Rights of first refusal (“ROFRs”) are relatively common in operating agreements in the oil and gas industry. These provisions require that, prior to transferring assets to a third party, a vendor must first offer the assets to the other party(ies) to the operating agreement, on the same terms.
In Northrock Resources v ExxonMobil Canada Energy, 2016 SKQB 188, the Saskatchewan Court of Queen’s Bench considered whether ExxonMobil Canada Energy (“ExxonMobil”) had breached ROFR obligations owed to Northrock Resources (“Northrock”). ExxonMobil was conducting a disposition process for certain oil and gas assets in Saskatchewan (the “Assets”). The transaction proceeded by way of a transfer of the Assets to wholly-owned subsidiaries of ExxonMobil, with a follow-on share sale of the subsidiaries to a third party; Crescent Point General Partner Corp. (“Crescent Point”) was the winning bidder and acquired the shares of the subsidiaries, and Northrock held a ROFR on the Assets.
The Court found that because the ROFR provisions unambiguously exempted transfers of assets to subsidiaries, there was no need to read in change of control provisions that would prevent subsequent transfers of shares in subsidiaries to third parties without first offering those shares to ROFR holders. It also found that ExxonMobil’s sole reason for structuring the disposition as a transfer to subsidiaries followed by a sale of the shares of the subsidiaries was maximizing the transaction’s tax effectiveness. As a result, ExxonMobil had not breached the rule set out in GATX Corp. v Hawker Siddeley Canada Inc. (1996), 27 BLR (2d) 251 (Ont. Ct. J.), (“GATX”), which precludes transactions which are structured for the purpose of avoiding ROFR obligations.
The Assets were governed by the Battrum Weyburn unit operating agreement and the New West Prairie Agreement (collectively, the “Operating Agreements”), both well-known agreements in industry. These agreements contained ROFR provisions similar to those set out in in the CAPL Operating Procedures, but they were stand-alone agreements that did not incorporate the CAPL Operating Procedure.
The Operating Agreements stipulated that ExxonMobil was required to provide Northrock as counterparty with ROFR notices if it intended to dispose of the Assets, but the ROFR provisions explicitly exempted dispositions to “Affiliates”, defined to include corporations controlled by ExxonMobil. In mid-2005, ExxonMobil decided to divest the Assets, and advised potential bidders that, for tax reasons, two transaction structures were possible. Bidders could either purchase the Assets outright, or the Assets could be transferred to ExxonMobil subsidiaries, the shares of which could be purchased by the bidder (referred to as a “busted butterfly” transaction.) Most prospective purchasers, including Northrock’s corporate parent, submitted an offer for each transaction structure, offering significantly less cash consideration under the busted butterfly structure due to the significant tax advantage being retained by ExxonMobil, and the corresponding tax detriment being borne by the purchaser. Crescent Point, due to its structure as a specified flow-through investment trust, was not affected by the tax consequences of the transaction structure, and accordingly offered the same cash amount for each structure.
ExxonMobil chose Crescent Point’s busted butterfly offer and signed a letter of intent that contemplated a transfer of the Assets to ExxonMobil’s subsidiaries and a subsequent purchase of the subsidiaries’ shares by Crescent Point. Northrock consented to the assignment of the Assets to the subsidiaries, but objected to ExxonMobil’s plan to transfer the subsidiaries’ shares without issuing a ROFR notice.
After the transaction closed and Crescent Point acquired the shares of the subsidiaries, Northrock sued ExxonMobil, Crescent Point, and the subsidiaries, alleging that the transfer of Assets to the subsidiaries and subsequent share sale were in fact a single transaction, designed to avoid the ROFR obligations (in line with the GATX jurisprudence). Northrock brought claims in breach of contract, breach of the duty of good faith, inducing breach of contract, and conspiracy.
In relation to the breach of contract claim, Northrock argued that it could not have been the intention of the parties when they originally signed the Operating Agreements that ROFR obligations could be avoided simply by transferring assets to a subsidiary with a follow-on share sale, and that the ROFR provisions should not be interpreted to permit a transaction that allowed ExxonMobil to avoid its substantive ROFR obligations. The Court rejected these arguments, holding that the ROFR provisions were unambiguous in permitting an unqualified disposition of assets to affiliates without a ROFR notice. The Court noted that in negotiating the ROFR provisions, the parties “chose which divestures would be singled out for a restriction on the right of a party to deal with its own property” (para 54). The plain meaning of the ROFR provisions did not defeat the parties’ intentions, but rather was an expression of those intentions. Northrock and its predecessor interest-holders could have bargained for more expansive ROFR protections, but they had not done so. ExxonMobil’s failure to issue ROFR notices in the circumstances was therefore not a breach of contract.
In reviewing the law on the duty of good faith, the Court noted the Supreme Court of Canada’s decision to recognize a general duty of honest contractual performance in Bhasin v Hrynew, 2014 SCC 71. In the context of ROFRs, the Court held that a party wishing to dispose of assets has a duty not to specifically structure a transaction to avoid a ROFR, in line with the GATX jurisprudence. However, if a transaction structure is chosen to achieve a legitimate business purpose, the fact that the structure also has the consequence of avoiding a ROFR will not constitute a breach of the duty. The Court found that ExxonMobil was aware that the busted butterfly structure could have an impact on Northrock’s ROFR rights, and had sought internal and external legal opinions regarding the effect of using the busted butterfly structure on the ROFRs. Northrock argued that the fact that ExxonMobil had sought legal opinions was evidence that ExxonMobil had been scheming from the beginning to avoid honoring its ROFR obligations. The Court rejected this argument, holding that it was reasonable for ExxonMobil to attempt to learn about all facets of a prospective transaction before entering into it. This was evidence of informed decision-making, rather than bad faith.
ExxonMobil had also received internal tax advice which expressed a belief that the busted butterfly structure would likely result in significant tax savings to ExxonMobil. The tax advice and the legal opinions indicated that there was some uncertainty regarding both whether ExxonMobil would achieve the tax savings, and whether the ROFR provisions would be breached. Northrock argued that this uncertainty meant that the decision to choose the busted butterfly structure could not have been motivated by tax reasons, exclusive of ROFR considerations. The Court rejected this argument, noting that it is the nature of business decisions to weigh options and probabilities, and make choices in the face of uncertainty. The presence of uncertainty was not itself an indicator of whether the transactions were motivated by tax reasons or by a desire to avoid ROFR obligations.
Ultimately, the Court found the testimony of the relevant ExxonMobil decision-maker to be credible. The decision-maker’s credibility was reinforced by the documentary evidence produced by ExxonMobil. Based largely on this testimony, the Court found that the busted butterfly structure was chosen for tax reasons, and that ROFR avoidance considerations played no part in the decision. Knowledge of the ROFR considerations did not, in this case, translate into intention to avoid the ROFR.
Regarding Crescent Point, the Court found that it was indifferent to the transaction structure, as it would face the same tax consequences either way. While Crescent Point may have been aware that the busted butterfly structure could operate to circumvent ExxonMobil’s ROFR obligations, this did not motivate Crescent Point to make the bid that it made. Rather, Crescent Point’s motivation was to win the bidding competition, and it recognized that its unique tax position meant that the busted butterfly structure could help it to do so.
As the Court found that there was no breach of contract, claim of inducing breach of contract failed. The Court also found that there was no intention to injure Northrock, and no unlawful conduct, and thus the claim of conspiracy failed.
This case is a reminder of the need to be detailed and explicit when negotiating and drafting ROFR provisions. Courts will not permit parties to structure transactions to deliberately avoid clear ROFR obligations, but will be hesitant to read in implied terms that expand the scope of ROFR protections to limit the rights of parties to deal with their own property. The only reliable ROFR protections are those that are explicitly spelled out in ROFR provisions. Courts have historically viewed ROFRs as options held by ROFR holders, and as options, they are invariably strictly construed.
The case is also notable with respect to asset dispositions, in that it confirms the widely held view that the existence of ROFR obligations may not preclude creative structuring, provided the purpose of the structuring is not to avoid the ROFR. Notwithstanding the fact that this decision considered non-CAPL Operating Agreements, the ROFR language is similar enough that the case could have precedential value in future cases which consider transactions governed by CAPL Operating Procedures.
The case turned on the quality of the evidence provided by ExxonMobil at trial – both through its main witness, and as importantly, through documentary evidence. It was clear from the documents that ExxonMobil had considered the ROFR in its structuring, but the risk of the ROFR being triggered as a result of a bad faith claim was outweighed by the significant tax savings to ExxonMobil. The decision-making process was laid out in detail in the documents.
While the credibility of a witness is by no means a certain thing, transaction parties can control the documents which are created in real time. Therefore, a key takeaway from the case is the importance of transaction parties maintaining a record reflecting how the transaction proceeded. By having consistent and detailed notes and memos, as well as decision processes and requests for legal opinions set out in the record, ExxonMobil was able to show that it was in no way exhibiting bad faith by using the busted butterfly structure. Had it not been able to rely on the extensive documentary record, the Court may have been convinced to draw conclusions based on imputed intentions.
Sellers should remain cautious however. Where a decision-maker knows that a certain structure will defeat ROFR obligations, there will always be a risk that a court will find on the facts that this knowledge motivated the seller to structure the transaction accordingly. Any indication that the structure chosen for an asset sale has been motivated, even partially, by a desire to avoid ROFR obligations may increase the risk of a finding that the duty of honest contractual performance has been breached.
This case may have relevance in other contexts involving the duty of honest performance of contracts. In particular, the request for legal opinions may itself be evidence of informed decision-making, which could be used to show the contract is being performed honestly, as opposed to evidence of scheming to avoid contractual obligations.