods override any pre-existing pre-emption time periods in the JOA;
• under the ‘optional procedure’, the JV partners can, within 7 days, voluntarily serve an intention to reserve their rights to pre-empt or waive them in accordance with the pre-existing arrangements in the JOA;
• if a partner does not respond to the disposal notice within 7 days, it is deemed to have reserved its rights to pre-empt;
• JV partners who have reserved their rights to pre-empt must within
30 days of the disposal notice elect to either exercise their right to pre-empt or waive their rights; and
• a JV partner that does not respond to the disposal notice is deemed to have waived its rights to pre-empt.
9 LOGIC: http://www.logic-oil.com/master-deed <accessed 25 July 2014>
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3.4.6 Practical considerations relating to pre-emption rights As seen above, it is very important to identify from an early stage of the legal due diligence whether any agreements (mainly joint operating agreements) which the seller has entered into with its other joint venture partners contain any pre-emption/preferential rights which would affect the proposed sale of the assets. It is quite common for such provisions to be included in many oil and gas JOAs, therefore it will be important for the buyer to analyse the impact that any such procedure might have on the overall timeline for completion of the deal. Where more assets are being sold in a â&#x20AC;&#x153;package dealâ&#x20AC;?, it is also essential that a buyer clearly identifies:
(i) which assets are deemed to be more valuable to it;
(ii) w hether there are any assets which it would not want to complete the deal without having; and/or
(iii) i f there are any assets which, if they became excluded assets due to the exercise (and completion) of the pre-emption right procedure by a JV partner, it would not view as prejudicing the deal as a whole.
Another consideration which is worth bearing in mind when considering issues relating to any pre-emption rights is the possibility that, although from a legal perspective a buyer (and in some instances, the seller as well) will view the preferential right procedure as not being applicable to the transaction (e.g. because it is a share deal and the preferential rights only apply if the proposed transaction is an asset deal), a prudent seller may still wish to seek their JV partnersâ&#x20AC;&#x2122; approval that its legal interpretation of the relevant JOA provisions is correct in order to avoid as much as possible potential later disputes. In circumstances where there may be some doubt, a seller may wish to undertake the preferential right procedure in any event.
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Therefore, it is very important to engage the seller at the earliest opportunity in relation to these issues to ascertain what feedback it has received from its JV partners and how it proposes to comply with any preferential right procedure, bearing in mind that this may still apply to the proposed sale despite being prima facie inapplicable. In this context, there are two further considerations worth noting:
(i) t he feedback a seller receives from its partners will be important to the overall pricing strategy of the buyer. This is because a buyer will want to put a higher price on assets which are more valuable to it, especially if these are assets in respect of which one or more JV partners have expressed an interest. In contrast, it will wish to put a lower/nominal price on other assets which it does not view as important to the deal as a whole and/or in respect of which there is a strong indication that no other partners will wish to exercise pre-emption rights; and
(ii) the buyer in these circumstances will also want to include in the SPA an express indemnity provision in its favour given by the seller in relation to any claims which may arise as a result of seller not having complied with the preferential right procedure. It will also expect this indemnity to not be subject to any limitations (in time as well as in amount) since complying with the procedure set out in the relevant JOA(s) is entirely outside its control and within sellerâ&#x20AC;&#x2122;s remit.
In a competitive bidding process, any preferential rights procedure applicable to a proposed sale will be crucial to the seller as it will be obliged to comply with it. Therefore, a buyer who is willing to accept the risk of potentially losing any one or more of the assets that form part of the sale package will be regarded very favourably by the seller. Although the â&#x20AC;&#x153;threatâ&#x20AC;? of the preferential rights may present difficulties to the buyer, it is possible to consider creative legal solutions seeking to reduce the risk associated with this to a minimum.
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4.0 Sale and Purchase Agreements
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The sale and purchase agreement will be at the heart of any oil and gas acquisition. Its content will depend on whether, as seen above at section 2, the deal will be structured as a share sale or an asset sale. Under a share purchase agreement, the buyer agrees to purchase from the seller part of or the entire share capital of the target company and with its the assets and the liabilities attached to it. The buyer agrees to pay consideration to the seller in exchange for title in the share capital. The negotiation of a share purchase agreement will also involve agreeing a tax indemnity as well as other ancillary documents which are necessary to effect the sale, such as the share transfer, directors’ resignations and appointments, and termination of any powers of attorneys. An asset sale will involve the negotiation of an asset purchase agreement, which will describe in detail the assets being sold. Such negotiation will also include preparing other documents, such as assignment of the seller’s interest in the assets, novation of the JOAs, third party consents, waivers of preferential rights and any governmental consents. The buyer will want to ascertain that the seller passes full title guarantee. The negotiation of the SPA largely focuses on allocation of risk of the target company’s liabilities. This is mainly because the buyer receives very little protection under common law or statute if the acquired business turns out not to be what the buyer had expected (due to the principle of “buyer beware”). Therefore, the buyer will be concerned to ensure that the wording of the seller’s warranties is suitable and will afford the necessary protection.
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4.1 Effective Date, Execution Date and Completion There are three important dates for the purposes of an acquisition transaction and the relevant sale and purchase agreement:
(i) the “Effective Date/Time”;
(ii) the signing/execution date of the SPA; and
(iii) Completion (sometimes referred to as Closing).
The concept of “Effective Date” is used in oil and gas transactions as the chosen date on which the economic benefit and risk relating to the business being sold is deemed to have passed to the buyer, despite the fact that physical and legal ownership will occur at a later date (i.e. at Completion). This is done for accounting purposes – the seller will often select an effective date which is consistent with the timing of annual work programmes and budgets (in the case of the sale of a single upstream asset) or a date immediately following the end of a reporting period such as the first day of seller’s fiscal year (in the event of a package sale). The general principle is that all receipts and expenses attributable to the period prior to the Effective Date in relation to the target will be borne by seller. Once Completion has occurred, all the receipts and expenses attributable to the period on and from the Effective Date will be borne by the buyer. This enables the buyer to base its valuation of the target business as of the Effective Date, which in essence will mean that the purchaser will be able to assess the reserves in the ground and apply its own valuation methodology to them as at that date. Usually this will entail a discounted cash-flow evaluation, which is based on the concept of “time value of money”, whereby future cash flow projections are estimated and discounted to give their present value. The sum of all future cash flows, both incoming and outgoing, is the Net Present Value (“NPV”). Because the receipts and expenses amounts may not be known at the time of signing, or potentially even at Completion, the SPA will need to contain specific purchase price adjustments to ensure that the seller and the buyer are put in the same economic position as if the physical and legal transfer of the assets or shares occurred on the Effective Date.
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4.2 Consideration / Purchase Price In a transaction, a key issue is of course consideration. Consideration (or Purchase Price) can be agreed using different methods but as mentioned above in oil and gas transactions it will usually involve an assessment of the value of the reserves being acquired. In deals which are not related to oil and gas assets (and in some deals which are) when buying shares in a company, the starting point is commonly for the buyer to assess the “enterprise value” of the business – this is typically done by reference to a multiple of EBITDA (earnings before income, tax, depreciation and amortisation). This initial assessment does not take into account the financing background or the net asset strength of the business. This is the reason why the enterprise value of the business is usually assessed on a “cash free/debt free” basis – i.e. requiring the buyer to pay for any cash left in the business and the seller to pay for any debt. The other assumption which is relevant to a buyer’s valuation is that there will be a normalised level of working capital. In other words, in order for the business to operate and generate a profit, it needs to be sold with a certain level of inventory, cash, etc. – but the level of those balances will not be directly reflected in the calculation of the EBITDA. Rather, the buyer and seller will negotiate the agreed reference levels, so that any offer will assume that level of working capital in the business. In circumstances where the level of working capital is not “normal” (which in practice is quite often the case), then certain adjustments will need to be made to the enterprise value based on some reference accounts, in order to establish the purchase price which is actually to be paid for the business (i.e. the “equity value”). Another form of valuation of a company includes that based on its net asset value (NAV) commonly using the numbers in its last audited accounts and then applying adjustments after completion as we explain below. Consideration is typically paid in cash and at completion. This is the most common and preferred approach and generally drafting a clause to reflect this arrangement is more straightforward than in deals where a non-cash consideration is involved. Usually a deposit of up to 10% will be paid at signature of the SPA. The main forms of consideration include:
• Cash: this is the most common and simplest form of payment; • Paper: payment in the form of issuing shares and or loan notes;
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• Earn-outs: this involves part consideration paid on the date of completion and the remaining balance on a later date.
The latter is a common form of deferred consideration and the payment will largely depend on the earnings of the target company post-Completion. An earn-out is more suitable in circumstances where the seller is involved in the target’s business after Completion and where the target is valued on future profits. The SPA will need to reflect this arrangement by taking into account the earn-out period and the target’s performance and profits during that time.
4.3 Purchase Price Adjustments A common approach to adjusting the purchase price after Completion is for the parties to prepare completion accounts – these are prepared post-Completion and showcase the target company’s financial position between Execution and Completion. For example, on a debt free/cash free evaluation, the consideration may be adjusted depending on any cash or debts that remain with the target at Completion. On a NAV evaluation (where for example the consideration is based on the NAV of a company as of the last audited accounts), the consideration would be adjusted on the basis of any differences between the initial NAV and the NAV at Completion. The parties usually agree to set caps on the consideration adjustment whether in the form of an increase or decrease in price. Under this mechanism, the buyer will pay for the actual level of assets and liabilities of the business as at the Completion date. Another method for price adjustment is the “locked box” mechanism. Pursuant to this mechanism, the parties usually agree to use previously drawn up accounts to finalise the price before signing of the SPA. In essence, the buyer takes the economic risk and benefit of the transfer at an agreed Economic Date. This provides certainty and saves cost and time by not having to prepare completion accounts whilst allowing the parties to check the components that went into agreeing the purchase price after Completion when they are finally determined. Moreover, where it is a share sale, a seller would usually indemnify the buyer against any ejection of cash from the target company that is outside the normal course of the business in the period between the Effective Date and Completion ((this is commonly referred to as “Leakage” – for example, dividends, man-
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agement payments and bonuses, transaction expenses etc.). It is also worth noting that Leakage can be very difficult to identify in an asset sale where the target group may well not be able to ring-fence the actions of the trading business being acquired after the Effective Date if they are all undertaken within a single entity (e.g. where it does not hold its own books). For this reason, the locked box mechanism will be mostly appropriate for share transactions. The key distinction between the two mechanisms is in the timing where the risk and benefit in the target passes to the buyer, i.e. usually at Completion under the completion accounts mechanism and at the agreed Effective Date (prior to signing) with the locked box mechanism. This has direct consequences in terms of the level of due diligence which will be required, as with the locked box the financial scrutiny will be far higher given that the buyer will not be able to assess the level of the assets on which it has formed its valuation once it has bought the business, so this may prolong the timing of the transaction. On the other hand, sellers are commonly concerned that by using the completion accounts methodology a buyer will in effect try to negotiate down the price post-completion. In this sense, the locked box mechanism – which as mentioned does not usually allow for post-completion pricing adjustments, other than for “Leakage” – is very attractive to Sellers. Another key difference is one pertaining to who drives the process. Under the completion accounts, the buyer will be normally the party who has control over the financial information and therefore in charge of the post-completion “true up” adjustment, with the seller having to review the proposed adjustments. Pursuant to the locked box mechanism, it is the seller who has control over the information relating to the Effective Date accounts and it is therefore the buyer and its team who will try to uncover as much of it as possible. The choice between the two different methods (completion accounts v locked box mechanism) allows each party to try to maximise value from the deal. Completion accounts have historically been the default mechanism and are commonly viewed as buyer-friendly. However, recently the use of the locked box mechanism has become more common, showing that they are the preferred mechanism chosen by sellers and are acceptable to buyers. It is essential that the relevant purchase price adjustment provisions in the SPA provide for a very clear mechanism regarding how each adjustment is to be made (including the accounting principles which are to be used) and to include detailed provisions to cater for the event of a dispute between the seller and buyer as to what these adjustments should be post-Completion (which can often occur in practice).
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Below is a chart showing the key differences between the completion accounts approach and the locked box mechanism10:
The Classical versus Locked Box approach Completion accounts March
Vendor recives actual cash profit (Via purchase price agreement)
• Referemce Balance sheet
Jun
Headline equity price agreed • Completion • Economic risks transfer to bidder • Equity purchase price paid (initial)
August
Completion accounts prepared • Purchase price adjustments •
Lock Box March
Vendor recives actual cash profit (Via purchase price agreement)
• Referemce Balance sheet • Economic risks transfer to bidder (subject to any other protection in the sale and purchase agreement)
Final equity price agreed
Jun
• Completion • Equity price paid (final) • Actual cash profits may be better or worse than expected - purchaser takes the risk
Source: Ernst & Young
It is worth noting that in most transactions, cash, debt and working capital are the key value drivers in the calculation of the equity price to be paid by the buyer, and as a result, they are usually the subject of any completion accounts “true up” adjustments. However, completion accounts normally calculate all the net assets of a business – i.e. they would also look at long-term fixed assets and liabilities as opposed to only current assets/liabilities. This would carry the risk that the price adjustments are made by reference to some items which do not actually go to the valuation of the business. As a result, many sellers prefer
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to agree to a completion accounts mechanism with a net cash/debt and working capital adjustment, rather than a full net asset adjustment. In practice, many oil and gas transactions use a “hybrid” mechanism, whereby the parties agree that the risk and benefit of the business will pass to the buyer on an Effective Date before signing, based on certain historical accounts, whilst allowing certain adjustments to be made following Completion (e.g. in relation to any prepaid expenses and receipts or petroleum receipts). It is often the case that the most common type of post-closing purchase price adjustment relates to net working capital (not on profits as exampled in the diagram above) and these tend to be some of the most complicated terms in an SPA and are therefore also the subject of extensive negotiations between the parties. For these reasons, great care must be taken by the parties’ legal, financial and tax advisers to verify these provisions. The most important elements of a Net Working Capital Adjustment provision are:
(i) t he definition of “Net Working Capital” - working capital is defined most often as accounts receivable plus inventory and prepaid expenses, minus accounts payable and accrued liabilities. If a transaction is structured as a share acquisition, working capital usually also includes cash and cash equivalents. The working capital accounts included in the adjustment, however, are specific to the target company. Lawyers who draft working capital adjustments must understand the target company’s balance sheet, its working capital accounts, and the accounting methodologies used to determine the value of those working capital accounts. Any ambiguity with respect to the working capital accounts included in the adjustment or the accounting methodologies used to value those working capital accounts can result in significant financial consequences to the buyer and the seller;
(ii) the standards of accounting to be used in calculating it;
(iii) w hich party initially determines the actual amount of Net Working Capital as of the Effective Date and at Completion and the access to relevant books and records by the non-preparing party; and
(iv) the mechanism for resolving any disputes in connection with it.
Attaching a list of the specific accounts or financial line items or a sample calculation of Net Working Capital as a schedule to the SPA are useful methods in seeking to reduce the risk of subsequent disputes.
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4.4 Conditions precedent If a SPA does not contain any conditions precedent the parties will be able to execute and complete the deal simultaneously. However in practice it is usual for oil and gas SPAs to have certain conditions which must be satisfied prior to Completion taking place. Wherever possible, both parties should seek to reduce the number of these conditions so as to increase the likelihood that the transaction will complete successfully. Typical conditions included in oil and gas SPAs may relate to:
• notice of waiver or non-exercise of pre-emption rights/rights of first refusal from the other JV partners;
• consents from other JV partners and other third parties; • novation of the JOA(s) and assignment of other contracts (in an asset sale);
• any government or antitrust/regulatory approvals; and • board approvals. There will usually be an obligation on the relevant party to use its reasonable endeavours to fulfil such conditions precedent. If a condition precedent is not met (usually by an agreed specific date, known as “Drop Dead Date”), then there will be no obligation to complete and either party will be entitled to terminate the agreement. The Drop Dead Date should be a realistic benchmark for the conditions to be satisfied whilst at the same time not being so distant into the future (because this could risk the purchase price no longer being representative of the market value of the assets). It will be important to draft the provisions to make it clear in what limited circumstances the deposit may be kept by the seller if Completion never occurs.
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4.5 Completion and the “interim period” Completion usually takes place at the same time as execution of the SPA or at a later agreed date. The former is referred to as simultaneous exchange and completion and the later as split exchange and completion. The SPA will detail issues and actions that the parties need to deal with at completion. This includes completion board meetings of the parties, the documents that need to be delivered and any other agreements that need to be executed. In a way this part of the SPA serves as a checklist for lawyers at completion meetings. Split execution of the SPA and completion is usually opted for where it is not possible to complete due to conditions, formalities or practicalities that cause delay or even prevent completion from taking place. This is also referred to as conditional completion, where execution takes place but completion is pending an action or a step to be taken. Examples include:
• • • •
shareholder(s) consent; competition authority consent; regulatory approvals; third party contractual consents, including government or JV partner consents;
• financing; and • tax considerations. A split deal needs considerable extra drafting and further consideration from both parties to reflect the time gap between execution of the SPA and completion (known as the “interim period”) and it is essential that these issues are identified at the outset of the transaction. Accordingly, the SPA will clearly state the steps that must be undertaken or rather the conditions that need to be met before completion, the party that is responsible for them and the timeframe that will lapse between signing the SPA and completion. Although the seller will retain control of the target’s business until completion (when the buyer will legally own the target’s business), it will be under an obligation to run the business on behalf of buyer during this interim period. The buyer will therefore seek to ensure that the target it is acquiring is not negatively affected by the actions of the seller during this time. For
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this reason, the SPA will include covenants, of both negative and positive nature, aimed to ensure that during the interim period the seller is not taking any actions or omitting to take any actions the result of which would cause detriment to the target company or assets being acquired. Such covenants are usually concerned with:
• ensuring that the seller runs and maintains the business as it did prior to completion;
• restrict the seller from taking certain actions, such as varying or terminating any material contracts (these will normally need to be carefully defined);
• requiring the seller to consult with the buyer (or possibly even
vote in accordance with buyer’s directions) when voting on work programmes and budgets or AFEs for the JV operations.
• restrict the seller from encumbering or charging the principal assets of the company and/or its share capital; and
• granting the buyer access to the target’s records. 4.6 Termination provisions Particularly in circumstances where Completion takes place sometime after execution of the SPA, the buyer would seek to protect itself by incorporating termination rights in the SPA in events where the value of the target business is affected in any material way before completion. An SPA usually grants the buyer with such termination rights in events where:
• • • •
the conditions of the SPA are not met; the seller breached its pre-completion undertakings; there is litigation involving the target or key assets; and here any other material change occurs between execution w and completion.
This later provision as one might expect is usually intensely debated.
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4.7 Warranties and indemnities Warranties and indemnities typically form a large proportion of the provisions of an SPA and are at the heart of negotiating an acquisition transaction. Both tools are used to reallocate risk between seller and buyer. In line with the “caveat emptor” principle (“buyer beware”), a buyer will seek protection via negotiating the inclusion of as many warranties and indemnities as possible. Conversely the seller will seek to protect themselves by giving less warranties and indemnities that the buyer wishes or by restricting their scope as much as possible. Key to a successful negotiation is finding a reasonable balance. 4.7.1 Warranties At its simplest, a warranty is a contractual statement of fact, it is generally made by the seller assuring to the buyer the relevant statement made is true and if proved otherwise, then the seller will be liable to the buyer for breach of that warranty. In an acquisition transaction, the buyer will carry out due diligence and by assessing the results would request the seller to give certain warranties as to the state of affairs of the target company and/or assets at completion. The buyer will also be concerned about the occurrence of any breaches of warranty post execution of the SPA but prior to the Closing and would typically negotiate the incorporation of a clause that deems warranties to be repeated at completion. A seller on the other hand will attempt not to repeat the warranties at completion or will at least seek to only repeat a number of the warranties it had given at execution of the SPA. This is a matter which is subject to heavy negotiation between the parties. However, it is essential for a buyer to ensure that seller repeats all the key warranties given by seller, in particular relating to having good title to the shares/assets and being authorised to enter into the transaction. Buyer should also insist that Seller repeats all the warranties the performance of which is directly under its control. In practical terms, this means that both parties’ legal and commercial teams should review the state of affairs just before completion and satisfy themselves that the warranties given are still true and accurate. This is important, since the accuracy of the warranties as of closing will usually be a “condition to closing” which, if not met, will entitle the grieving party not to close.
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4.7.2 Standard of disclosure and buyer’s knowledge In a disclosure exercise, the seller qualifies its warranties and so limits or avoids liability for breach of warranty – in other words, the disclosure is made against those warranties given in the SPA. The disclosures usually supplement and qualify the warranties by giving further information, either generally or for specific warranties. Thus, warranties and disclosures come hand in hand and must be considered, drafted and negotiated together. All the disclosures and their relevant documentation are recorded on a disclosure letter/schedule that is addressed to the buyer. The purpose of a disclosure is so that the seller can prove that the buyer is informed of a matter and accordingly the buyer cannot hold the seller liable for any loss arising out of the specific fact which was made known to buyer in the disclosure. In disclosing against the warranties, the seller must be guided by the standard of disclosure defined in the SPA. Commonly, the disclosure must be of a “fair” standard. The precise wording of the SPA will play a role in determining the level of disclosure necessary to qualify the warranties. In the negotiation stage, the seller will generally opt for general disclosures and the buyer would seek as many specific disclosures as possible. The seller can also limit liability arising out of any breach of warranty (as well as breach of any covenant) both in time as well as in amounts. In practice, this is achieved by setting a cap on the maximum liability as well as placing a minimum threshold on claims (below which buyer cannot bring a claim), by including so called de maximis and de minimis provisions. Moreover, the time limitation period is usually limited to, say, 2/3 years for non-tax warranties and, say, 6 years for tax warranties. These caps and limits are also important because they can largely affect the extent of a buyer’s protection and are therefore often the subject of prolonged negotiation.
11 Senate Electrical Wholesalers v Alcatel Submarine Networks [1999] 2 Lloyd’s Rep 423
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4.7.3 Remedies for breach of warranty If a warranty proves to be misleading or untrue then the buyer can bring an action for damages against the seller and possibly terminate the SPA if the breach is known before completion. The amount of damages awarded for breach of warranty is subject to contract law, which seeks to put the buyer in the position it would have been if the warranty had been true. To bring a successful warranty claim the buyer must show that:
(i) the breach of warranty has caused a loss in the value of the business being acquired — so that in a share sale for example where the target company incurs a liability as a result of a breach of warranty but the market value of the shares is not affected, the amount of damages would be nil11;
(ii) t he loss resulting from the breach is reasonably foreseeable—taking into account any special circumstances known to both parties, and
(iii) t he loss has flowed from the breach—i.e. the breach of warranty has caused a diminution in the value of the shares /assets.
The amount of damages is generally the decrease in the market value of the shares/assets as a result of the breach. The recoverable damages are limited by the rules of remoteness and the buyer’s duty to mitigate its loss. Moreover, the amount of damages will be limited further by any de maximis and de minimis clauses in the SPA. Alternative remedies to the buyer include damages for fraudulent, negligent, or innocent misrepresentation and rescission of the SPA. Moreover, rescission and damages can be sought as tortious remedies for negligent misstatement or vicarious liability for fraudulent statement made by target company employees.
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4.7.4 Indemnities An indemnity is generally a promise or a covenant made by the seller to reimburse the buyer for any loss resulting from a specific action or event. In the context of an SPA, indemnities are incorporated to provide the buyer protection from specific liabilities that the seller should be responsible for. They are most suitable for protection from matters where there is insufficient information or certainty, but where a potential liability is already known. 4.7.5 Advantages of an indemnity over a contractual warranty The advantages of an indemnity over a warranty include:
• the buyer is compensated on a £ for £/$ for $ basis rather than damages as the principle of remoteness does not apply;
• • • •
no requirement to prove breach but only that the indemnity applies; no requirement to mitigate losses; disclosure does not affect an indemnity claim; and the statutory limitation period usually runs from the date of the loss rather than the breach;
Although the agreed position will ultimately be a matter of negotiation between the parties, where the buyer is concerned about the covenant of the seller (e.g. because of concerns about the seller’s solvency or because the seller is based overseas and recovery may therefore be difficult), it will need to consider other practical options to provide the necessary comfort. It may take security in the form of a bank guarantee (or parent company/ related party guarantee) or part of the sale proceeds may be deposited into a retention fund, only to be released on the expiry of the warranty limitation periods.
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4.8 Post-Completion Issues Although on completion the buyer acquires the legal and physical ownership of the assets on sale, most buyers will view this date not as the final step in the transaction, but rather as the beginning of the “real work” which needs to be done. This is because from this date onwards the buyer will need to run the new assets from its existing operations and ensure successful integration of the same. This can sometimes be very challenging and a buyer should consider this issue and how it proposes to deal with it at the very outset of the proposed transaction. In most cases, it will be sensible to agree with seller (and specifically with the target company on a share sale) specific teams who will be communicating and working together to oversee and implement any changes and transitional arrangements. One of the key factors to consider and agree with seller at the start is whether the seller will remain involved in the business and if so, to what extent. There are two particular aspects which are relevant to a successful integration post-acquisition:
(i) employees’ status; and
(ii) transitional services which a buyer may require the seller to provide for a limited period of time following the acquisition in order to ensure a smooth handover of the business.
We will look at each of these in turn. 4.8.1 Employment issues post-Completion Some of the key employment considerations on an acquisition include:
• which employees belong to the acquired business/operations? The buyer
will need to determine their status – by e.g. ensuring they are transferred to it as part of the acquisition and/or dealing with any employees who are not transferred, if any, but remain on the seller’s payroll at closing;
• what pension and other employment benefits and schemes (and any
employment liabilities) exist in relation to which employees? These are important considerations and careful drafting will need to be included in the SPA to apportion the identified liabilities between buyer and seller prior and following Closing.
• which information and/or consultation obligations arise in connection with the transaction in respect of either buyer or seller?
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• will any dismissals be required in connection with the acquisition and if so who will be bearing the costs associated with these?
• will the acquisition itself give rise to any benefit payments to employees and who is responsible for them?
In order to assess the impact that any acquisition may have in relation to any employees, one has to consider whether the deal is structured as a purchase of shares or assets (or a mixture of both).
Types of employees There are generally three categories of employees that must be considered in acquisitions: • in share sales, the employees of the target company; • in asset sales, the employees employed by the business; and • ‘ non-assigned’ employees – in a share sale, these include people who work in the target company but are not employed by it; and in an asset sale, employees who work in that business as well in the seller’s business(s) which are not being sold / bought. Major deals can often involve a mixture of both share and asset acquisitions, and in such situations all three categories of employee would need to considered. (a) Employees in a share acquisition In share acquisitions, the employer does not change. Therefore, there is a continuity of the employment contracts – i.e. the buyer of the shares does not become the employer and new employment contracts are not generally necessary. The key difference is that the buyer indirectly assumes the target company’s liabilities in the employment contracts. That said, employment contacts could be affected by:
• share options and other incentive plans which are group wide (i.e. based on the seller’s corporate group);
• seller group-wide pension schemes; and • change of control clauses in the employment contracts or compensation agreements.
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The buyer of the shares may want to change the terms and conditions of the target’s employment contracts to bring them in line with its uniform group-wide employment contracts (‘harmonisation’). Since an employment contract is a two-way agreement, the seller would have to agree the changes with the employees individually and might entail terminating the contracts and entering into new ones. The buyer would likely have to enter into ‘settlements’ with the employees so they do not claim to have been dismissed. (b) Employees in an asset acquisition The buyer in an asset purchase will directly become the new employer. In the European Union, employees of businesses automatically transfer to the buyer under Council Directive No. 50/1998/EC. All rights and obligations of the seller under the seller-employee employment contracts transfer to the buyer and the terms and conditions of the old employment contracts largely remain the same. In principle and as a result, the buyer will assume responsibility for all pre-transfer liabilities in respect of employees transferring to its employ, and in certain circumstances it will assume responsibility for former employees as well. The situation of employees in asset sales in non-EU jurisdictions is not as straightforward as under the EU Directive, such as the Pacific-rim countries (including Australia) where the existing employment contracts must be terminated and new contracts being offered to the employees. Termination liabilities are normally borne by the seller. Employee issues form a vital part of any asset sale and as such the SPA would have to be drafted accordingly and will typically include warranties and indemnities in relation thereto. (c) Non-assigned employees Non-assigned employees can end up remaining with the seller at Completion despite giving their time to the target company or asset’s business (e.g. administrative and accountancy staff). If the buyer and seller intend on having non-assigned employees go with the target company/ business, said employees’ consent would usually be required.
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Indemnities and employment matters (i) Indemnities The SPA between the buyer and seller will normally contain indemnities to allocate liabilities relating to employment matters. It is normal for pre-Closing employment liabilities to be the seller’s responsibility and post-Completion employment liabilities to be the buyer’s, subject to relevant legislation which in some jurisdictions might dictate that both parties are liable for employment related claims pre and possibly even post Completion. Where an SPA dictates that one party alone will be responsible for employment obligations, it would be prudent for the non-responsible party to seek an indemnity from the other in case it is liable by law and it may even request parent company or affiliate guarantees (as it might request with all other indemnities). (ii) Employee benefits Some benefits that Target Employees or Business Employees enjoyed as part of the seller’s group may be difficult to replicate once they have transferred over to the buyer’s group. These can include share purchase schemes, group-wide pension schemes and bonuses. The buyer will try to give its new employees comparable arrangements to those enjoyed under the terms, conditions and benefits which were in place with the seller’s group.
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4.8.2 Transitional services Seller and buyer often will negotiate an agreement to legislate which services will still be provided by seller to the target/buyer at what costs and for how long. Often these end up being last minute arrangements. However, in light of the speed of transaction negotiations as well as the complexity of businesses being sold, it is becoming increasingly important for buyer to clearly identify what services it will still require seller to provide post-completion and is now forming a key part of any sale negotiation, particularly in respect of the necessary IT software and any other operational matters which are required to operate the business. Such issues often need early consideration, especially as in the case of IT software there may be issues relating to third party consents and licences which will need to obtained first and which may impact on the timeline and the ability of buyer to operate the acquired business properly after Completion.
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What is a “TSA”? A TSA (Transitional Services Agreement) is a legal agreement pursuant to which seller will continue to provide certain services to the divested business, in consideration of buyer agreeing to pay certain fees for each of the services in question. Buyer and seller will often spend some time trying to agree how long these services will have to be provided for, with buyer often requiring a longer period of time than a seller is willing to concede. Typically, these services will be provided for a period of 12 to 24 months, although there can be instances of shorter or longer timeframes being agreed. Obviously the duration of these services will be directly linked to the complexity of the business being sold. In international auctions, it is quite common for the nature of the transaction to be very competitive and to require a buyer to be willing to go through with the purchase and only be able to complete certain technical due diligence at a later stage, with both parties’ operational teams engaging as soon as practicable after execution of the SPA to determine what services the buyer will need in practice and to seek to agree the services and fees for each of these (which will form part of separate schedules at the back of the agreement). In this instance, it would be wise to also seek to negotiate what is known as a “missed services” clause, as it is likely that one or more services may not be identified and included in the document – such provision will provide the buyer with the opportunity to identify any missed services where these were not determined at the TSA’s commencement date i.e. at Completion. It will be important to identify and clearly set out the charges which buyer will have to pay seller for the services it receives. It may also be advisable (particularly where the speed of the transaction requires buyer to move very quickly) to agree to share the risk of fluctuating costs by defining a floor and a ceiling in respect of the TSA service charges, in order for a certain level of certainty to be obtained for both parties in terms of planning and accounting during the transitional period.
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In practice, it may be the case that analysing these costs will be challenging especially if a service has historically been provided intra-group by the seller. Buyers with some bargaining power will often seek to incorporate a “most favoured nation” clause – this will ensure that the service costs are in any event kept to a minimum and cannot be sourced cheaper elsewhere. They will also wish seller to provide the services “at cost”, i.e. not to make a profit from providing these but only passing the costs of offering these on to the buyer. These provisions will form the subject of the negotiations between the parties and their inclusion or exclusion will depend on the bargaining power of each buyer and seller in any specific deal. In terms of the services to be provided, it is of course of paramount importance that these are very clearly and specifically described and it is also advisable to specify which services will not be provided as part of the transition arrangements so to avoid any misunderstandings and later disputes. Another key consideration is the level at which these services will be provided. A seller will often wish to negotiate that it will provide the services stipulated at the same standard as at the time just prior to completion. A buyer will need to ensure that it is comfortable with how these were operated.
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5.0 Concluding Remarks
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Like a snow crystal, no deal is exactly the same. The parties, the negotiators, the advisers, the assets, the terms; there will always be a new factor to consider. This handbook seeks to point to some of the basic contours: • the nature of the asset must be clearly described; • t he time of transfer of the risks and benefit from seller to buyer must be clear and the mechanism to value the asset at that time must be certain; • the conditions to completion must be identified; • the price terms must be clear; • t he responsibility for negative events occurring and necessity to agree or consult on new matters in the period to completion must be determined in the interim provisions; • t he balance of risk must be agreed in relation to the state of the business being sold and the warranties, indemnities and limitations to these will set out that balance; and • the provisions to deal with any dispute (whether on price adjustments before a financial expert) or on a breach of the contract (usually by way of an arbitral process) need to be clear. In summary, the search for clarity in the way in which the commercial transaction is translated into the contract is always the goal, but is not always possible to achieve. The intention of the parties as expressed in a legal contract is not like that snow crystal which is unique and perfect in every way, although remembering the fundamentals we have looked at in this handbook will take the draftsman some way there.
We hope that you have enjoyed this contribution on Private Acquisition and that the few insights we have added for the benefit of the in-house energy lawyer will prove helpful. Safe Journey. LXL LLP
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2014 - A bird’s eye view of the energy industry We woud like to conclude this handbook by providing a “bird’s eye” view of the energy industry for the coming year. •T he market’s perception of reduced risk to Iraqi oil exports and news regarding increasing Libyan oil exports contributed to a drop in the Brent crude oil spot price to an average of $107 per barrel (bbl) in July 2014 which was $5/bbl lower than the June average. EIA has projected that Brent crude oil prices will average $107/bbl over the second half of 2014 and $105/bbl in 2015. West Texas Intermediate (WTI) crude oil prices fell from an average of $106/=bbl in June 2014 to $104/bbl in July 2014 and that was despite record levels of U.S. demand for crude oil. The WTI discount to Brent, which averaged $11/bbl in 2013, is expected to average $8/bbl and $9/bbl in 2014 and 2015, respectively.12 • U.S. total crude oil production averaged an estimated 8.5 million barrels per day (bbl/d) in July 2014, the highest monthly level of production since April 1987. U.S. total crude oil production, which averaged 7.5 million bbl/d in 2013, is expected to average 8.5 million bbl/d in 2014 and 9.3 million bbl/d in 2015. The 2015 forecast represents the highest annual average level of oil production since 1972. Meanwhile, natural gas plant liquids production in the U.S. are expected to increase from an average of 2.6 million bbl/d in 2013 to 3.1 million bbl/d in 2015. The growth in domestic production in the U.S. has contributed to a significant decline in petroleum imports there. The share of total U.S. petroleum and other liquids consumption met by net imports fell from 60% in 2005 to an average of 33% in 2013. EIA expects the net import share to decline to 22% in 2015, which would be the lowest level since 1970.13 • Natural gas spot prices fell from $4.47/million British thermal units (MMBtu) at the beginning of July 2014 to $3.78/MMBtu at the end of the month as natural gas stock builds continued to outpace historical norms. Natural gas working inventories on August 1 totaled 2.39 trillion cubic feet (Tcf), 0.54 Tcf (18%) below the level at the same time a year ago and 0.61 Tcf (20%) below the previous five-year average (2009-13). Projected natural gas working inventories reach 3.46 Tcf at the end of October, 0.35 Tcf below the level at the same time last year. EIA expects that the Henry Hub natural gas spot price, which averaged $3.73 per MMBtu in 2013, will average $4.46/MMBtu in 2014 and $4.00/MMBtu in 2015.14 • The UK is preparing to frack for shale gas and the government has announced the 14th onshore licensing round for petroleum exploration and development licences - the first onshore licensing round since 2008. The 14th round covers around half of the UK approximately seven times larger than the existing licensing area. • Mexico has been accelerating its energy reform efforts and after 76 years of state control of the oil rich country’s resources since expropriating the same in 1938, it is finally welcoming foreign capital, with its first oil and gas bid round expected in June 2015.
12 Source: U.S. Energy Information Adminstration - Short-Term Energy Outook (August 2014) 13 ibid. 14 ibid.
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LLP 28.08.2014. No part of this manuscript may be copied or reproduced without the consent of the author