Government intervention in emerging markets is a constant challenge. The following article looks at some instances where host governments have intervened in transactions in the oil and gas sector and the effects they have had on the transactions. The same risks are present in other sectors. Doing business in emerging markets can be challenging even without government interventions for a number of reasons, not least of which are differing cultural sensitivities, bureaucratic hurdles and investment motives. The challenges facing investors in emerging markets can increase exponentially when host governments are interventionist and prioritize nationalistic policies over the development of resource wealth. While the underlying sentiment can be well placed and fuelled by a desire to enhance the domestic economy, interventionist tactics can destabilize the investment climate within a country and deter investor appetite, thereby stalling the very economic growth that the host government is seeking to achieve. Disclosure of Confidential Information Kosmos Energy is a joint venture partner in the Jubilee field oilfield development off the coast of Ghana and is, accordingly, party to the petroleum agreement and joint operating agreement governing operations within the field. However in 2009, two years after the initial oil discovery was made, Kosmos sought to exit and sell its interest in the field to a third party. As part of this sale process, Kosmos made available to bidders copies of the petroleum agreement and joint operating agreement to which they would become party upon acquisition and copies of seismic data that Kosmos had available to it as a result of past operations. Without access to such information, it would have been impossible for bidders to come up with an accurate valuation of the interest being marketed. The government of Ghana accused Kosmos of breaching its confidentiality obligations under the petroleum agreement. The government may also have considered tortious Africa continued from page 19 SEPTEMBER 2014 PROJECT FINANCE NEWSWIRE 21 interference claims against the bidders by asserting that each bidder effectively procured a breach by Kosmos by expressing an interest in bidding; the argument would have been the expressions of interest induced Kosmos to breach its obligations. Section 3 of the Petroleum (Exploration & Production) Act 2010 says that all petroleum data and information belongs to the Ghanaian government (although the prior petroleum law in force when Kosmos commenced the sale process did not contain an equivalent provision). However, the 2002 model form petroleum agreement used by the government permits the disclosure of data and information “to a bona fide potential assignee of all or part of Contractor’s Interest hereunder provided the Ghana National Petroleum Corporation is notified concerning such potential assignee, subject to approval of GNPC (not to be unreasonably withheld).” Disclosures to third party purchasers are not subject to prior approval in other countries. Angolan and Nigerian production sharing contracts are examples. Kosmos, as a matter of ordinary course, had each potential bidder execute a confidentiality agreement to hold all data and information confidential on terms no less than those imposed on Kosmos under the petroleum agreement. Kosmos refutes the claim that it failed to notify the Ghanaian government of the identity of bidders. Given that Kosmos would only have invited experienced international oil and gas companies into the data room as bidders, it is unclear on what grounds the Ghanaian government could have refused consent. The standard of when it is reasonable to withhold consent is determined under Ghanaian law as the governing law of petroleum agreements in Ghana, but under English law, which tends to be the prevailing law in a substantial number of African oil and gas joint venture arrangements, a standard of reasonableness in relation to an oil and gas joint venture is commonly understood to refer to financial and technical capabilities. The Ghanaian government asserted that it also had a preemption right over any sale by Kosmos. Under section 26 of the Petroleum (Exploration & Production) Act 2010, the Ghanaian government has a right of first refusal to acquire the interest at a fair value. However, as a right of first refusal, this is not something that Kosmos can be compelled to accept and, in any event, what constitutes a “fair value” can only be ascertained when judged against what third parties are willing to pay for the asset in the market. The government can make an offer. Kosmos can then sell to any third party / continued page 22 lists services that data center companies can provide tenants and still treat rents paid by the tenants as entirely for use of real property. The services include installation, “cross-connect” services — data centers own wires and cables that connect and interact with the tenants’ computer equipment — and “remote hands” services. Examples are rebooting a server or changing a backup tape without having to log into a tenant’s computer. The ruling is Private Letter Ruling 201423011. A number of data center companies have set up REITs, including CyrusOne, CoreSite Realty Corp., Digital Realty Trust and DuPont Fabros Technology Inc. Several others are in the process of doing so. Despite the potential new interest, REIT initial public offerings were down significantly in the first half of 2014. There were 15 new IPOs of REITs in 2013 valued at nearly $5.7 billion. There have been just two REIT IPOs valued at $103.2 million through July 2014. MASTER LIMITED PARTNERSHIPS received a jolt in early August with news that Kinder Morgan, one of the first adopters, is abandoning the structure and moving its assets into a corporation. At the same time, Perry Capital, a hedge fund, is encouraging International Paper and other corrugated paper and packaging companies to boost their share prices by putting some assets into MLPs. MLPs, or master limited partnerships, are large partnerships whose units are publicly traded. No taxes are collected at the entity level. Rather, earnings are taxed directly to the partners. MLPs must receive at least 90% of their income each year from good sources. Good income includes rents from real property, interest, dividends and from “exploration, development, mining or production, processing, refining, transportation . . . or the marketing of any mineral or natural resource.” Companies organized as MLPs can raise equity at high multiples to earnings because no taxes are / continued page 23 22 PROJECT FINANCE NEWSWIRE SEPTEMBER 2014 Heritage’s case appeared to hinge on section 89G of the Income Tax Act of Uganda which, as it applied when Heritage entered into its production sharing contract with the Ugandan government in 2004, waives any taxes on gain upon a transfer of interests in petroleum operations. However, section 89G of the Income Tax Act of Uganda was repealed by the Finance Act 2009. Upon completion of the purchase by Tullow, Heritage disputed the tax charge being levied on it and, in accordance with Ugandan law, paid 30% of the disputed tax charge to the government pending resolution of the dispute. This left a significant amount of unpaid taxes (approximately US$313 million) that the Ugandan government asserted were due. Tullow deducted the tax from the purchase price to Heritage and put it in an escrow account pending the outcome of legal proceedings that Heritage had commenced against the Ugandan government. Obviously, Heritage was no longer in-country after the sale of all its Ugandan assets to Tullow. The Ugandan government took action against Tullow to try to seize the money. It said failure to pay the tax invalidated the acquisition as the consent it granted for the acquisition was conditioned on the tax owed by Heritage being paid. The Ugandan government looked to Tullow to pay the taxes, and it had the upper hand. There were discussions about whether various licenses that Tullow acquired from Heritage would be renewed or revoked, thereby jeopardizing operations. The government explicitly conditioned its consent to the required subsequent sell down by Tullow to CNOOC and Total on the payment of the outstanding balance of the taxes. This left Tullow in a sticky situation given that it remained in-country with substantial assets in Uganda. After months of wrangling, which involved escalation of the matter to ministerial representatives from the United Kingdom and the Ugandan government, an agreement was reached that the sale by Tullow to CNOOC and Total could proceed. However, the outstanding tax owed by Heritage had to be paid, and a similar capital gains tax also had to be paid by Tullow as a consequence of its sale to CNOOC and Total. CNOOC and Total eventually deducted the capital gains taxes owed by Tullow, on both Tullow’s purchase from Heritage and their own purchase from Tullow, from the purchase price payable to Tullow and paid the amount to the government. Tullow pursued a claim for taxes against Heritage, and Heritage pursued its own claim against the Ugandan government over the legitimacy of the tax charge in the first place (in which to date Heritage has been unsuccessful). offering a higher price. The Ghanaian government does not have a last-look matching right as long as the third party bids a higher price than the government offered. The effect of the allegations by the government was to significantly impede the Kosmos sale. Bidding had to be suspended twice, and bidders had to reassess their risk appetites. In the end, Kosmos did not sell its interest, notwithstanding having found a willing buyer (ExxonMobil) that was prepared to offer approximately US$4 billion for the interest. The sale did not receive the consent of the Ghanaian government. Unlike the consent provision included in the confidentiality clause, the consent to an assignment was not subject to a standard of reasonableness. Partly due to the experience of Kosmos, it is not uncommon today for confidentiality agreements entered into in proposed oil and gas acquisitions to include a representation from the seller that it has all the approvals and consents necessary to disclose the information to bidders, thereby giving bidders a means to hold the seller accountable if a host government raises questions. Non-Payment of Exit Taxes In 2009, Heritage Oil & Gas entered into an agreement to sell its assets in Blocks 1 and 3 in the Lake Albert basin in Uganda to Eni. However, Tullow Oil exercised pre-emption rights under a joint operating agreement with Heritage and stepped into the shoes of Eni as buyer on the same terms as were agreed between Heritage and Eni. The purchase would have given Tullow a monopoly over the Ugandan upstream sector and, as such, Tullow’s acquisition from Heritage was on the understanding that it would sell down a proportion of the acreage acquired to two new market entrants (CNOOC and Total) with each taking a one-third stake in Blocks 1 and 3 and Block 2 in which Tullow already held a 100% interest before the acquisition. The purchase price for Tullow to buy the Heritage acreage was US$1.45 billion, and the Ugandan government imposed a 30% capital gains tax on Heritage. Heritage refuted the tax charge on the basis that it was inconsistent with past practice and previous acquisitions had not been taxed in this manner. Emerging Markets continued from page 21 SEPTEMBER 2014 PROJECT FINANCE NEWSWIRE 23 It is possible that in a less high-profile transaction that does not involve parties with such credible financial strength, the proposed purchasers to which a tainted asset is marketed would have backed away and withdrawn from the acquisition, leaving the seller, who inherited the tainted asset from a third party no longer in-country, attempting to deal directly with the host government over the unpaid claim. Corporate Takeover In early 2009, the shareholders of Verenex, an oil and gas company listed on the Toronto Stock Exchange with assets in Libya, received a takeover offer from the China National Petroleum Corporation at CN¥10 a share that valued the group at about CN¥460 million. Shortly thereafter, the Libyan government notified Verenex that it intended to exercise a pre-emption right in its favor and acquire Verenex on the same terms as were offered by CNPC. However, later in 2009, the actual offer received by Verenex from the Libyan government was only CN¥7.09 a share, or a drop of almost 30%. While this much reduced offer met with resistance from certain Verenex shareholders, the offer was eventually approved, and a purchase agreement was signed in November 2009. The precise scope of the pre-emption right that the Libyan government invoked remains unclear. For example, did the right apply to a corporate takeover of a non-Libyan company, and did it apply only to Libyan oil and gas assets so that, if Verenex held a mix of both Libyan and Nigerian assets, could the Libyan government have pre-empted the entire group and taken both the Libyan and Nigerian assets? It is not uncommon for a transfer of shares in a company holding oil and gas interests to require the prior approval of the host government in which the oil and gas assets are located. This is always the case with a direct transfer of assets and sometimes the case for a transfer of shares in a company. A pre-emption right is a different beast. In this case, the exercise by the Libyan government of the pre-emption right had a material and adverse effect on the exit strategy of Verenex and its shareholders and sent a dangerous signal to the international oil and gas market that the Libyan government can step in and do as it pleases. Once the discounted offer was made to Verenex, the options open to its shareholders were not appealing. They wanted an exit. Aside from seeking another purchaser and hoping that the Libyan government would not taken out of the earnings at the company level. Investors also pay a premium for liquidity or the ability to sell the shares on a stock exchange or in a secondary market. Kinder Morgan plans to pay $44 billion to buy and consolidate two MLPs and put their oil and gas pipelines under a single taxable corporation known as Kinder Morgan Inc. The goal appears to be to simplify what had become too complicated an ownership structure and to realize still greater tax savings by operating in the future as a corporation. The two MLPs are operated by a Kinder Morgan management company that is a corporation. Management companies earn larger splits or fees the more cash they can distribute each year to partners. Between 45% and 50% of the cash generated by the MLPs was passing through the management company in fees. The corporation is buying the MLPs for a mix of stock and cash. It will get a step up in asset basis and be able to depreciate the assets anew. It will also be able to use interest deductions at the corporate level as additional tax shelter. The company expects to realize $20 billion in tax savings over the next 14 years. The tax advantages are expected to allow it to increase its dividend per share from $1.72 to $2 next year. It said it expects dividends to increase by 10% a year through 2020. The company will pay a 15.4% premium to the MLP unit holders in the buyout. Many, perhaps most, unit holders will end up having to pay more taxes than they will receive in cash. One analyst estimated that the average investor in the larger of the two MLPs could owe between $12.39 and $18.16 in taxes per unit while he or she is expected to receive only $10.77 in cash per unit. The analyst compared the buyout to a transfer of tax benefits from unit holders, who have been able to defer taxes on their capital gains, to Kinder Morgan Inc., which will now be able to depreciate the MLP assets anew. / continued page 25 / continued page 24 24 PROJECT FINANCE NEWSWIRE SEPTEMBER 2014 Emerging Markets continued from page 23 prohibit the sale, their best alternative would have been taking action against the Libyan government to compel it to match the offer from CNPC in a proper exercise of the pre-emption right. However, as with Tullow, Verenex would have remained in-country battling the host government while trying to operate an asset that it no longer wanted to own. The cards were stacked in favor of the government. Lessons What lessons should one take away from these experiences? The demands of the host government can never be ignored. These issues will become more frequent as more and more transactions take place across emerging markets. A number of US independent oil companies have already exited Africa in the last 10 years. While this may in large part have been driven by their desire to focus on the US shale market, the fact that the US is a known market and also offers a more stable fiscal investment environment and supportive legislative regime must also have played some part in the decisions to exit. Provided Asian demand for energy grows, the oil price should remain high enough to make new exploration and development economic in the near term, and oil and gas companies will continue to invest in frontier basins and emerging markets in the hope of finding and monetizing the next big discovery. However, there will inevitably come a tipping point when demand slows, gas prices de-link from oil and the oil price drops when investors decide that the political risks present in emerging markets outweigh the potential marginal benefits of further discoveries. Who knows when that day will come? We are inching ever closer to it as developed countries pursue their own shale gas and shale oil resources and new technological advances make renewable energy as or even more cost effective than fossil fuels for new generating assets. When that day comes, the memories of government actions taken in the name of resource nationalism will be an enormous impediment to foreign investment.