The upstream oil and gas sector has always been different from other sectors, insisting on "doing things its own way". There are good reasons for this, particularly in relation to M&A, or A&D, transactions, as oil and gas businesses, their assets, and the companies owning them, are so different from businesses and companies operating in the wider economy. But does the plunge in the oil and gas price, the revenues of the industry, challenge standard market practice, particularly in relation to transactions relating to companies holding oil and gas assets (and SPAs in relation to the sale and purchase of shares in such companies)?
What was "market practice" in respect of SPAs relating to O&G companies and assets
Although the relative negotiating strength of the buyer and seller will always have a significant influence on the terms which they enter into, the standard practice in relation to the sale and acquisition of companies holding oil and gas (O&G) interests has been:
- Light warranties in the Sale & Purchase Agreement (SPA), particularly non-O&G aspects
- Light legal due diligence, concentrating on O&G interests
- Short claim periods and high de minimis and thresholds applicable to buyer's claims under warranties
- Working capital adjustments to an Effective Date (more like as asset sale agreement)
- Full indemnities from buyer in relation to decommissioning and abandonment (D&A), with effect from the Effective Date (subject to satisfaction of any conditions), so that effectively the seller is held harmless by the buyer, even though it retains liability under statute (particularly applicable in the UKCS).
What was the reason for this? In our view it was a combination of:
- The fundamental difference between E&P companies and other companies – E&P companies aren't like other companies, they have O&G interests, which are "wasting assets", rather than a business that can sustain and grow indefinitely
- Therefore, they are more akin to Special Purpose Vehicles (SPVs), so a more generic and "one size fits all" approach (with limited modification to reflect sector specific issues) which is adopted in relation to non-O&G SPAs is not appropriate
- Acceptance that although in theory there could be risks in relation to other areas (pensions, employees etc.), this was unlikely and therefore the risk was acceptable as compared with lengthy warranties, indemnities and legal due diligence
- The risks and costs in other areas (for example the cost of drilling, and high risk that the well would be dry). Why should a buyer differentiate between business risks and legal risks relating to the acquisition - if you are accepting multi-million $ risks on a day to day business, why argue over relatively small amounts?
- The inherent need to trade, including at corporate entity level, so that deals could be carried out quickly and predictably, which also needed professional advisers who understood this and could operate in this way
- Low credit risk, as everyone seemed to be trading profitably what was the risk that a buyer would default on an indemnity given in relation to D&A?
- Laziness, the industry was doing well so why bother changing this aspect, and it was easy for those operating in the market.
Changes in market practice
First, a health warning: the terms of SPAs are confidential, so it is not possible to verify the changes from a purely objective perspective (unless we have been involved in the transaction). However, we do advise on a material number of M&A transactions in the O&G sector. We also talk with other participants in the market, and our analysis is consistent with what we have seen, as well as the observations of others.
We have detected the following trends in relation to SPAs relating to the sale and purchase of shares in companies owning O&G assets:
- More aggressive "buyer friendly" position in relation to warranties and indemnities (which has a number of facets, summarised in the following bullet points):
- warranties are more "risk related", rather than related to the knowledge or what might be considered reasonable, so that if the position (even if not known by the seller or the company) is contrary to the warranties, the buyer will have a warranty claim
- warranties are more akin to a non-industry specific SPA, in some cases even if they are not particularly appropriate to a company holding O&G assets
- limitations (including time limits in relation to which claims under the warranties and indemnities, as well as de minimis, threshold "basket" and maximum liability of the seller) are much more biased in favour of the buyer, and against the seller, in addition to aggressive warranties
- indemnities in relation to possible liabilities are more prevalent, so that a buyer may not be required to pursue a warranty claim and prove the loss it has suffered, but simply require the seller to "pay up"
Seller retains liability in relation to D&A liabilities, in whole or part, so that there is no longer a "clean break". This is particularly relevant in relation to the UK.
Reasons for the change in market practice
The biggest reason for the change in market practice is, of course, the huge fall in O&G prices. This has also led to a reduction in the number of O&G deals being completed, but this might be about to change. See the box below. This has led to a massive shift in negotiating power from seller to buyer/ This has been magnified by the increased interest of private equity backed and other non-traditional buyers (and their "take it or leave it" approach). In terms of supply and demand, it is a buyer's market.
In relation to the UK market, the change in the approach to D&A, and the move away from a clean break, is a reflection of the maturity of the O&G assets being sold and their dwindling recoverable resources as well as the increasing and uncertain costs of D&A. In many cases the tipping point has been passed, or there is a risk (and uncertainty) that it has: the D&A liabilities are greater than the return from the resources which are being marketed.
There are currently more assets (including companies holding assets) being marketed, but less deals are being agreed or completed. The bigger more strategically attractive assets are being snapped up, but most are languishing and remaining unsold.
The market view is that many potential bidders and their backers are waiting for the bottom of the market before they make their offers (and that when the bottom is reached, the floodgates will open). This is accelerated by the number of O&G companies who are seriously distressed.
Are we near to the bottom of the market, or at least near the point where the market players think that even if we aren't it's near enough not to be too upset that one has overpaid for assets. If we are there, then M&A activity could increase significantly.
What can parties do?
We look at the key issues from the respective positions of the buyer (and its backers) and the seller. However, both parties have an interest in getting deals done quickly and efficiently and, therefore, although there are likely to be deviations from what has previously been considered to be market practice, the parties and their advisers and lawyers should ensure that the changes in market practice are reflected in the contractual documentation, particularly the SPA, appropriately and in a coherent manner. In other words, in relation to the essentially different nature of O&G companies, we should not revert to an inappropriate non-sector specific approach, but, rather, modify what has been developed.
- focus on the key issues, and tailor their demands, rather than just demanding aggressive warranties and indemnities
- carry out increased legal due diligence, in relation to the O&G interests, but also in relation to any corporate entity being acquired, its D&A obligations and the seller
- calibrate the risks and consider "hiving up" the assets to a group company of the buyer immediately after completion
- ensure that the warranties and indemnities concerning O&G interests and liabilities are appropriate for the risks - ensure that these are linked
- "beef up" non-O&G warranties and indemnities, but ensure that these are consistent with the O&G warranties and dovetail with them
- focus particularly on the sharing of D&A liabilities, so do not expect that the standard mutual indemnities as at the effective date will apply, but really understand the issues and be prepared to be creative
- ensure that O&G specialist legal input is given, and that you are not "barking up the wrong tree"
- ensure that any warranty or indemnity cover is supported by a seller of substance or supported by an appropriate guarantee or other form of security, such as a letter of credit
- don't change things so much that a quick and efficient deal cannot be done
- ensure that, although the SPA might be more "buyer-friendly" than the norm, palpably unreasonable terms are rejected
- carry out thorough investigation of the O&G assets and liabilities concerned, in advance of the transaction, don't just treat this as a marketing exercise
- carry out thorough investigation into the company being sold, beyond its O&G assets and liabilities, really understand the issues and risks, allowing much more confidence in negotiating the warranties and indemnities (or accepting blanket risk-based warranties and indemnities, if you have nothing to fear)
- ensure that any D&A sharing really works, in relation to the terms of the JOA and the rights of the other co-venturers and so as to protect the seller, so that it is not left with open ended and uncertain obligations (which the buyer is seeking to avoid) and little protection
- ensure that limitations are fair
- Don't be bullied!
Although there is huge uncertainty in the O&G world, we believe that there will be an upturn in M&A activity. The major challenge for those carrying out M&A transactions will be to absorb the likely changes in market practice whilst allowing deals to be done quickly and efficiently. With our sector based approach and resources our objective is to enable our clients to meet this challenge.