ACCOMMODATING TIMING ISSUES IN STRUCTURING OIL AND GAS ACQUISITIONS
| Jurisdiction | United States |
(Nov 1995)
ACCOMMODATING TIMING ISSUES IN STRUCTURING OIL AND GAS ACQUISITIONS
Attorney at Law
Houston, Texas
FORMS ON DISK
Following this paper is a pouch with a 3.5-inch PC-format high-density 1.44 MB diskette containing forms of agreement used in the three largest negotiated oil and gas transactions during the first half of 1995. By chance, the three transactions are examples of three fundamental deal structures: an asset acquisition, a stock acquisition, and a merger.
> Filename APA_TEX: Apache Corporation acquires 315 oil and gas fields from Texaco Inc. for $571 million.
> Filename ENSERCH: Enserch Exploration Inc. acquires 100 percent of the capital stock of DALEN Corporation, a subsidiary of Pacific Gas & Electric Company, for $340 million.
> Filename APA_DKLB: Apache Corporation merges with Dekalb Energy Company, with Apache as the survivor, in a transaction valued at $285 million.
The forms have been retrieved from public sources, and have been re-formatted somewhat in the course of retrieval and cleanup. The diskette contains the contracts in two layouts: unformatted ASCII (with a.TXT filename extension) and WordPerfect 5.1/5.2 (with a.WP5 filename extension). The ASCII format, while compatible with a wide range of word processing software, will necessarily involve a certain amount of cleanup because (1) tabs, centers, and indents have been replaced with spaces, and (2) fonts, bold, italics, margins, headers, footers, and other formatting features have been eliminated.
These forms are provided only for their reference value to licensed attorneys, and as part of the study materials for this Special Institute on Oil and Gas Acquisitions. There is no representation or warranty of the accuracy, completeness, or adequacy of the forms; use them at your own risk.
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TABLE OF CONTENTS
THE FIVE-STEP OBSTACLE COURSE
DUE DILIGENCE OVERLAYS THE FIVE STEPS
THE EFFECTIVE DATE IS AN IMPORTANT MILEPOST
FOUR TIMING ISSUES EMERGE
DUE DILIGENCE JITTERS TEND TO CAUSE TRIPLE CONVERGENCES
THE EFFECTIVE DATE HAS LIMITED USEFULNESS
REPS, WARRANTIES, AND COVENANTS MUST BE CAREFULLY TIMED
POST-CLOSING RECONVEYANCES RAISE TIMING ISSUES
FREEZE DATES CAN SOLVE PROBLEMS WITH FIXTURES AND PERSONALTY
TIMING AND RISK OF LOSS
PREFERENTIAL RIGHTS RAISE TIMING ISSUES
SHOULD INTEREST BE PAID ON THE PURCHASE PRICE?
QUESTIONS OF TIMING ARE PERVASIVE
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THE FIVE-STEP OBSTACLE COURSE
Considerations that go into choosing the acquisition structure for oil and gas assets or stock are embodied in the Purchase and Sale Agreement ("PSA")1 , a contract that fits neatly into the center of a traditional documentary obstacle course:
> Confidentiality Agreement
> Letter of Intent
> Purchase and Sale Agreement
> Closing Conveyances and Paperwork
> Post-Closing Adjustments and Documentation
These five steps are familiar to most transactional lawyers. In a textbook acquisition, the parties will proceed in an orderly manner along the course, pausing at each juncture to catch their breath and consider what lies ahead. In the real world, the process is likely either a pell-mell dash to the finish line or a frustrating slog through a swamp of negotiations.
DUE DILIGENCE OVERLAYS THE FIVE STEPS
At the same time that the transaction is proceeding through the five steps, another important process is taking place: due diligence. When does this investigation of the seller and its assets begin? It
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should commence at some point after execution of the confidentiality agreement, but the particular point is subject to wide variation. Sometimes due diligence does not begin until after execution of the letter of intent. Usually it begins before negotiation of the PSA commences, but not always. In appropriate circumstances due diligence may not begin until after the PSA is signed.
Once due diligence begins, there is no uniform point when it should be complete—perhaps on a brief and rigid schedule, perhaps at the moment that the PSA is signed, or perhaps not until some time after closing.
Part of the problem in predicting the beginning and end of due diligence is identifying those events. If due diligence is defined to include every facet of familiarization with the properties involved in the transaction, then inevitably due diligence continues until some months or years after the buyer takes possession. But normally due diligence is thought of as investigation undertaken while the buyer still has the option of avoiding ownership. If a buyer's options do not include avoiding ownership, somehow the term "due diligence" becomes inapposite, even though the nature of the investigation may be indistinguishable from performance of due diligence.
Many PSA's that are signed before diligence is complete permit the buyer to exclude unsatisfactory properties from the transaction. Typically, if excluded properties exceed some threshold (an amount or percentage of dollars, acres, or wells), then the buyer (and perhaps the seller) has the option to cancel the transaction. If the PSA does not include a right to exclude properties from the deal, then due diligence ends upon signing the PSA.
Sometimes transactions are closed in a hurry, with diligence lagging behind. In these cases, the PSA may permit the buyer to put properties back to the seller after closing. As will be mentioned below, this approach, which effectively permits due diligence to extend beyond closing, may be unsatisfactory for the buyer.
In the more typical case, the buyer's post-closing remedies for unexpected surprises do not include shedding properties, except perhaps for narrow categories of problems that take a long time to analyze—title and environmental issues might receive this treatment, for example. In this circumstance, due diligence on all but those problems should be viewed as having been complete at the time of closing.
THE EFFECTIVE DATE IS AN IMPORTANT MILEPOST
The due diligence process is a partial overlay of the five-step obstacle course, and in a mixed-metaphor sort of way the choice of an effective date creates an anchor. It is unusual for an oil and gas acquisition to be effective on the date that it is closed, or on the date of the PSA. Effective dates
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are chosen for necessities of engineering, pricing, and accounting. There must be a date as of which buyer and seller both engineer reserves, as of which they debate the value of that engineered quantity of oil and gas, and as of which accountants split up income and expense. This may or may not be the date on which legal rights and obligations shift, as will be seen below.
The effective date is usually chosen at a very early point in the process. If the transaction occurs close to the fiscal year-end of a publicly-traded seller, that year-end is likely to be the effective date, because reserves are engineered as of that date for Securities and Exchange Commission reporting. If the transaction emerges mid-year, the reserves may be specially engineered as of another date. In an auction, the seller may include an independent engineer's report as part of the data room package, and that report may dictate the effective date. In a negotiated transaction, it may be the buyer who specially engineers the reserves (with or without an independent engineer's assistance), while the seller relies on its internal engineering reports.
The effective date may be before or after execution of the PSA. Often it is before, allowing the parties to use look-back pricing. But in some transactions, including some very substantial transactions, the effective date is after the date of the PSA, meaning that buyer and seller must make reserve and price projections as of a future date.
However it transpires, the effective date wags the rest of the dog, dictating the effective date of every other issue that pivots on the amount of oil and gas in the ground.
FOUR TIMING ISSUES EMERGE
Assuming that the transaction has already progressed beyond the confidentiality agreement and the letter of intent, and assuming that some amount of due diligence remains, four questions of timing emerge that will affect how the transaction is structured:
> What is the effective date?
> When will due diligence be complete?
> When will the PSA be signed?
> When will closing occur?
The first question is typically already settled; its presence on the list of four timing issues is not intended to suggest doubt about the answer, but importance of the answer. The remaining three questions are different.
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Though rare, there have been documented cases where the second question was answerable. These usually involve a data room, an auction, a seller that rigidly insists on a timetable, and a buyer with a healthy appetite for risk. The more common pattern, even in the context of data rooms and auctions, is that due diligence continues in some fashion until the moment of closing. If closing comes quickly, due diligence may continue after closing.
To the experienced transactionalist possessed of a dash of cynicism, there is a probable answer, albeit an unsatisfactory one, to the last two questions: the PSA will be signed at closing. There will be no tidy gap between contract execution and the closing ceremony. The CEO will sign the PSA, and will move her pen to the adjacent stack of assignments and bills of sale.
Add another dash of cynicism, and the answer may become this: the end of due diligence, the execution of the PSA, and the closing will all happen at once. Perhaps this triple convergence is more characteristic of large-scale transactions, where buyer and seller are important, competitive, industry leaders imbued with the urgency of successful oilpatch survivors. But perhaps it is just as likely to be found in the case of a small, cash-strapped buyer that drags its feet in contract negotiations...
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