Due diligencei Overview
In connection with acquisitions of energy assets, there are various due diligence work streams that must be completed, including financial due diligence, operations due diligence and legal due diligence. Although these work streams often overlap and require interaction among various specialists, this chapter focuses on the requirements of legal due diligence. Under the rubric of legal due diligence, both in-house and outside legal counsel and other advisers analyse some or all of the target assets and applicable contracts to determine compliance with laws and regulations, legal title to the assets, required consents to consummate the transaction and compliance with other legal requirements (including contract terms).
Key components of the legal due diligence process for upstream transactions are reviewing title to oil and gas properties (whether in fee or in leasehold interests) and conducting appropriate environmental diligence, as described further in subsection ii. Asset-level M&A agreements typically contain defect provisions for both title and environmental diligence, where the purchase price can be adjusted for amounts related to defects in those areas. In addition to title and environmental diligence, it is also important to review drilling contracts (as they can carry multi-year commitments at significant cost), midstream contracts (including whether the upstream company is required to deliver minimum volumes or make minimum payments to the midstream company) and saltwater disposal arrangements. Permitting and general regulatory diligence is also imperative.
A key component of the legal due diligence process for midstream transactions is reviewing key commercial agreements (such as gathering, processing, transportation and capacity agreements) associated with the assets. These agreements are particularly important to review given that they in large part determine the value of the midstream assets (and, in some instances, the associated upstream assets) and are generally long-term arrangements. Because so much of the asset value depends on the fees paid under these agreements, it is imperative that the purchaser carefully review the agreements prior to executing the acquisition agreement. The purchaser should also evaluate the creditworthiness of the applicable upstream counterparties to obtain relative comfort surrounding any long-term dedications.
Unlike many other agreements in the oil and gas space, one initial point of emphasis when reviewing a gathering, processing or fractionation agreement is that there is no standard form. Indeed, midstream agreements are typically the subject of significant negotiation between the parties and are limited only by the collective imagination of the negotiating parties.
Key components of the legal due diligence process for power and utilities transactions are reviewing revenue-generating contracts (such as power purchase agreements), other key commercial and project agreements (such as interconnection agreements, engineering, procurement and construction agreements, operating and maintenance agreements, and hedging agreements), site documents (particularly for wind and commercial solar assets but also for conventional power assets) and permits, as well as conducting appropriate environmental diligence, as described further in subsection ii.ii Environmental due diligence
Environmental due diligence for energy M&A transactions varies by market sector and segment, transaction type and the risk tolerance of the parties involved, and depends largely on the scope and timing of the due diligence process overall. A standard environmental due diligence review includes:
- submission of diligence requests;
- review of documents provided by a target company, securities filings (for public companies), and environmental permit transfer and change-of-control requirements (for asset transactions);
- searches of public environmental databases and news and litigation sources;
- interviews with company environmental personnel;
- analysis of the relevant environmental regulatory framework impacting the target company's operations and anticipated changes to the same; and
- preparation of a due diligence summary or other work product.
In many instances, an environmental consultant is retained to conduct a technical environmental due diligence review. Depending on access to a company's facility and personnel and the factors noted above, the technical review can include site visits (e.g., Phase I environmental site assessments) or consist solely of a 'desktop' (i.e., review of written and spoken records only) review.
Certain specific considerations for environmental due diligence in energy M&A are outlined below.Oil and gas
Environmental due diligence in upstream oil and gas transactions traditionally involves a defect process, whereby access to the assets is granted for a period of time between signing and closing to identify environmental defects, which are then addressed pursuant to the negotiated terms of the agreement (e.g., the seller remediates the defect, the purchase price is reduced by the cost to remediate the defect, the asset impacted by the defect is excluded from the transaction or the seller indemnifies the buyer for the defect). The buyer typically retains an environmental consultant with oil and gas expertise to visit all or a subset of assets during the review period to identify and value environmental defects. This review is often limited by the agreement to visual inspections of the assets (i.e., no Phase II environmental site assessments or other subsurface sampling or testing), but the buyer often has the right to exclude properties if a Phase II is warranted and consent is not granted from the seller. If the consultant identifies an environmental defect, the buyer or its counsel will work with the consultant to prepare a defect notice for submission to the seller. The parties will then negotiate a remedy to address the defect.Power and utilities
M&A transactions in the power and utilities sector often involve complex environmental issues. Key focus areas for operating assets include allocation of emission credits and other environmental attributes, environmental obligations under consent decrees with regulators, environmental and toxic tort legacy liabilities, planned or anticipated capital expenditures (e.g., for pollution control equipment) and impacts of evolving environmental regulations. The environmental due diligence process typically follows the standard review described above, including retention of an environmental consultant. Key focus areas for development assets include environmental permitting, a National Environmental Policy Act (NEPA, or state equivalent) review of projects on public lands, lender liability protections for environmental conditions at the project site, access to water supply and waste disposal services, and third-party project challenges to the project (such as appeals of issued environmental permits). Assistance of local counsel in the jurisdiction where the project is located is often crucial. In most instances, rather than retaining its own consultants, the lender in any planned project financing will require and rely on independent engineer and environmental reports prepared by the borrower's consultants in connection with the financing.ESG and Climate Resiliency Review
Due, in part, to increasing interest in sustainable investment by investors, regulators and other stakeholders, more M&A practitioners are considering ESG factors, including projected climate-related risks, as part of their due diligence processes. Whether led by counsel or a third-party consultant, key components of managing an ESG due diligence review include understanding the drivers of the review, identifying the key ESG topics most likely to be material to the transaction, developing an appropriate scope and work product, and integrating the review into other due diligence work streams. In addition, certain parties are conducting diligence on assets that may be exposed to physical climate risks, such as wildfires, hurricanes, flooding, and extreme heat. Such reviews are typically conducted with the assistance of a third-party consultant.
Purchase agreements and documentation
Recent developments affect the way parties in the US conclude purchase agreements and draft documentation.i Oil and gas
In the negotiation of a typical upstream oil and gas purchase and sale agreement (PSA), the title and environmental defect mechanics are among the most intensely negotiated provisions because the value being transferred is derived from the value of the oil and gas reserves (assuming no environmental contamination) and the reserves yet to be produced. While the variations of a title and environmental defect mechanic are virtually unlimited, and such provisions must take into account the negotiating posture, size and complexity of the deal, upstream counterparties have developed a market for defects that takes into account the seller's desire to complete the deal with minimal ongoing title liability and the purchaser's desire to have meaningful rights in the event that a title or environmental issue is identified and quantified.
A seller typically provides limited title and environmental documentation before the signing of a PSA. It is customary for most diligence to be conducted during the interim period; however, once the parties have moved into the interim period, the seller will be required to provide copies of all title documentation in its possession, including any previously commissioned title opinions and landmen run sheets, and provide access to the properties to conduct a customary Phase I review.
The purchaser's protections for title issues (other than a special warranty of title included in the assignment or deed) and environmental issues are typically limited to a defect process with notice provided to the seller a certain number of days prior to closing. Under this construct, the purchaser has the ability to access and verify title to the assets and the environmental status of the assets during the period between the signing and closing of the PSA. Subject to agreed limitations, including specified thresholds and deductibles, the purchaser is entitled to a downward purchase price adjustment for identified defects affecting the assets. Once the defect claim period expires, the seller typically provides no ongoing warranties related to title or environmental issues (other than the special warranty of title).
Outside of the title and environmental construct identified above, PSAs typically include a suite of non-fundamental representations and warranties related to the status of the assets. A seller's representations 'package' is usually heavily negotiated, including exceptions and limitations on the representations, knowledge qualifiers and survival. Typical representations include:
- pending or threatened litigation;
- unwaived third-party rights;
- material contracts;
- outstanding authorisation for expenditure commitments;
- wells and equipment;
- known title and environmental issues;
- correct payment of royalties;
- suspense amounts or imbalance;
- compliance with laws;
- no previous transfers of interests outside the target depth or depths;
- accuracy of lease operating statements; and
- no material adverse effects (MAEs).
A buyer will typically have the right to terminate a PSA in the event the seller materially breaches a representation or warranty as of the closing, but the actual 'bring down' standard is often heavily negotiated (e.g., MAE, material breach, etc.). In addition, to the extent the representations survive the closing, a breach may give rise to a cause of action for damages.
In addition to asset-level representations and warranties, a PSA typically provides for indemnity for certain retained obligations, which unlike representations and warranties is not typically subject to thresholds, deductibles and caps. Although the scope of retained obligations is heavily negotiated, in most recent deals, buyers were able to require that a seller retain liabilities associated with known environmental matters and offsite waste disposal, mispayment of royalties prior to the effective time, specified litigation, taxes and excluded assets.ii Power and utilitiesUnderstanding the regulatory landscape
Antitrust regulatory considerations under the HSR Act are relevant to acquisitions and divestures in the power and utilities sector, as discussed in Section VIII. However, the nature of power and utilities assets poses additional regulatory complexities that are critical to assessing deal execution risk and closing certainty.
Due to the regulated natured of power and utility assets, additional regulatory approvals from FERC and state public utility commissions can impose conditions and commitments on prospective owners of these assets. The level of effort required of parties to obtain these additional regulatory approvals (and the limitations on such effort) and the consequences for the termination of transactions because of a failure to obtain these regulatory approvals can vary greatly across transactions. To mitigate the risk of regulatory failures, M&A purchase agreements will often include a broader scope of representations and warranties covering regulatory matters, such as the regulatory status of the seller and target and the absence of any regulatory impediments with respect to the buyer's ability to consummate a transaction, specific interim covenants relating to actions that would prevent or materially delay the ability of the parties to obtain regulatory approvals, and termination fees tied to failures to obtain necessary regulatory approvals.Risk of loss and casualty and condemnation provisions
Much like industry-agnostic M&A agreements, enhanced closing certainty is a key consideration for parties in power and utility transactions, but to preserve value, buyers will often seek risk of loss provisions addressing casualty and condemnation in their transactions: these continue to be heavily negotiated as they diminish closing certainty for sellers. Risk of loss and casualty and condemnation provisions allocate the risk of loss to operating facilities as between the seller and the buyer during the interim period of a transaction: they generally seek to protect the buyer from loss of the value derived from uninterrupted operation of target facilities. While these provisions can take a variety of forms, they generally provide a remedy for buyers in the event of a casualty or condemnation event resulting in some pre-agreed amount of damage to or loss in value of the target facilities, and a termination right allowing either the buyer or the seller to terminate the transaction should such damage or loss in value exceed a material percentage that would likely fall short of constituting a material adverse effect as construed in Delaware.Value considerations
Both sellers and buyers in all M&A purchase agreements will seek to include provisions to maximise and preserve value in their transactions: the most common provisions tend to relate to purchase price adjustment mechanics or the covenants that bind the seller during the interim period.
In power and utilities M&A transactions involving private targets, sellers will often include purchase price adjustments for items that are specific to power and utility assets such as capital expenditures, spare parts and fuel inventory, which complement the more generic adjustments for working capital, indebtedness and cash. Buyers will seek to either eliminate these additional adjustments or limit their applicability by negotiating target amounts or introducing caps.
Additionally, power and utilities buyers have been increasing their use of 'modified' locked box constructs to adjust the purchase price in their M&A agreements. A traditional locked box purchase price adjustment fixes the price at the time of execution of the acquisition agreement based on historical (usually the last audited) balance sheet accounts: the buyer, therefore, takes on the economic risks and benefits of the target during the period between signing and closing of the transaction. In a modified locked box construct, these same principles apply, but the price is instead fixed at some later-agreed date, typically representative of the valuation date underlying the buyer's model of the target, and which may follow the execution date of the acquisition agreement. Buyers are increasing their use of modified locked box constructs to ensure an alignment of purchase price and their modelling assumptions, including assumptions regarding seasonal outputs, upcoming major maintenance and other similar external factors.
Buyers will similarly attempt to maintain value in power and utility M&A transactions by imposing additional tailored covenants on sellers during the interim period. Examples of these interim period covenants include requiring the seller to spend capital expenditures in accordance with an interim period budget (if ultimately agreeable, the seller will want to ensure that this aligns with a budget it previously represented during diligence) and implementing a specific hedging programme designed to secure the economic assumptions on which the buyer based its financial model prior to actually owning the target assets. Deal teams should involve HSR counsel in drafting specific language for these provisions to ensure that the parties do not run afoul of gun jumping rules; there is less risk of gun jumping the more the covenants are consistent with the seller's historic ordinary course of operations of the target assets.iii Representation and warranty insurance to reduce transaction risk
Dealmakers in the power and utilities and oil and gas sectors are keen to reduce transaction risk as much as industry-agnostic dealmakers and are continuing to avail themselves of a trend that has become more prevalent in M&A agreements generally across all industries and sectors in recent years: representation and warranty insurance (RWI) and other M&A insurance products. As described in more detail in Section IX, more M&A practitioners in the power and utilities and oil and gas sectors are turning to these insurance products to help eliminate transaction risk.