Mergers and acquisitions (M&A) activity in the commodities trading sector has been buoyant over the past 18 months, affecting the trading operations of both financial institutions and energy companies. There have been a number of factors at play, including the collapse of significant market players, changes of ownership where new owners have a different market appetite for the particular market risk, and the desire by some market participants to rebalance asset portfolios (either by upsizing or downsizing) in response to the crisis in the financial markets.
In these circumstances, institutions and companies that take a favorable view of the sector have been able to take advantage of opportunities either to enter the market or to strengthen and diversify existing operations. Examples of transactions over this period are the acquisitions by JPMorgan of various business units of RBS Sempra Commodities; the sale by UBS AG of its commodities trading business, part of which was sold to Barclays Bank plc; and the sale of Constellation Energy’s coal, freight and international commodities business to J. Aron / Goldman Sachs.
Transactions such as these present interesting structuring options, particularly in the context of risk transfer where there is a sale and purchase of the assets and liabilities of a company, which this article focuses on, rather than the shares of the business itself. Cross-border regulatory issues are also a key consideration given the international nature of many businesses in this sector.
Structuring the Transaction
The first structural decision in M&A transactions in the commodities sector, as in any other, is whether the subject of the transaction will be the shares in the company conducting the target business and holding the assets and liabilities, or only some of its assets, liabilities and business activities.
An asset purchase, particularly in the commodities trading sector, will typically be more complicated procedurally than a share purchase due to the need to transfer each of the separate assets (transactions or trading relationships) that constitute the business. Because a commodities trading portfolio will, by its very nature, involve a multitude of trading relationships with counterparties, more consents and approvals are likely to be required than on a share purchase, in particular in respect of the assignment or novation of trading contracts.
However, depending on the commercial agreement between the parties, an asset purchase will confer a greater degree of flexibility, particularly in circumstances where the seller has liabilities that cannot be easily quantified or identified, or where it has infrastructure or other assets that the buyer does not want.
Options for Risk Transfer
If the parties decide to proceed by way of a share purchase, all the benefits and risks associated with the business will effectively transfer at closing. There may be a need for closing to be deferred depending, among other matters, on the regulatory position (for example, whether there will be a need to obtain merger control clearances). If there is a gap between signing and closing, there will need to be a purchase price adjustment mechanism for any value changes occurring during this period.
In the case of asset purchases, the position may be more complex and the following structures may be used to deal with the transfer of benefit and risk:
An asset purchase of the relevant commodities transactions is made for a fixed price set at the signing of the sale and purchase agreement (SPA) and paid at closing. The closing date will be the date on which the transfer of the portfolio is effective. There will be a purchase price adjustment mechanism for changes between signing and the closing date, and all assets will be transferred on the closing date.
An asset purchase of the relevant commodities transactions is made for a fixed price paid at signing, with a total return swap (TRS) being effective on signing to transfer specified risks of transactions from the seller to the buyer. Alternatively, the TRS may be effective on the closing date rather than at signing. There will be no price adjustment mechanism because the TRS will transfer the economic and other risks to the buyer, and once all underlying trades are transferred to the buyer, the TRS will terminate.
An asset purchase of the relevant commodities transactions is made for a fixed price paid at signing, with mirror transactions between the seller and buyer that transfer price (market) risk between signing and the closing date. No price adjustment mechanism is needed because mirror transactions (followed by the TRS) transfer the price risk to the buyer at signing. Once the underlying assets are transferred to the buyer, the TRS terminates.
Sale and Purchase Agreement
In the context of a share purchase, the main negotiation points on the SPA will be relatively consistent with transactions in other sectors, although the price adjustment mechanism, if there is one, will be very specific to valuation methods relating to the underlying assets. The representations and warranties will also be tailored to the particular characteristics of the market.
In an asset purchase, the SPA may look more different than the norm, principally because of the procedural aspects of the transfer of the underlying assets and liabilities, and the time the process is likely to take, which is often considerably longer than in other types of transactions. The following points may give rise to particular difficulty:
- Conditions Precedent to Closing: Apart from any required regulatory conditions, there may well be tension between the buyer and seller as to the required level of counterparty novations that are achieved before the transaction may be closed.
- Novation Process: There will need to be clear agreement over the conduct of the novation process. In addition, one of the critical components of a portfolio purchase will be the need to novate the transactions comprising the portfolio. Therefore, the parties may include in the SPA the process for transferring the underlying trades, and the SPA will need to cover issues such as the seller using commercially reasonable efforts to obtain counterparty consents to the novation of transactions and to agree on a form of novation agreement.
- Conduct of the Business Between Signing and Closing: In view of the estimated time that the novation process is likely to take, there will be more than the usual focus on the provisions relating to the conduct of the target business between signing and closing.
- Termination Rights: A combination of all these factors is likely to lead to close discussion about the rights of either party to terminate before closing (including on the basis of material adverse change), particularly if the novation process is not proceeding as envisaged.
TRS / Mirror Transactions
Structures Two and Three described above contemplate the use of a TRS. Pending required consents or approvals to the transfer of the portfolio, the parties can use a TRS to transfer the benefits and burdens of trades from the seller to the buyer before the trades are legally transferred by novation. Risks that may be transferred include market, credit, legal and operational risks, and the buyer may agree to assume all or some of these risks. For example, in terms of credit risk, a TRS allows flexibility as to who is going to take the risk if a counterparty to a particular transaction does not pay.
The Regulatory Environment
As with any M&A transaction, the impact of competition law will need to be considered. Generally speaking, trading activity in the commodities markets is considered by competition authorities to be sufficiently fragmented that substantive competition issues are unlikely to arise, although the markets in each of the commodities that are the subject of an M&A transaction must be considered separately; the levels of competition differ in each of them. Therefore, substantive issues may arise.
The first question is whether the transaction satisfies the relevant tests that might bring it within the scope of merger control regulations, either on a national or supranational level. In the case of jurisdictions such as the European Union (EU) where the relevant tests are based on turnover of the acquirer and the target, the character of the parties and the nature of the target business make it more likely than in many other types of transactions that the tests will be met.
A further element of the analysis, at least for EU purposes, is whether, in the case of an asset purchase, the portfolio of contracts (along with any ancillary assets or personnel) comprises an “undertaking.” If it does not, the transaction will fall outside European Commission merger laws.
Other regulations must be considered on a jurisdiction-by-jurisdiction basis. As a general rule, there is no single regulatory regime that will apply to these types of transactions. However, in the United States, for example, energy sector regulatory approvals may need to be considered, as well as approval under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. In the United Kingdom, it is highly likely that certain activities undertaken by the target will be covered by financial services regulations.