The fall in oil and other commodity prices is prompting deal activity in the petroleum and minerals sectors. Because many resource assets are held in unincorporated joint ventures, M&A and other transaction activity must navigate through any disposal restrictions in the joint operating agreement.
A recent decision of the Supreme Court of Western Australia1 provides a reminder of the difficult practical issues that arise in drafting and applying pre-emption clauses. The approach taken by the Court may be of interest to incoming buyers, outgoing sellers and remaining joint venture participants.
Pre-emption in resource joint ventures
Pre-emptive rights are commonly triggered when a participant proposes to sell its interest in a joint venture, or when a participant is to be the subject of a change in control (broadly, an upstream corporate transaction impacting on control of the participant). They give the other joint venture participants the opportunity to pre-empt the triggering transaction (be it asset sale or corporate change in control), usually to the extent of purchasing the participating interest of the outgoing participant.
What purposes do pre-emptive rights serve?
Selecting appropriate co-venturers is usually undertaken carefully when entering into a resource joint venture. However, these relationships and projects may continue for a considerable period of time, so participants should be prepared for the prospect that one or more of them may – in time (and particularly as market conditions change) – seek to exit the joint venture.
Pre-emption is a mechanism commonly adopted in joint operating agreements to address this. It does so by balancing the interests of existing participants being forced to risk their capital unwillingly with a new participant on the one hand, with the interests of participants in exiting the venture on the other. It does so by giving existing participants an opportunity to acquire the interest offered to third parties.2
Price and other terms and conditions of the pre-emption transaction
Pre-emption clauses must define, with precision, the events or transactions that trigger them, and clearly prescribe how the participants are to ascertain – to the requisite degree of certainty and completeness – the terms of the pre-emption transaction.
The pre-emption transaction represents the sale and purchase of a valuable participating interest. In the ordinary course, this is a transaction in which the buyer and seller negotiate and address, in detailed terms, consideration, transfer of title and risk, adjustments in the period to completion, claims, warranties and indemnities, among other things.
Joint operating agreements usually prescribe that a subset of relevant terms from the triggering event or transaction is to be identified and, where necessary, modified to produce the terms of the pre-emption transaction. Where the triggering transaction is a transfer, for cash-only consideration, of just the participating interest, ascertaining the terms of the pre-emption transaction should be relatively straightforward (same price, largely same terms - perhaps modified in relation to timing). However, the task will become less straightforward as the triggering transaction departs from a simple cash consideration transfer, for example if the triggering transaction:
- involves assets or liabilities other than just the relevant participating interest,
- is an upstream change in control transaction (eg a merger or share sale), or
- is to be effected by a series of related transactions, involving multiple parties.
The consideration to be paid by the pre-empting participant(s) to acquire the outgoing participant’s interest is critical. Usually, cash-only consideration is prescribed.3 It may be referrable to the objective market value of the relevant participating interest or the actual price provided for in the triggering transaction (this may be difficult to discern from the less straightforward kinds of triggering transaction identified above).
If objective market value is used, a readily ascertainable valuation date should be prescribed. The parties will also need to address how the imported concept of objective, market value pricing as at a prescribed date might fit (or not) with terms drawn from the triggering transaction (based on potentially different timing and measures of consideration).4 Remaining participants weighing whether to exercise a right of pre-emption will be on guard for any attempts to inflate the true consideration payable by the imposition of costly, cherry-picked terms and conditions, to assess whether they are properly referrable to the relevant participating interest and its acquisition by the pre-empting participant.5
If the pre-emption transaction is to draw its terms from the triggering transaction, then the joint venture agreement should prescribe the criteria to be applied to identify and, where necessary, modify triggering transaction terms to produce pre-emption transaction terms. Possible criteria include:
Relevance6 – only terms that are relevant to the participating interest are drawn from the triggering transaction to form the terms of the pre-emption transaction;
Equivalence7 – by which relevant triggering transaction terms may be modified as necessary to produce legal and commercial outcomes for the pre-empting participant that are broadly equivalent to the relevant legal and commercial outcomes provided for the buyer in the triggering transaction;
Sterilising or converting non-cash consideration8 – as indicated above, pre-emptive rights usually provide for cash-only consideration and so triggering transaction terms effecting movement of non-cash value in exchange for the acquisition of the participating interest (or control of the joint venture participant)9 may require modification. It may be difficult to distinguish between terms that meaningfully affect value and terms that do not (and to sterilise or convert the former), and
Modifications necessitated by differing transaction structure10 – this might include converting a share sale to an asset sale.
Finding the right match between resource joint venture participants can be critical to the success of a high cost, high risk and time consuming enterprise. Maintaining alignment is probably even more important in challenging market conditions. Pre-emption clauses in joint operating agreements should reflect the true, negotiated intentions of the parties, and cannot safely be treated as boilerplate clauses.
Uncertainty in their application can hamper transactions that are necessary for the efficient conduct of the industry and deprive remaining participants of the opportunity to fairly assess their options.